Unlocking Capital Efficiency: A DeFi User’s Journey Through Element

Users who are active in the DeFi space today are already depositing in their favorite yield positions, such as on Yearn or Compound…

Unlocking Capital Efficiency: A DeFi User’s Journey Through Element

Users who are active in the DeFi space today are already depositing in their favorite yield positions, such as on Yearn or Compound. Element unlocks further paths of revenue, leverage, and capital efficiency on these positions. Let’s start by walking through the journey of one such user, Jonny.

This is Part 2 in the series of how different users may use and navigate the Element Protocol. For Part 1, covering a casual user’s journey through fixed rate interest using Element, go here.

Jonny’s Current DeFi Strategies

Jonny currently uses Yearn and sees excellent returns on his assets. He made deposits in the Yearn ETH and DAI vaults. Because Jonny likes to keep his exposure to the upside on ETH, he collateralizes ETH and takes out a loan for DAI. He then deposits that DAI on Yearn.

Some days he may see a better opportunity for his DAI or want to change to a different stablecoin or asset that provides higher APY. Maybe there is a farm he wants to participate in. Either way, he withdraws from the DAI vault and switches out his debt to another asset or pays off his debt. He may also see other opportunities in the market for his ETH. In these cases, he also withdraws from the ETH vault and repositions.

Through all of this, Jonny does not realize he lacks capital efficiency. With his deposits, his principal is locked up and sitting idle. He cannot use that principal elsewhere to further access revenue opportunities or leverage. He only has one option, he can withdraw his gains from the vault and choose to allocate his capital to a different position offered in the market. When he exits, he no longer has access to the yield of the position he exited from.

Jonny’s Strategy Using Element

Jonny can make the exact same deposits he was already doing, but he can do it through the Element Protocol. By doing so, he can gain further avenues of revenue, leverage, and capital efficiency. Let’s walk through it.

Jonny wants to deposit 100 ETH in the Yearn ETH vault giving 20% APY, so he deposits through Element. He chooses a term or deposit period of 3 months. Element splits his Yearn LP tokens into two new tokens representing the principal and yield. This process is called Minting.

He now owns 100 principal tokens, eP:yETH, representing the 100 ETH in principal and 100 yield tokens, eY:yETH, representing the yield he will receive on that principal over 3 months. In 3 months, he can redeem the principal for 100 ETH. If the position holds a 20% APY, he can redeem the yield tokens for 5 ETH.

So why would Jonny choose to lock up his position for 3 months? What benefit does it bring him? At the very least, if he just sits on the issued tokens for the 3 months, he gets the same benefit as depositing in the Yearn ETH vault. However, he now has many other avenues he can pursue to further increase the gains in his portfolio, including exiting his position if he’d like to. Such avenues consist of:

  1. Stake his principal tokens or yield tokens in an AMM to further increase his APY.
  2. Sell his principal tokens to allocate his capital elsewhere, while maintaining exposure to the yield on the yETH vault.
  3. Sell his principal tokens to re-invest in the yETH vault. In essence, Jonny trades his principal to increase his exposure to the yield, also known as leveraging.
  4. Similar to number 3, but more explicitly Yield Token Compounding (more on this later).
  5. Exit by selling his tokens based on the current market pricing, realizing early gains, or achieving instant profit.
  6. He may also use minting as an alternative to collateralizing or borrowing to maintain exposure to his preferred base asset, ETH. He may gain more exposure to interest and avoid liquidation risks.

Let’s dive deeper into each of these avenues, but first, let’s give an overview of how principal tokens work and why Jonny can sell them on the market.

Principal Tokens and Fixed Yield Income

After 3 months, the 10 Principal tokens Jonny owns can be redeemed in full for the principal he deposited, 10 ETH. He can sell his principal tokens at a discount due to the opportunity cost of having to wait to redeem them.

