In a succinct whitepaper they describe how the system is meant to work, with it led by Robert Leshner, who says he is a Chartered Financial Analyst.
The idea is simple. You can lock wrapped eth (WETH), which is basically eth trustlessly tokenized – or for now BAT, ZRX, Augur and soon DAI – in the smart contract, and then you can borrow about 67% of the amount you put in.
The interesting thing here is that this locked eth itself earns interest. That interest comes from the borrower, with a fairly big gap between the two.
Leshner says this gap of circa 6% between borrowing and lending is algorithmically determined to ensure there are sufficient funds to pay the lenders on all of their assets.
Instead of the lender being paid for just the amount borrowed, they are paid for all of the amount they make available for borrowing.
That means the current borrowing rate is somewhat high, nearing 10% for BAT, but it is an annualized rate. Just as it means the lending rate is very low at effectively zero, especially for Augur as of now.
That can change depending on how much people put up to lend and how much they put up to borrow, with it necessarily – due to the 1.5x collateral requirement – swaying towards a far bigger lending supply than borrowing demand.
The liquidation discount is what you are charged if price moves against you. As a simple example, say you lock 1.5 eth and you borrow 1eth. The price moves against you, let’s say by just a penny. You are liquidated.
Is that all gone, or is just a penny worth of eth lost? Leshner says “just a penny is lost and you keep all of what you’ve borrowed.” Then on top there’s the 5% fee. “It’s a 5% fee on that penny. So 1.05 pennies,” are lost in this scenario according to Leshner.
Meaning this isn’t quite a margin call, but more of an algorithmic management of what you own and what you owe to the network.
There have been suggestions that this crypto borrowing method has tax benefits. So as a CFA, we asked Leshner for his views, but he said little more than:
“It may, for many users, look exactly like traditional borrowing and lending; a small amount of interest income, and some interest expense.”
The collateral here is itself used to lend, which would make one think this is a fractional reserve of sorts, but as the collateral is 150%, “it’s the opposite of fractional reserve, it’s more than full reserve,” says Leshner.
They say you can withdraw at any time from a lending position, so what happens if everyone does so at or near the same time or if eth’s price drops 50% in minutes.
“There are members of the community running nodes that automatically liquidate borrowers below a 1.5x collateral ratio,” Leshner says before adding:
“If there was a doomsday, 50% decline, instantly, it’s possible there would be an issue, but the ‘loss’ is first borne by the protocol, not the users.”
In MakerDAO, they have MKR which acts as a last resort if things go south. Here they have what Leshner calls “sponsor equity,” or the whitepaper calls spread.
As you can see above, there’s the originating fee of 0.02%. In addition there’s “the portion of interest retained by the protocol, which is currently set to be one-tenth of all interest,” Leshner says.
This is all very new, and Leshner seemed a bit too busy, so we couldn’t get to finer edges like whether there’s a more DAO like fail safe mechanism as MakerDAO employs.
Meaning necessarily this will need some time to prove itself. Not least because this is a land where code does rule, and where the code is indeed the contract. So any tiny error in that code can potentially mean all funds are gone.
Leshner says the contract has been audited twice. As can be seen above it is currently holding about $5 million worth of four prominent tokens. Naturally we had a test-run.
At first, after connecting our testrun MetaMask, we’re shown no funds available to lend or borrow. Obviously we have some, but you have to enable each token through a blockchain transaction for it to actually connect.
Ethereum is Turing complete. That means you can have an ethereum token running on ethereum. That’s weth. We have a tiny amount of it, but if we didn’t, the dapp would have allowed us to convert eth into weth in a few clicks.
Above, we’re just enabling weth to begin with. Metamask is telling us we’re giving access to this smart contract for all of our weth. It’s 0.01 weth we have, so we don’t care. But as a sidenote, tokens are different from eth in that tokens have a very, very, primitive level of intelligence.
You can’t quite communicate with eth itself, because eth sort of runs everything. You can “speak” to weth however. You can say: hey weth, this is my code, you want to abide by it? If you agree, then weth has now entered into a self-executing contract.
That contract can take your weth without requiring your input, based of course on the rules of the taking contract.
In this case above, there appears to be some sort of malfunction from a UX perspective because no one can insta read 1.158e+59, but the number is presumably so large that it amounts close to infinity.
Weth access is now enabled. Thankfully for today all those airdrops seem to have taken a break, so it didn’t take long for it to confirm.
We thus have a new nicer screen where some numbers have replaced the previous zeros across the board.
We’re playing with small amounts because this is a test-run and this is all very new, but this says we can borrow nearly $1.50 of the listed tokens.
We went with Augur because that had the lowest lending interest rate. Obviously since we are borrowing, we would have been more interested in the borrowing rate, but if the lending rate is the lowest, you’d think the borrowing rate is too.
So we went through the approval process once more for Augur, which means giving MetaMask authorization to perform the on-chain transaction, and then we asked to borrow.
At 5% a year, it doesn’t sound that bad. Especially if you are trading on margins, or even hedging, or for whatever other functionality.
This is all open and permissionless, of course, so you can build stuff on top of it or incorporate it in your own dapp.
Any arbitrage window would be easy for bots, but we’ll see what human imagination can come up with.
Now we’re done. Our 0.01 eth, initially worth $2.18, is now kind of worth $3.50. Yes, the gods playing with us, memeing tree fiitty stuff, but as we check again the dapp, it says our supply balance is now $2.19.
So we made a penny on our weth, meaning we can benefit from any price gains in ethereum, just as we’d be punished by any price losses. At the same time, our MetaMask tells us we have this new Rep.
This is a test account, so don’t get any ideas about what token we support or don’t. Totes neutral. But clearly we can now move this Rep to wherever we like. Meaning it’s ours. Not an IoU.
We’ll leave it there to see how it actually moves. To see what we get when Rep crashes or moons. But the idea, even the execution, looks interesting.
If it works. This is very new. We’re being told all sorts, but time alone will tell us the truth. Yet one can feel a new spirit. A new world. Code creations that bite at the edges. That show the capabilities of a global network. That hint at a new dawn.