Lending protocols in DeFi aim to create decentralized, permissionless loans, which enable capital-efficient strategies for users. Users can lend their money out and earn interest yield. Borrowers can then take out a loan if they’re willing to pay the interest.
Like all forms of leverage, the most front-facing risk comes in the form of liquidation.
Once funds are deposited into a lending protocol’s smart contract and a position is opened, the borrower is assigned a Health Factor (HF). A health factor represents the solvency of the principal value of the borrowed assets relative to deposited assets. Initial HFs vary, as each protocol differs in the risk parameters used to define the liquidation thresholds for different assets. A simplified view is that the closer a borrower’s HF is to ‘1’, the closer they are to defaulting on the loan.
If a default occurs, the lending protocol seizes and liquidates the locked collateral to cover the underlying debt. Additionally, before paying out the remaining collateral to the borrower, a penalty fee is charged against the debt.
Model: Shared Lending Pools – First-generation lending protocols like Aave utilize a liquidity model called ‘Shared Pools.’ Assets deposited get put into a single ‘shared’ pool containing all the collateralized assets the protocol holds.
Risks & Considerations
While this model is technically more capital efficient than other more isolated protocols, it comes with a substantial risk increase. Since there is only one lending pool for numerous tokens, the entire pool is considered compromised if one token is exploited. As a result, these markets are more suited for short-tailed assets to avoid potential exploits. We’ve seen these instances in examples such as the C.R.E.A.M. Finance exploit on October 27, 2021, which led to the hacker getting away with $137 million worth of crypto assets
Model: Isolated Lending Pools – Users can create their own isolated money markets called Fuse pools. These pools consist of many tokens, as pool creators can use any asset, oracle, or interest rate model. These pools consist of numerous tokens, creating an efficient money market model.
Risks & Considerations
Isolated lending pools have improved security over shared pools. That said, each pool still depends on the individual security of all its assets. If one asset inside a pool is compromised, so is the entire pool. Also of note is the issue of centralization. Each pool creator can adjust the parameters of the pool as they see fit, placing further pressure on the pool’s security. Note: Due to recent regulatory pressures and a major exploit, Rari and Fei have decided to shut down the protocol. To read more, please refer here.
Model: Isolated Risk Markets – Users can provide liquidity and create a money market for any pair they want.
Risks & Considerations
This model achieves a high level of security because each pair is completely isolated from the other. If one pair is compromised, it would only affect that specific pair. However, this level of isolation does come with its setbacks. Liquidity is spread throughout many pools. USDC, for example, has over 30 pools. This becomes an issue as the liquidity is fragmented, so borrowers must pick and choose the suitable pools for their order size.
Model: Tiered Lending Markets – Euler utilizes Uniswap v3’s price oracle to create risk-based asset tiers to protect the protocol and its users. The three asset tiers are; Collateral tier, Cross tier, and Isolated tier.
Risks & Considerations
The main concern is oracle risk. Euler depends on Uniswap V3’s price oracle, which has been exploited multiple times in the past.
Model: Isolated Lending Markets Variation
Users can create a money market for any token asset they want by utilizing a preset bridging asset(ETH).
Risks & Considerations
Silo utilizes Uniswap v3 and Balancer v2 price oracles. This means that market creation is limited to token assets with liquidity pools within one of those platforms. By isolating the different money markets, risk also becomes isolated, enabling a high-security level by design. Each money market is paired up with what Silo calls a bridge asset. At the moment, $ETH is the only asset being used as a bridge asset. All transactions are routed through this asset; therefore, it is the only asset that needs to be trusted. If a token is compromised or exploited, the only ones affected are the bridged asset suppliers of that isolated pool ($ETH lenders).
Silo Protocol Overview
Silo Finance is a decentralized, permissionless lending protocol that offers secure and efficient money markets by utilizing isolation elements. Silo was designed to address the primary pain points of existing lending protocols. The security flaws of shared pools are addressed by isolating each lending pool, similar to what Kashi does. The difficulty that Kashi faces is that liquidity is fragmented between too many pools. While this model ultimately achieves high levels of security relative to shared pools, it comes at the expense of efficiency.
Silo introduces an improvement on the isolated lending markets model by:
- Whitelisting any token assets without the reliance of governance. Liquidity constraints are set by the market, not governance.
- Enabling deeper liquidity by having one isolated pool for each asset
- Improved scalability by allowing any crypto asset to be listed as long as it can find a counterparty.
The design itself is straightforward. When suppliers use their collateral to borrow, the underlying process requires creating two positions.
The first step proceeding the decision to open a position is to collateralize the token you want to borrow against. Since each token is paired with a trusted bridge asset (ETH), that is the token that users receive in return for borrowing against their collateral. The second step is to deposit the borrowed bridge asset into the Silo that holds whichever desired asset the user wishes to borrow. One consideration to keep in mind is that due to the nature of this model’s process, it takes four transactions, which also means four transaction fees (gas), making it an expensive protocol to use for smaller investors.
Interest Rate Model
Silo employs a novel dynamic interest rate model that differs from the models used by other lending protocols. The generic model is a simple one; Borrowers generally pay depositors interest, so borrowing interest rates consequently fund lending interest rates; When the demand for borrowing an asset rises, so will the borrowing interest rate
Silo’s interest model was designed to maintain demand for borrowing any given asset within the optimal range(green rectangle in the image above). The optimal range is the mean/middle point between the ulow (Utilization Low) and ucrit (Utilization Critical). When utilization reaches a critical level, the model is designed to adjust the interest rate(r) to modify user behaviors and mean revert utilization back into the optimal range.
