Notional Finance: Borrowing and Lending at Fixed Rates… in Crypto?!

The following report was written by Messari Hub Analyst(s) and commissioned by Notional Finance, a member of Messari Hub. For additional information, please see the disclaimers following the article

Looking into Fixed Rates

Fixed income financial products offer fixed interest rates until maturity. Today, they are a bedrock in the global financial system with U.S. Treasury bills, notes, and bonds all employing a safe, fixed interest rate for the lender. At the time of publishing, the 20-year T-bond has a virtual 0% chance of default. In exchange, these debt instruments offer a measly 1.9% APY, used as a rough baseline investors equate to for the risk-free rate. While other TradFi products such as junk bonds offset higher returns with higher risk, it is the relatively low yield, low risk combination offered by Treasury-backed securities which set the economic cadence for lending around the globe.

However, alternatives exist beyond the TradFi world. Crypto markets are notorious for having the opposite risk profile - high risk, high reward, and attractive for the volatility-seeking trader. The rise of DeFi and stablecoins, however, produced several crypto-based offerings similar to TradFi products. This allows more investors to flock into markets built atop the blockchain without the prerequisite of a high risk appetite. One such protocol bridging this gap through the implementation of a fixed-rate lending protocol is Notional Finance.

Notional’s APY? 10%+ (across multiple assets).

History of Notional

Notional Finance is an Ethereum-based protocol which enables users to lend and borrow cryptoassets at a fixed rate via on-chain liquidity pools. Its mission is to allow the DeFi ecosystem to facilitate longer-term lending markets at predictable fixed rates in order to further the creation of an alternative global financial system with congruent utilities to the traditional system of today.

The project was founded in January 2020, but work on it began two months earlier by Teddy Woodward and Jeff Wu at a San Francisco-based hackathon. After a year of development, the project went live and immediately garnered attention and deposits. In April 2021, Notional announced the closing of a $10 million Series A funding round led by Pantera Capital. At the time of funding, Notional had attracted over $17 million in TVL and executed $10 million in loans.

On July 6 of this year, Notional announced a protocol upgrade called Notional V2 scheduled for a November 1 launch. High level changes included longer-dated maturities for lenders and borrowers, flexible dates for lenders and borrowers, and an announced partnership with Compound to improve the liquidity provider experience. Activity on the protocol has exploded over the past week as Notional nears $1 billion in total TVL.

fCash Allows for Fixed Returns

Notional achieves its fixed returns for both borrowers and lenders through a zero-coupon bond-like instrument known as fCash. fCash is a transferable token which represents either a positive or negative claim on the one-time cash flow paid out at maturity. The protocol currently supports DAI, USDC, ETH, and WBTC, ensuring a fixed return regardless of market performance.

Timing on loans is known as tenors and denotes the time between contractual inception and maturity. Tenor cadence as of V2 is three months, six months, one year, two years, five years, 10 years, and 20 years. However, at any given time there may only be a subset of these tenor options active for a given currency. Please note that none of these tenors have reached maturity as V2 launched on November 1, 2021. It’s also worth noting the length of time until a liquidity pool reaches maturity may not match up with that same pool’s tenor. These actual maturities of liquidity pools are calculated as offsets from a determined reference time which typically correspond to the lengths of the tenors. As an example, if the reference time is March 1 and the current date is March 15, the three month maturity would still be June 1 even though that is less than three months away from the current date.

Source: Notional Finance

Every fiscal quarter, reference times roll forward to match the length of the loan. Active maturities remain constant throughout the quarter and can only change at the rollover. Once the maturity date of a loan is reached, pools are re-initiated for the duration of the tenor with a new maturity date.

If fCash has a maturity that does not correspond to an active liquidity pool (i.e. if the reference time and tenor are not equal), then it is considered idiosyncratic. Idiosyncratic fCash cannot be traded on Notional’s on-chain liquidity pools because its maturity does not match any of the pools’ maturities. A user has to either wait for a roll forward, or find an external orderbook to make a transaction, though that option is currently unavailable.

fCash is always denominated as an asset and liability pair, representing the lenders and borrowers’ respective claims at the future maturity date. Positive fCash tokens are for lenders who can redeem currency at a future point, while negative tokens represent future obligations to the lender.

