The size and complexity of DeFi protocols continues to grow. Continued innovation in how protocols are established, operated, and incentivized has created new classes of sophisticated platforms, with various purposes and business models. These new successful protocols all have one thing in common: they are active users of considerable amounts of capital.
The case for ingesting capital is clear - they need cheap, reliable ammunition to fuel continued growth and remain competitive in this new landscape. Despite this clear and pressing need, the market has yet to respond with an adequate solution. Options for protocols to borrow and lend at fixed rates are limited, expensive, and inflexible.
Protocols could, in theory, use collateralized, fixed rate borrowing on protocols like Aave or Yield Protocol to get fixed rates, but this has certain drawbacks:
- If not actively managed, a DAO can be liquidated in a sudden fashion
- Limited ability to set various terms in advantageous ways (tenor, discount, etc)
- Critically, the need to overcollateralize in highly liquid assets ensures that the DAOs that need this option the most, even when they have strong balance sheets, are unlikely to use this option.
In addition, from the Frax perspective, there have been many proposals from protocols interested in receiving Frax to seed liquidity for their new products or Rari Fuse pools. The risk adjusted returns from these sorts of opportunities have been poor (see the recent Float Protocol incident).
To this end, Debt DAO, Yield Protocol, and Frax are working on creating fyFRAX, a primitive for how DAOs can be funded.
- Debt DAO will allow this loan to be distributed among the marketplace to allow for service providers (underwriting, insurance, collateral management)
- Yield Protocol will be providing the technology to allow for trading + secondary liquidity
- Frax will be the initial capital provider, and function as a liquidity backstop.
The existence of deep, liquid, low cost debt markets for protocols could unlock a large number of new use cases, like investing in developers for protocol development, acquiring users, earning significant returns from yield farming, and more. For example, a protocol engaged in liquidity mining could lock in fixed costs for liquidity and distribute stables rather than distribute the project token. Debt DAO is exploring some of these use cases, with this recent Medium post here regarding payroll.
To enable these new use cases for protocols, there is a strong need for an approach to fixed-rate borrowing that is protocol-friendly, allowing protocols to control terms of the borrow, borrowing period, interest rates and more.
Yield Protocol pioneered an approach to fixed-rate debt that uses tokens to represent debt. Yield calls these tokens “fixed yield” tokens or “fyTokens.” fyTokens standardize debt to make it easily tradable to encourage the development of liquid debt markets. fyTokens can be traded in a special purpose automated market maker called “YieldSpace” that is designed to trade fyTokens in an efficient and easy manner. Standardized, tokenized debt may also be excellent collateral for protocols that enable leveraged lending, such as FIAT DAO.
The fyTokens will be denominated in FRAX, with the initial liquidity and a backstop reserve seeded by the Frax protocol.
As an example, let’s consider a hypothetical borrowing DAO, gamingDao, that purchases and loans out in-game assets to generate liquid P2E tokens. Say this DAO is looking to scale up by purchasing additional types assets to loan out, and wants to fund these purchases via debt (assume the DAO has strong revenues and a stable balance sheet denominated in various liquid P2E tokens).
Initially, gamingDAO decides to seek a 3 month loan, capped at 8%, to finance this expansion into land assets in Cryptoland. To begin the bidding process, GamingDAO governance approves the loan and locks the collateral (this can be a mix of their governance token along with stables).
There are two potential lending outcomes. In this hypothetical, for the most borrower-friendly, imagine investors are actively seeking products to increase their exposure to GameFi as an asset class, and the offering is oversubscribed in the Debt DAO marketplace. Competition to service this loan drives down the rate, and gamingDAO is able to receive a strong rate at a 5% APR.
For the outcome where this offering isn’t oversubscribed, the Frax AMO would step in and provide financing at 8% APR, ensuring that the gamingDAO is still able to finance their expansion into land assets in Cryptoland in-line with the pre-approved cap rate.
Frax commits to funding $50 million in FRAX for protocols looking to leverage fyFRAX. The initial loan sizes will be single digit millions, with well known protocols, however it is important to signal that Frax is serious about funding these kinds of opportunities.
In addition, Debt DAO will work through Frax governance to provide the risk analysis outlining the risks of the deal and the term sheets provided for the initial deals, such that if the terms of the deal are unsatisfactory, Frax governance can veto the deal.
- Create liquid markets for Frax denominated bonds, and generate long term demand for FRAX from DAOs
- Bootstrap a new financial primitive for DAO financing
- Create a standard process that allows for risk analysis for protocols looking for liquidity from FRAX to bootstrap Fuse pools, or other use cases that reduces the moral hazard involved.
- Default Risk (mitigated as this is secured lending)
- Smart Contract risk (we’ll be leveraging Yield Protocol’s contracts, which have been audited, and will also have audits for any new code that is leveraged)