When utilization expands beyond ucrit, interest rates increase rapidly. Increased interest rates encourage lenders to deposit more funds in order to capitalize on higher lending rates. Additionally, since the cost of borrowing is higher, borrowers may be more inclined to pay back their loans sooner.
If utilization drops below ulow (Utilization Low), interest rates fall rapidly. Reduced interest rates appeal to borrowers looking to take advantage of lower borrowing costs, consequently increasing utilization.
To read more about Silo’s interest rate model, refer to the paper found here.
Starting December 1, 2021, and over the next four years, 1B $SILO tokens will be minted with the possibility of future inflation voted on by governance. As of the time of writing, Silo has committed to zero emissions.
- Genesis Protocol-Owned Liquidity (10%) — Distributed in the public auction; claimable immediately after the auction
- Community Treasury (45%) — Linear vesting for three years; controlled by the community through governance
- Early Contributors (6.75%) — Linear vesting for four years with a 6-month cliff starting after TGE
- Founding Contributors (21.75%) — Linear vesting for three years with a 6-month cliff starting after Token Generation Event (TGE)
- Early Community Rewards (0.2%) — Airdropped to community members in January 2022
- Early Investors & Early Advisors (6.30%) — Linear vesting for two years with a 6-month lock starting after TGE
- Future Contributors & Future Advisors (10%) — Linear vesting for four years with a 1-year cliff starting after joining the DAO
On March 6, 2022, Silo created a proposal to build a $SILO pool on Curve V2 and incentivize liquidity through CRV emissions.
Silo’s plan was the following:
- Start SILO: FRAX Pool on Curve v2 to drive liquidity
- Market buy $CVX tokens to gain voting power within the Curve DAO
- Use the newly obtained voting power to vote for CRV emissions to the SILO: FRAX pool.
The team took action on this proposal and began acquiring CVX. Between March 4th and March 6th, the team had acquired $250,000 CVX, spending $4.41mm USDC, with an average position size of $17. Fast forward a few months, and, despite high yields (~130% at peak), Silo was only able to attract a relatively modest amount of liquidity on Curve. This has resulted in high slippage, putting a bottleneck onSILO’s investor accessibility.
Since then, the community came together to create and pass a proposal to migrate Silo’s liquidity from Curve to Balancer. By enabling a gauge for the SILO:ETH Balancer pool, SiloDAO will be able to create a primary source of liquidity for their token through incentives (supported by bribes). Balancer is far more integrated by price and DEX aggregators than Curve, making it more optimal from a liquidity standpoint. In addition, the ETH, as opposed to stablecoin, pairing exposes LPs to lower Impermanent Loss.
Now that the proposal for Balancer incentives has recently passed, Silo will start the flow of ETH to Balancer. While there’s no exact date yet, the incentives are set to start by mid-September.
While there’s no official name yet, Silo is in the process of launching its own stablecoin. The stablecoin will be utilized as a bridge asset alongside ETH.
The plan is to develop a mechanism that mints a decentralized stablecoin against collateral rather than wrapping one or a basket of existing stablecoins. This is especially important now given recent developments with USDC and decentralized stablecoins that use USDC as a backing asset.
Earlier this week, on August 22nd, Silo announced that their lending app was officially live. They will be starting off with nine silos; each capped at 500 ETH TVL (250 eth per asset per silo).
The initial silos include:
- USDC, CRV, CVX, FXS, FRAX, APE, BAL, wstETH, WBTC.
ETH is the bridge asset and can be used as collateral to borrow all token assets. Including ETH, there are ten token assets that users can currently be used as collateral:
- USDC, CRV, CVX, FXS, FRAX, APE, BAL, wstETH, WBTC, ETH.
It’s important to reiterate that Silo adapts an isolated lending model so that every time a user opens a position, that position is isolated from other silos; therefore, the risk is isolated from any external exploits.
- Silo Finance has completed audits from ABDK and Quantstamp, as well as released a Certora Formal Verification Report, all of which can be found here.
- At the time of writing, SILO token’s only use-case is for governance. The Silo DAO will use it for voting on proposals that include controlling pool parameters, directing DAO-owned liquidity, veSILO emissions, etc. There is currently no other incentives/utility built into the $SILO token.
- The price of $SILO is expected to be volatile over the coming weeks as the market seeks fair value post-launch/Balancer incentives.
Silo Finance is a money market protocol that utilizes a novel design model to isolate risks while maintaining capital efficiency. They are able to accomplish this through some of their flagship features, such as isolated two-asset “Silos” for each market on the platform(isolated risk) and dynamic interest rates(optimized utilization). That said, it’s important to note that Silo is still very much in its infancy and volatility in token price is to be expected as liquidity sources start to build up post-launch.
This report is for informational purposes only and is not investment or trading advice. The views and opinions expressed in this report are exclusively those of the author, and do not necessarily reflect the views or positions of The TIE Inc. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report. You are fully responsible for any decisions you make; the TIE Inc. is not liable for any loss or damage caused by reliance on information provided. For investment advice, please consult a registered investment advisor.