De-Collateralize, an Alternative to Collateral Backed Loans

One of the main use cases of taking out a loan on Compound, AAVE, or Maker has been to maintain exposure to your asset of choice. You like ETH, and think it will rise in value, but want to access the juicy yields offered from stablecoins. Instead of missing out on the gains from ETH doubling in value to get access to the stablecoin yields, you use your ETH as collateral to take out a loan for stablecoins, which you then stake or farm to get those juicy yields. You get the best of both worlds.

However, this route comes with its own set of risks and tradeoffs. If ETH drops in value, you could have your loan liquidated. Also, you may end up paying high borrowing rates depending on demand. Because of over collateralization requirements, you lack capital efficiency and only get a portion of stablecoins from your input of capital.

Element enables users to pursue an alternative on their own. We call it De-Collateralize. You choose your input token, your yield position, then your output token. There are no collateralization requirements. You maintain exposure to ETH and still get exposure to your favorite stablecoin yield position. You pay what is akin to your borrowing APY upfront for a set period and then maintain exposure to the yield via a representative yield token. The yield token gives you further optionality. You may redeem it for the accumulated yield, sell it, or even use it to provide liquidity on Balancer, gaining further yield. In essence, Element’s protocol enables users to offer their own fixed term loans backed by yield positions such as Yearn vaults. We explain this mechanism later and how you can accomplish the De-Collateralize route, but first, let’s discuss Bull and Bear markets!

Bull Market

In a bull market, participants overwhelmingly situate their funds in non-stables tokens such as ETH and BTC. People want access to the rise of these assets and are less likely to sit in the safer, stablecoin pairs. As a result, borrowing begins to spike. People use their favorite non-stable assets as collateral to borrow stablecoins such as USDC or DAI. They then stake those stablecoins in various vaults, protocols, or farms to get juicy yields. In a bull market, since people are overwhelmingly situated in non-stable tokens, yields from stablecoins are likely to be higher than their previous value as well as their non-stable counterparts.

If stablecoin yields are extremely high, De-Collateralize may not always make sense. We discuss this further in the mechanism section.

Bear Market

In a bear market, it’s possible that yields may flip in value. The market is overwhelmingly situated in stablescoins to protect against volatility, so the stablecoin yields drop. It is entirely possible that the going rate for staking ETH, BTC, and other non-stable tokens could rise above the available stablecoin yields in the market. In this case, using stables as collateral to borrow ETH is a possibility, but comes with its risks and has not appeared to be the preferred mechanism. Instead, people seem more likely to diversify. They hold a portion of both stablecoins and ETH in their portfolio. However, there is more risk as the non-stable tokens could drop in value.

Alternatively, if yields have not flipped, people may still use their ETH as collateral for stablecoin loans. Collateralization ratios tend to increase in order to avoid liquidation if ETH drops in value. This means the market is operating at a loss of capital efficiency. Some may be as cautious as to overcollateralize by 400%. Additionally, even if the yields have not flipped, yields, in general, would likely be lower than in a bull market due to the higher saturation of stablecoin holders and other effects.

In both the above scenarios, De-Collateralize provides immense value. If yields flip, people can continue sitting on their portfolio of stablecoins while getting exposure to the yields of their non-stable counterparts. If yields are generally lower, de-collateralization as an alternative to lending is quite appealing.

De-collateralize, Mechanism

In the Element ecosystem, an alternative to collateralizing is made possible. We call it De-Collateralize. In essence, it is a fixed-term loan, paying the capital upfront, backed by a yield position such as a Yearn Vault. The steps included below would ultimately be reduced into one contract call or click. It’s quite simple and the flow is as follows:

1. Select your input capital. The token you want exposure to. For this example, we pick ETH.

2. Pick the yield position you want exposure to. We’ll go with the DAI Yearn vault at 8% APY.

3. Pick the output capital or token you want to keep your exposure to. This will usually be the same as your input capital but can be anything in reality.

Now, we de-collateralize:

1. Take the 10 ETH and swap it for 25,000 DAI

2. Using Element, you use the 25,000 DAI to mint Principal and Yield tokens into the Yearn V2 DAI vault.

Since Element splits the yield position into the principal and yield token components, our current portfolio looks as follows:

We now have 25,000 principal tokens (epDAI) and 25,000 yield tokens (eyDAI) representing the principal input and the variable yield of the Yearn DAI vault. Let’s continue…

3. Keeping exposure to the yield tokens is important since our goal is to maintain exposure to the stable yield. We decide to sit on them or provide the yield tokens as liquidity to gain further yield.

We still have exposure to DAI via the 25,000 epDAI or principal tokens, but we want exposure to ETH instead. We decide to sell our principal tokens back for ETH at a discount. The discount is relative to the current fixed APY principal tokens that are being offered. This fixed APY is relative to the yield of the underlying position. If the underlying vault provides 8% APY, then the fixed APY might be 4–5%.

4. Sell 25,000 epDAI for 9.9 ETH.

We now have 9.9 ETH and exposure to 25,000 DAI worth of yield on the Yearn v2 DAI vault. There is no liquidation risk. Instead of loan fees, we pay the discount upfront on the principal, listed at 4% APY, reduced to the 3 month period. We gain a significant increase in capital efficiency since we gain full exposure to the 25,000 DAI worth of yield. If we collateralized at 150% or 200%, we would have received significantly less DAI. Congratulations, you’ve just witnessed the creation of user offered fixed-term loans backed by yield positions on the Element Protocol.

Summary

As discussed above, collateralization is not always the best route to gain exposure to your favorite stablecoin yield positions. Additionally, if yields are flipped (ETH yields are higher than stablecoin yields) and you are sitting on a pile of stablecoins to hedge against a market downturn, collateralization makes even less sense. The De-Collateralize route, which is in essence a fixed-term loan that pays the borrow fees upfront while being backed by a yield position, can be the optimal route to go. It also brings significant capital efficiency since there is no collateralization requirement.

Since the borrowing rate in the De-Collateralize route is paid upfront and relative to the going yield rate of the position you gain exposure to, borrow rates in a strong bull market where stablecoin yields are extremely high (20–40%) may not be the best route. However, as yields begin to lower or even flip between stable and non-stable tokens, De-Collateralize is the optimal solution.

To implement De-Collateralize, the steps listed in this blog post’s mechanism section would simply need to be consolidated into one contract call. All the pieces and underlying technology are offered by the Element Protocol. If you are interested in building out this product, let us know and we can support you via a grant.

Happy bull or bear market!

Element Finance does not loan or provide leverage. It is an open source protocol, that allows users to participate in experimental activities. Decollateralize is a product that could be built on top of Element and other protocols and is not a product offered by Element. If users partake, they do so with their own funds and at their own risk.

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