DeFi: Will it really be possible to borrow from yourself at 0%?
A recent offer in the realm of Decentralised Finance (DeFi) caught my attention: “Borrow money with your bitcoin. At 0% interest”. Expected to launch at some point in Q1 of this year, this could serve as an accelerator for DeFi in the bitcoin ecosystem and potentially also for DeFi as a whole, as the interest-free borrowing protocol introduces new ways to monetise digital assets.
The offer comes from Sovryn, a relatively new DeFi stack built on bitcoin. It is a non-custodial and permissionless smart contract-based system on the bitcoin sidechain RSK, which is a layer 2 bitcoin smart contract protocol. It’s built to enable lending, borrowing, margin trading and more for bitcoin on RSK (rBTC), which is currently only available on a few exchanges. Sovryn recently announced that it will soon be releasing Zero, a subprotocol that will promote the adoption of bitcoin-backed stablecoins.
Issuing a loan with bitcoin serving as collateral is nothing new. The innovative part is the 0% interest for an undefined period. After all, fixed-interest loans are highly unusual in DeFi. In other words, if you take out a loan using protocols such as Aave, Maker or Compound, the interest rate will fluctuate over the course of the loan depending on market dynamics. This is not the case with the Zero protocol.
Achieved through a combination of stablecoins and liquidation mechanisms
Critical to the concept is the soon-to-be-introduced fully programmable Zero USD (ZUSD) stablecoin that is pegged to the US dollar. The Zero protocol enables borrowers to take out ZUSD loans against bitcoin (rBTC) collateral. A minimum of 110% collateral coverage ratio is required to be able to take out a loan. The ZUSD is kept stable through an automated market of buying and selling.
If the collateral coverage ratio falls below the 110% threshold (e.g. when the price of bitcoin tanks), the collateral and the loan are liquidated automatically. The likelihood of that happening is a function of the collateral ratio at any given moment and the value of the collateral. The latter can fluctuate considerably due to the price volatility of bitcoin. In the event of such a liquidation, the borrower effectively incurs a 10% cut on their collateral. This incentivises the borrower to keep the collateral coverage ratio well above the 110% threshold. Borrowers need to keep the price volatility in mind when deciding on the maximum size of their loans relative to their collateral.
The longer the loan, the cheaper
One-time fees are due for the borrower for initiating the loan. Other costs can be found in the conversion from ZUSD into rBTC, plus there are transaction fees for moving out of the Sovryn ecosystem into exchanges. As a last step, there is the conversion of rBTC into fiat and bringing the fiat into a regular bank account for spending in the real economy. These are all one-time fees, so the Zero protocol loans aren’t for short-term loans. The longer the duration of the loan is, the lower the costs will be. That in itself is a unique property.
Zero could spark increased interest in DeFi in the bitcoin ecosystem
With the Zero protocol, it will be possible to take out cheap loans (via a stablecoin) against bitcoin and spend them in the real world. For example, instead of arranging a mortgage for a house or a loan for a car, people will be able to take out a loan against their bitcoin and then use the money to buy a house or a car. Collateralised trading is today’s killer application in DeFi lending, and that will probably be a similar story with Zero.
For people and organisations who believe that the price of bitcoin will continue to go up in the long term, lending against bitcoin at 0% can be an interesting value proposition. It preserves the long-term upside of their bitcoin while allowing them to enjoy the liquidity of their bitcoin in the short term. In the positive event that the value of their underlying bitcoin increases over time, their debts will decrease proportionally. Additionally, as their collateral coverage ratio will have increased, they will be able to take out additional loans against their bitcoin.
Conversely, in the worst-case scenario, the value of their underlying bitcoin could fall below the 110% collateral coverage ratio, resulting in their entire collateral being liquidated. They will incur a 10% fee on their loan and will also have to repay the loan instantly.
Nonetheless, if the Zero protocol is successful, it could spark increased interest in DeFi on top of the bitcoin stack. To date, there has been little DeFi activity in the bitcoin ecosystem due to the lack of smart contracts. Meanwhile, there has been an increase in usage of wrapped bitcoin in DeFi on other smart contract chains such as Ethereum.
DeFi is not risk-free
All of the above sounds attractive, but as we know there is no such thing as a free lunch. DeFi is not risk-free and zero-cost. The nascent DeFi ecosystem is still under development and there are many unknowns. The risks include protocol bugs, liquidations and the functioning of the stablecoin markets. For example, the high volatility of crypto assets may lead to loans being under-collateralised and getting liquidated as a result, further increasing the selling pressure. This could create a domino effect in the entire DeFi ecosystem. The exact dynamics in which this unfolds depend on the complexity and interconnectedness of any particular DeFi ecosystem. Similarly, the drop in crypto markets in January 2022 led to instability in the LUNA DeFi ecosystem. The volatility resulted in an imbalance between loan demands and deposits in borrowing protocol Anchor, causing the protocol reserves to rapidly evaporate. Similar risks may be present in the Zero protocol and they will emerge over time as the protocol rolls out. But as we’ve already seen during several crashes, the market unravels in an orderly fashion; the risks fall where they are supposed to fall and no ‘central intervention’ is needed.
In the coming months, we will closely monitor the introduction of the Zero protocol, as this novel proposition could be one of the first lending protocols in the relatively non-existent DeFi ecosystem on the bitcoin stack.