With the recent V2 update, a significant change was made to the redemption structure, distinguishing the denomination currency from the settlement currency. fCash is denominated in any of the base tokens, but settled in a separate base cToken. Redemption of fCash at loan maturity is made with an equivalent token value of the cToken, not the underlying token.

While the introduction of a cToken may seem like an extra step in an otherwise simple process of lending, it is crucial to Notional’s success. Splitting the currencies allows Notional to optimize cToken capital efficiency while maintaining the ability to lend and borrow at fixed rates. Liquidity providers deposit cTokens into pools to enhance their returns as they receive both the cToken lending rate and LP fees. cToken balances also accrue interest in the underlying cryptoasset which circumvents the need to roll loans forward. This unique feature is why Notional is the only protocol which allows both fixed borrowing and lending across multiple cryptocurrencies.

Once an fCash asset reaches maturity, a settlement exchange rate set by Notional determines the payout of cToken based on the underlying denomination currency. The settlement exchange rate can be defined as cToken / Denomination Token and is set upon maturity, remaining unchanged afterwards. The premium of fCash over the denominated par value represents the interest paid by the borrower to the lender.

nTokens Makes it Work

There is one more topic that we need to cover before we can fully walk through a transaction: nTokens. If you are following along at home, this is the third composable token we have looked at, but nTokens build the entire incentive structure for liquidity providers on Notional.

nTokens are ERC-20 tokens that enable users to provide liquidity across all active maturities without interacting with specific liquidity pools tied to a particular maturity. This means that the LP can make a single deposit into one liquidity pool using cTokens which distributes liquidity across underlying pools and the LP with nTokens.

Holders of nTokens earn returns in three distinct ways. The first is through a blended interest rate of the interest earned from cTokens and fCash held by the nToken account. This average is calculated using the token interest rates at different maturities weighted by nToken holdings. This rate will sit somewhere between the fCash interest rate and cToken supply rate.

Source: Notional Finance

Lending and borrowing across liquidity pools results in changes to interest rates and are tied to changes in nToken’s fCash holdings. Because borrowing drives up interest rates, the nToken accounts receive fCash while cToken are deposited. The opposite holds true for falling interest rates and greater demand to lend.

Source: Notional Finance

Second, nToken owners can earn a return through traditional liquidity fees which may be offset by impermanent loss. Potential for nTokens to achieve impermanent loss is low given stable exchange rates of fCash. Third, is the accrual of NOTE tokens, Notional’s governance token, which are awarded proportional to the total share of nTokens in a specific currency.

Leveraging nTokens for additional return is possible as they are automatically eligible as collateral on Notional, allowing users to borrow against them, further increasing capital efficiency. For example, users could mint nTokens, borrow against them, and then mint more at a fixed interest rate. While this does provide for attractive returns, there are still liquidation risks if the value of the nTokens a user is putting up for collateral decreases. nTokens are subject to price fluctuations that mirror changes to its yield.

Full Transaction Walkthrough

That was a lot of setup, so to better understand the mechanics of fCash, cTokens, nTokens, and the broader Notional ecosystem, it is best to walk through a very simple step-by-step example from the perspectives of the liquidity provider, lender, and borrower.

Source: Notional Finance

Liquidity Provider Perspective:

Liquidity providers are the most important player in the Notional arena as they capitalize liquidity pools with cTokens to act as the counterparty to all other lenders and borrowers. They earn the aforementioned rewards and liquidity fees for doing so.

If an LP wants to provide 100 DAI worth of tokens into a pool in V2, they will do so through their nToken account. The LP will first mint a pair of fDAI tokens (remember the positive and negative cash flows?) into their nToken account. Through the nToken account, they then deposit their cDAI (worth exactly 100 DAI) and positive fDAI into the pool. In exchange, the LP receives liquidity tokens representing their proportional contribution to the pool. The LP now holds these liquidity tokens, as well as the negative fDAI minted in the original pair.

Source: Notional Finance

Because of the structure of nTokens, the nToken account may interact with multiple maturity pools in a single deposit. At any time, the LP can exchange their liquidity tokens for the offsetting positive fDAI and 100 DAI worth of cDAI.

Source: Notional Finance

Lender Perspective:

Lending on Notional is fairly straightforward and typically offers a better rate than other fixed-rate protocols.

