‍Ready for a mature market?

It finally happened! After months of teasing and two fake tweets later, the SEC finally approved the spot Bitcoin ETFs. However, all of this talk about ETF and Grandpa Traditional finance money flowing into Crypto as a result only points to one thing: Crypto is evolving to become a mature financial market. The question, however, is, are we ready for a mature market? Do we have protocols that reflect the maturity seen in the Tradfi environment? What are some of the characteristics of a mature financial market that we can incorporate without losing the rudiments of the value the blockchain provides? 

A financially mature market is usually characterized by high liquidity, which is possible with the ETF being approved, more sophisticated players, steeper markets, and price efficiency, amongst many other characteristics. Another significant trait of a mature market, and quite frankly, the one that sets the tone of today’s discourse, is that interest rates are usually fixed. You would agree that this trait is missing in the crypto lending market, wherein fluctuating lending rates are the dominant theme. 

But what if things were to change? What if we were to see the introduction of noncustodial fixed-rate collateralized lending in Crypto? What would such a protocol look like, and how would it work such that we can finally experience large-scale and more sophisticated on-chain lending and borrowing from institutions in a way that can be likened to what is obtainable in Tradfi?

Introducing Term Finance. 

What is Term Finance? 

In line with the above, Term Finance provides fixed-rate collateralized lending on-chain by combining the elements of fixed-rate lending with a Tradfi concept of a tri-party repurchase agreement or tri-party repo for short. If you’re DeFi-Savvy, what this refers to is simply an isolated non-custodial collateral pool.  

Albeit, for those who have zero exposure to Tradfi terms and practices and are not so DeFi-Savvy, this is what it entails: 

• Fixed-rate lending means an affixed or known interest rate is constant for the loan period. It implies a situation wherein the borrower and the lender are aware of the interest that accrues to the loan even before borrowing. 

• On the other hand, a Tri-party repurchase agreement is a three-person deal that involves the borrower, lender, and a middleman, commonly called a “clearing agent.” This third party is in charge of facilitating the loan between the lender and the borrower, helping to exchange collateral and repayment with interest between both parties. 

These two terms are the foundation for Term Finance’s approach to fixed-rate collateralized lending. But let’s go beyond the basic level to examine how to use Term Finance and how all of this works on-chain — all the moving parts to Term Finance, including the risks associated with how it works. 

How to use Term

Term is a two-sided marketplace that matches borrowers, on the one hand, and lenders, on the other, through weekly auctions. 

To lend

To lend, submit one or more “Offers” into a live auction specifying (i) the amount you are willing to lend and (ii) the minimum interest rate at which you are willing to do so. 

Once an offer is submitted, all you have to do is wait until the auction closes to see whether your offer was accepted in the auction! You will never be assigned loans at a rate less than the minimum you specified, and in most cases (assuming you are filled) will lend at a more favourable rate.  Lenders who are assigned in the auction will automatically receive receipt tokens (called Repo Tokens). Don’t lose these tokens! RepoTokens are what you will use to redeem for principal and interest at loan maturity.

To borrow

To borrow, submit one or more “Bids” into a live auction specifying (i) the amount you want to borrow, (ii) the maximum rate you are willing to pay, and (iii) the amount of collateral you want to post to back each bid. 

Once a bid is submitted, all you have to do is wait until the auction closes to see whether your bid was accepted in the auction! You will never borrow at a rate higher than the maximum you specified, and in most cases (if you are assigned), you will borrow at a more favorable rate. Borrowers who are assigned will automatically receive loan proceeds from the protocol. 

Borrowers should remember to maintain loan health by ensuring their collateral value remains above the required maintenance collateral ratio. If the value of your collateral falls below this minimum, your loan will be liquidated. Also, be sure to repay the loan within 24 hours of maturity (repayment window), or your collateral will be liquidated with a penalty.

How it works

Clearing Rate 

In Term Finance, the interest rate for a loan (or clearing rate) is established through a blind auction process that matches sealed bids from borrowers with sealed offers from lenders. This is a blind auction in the sense that participants are not able to see the rates at which others are willing to transact until after an auction is closed. Once an auction is closed, the clearing rate is determined by finding the rate that maximizes the amount of borrowers and lenders that can be matched.

Borrowers with bids at or above the clearing rate end up receiving loans, and lenders that submit offers at or below the clearing rate get to make loans to borrowers. It’s all a price-discovery process to find a market equilibrium rate given both parties' desired interest rates. Since the auction clears at a single market clearing rate, in many cases, borrowers and lenders experience price improvement vs. the interest rate they submit in the auction. 

Auction timeline

Before an auction commences, it is announced at a specific date to provide details about the auction, such as terms of the Term Repo, the purchase and collateral token involved, the initial and maintenance margin ratios, as well as full disclosure of fees involved. 

Furthermore, an auction is expected to last for a specific period of time called the Auction Window. During the window, borrowing bids and lending offers can be sent. However, no other party can make a bid or throw in an offer after the auction window closes. Term finance auction windows commence 24-48 hours before the auction time. 

After hashed bids and offers have been sent in, they must be revealed by protocol keepers to match borrowers and lenders. This is known as the reveal period. The reveal period begins immediately after the auction window ends. What comes next after the auction window and reveal period is the matching (Assignment) of bids and offers with a clearing rate using an algorithm that identifies where supply meets demand on interest rates. The algorithm does this by taking the average between the second most competitive bid and the second most competitive offer to arrive at the desired clearing rate.