If the current variable yield rate in the market for staking ETH is 20%, then owning ETH that cannot be deposited in that yield position for 3 months comes with an opportunity cost. You would expect to buy it at a discount, relative to the going yield rate on the asset.

For example, since the current ETH staking rate Jonny is receiving is 20% APY, he may sell the principal token at a discounted rate that is lower, say at a 10% APY value. Over 3 months, 20% APY on 10 ETH is 0.5 ETH and 10% APY is 0.25 ETH. This means Jonny can sell his 10 ETH principal for 9.75 ETH.

The purchaser gets a guaranteed stable interest rate in a market of variable interest, preventing them from having to shift their assets regularly between DeFi protocols or be exposed to shifting variable rates. They also get the discounted ETH from a simple AMM trade, reducing typical gas fees required to deposit, withdraw, and collateralize. The Element platform allows users to secure fixed yield income by purchasing principal tokens. However, they can still exit at any time by selling them again on the market.

Avenues of Further Revenue

Let’s now dive into the ways Jonny can use his 10 principal and yield tokens to further his gains on the 20% APY Yearn position he deposited into.

Minting and Staking Yield Tokens on an AMM

Now that Jonny has minted his principal tokens and yield tokens, he may stake them on Balancer to provide liquidity for the market to buy and sell both. For principal tokens, he stakes on a custom trading curve or the invariant Element built on Balancer V2. The curve is specialized for principal tokens, whose value merges in price over 3 months. After 3 months, 10 eP:yETH will be redeemable for 10 ETH. The curve close to eliminates impermanent loss and acts more akin to stable pair swaps such as on Curve, while still leaving room for price discovery, especially at the beginning of the 3-month term. The curve was based on the work by Yield Space and our modifications can be found here in our construction paper.

Our analysis leads us to believe that both markets, for yield tokens and principal tokens, will carry high trading demand. Due to this trading volume, Jonny believes he can make a significantly greater APY by staking the tokens on an AMM and collecting fees. With his initial estimated APY of 20%, he now believes he can see that amount increase significantly.

Jonny chooses to stake his principal and yield tokens in Balancer for the next 3 months. Once the term is complete, Jonny redeems both the trading fees and yield/principal during that time period.

Our construction paper shares charts and numbers on what the expected increase may be in APY based on different trading volumes.

Unlocking Capital Efficiency

Jonny decides he wants to gain exposure to more yield or move to another yield position. His initial capital of 10 ETH can enable him, through the Element protocol, to increase his leverage. For the sake of simplicity, this example presents a 1-year lockup.

  1. Jonny mints yield tokens and principal tokens through the Yearn vault providing 20% APY.
  2. Jonny now has 10 eP:yETH representing his principal and 10 eY:yETH representing the yield over the next year.
  3. Due to people minting and staking yield tokens with an active market, Jonny may now sell his principal of 10 ep:yETH to reinvest in the Yearn vault or put in another yield position.
  4. Principal tokens are going for a 10% fixed rate yield on ETH. He sells his principal at a discount for ETH, receiving 9 ETH.
  5. Jonny now has 9 ETH and full exposure to 20% APY on 10 ETH. He is now free to deposit the 9 ETH into any other yield position or deposit again through the Yearn vault.

In simple terms, he has introduced capital efficiency to his position. He no longer gains exposure to a yield position without efficacy or use of his principal. His principal is freed up to deposit in other yield positions.

Yield Token Compounding and Leveraging

If Jonny continues to repeat the steps above, he is following a process we call Yield Token Compounding, which increases his leverage recursively. He continues to sell his principal at 10% APY and re-deposit in the yield position at 20% APY.

As a simple example, multiple compounds may result in the following:

Calculations in this example do not take into account gas fees, slippage, or trading fees to maintain simplicity. View this analysis for analysis on compounding with real-world values.