Once again, we will use the example of a lender looking to lend out 100 DAI. The lender will convert the100 DAI into cDAI and then deposit it into a select pool. In exchange, they will receive fDAI to be redeemed at a future maturity date (in this case December 1, 2021). The fDAI exchanged will be greater than the original cDAI deposited. This represents the fixed exchange rate received by the lender.

Source: Notional Finance

The lender is only eligible to cash in their fDAI once the maturity date is reached. Once the loan matures, they will redeem their original base token in exchange for the negative fDAI.

Source: Notional Finance

Borrower Perspective:

Borrowing represents the exact flipside to lending, but with some more nuance due to collateralization. The borrower first mints collateral into their portfolio (say 1 ETH) and then once again mints fDAI tokens at their selected maturity. This time, however, the borrower sells the positive fDAI in exchange for 100 DAI worth of cDAI.

Source: Notional Finance

Thus, the borrower must repay their future obligation by the maturity date which has a fixed rate represented by the difference between the fDAI to be repaid and cDAI received. The amount borrowed is fully collateralized by the 1 ETH they deposited. If the borrower fails to maintain adequate collateral due to market fluctuations, Notional may take some or all of the collateral. Should the borrower not want to repay the loan, they may elect to roll it forward to a future maturity. A third-party can also roll it forward on their behalf with an additional penalty interest rate.

Governance through NOTE

Operations of the protocol, including the use of the aforementioned composable tokens, are tied together through NOTE tokens. NOTE tokens were first introduced in May 2020 through a $1.25 million private seed round. Fundraising continued in the form of a $10 million Series A in April 2021. These governance tokens are ERC-20s used to vote on changes to the Notional smart contract. Beyond dictating how liquidity is distributed, NOTE holders also vote on collateralization requirements and the addition of new cryptoassets to the platform. Total supply of NOTE is 100,000,000 tokens with the following allocation:

• 50.00% to liquidity incentives
• 23.60% to the team and future team members with a three year vesting schedule
• 19.78% to early investors with a three year vesting schedule
• 6.62% to development grants and community building

Notional also completed an airdrop for all users who have borrowed, lent, or provided liquidity in any amount greater than 50 DAI/USDC as of July 4, 2021. 741 addresses were eligible for the reward of between 600 and 1,800 NOTE tokens.

A layer of complexity complemented by NOTE is how the cTokens are distributed to the underlying pools. NOTE holders dictate how to divide up liquidity provisions in order to manage end-user demand. Pools with later maturities tend to receive the lion’s share of liquidity due to their higher yields, and therefore receive higher demand.

Source: Notional Finance

While investing in NOTE differs from revenue-bearing tokens, investors still face risks derived from overall protocol performance. As a lending protocol, demand for the governance token may have a positive correlation with an increasing TVL, which acts as a proxy for activity on the platform. However, TVL is not as tied to token performance as say earnings is with a traditional public equity investment. Fixed-rate lending is attractive when a cooler market arises, but loses investors’ attention when better returns can be achieved elsewhere. Thus, in a market downturn, one should expect a flight to safety amongst crypto investors, leading to a higher TVL on Notional. Conversely, in a bull market, investors may rotate out of safer assets and into riskier alternatives.

The ability to vote on governance proposals of the Notional protocol is crucial in ultimately achieving complete decentralization - NOTE makes this possible. Furthermore, there is incentive to provide liquidity to gain NOTE and then vote on where liquidity should be allocated. This aligns incentives of an unknown number of third party actors, bringing Notional closer to full community control.

Looking into the Future

Notional Finance is a fascinating project that is continuing to gain traction in DeFi. Following the successful launch of V2, Notional plans to continue to build on top of the core principles of security, liquidity, and capital efficiency. It recently announced a partnership with Immunefi for bug bounties to sort out any outstanding issues with the protocol. Longer term, Notional looks to launch Antonio, a generalized layer-two implementation, sometime in Q2 2022.

Many projects in DeFi strive to achieve full decentralization and Notional is no different. The team plans to pursue a strategy to progressively decentralize over the next few years and completely relinquish control of the protocol, handing it over to the community. Notional is well on its way to achieving this goal as a vast majority of NOTE tokens are controlled by third parties, and not the founding team.

