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We developed a fixed-income protocol to facilitate peer-to-peer, fixed-rate, and fixed-term lending and borrowing in decentralized finance (DeFi). Fixed-income products enable institutions and individuals to predict future cash flows and make investments according to their risk appetite. However, such products are currently absent in DeFi. By building the Term Structure Protocol, we empower users to manage their finances more effectively. Moreover, once fundamental fixed-income products are established, they pave the way for developing more advanced financial products including forwards, futures, and options. These tools can be used for purposes such as hedging, valuation, and pricing.
In traditional finance (TradFi), the term structure for USD interest rates is enabled through the issuance and trading of Treasury bonds in the US government bond market. Investor activities, market expectations, and risk evaluations collectively shape both the pricing and yields for different bond maturities to create that term structure. These interest rates for various bond maturities, often referred to as risk-free rates, serve as a fundamental benchmark. They are commonly used as the foundation for a range of financial calculations, such as discounting future cash flows, pricing financial instruments, and evaluating the relative value of different investment opportunities.
Similarly, such fixed interest rate markets must exist to create the term structure of interest rates in DeFi. They must comprise Primary, Secondary, Repurchase (Repo) Markets, and subsequently derivatives markets so that risks can be efficiently hedged and transferred among participants. In particular, Primary and Secondary Markets are symbiotic building blocks: issuers raise capital in Primary Markets, and investors can trade in Secondary Markets to enhance liquidity. At Term Structure, we aim to build this missing piece of the DeFi puzzle, with an initial focus on developing Primary Markets via auctions and Secondary Markets via orderbooks. Once the fixed-income token pool and trading volume reach a certain level, Repo markets will be introduced in the next stage.
We use a peer-to-peer mechanism - instead of peer-to-pool - because this enables users to trade with one another at their preferred price without intermediaries. The automated market maker (AMM) pricing algorithm often yields take-it-or-leave-it prices determined by the immediate liquidity in a particular protocol pool and overlooks broader market supply and demand dynamics.
On a fixed-rate borrowing and lending platform like ours, a peer-to-peer model offers greater capital efficiency because unused funds do not remain idle in a pool with a low utilization rate. The advantages of the peer-to-peer model become especially clear when the peer-to-pool model has a very low loan-to-deposit ratio whereby the interest rates shared among the pool of lenders can approach zero, and the deposited funds become idle as a result. In cases where the loan-to-deposit ratio is close to 1, lenders might be unable to withdraw their funds because most of their funds are being utilized. By contrast, lenders who use a peer-to-peer platform avoid this problem because both borrowers and lenders set their preferred interest rates and wait for their orders to be matched.
Below is a comparison between Term Structure and AMM-based counterparts
Users only need to pay gas fees for deposits and withdrawals on Term Structure
As users frequently perform various activities on the protocol, gas fees must be contained to the greatest extent possible. That said, an off-chain service provides the best user experience by improving transaction efficiency and minimizing gas fees.
The core engine of Term Structure must be efficient and flexible to support a comprehensive fixed-income protocol, consisting of Primary Markets via auctions and then Secondary and Repurchase Markets via orderbooks. Across these three markets, there are many trading actions, including making deposits, transferring funds, withdrawing, placing orders, matching orders, canceling orders, etc. If the protocol were built directly on Ethereum, this would result in exorbitant user gas fees every time they execute any of the above actions. Therefore, this protocol needs a scaling solution to process transactions off-chain before sending them on-chain for the smart contract to verify their validity.
We use a ZK-rollup solution because it increases transaction throughput and lowers gas fees. Unlike other scaling solutions, such as sidechains, plasma, and optimistic rollups, ZK-rollups stand out by instantly compressing and submitting transaction data to the underlying blockchain to ensure the validity of transactions and achieve privacy.
Ethereum has faced challenges with low transaction throughput and high fees. As a result, this has led to the development of diverse scaling solutions. Although each of the solutions has its advantages, there are significant drawbacks that make them undesirable for financial transactions. For instance, sidechains offer quicker transactions but rely heavily on their validators. This can potentially compromise Ethereum’s inherent security and consensus mechanism. Likewise, the plasma solution, while faster than some sidechains, raises concerns about data withholding by operators. Considering these factors, it becomes clear that these solutions are not suitable for financial transactions that demand a high level of security and instant settlement time.