Before examining what comes next after the borrower and lender have been matched, let’s look at how term repos work. 

Term Repos

Recall the earlier mention of the tri-party repo concept. Term Repos mirror this concept on the blockchain. Term Finance emulates the tri-party repo, incorporating distinctive features like fixed-term and fixed-rate loans, requiring borrowers to repay the loan on a specified repurchase date. Borrowers have the ability to repay earlier but are on the hook to repay all the interest. Lenders cannot recall a loan before the maturity date of the agreed term. Additionally, Term Repos are over-collateralized by liquid digital assets, including wBTC, WETH, USDC, and USDT. Term Repos exhibit flexibility, with the loan duration varying from 4 to 12+ weeks based on the loan terms for the specific Term Auction.

The off-chain implementation of the tri-party repo concept induces the use of a collateral agent, while term repo utilizes noncustodial smart contracts to lock collateral (Term Repo Lockers) specific to each loan term. Term Repo Lockers are segregated by collateral type and maturity date, so lenders are not exposed to collateral risk belonging to loans they are not party to.

Once lenders are matched with borrowers through a Term Auction, loan proceeds are sent to the borrower and ERC-20 receipt tokens (Repo Tokens) are sent to lenders that are redeemable for principal plus interest at maturity. Term Finance uses decentralized price oracles such as Chainlink to monitor the value of the collateral. Term Finance also provides for situations where a borrower can withdraw a portion of their collateral if the collateral asset rises way above the required collateral margin in such a way that doesn’t put the collateral at risk of liquidation. In the same way, the borrower can also add more collateral to their margin. 

When a Term Repo reaches its maturity or expiry date, a 24-hour repurchase window is opened to allow the borrower to repay their loan. A liquidation event will occur when the borrower is unable to repay the loan within the repurchase window. On the other hand, lenders redeem their tokens in an open-ended redemption period by burning the term repo tokens issued during the period of assignment to receive purchase tokens (interest included). 

A few paragraphs above, we mentioned that Term repos are non-callable loans, implying that neither the borrower nor a lender can halt their agreement before the maturity date. However, borrowers can exercise the “Collapse position” process to exit a term repo by purchasing the term repo tokens from the lender and burning them against their repurchase balance or by repaying the loan early with full interest also due. 

How Liquidation and Fees work on Term Finance

Term finance employs a decentralized liquidation model similar to Aave and Compound. Liquidations are executed via a public function that can be called by anyone on the blockchain to liquidate a defaulting borrower. A Liquidation event occurs when a borrower’s collateral falls below the required margin. In a situation where this occurs, a liquidator may step in by purchasing a portion of the collateral at a discount, specifying the amount to repay or cover on behalf of the defaulting borrower. 

Liquidated damages are applied to liquidated collateral term repos in the form of liquidation incentives and protocol liquidated damages. 

It’s important to note that a liquidator cannot fully liquidate a defaulting term repo except if necessary, as the amount to be liquidated is limited to that which will bring the margin ratio to the initial margin ratio.  

Concerning fees, borrowers utilizing Term Finance incur a loan servicing fee, typically 0.5%, which is annualized over the term of the loan. Although the servicing fee is formally imposed on the borrower, they consider it in their bidding strategy, resulting in the economic impact of the fee being shared by both borrowers and lenders.

It’s also important to add that Term Finance operates an isolated lending market to reduce market exposure to systemic risks. This is implemented to ensure that in the event of external or systemic risks affecting a particular market, others remain unaffected, thereby safeguarding users from unforeseen losses.

Term Repo tokens

While it is unclear if Term Finance will have a native token, there are tokens that exist within Term Finance as a result of the process (Term Auction) of matching borrowers and sellers. These tokens are called Term Repo tokens, and they are composable ERC20 tokens representing a claim to payment on a specific maturity date. 

State of the protocol 

Term Finance has been on Mainnet since August 2023, and has commenced Term Auctions weekly. The protocol is also fully audited by Sigma Prime, Runtime, and Dedaub, with the audit reports available here. The protocol is useful for boycotting high liquidity squeezes for borrowers and subverting the exorbitant funding costs associated with borrowing on variable rate lending protocols, like Aave, or  trading on regular Perp exchanges. 

The protocol is backed by noteworthy investors such as Electric Capital, Coinbase Ventures, Circle Ventures, Robot Ventures, and MEXC Ventures, with angel investment from Maelstrom (Arthur Hayes’ family office), Crypto McKenna, Ledgerstatus, DeFi Dad, and others.

Closing thoughts 

Term Finance’s approach to lending and borrowing in DeFi is a lot different from the norm, especially fixed-rate AMMs that are capital intensive and rely on perpetually locked liquidity to facilitate lending and borrowing activity. The Term Finance approach is simple, straightforward, and effective, the type of solution that attracts large-scale borrowers. 

Term Finance works to solve the uncertainty issue with lending and borrowing in DeFi while maintaining the core values of the space, such as the utilization of decentralized smart contracts in place of tri-party agents to facilitate the exchange of collateral and money between lender and borrower. 

We will advise you to keep a keen eye on the progress of this protocol and join the community on Discord to keep tabs on weekly auctions in search of opportunities.