A Challenger Approaches…

Notional is unique from other fixed-rate lending protocols in that it allows users to both lend and borrow a variety of cryptoassets with flexible collateral requirements. There are however a few competitors that should be examined.

BarnBridge (SMART Yield):

BarnBridge offers users fixed or levered yield on their stablecoins through integrations with external lending markets. Their SMART Yield product allows investors exposure to senior or junior pools, with senior pools offering lower yield at a fixed rate, allowing users to mitigate the variable yield volatility of other lending protocols. The rate is determined by the underlying market rate, as well as the ratio between senior and junior positions. Junior token holders provide necessary liquidity for senior bond holders to receive a fixed yield, but risk comes in the form of a potential inability to meet senior debt obligations if variable rate annuities from the juniors fall. Seniors are the fixed-rate component of SMART Yield and generate extra yield for juniors when the variable rate of the underlying debt pool exceeds the weighted average guaranteed yields of current seniors.

Source: BarnBridge

Senior bonds are ERC-721 tokens (NFTs) called sBonds and are minted each time a user deposits into the pool. After the senior bonds reach a maturity date, the principal and gain (which represents fixed interest) can be redeemed by the holder and the NFT is burned. Interest rates for senior bonds are denoted as the annual percentage yield that is available for the next marginal senior bond to be minted, and fluctuates with a rolling average of the underlying interest rate. BarnBridge’s SMART Yield is a novel approach to creating fixed rates on the blockchain and differs from Notional in a few key areas:

1. Senior bonds on BarnBridge are ERC-721 tokens while Notional uses a combination of ERC-20 and ERC-1155 tokens to generate fixed yields.
2. BarnBridge offers tranches of both variable and fixed yields from the junior and senior bonds respectively. Meanwhile, Notional only allows for fixed-rate transactions.

Yield:

Yield has an offering similar to that of Notional with fixed rates generated through zero-coupon bond-like instruments called fyTokens (sound familiar?). It is fully integrated with the MakerDAO ecosystem and plans to fully enable collateralized fixed-rate borrowing and lending in DAI. Interest rates are determined in a fashion similar to that of Notional. However, as of the publication of this piece, Notional rates for the same maturities are considerably more attractive from a lending perspective than on Yield.

Source: Yield

Source: Notional Finance

Beyond the difference in lending rates, some other key differences between Yield and Notional include:

1. Notional’s implementation of ERC-1155 tokens for transferring fCash meaning fCash tokens of the same maturity can be interchangeable for one another.
2. Yield uses its own AMM called Yieldspace to manage slippage while Notional uses a proprietary algorithm consisting of logistic curves.
3. Yield only supports DAI while Notional currently supports DAI ,USDC, ETH, and WBTC.

88mph:

88mph acts as an intermediary between liquidity providers and lending protocols. Loans are shorter term with liquidity locked between seven days and one year. Capital is automatically deployed to the highest-yielding lending protocols at a given interval, thus creating a variable interest rate. 88mph tracks this rate and its exponential moving average (EMA) over a one month period, offering 75% of the EMA as a fixed rate to investors. The protocol is unique in that it does not directly provide yield itself, but instead plays the role of middle man between pools of capital and attractive interest rates. A few of the major differences between Notional and 88mph include:

1. Notional’s maturity dates range from three months to 20 years while 88mph is much shorter with maturity dates ranging between seven days and one year.
2. Notional directly provides yield to lenders from the borrowers on the opposite side of the platform. 88mph simply acts as a middleman, allocating user funds to the most attractive lending options available.
3. Notional is currently only available on Ethereum while 88mph can be accessed on any of Ethereum, Fantom, Avalanche, or Polygon (Matic).

Conclusion & Takeaways

Notional Finance is clearly just getting started and plans to grow its TVL and activity. It is currently the only fixed-rate protocol that allows both lending and borrowing in a variety of cryptocurrencies. On top of that, the interest rates are more attractive than any competitors, both inside and outside of DeFi. Fixed rates are a new concept in crypto, but have represented the fundamental foundation of the traditional financial system for centuries. As Notional continues to attract investors looking for a simple way to gain attractive yields on their cryptoassets, it may also attract the attention of TradFi investors looking to supplement their portfolios. In time, we will see if Notional can act as one more bridge between the ever converging worlds of DeFi and TradFi.

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