After eliminating the above-mentioned scaling mechanisms, only two remain: optimistic rollups and ZK-rollups. Unlike an optimistic rollup, which uses fraud proofs and has a long challenging period, ZK-rollups apply validity proofs to prove and verify transactions instantly without exposing any sensitive data. Once the proof is verified, all transactions are accepted. This clearly demonstrates the unique advantage of using ZK-rollups, and we have adopted this scaling solution precisely for this reason.
This protocol uses a customized ZK-rollup for a couple of reasons.
Abundance of Liquidity
zkTrue-up allows Term Structure to operate as a decentralized application (Dapp) on the Ethereum mainnet. This enables users to deposit tokens directly from Ethereum, leveraging its high liquidity across major blockchains. This seamless process facilitates order placement in both Primary and Secondary Markets on Term Structure.
Minimum Gas Fees Required
With zkTrue-up, users do not need to pay L1 gas fees or even other L2 fees when they place or cancel orders.
zkTrue-up is on the Ethereum mainnet. When users withdraw their assets from Term Structure, they can directly interact with other Dapps on L1. This will broaden the use cases of Term Strcuctre’s tsbTokens in the Ethereum ecosystem.
Since zkTrup-up is on Ethereum and rolls up all the transaction data to L1, bots can automatically liquidate users' loan positions in the Primary Markets if the collateral value falls below the liquidation threshold. Moreover, compatibility is also ensured by enabling users to transfer their loan positions from Term Structure to AAVE when they wish to convert their loans into those without a maturity date.
The Term Structure team was built in Q2 2023. The customized ZK Rollup solution for Primary and Secondary Markets involves intricate design. As the team expands its product offerings following the roadmap, additional enhancements are required. This customized solution allows us to determine our development schedule independently without relying on third-party applications.
Having a customized zkTrue-up allows Term Structure to make decisions according to our business requirements. For example, we can decide our roll-up frequency and timing according to our business growth and cyclic price movement of gas fees within a day. We have also built the Forced Withdrawal and Evacuation functions to uphold our commitment to being a responsible DeFi protocol. Many L2s have not implemented this feature.
We use auctions for our Primary Markets because competitive bidding is the most transparent and effective way to define fair market price. The auction mechanism has been proven to be sustainable and resilient, as demonstrated by the US Treasury, which has been using the auction mechanism to successfully raise funds and manage debt. The yields for different maturity dates resulting from these auctions have also become the foundation of all financial products in TradFi. Therefore, rather than relying on formulaic interest rates from an AMM, we have adopted the auction mechanism that allows borrowers and lenders to deal at their preferred interest rates for specific maturities.
Moreover, the auction mechanism serves as an effective means to maintain market momentum, especially during periods of market fluctuation. The bidding window provides participants with the opportunity to carefully monitor price changes in Secondary Markets before placing orders.
A central limit orderbook (CLOB) is effective for trading in financial markets because it can accurately reflect the overall market supply and demand. This stands as a stark contrast to relying on an AMM pool in a protocol. With this mechanism, users can place orders at the prices they desire and trade at those levels if matched in Secondary Markets. They can also select between limit and market orders based on their trading strategies.
The protocol will collect transaction fees only on matched orders in the respective Primary, Secondary, and Repo Markets. The protocol will also collect a USD 1 withdrawal fee upon each withdrawal request.
Primary Markets (Per Order)
Users should first connect their wallets and deposit before they can start trading. After they deposit funds into their Term Structure accounts, they can place orders in Primary Markets to borrow or lend mainstream tokens and stablecoins with their preferred interest rates, collateral, and maturity dates. Alternatively, users can also buy and sell tsbTokens, the native token of Term Structure, in any of our Secondary Markets. They can do this to earn a fixed income or to trade these tokens for hedging and risk-taking purposes against Primary Markets and other DeFi protocols.
The liquidation threshold is the maximum acceptable LTV ratio for a loan during its lifetime. If the LTV ratio of a loan reaches this threshold, the liquidation process can be triggered by liquidators. The liquidation threshold varies depending on the collateral and borrowed tokens used in the loan. The liquidation can be either full liquidation or half liquidation, depending on the value of the collateral. Full liquidation applies when the collateral value is no more than USD 10,000, while half liquidation applies in all other cases. Please note that if borrowers fail to repay their loans before 00:00 UTC+0 on the maturity date, full liquidation will apply. The liquidation process is fully on-chain, decentralized, and open to any liquidator to maintain the stability of the system. There are incentives for liquidators and penalties for borrowers. For more information, please refer to our docs at Liquidation Mechanism - Term Structure Docs.