After 10 cycles of yield token compounding, Jonny gains exposure to 6.5x as much yield of his initial balance. Jonny has essentially gained 6.5x leverage. The 65.13 ETH of exposure at 20% APY yields 13.02 ETH. He has 3.87 ETH in unlocked principal, giving him a total of 16.9 ETH. If he had traditionally invested his 10 ETH, without capital efficiency, he would have 12 ETH at the end of the year assuming a 20% APY. Through yield token compounding, Jonny has netted 4.9 ETH and increased his yield from 20% APY to 69% APY. Jonny could continue the cycles of yield token compounding to boost his APY further.

Yield token compounding can be achieved more efficiently via flash loans. In this example, the 10th cycle of compounding leaves 3.87 ETH in available capital. This means the total capital expended was the difference, 6.13 ETH. Jonny could have achieved the compounding operations via a flash loan with 6.13 ETH of capital. In this example, it would take 6.13 ETH to gain exposure to 65.1 ETH in yield, effectively providing 10.6x leverage without liquidation risk.

Minting Instead of Using Lending Protocols

Many DeFi users take out loans in order to maintain exposure to ETH but also to grow their portfolio through the high APYs provided by stable pairs or other tokens.

As an example, Jonny likes ETH a lot. He believes ETH will grow significantly over the next year. However, Jonny also sees that he can receive 30% APY by staking stable coins such as DAI. Jonny does not want to trade his ETH for DAI to obtain the yield because he misses out on ETH’s increase in price, which he believes will exceed the APY he obtains through staking DAI. Currently, the solution is simple. Jonny will do the following:

Method Via Lending or Collateralization

  1. Jonny opens an over collateralized Maker vault and borrows DAI.
  2. He stakes his borrowed DAI in a yield position giving him 30% APY.
  3. If the price of ETH rises, Jonny can borrow more DAI and gain more exposure to yield. He also realizes the gains on the price of ETH.
  4. If the price of ETH drops, Jonny adds additional collateral to avoid liquidation of his loan and losing his 150 ETH.

Jonny now keeps his ETH and also gains yield on DAI. However, this process does carry some risk. If the price of ETH drops significantly, Jonny can be liquidated and lose his precious ETH. Additionally, due to the need for over-collateralization, he only receives exposure to the yield for 200,000 DAI while collateralizing 300,000 worth of DAI. Lastly, Jonny lacks capital efficiency as he cannot use his 150 ETH or stake it to gain any additional yield.

The Element Alternative

Using the Element Protocol, there comes a new alternative. If the market conditions are right, Jonny can still maintain exposure to ETH or his preferred base asset, but without liquidation risks or needing to over collateralize. He can also obtain capital efficiency and use the majority of his ETH freely. Let’s go through an example:

  1. Jonny has 150 ETH. He trades the 150 ETH for 300,000 DAI.
  2. Jonny mints via the Element Protocol into a DAI-backed yield position, yDAI.
  3. Jonny holds 300,000 eP:yDAI and 300,000 eY:yDAI.
  4. Jonny sells his 300,000 eP:yDAI for ETH (at a 4% yearly discount, reduced due to the 3-month term), receiving 148.5 ETH.

Jonny now holds 148.5 ETH and maintains exposure to the yield of 300,000 DAI. Jonny has capital efficiency since he can now utilize his 148.5 ETH any way he wants. It is not locked up. He also has no liquidation risk and can now stake his 148.5 ETH on any platform, gaining yield to recoup the decrease. He has yield exposure to 100,000 additional DAI he would not have had if he had followed the traditional route.

Other Avenues of Revenue

To read about other avenues Jonny can take with his principal and yield tokens, take a look at section 5 and further in our construction paper.

Summing it all Up

Element is an open, self-sustaining, community-governed protocol that initially allows users to access BTC, ETH, USDC, and DAI at a discount. Element introduces further avenues of capital efficiency to DeFi users and is dedicated to continued innovation. The team is protocol first, focused on introducing new primitives as the foundation for more products to be built in the DeFi space.

Examples provided in this post are examples only. Actual results may differ and could result in losses.

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