Interpretation of the Lending Agreement Euler: How to Achieve Permissionless Listing and Optimize Liquidation

Written by: Karen, Chain News

On August 25, the permissionless lending protocol Euler completed an $8 million Series A funding round led by Paradigm, with participation from Lemniscap and individual investors including Anthony Sassano, founder of The Daily Gwei, Ryan Sean Adams and David Hoffman, founders of Bankless, Kain Warwick, founder of Synthetix, and Hasu, host of the Uncommon Core podcast.

Euler has not yet launched; what advantages does it have to attract capital? The following characteristics make Euler stand out compared to most existing collateralized protocols:

**1. Assets with WETH pairs on Uniswap V3 can be added to the lending market and categorized into three tiers: isolated layer assets, cross-layer assets, and collateral layer assets, with the last category usable as collateral;

2. The volatility factors of the borrower's liability asset prices are also considered, customizing the liquidation threshold based on collateralization and borrowing rates;
3. A Dutch auction and a discount acceleration mechanism for liquidity providers are used to limit the use of MEV (Maximum Extractable Value) during liquidation;
4. Adopting Liquity's multi-collateral stable pool to replace collateral auctions.**

Next, Chain News will take you through Euler's operational model, innovations, and differentiating features compared to other competitors.

Background of the Euler Team

Euler is a permissionless lending protocol founded by Oxford University researcher Michael Bentley, with the development company being Euler XYZ. In addition to this month's $8 million funding, it previously secured $800,000 in seed funding led by Lemniscap at the end of last year, with other participants including LAUNCHub Ventures, CMT Digital, Divergence Ventures, Block0, and Cluster, as well as angel investors like Luke Youngblood from Coinbase, Richard Burton from the DeFi space, and Josh Buckley, CEO of the product information site Product Hunt.

Additionally, two co-founders, Doug Hoyte and Jack Prior, also serve as developers. Jack Prior has previously worked as a developer at Salary Finance and Fintricity, while advisor Mick de Graaf is the chief developer of the on-chain index fund PieDAO.

Euler's Operational Model and Innovations

Among the existing lending protocols, most protect users from the risks of low liquidity or long-tail assets through a permissioned listing mechanism, while issues such as low capital efficiency remain major bottlenecks in the lending sector. Euler primarily helps users earn interest and hedge in the lending market through a permissionless mechanism, with the biggest advantage being the permissionless listing mechanism.

Specifically, when lenders deposit liquidity into the Euler pool, they receive interest-bearing ERC20 eTokens (similar to Compound's collateral certificates cTokens). As long as there are unborrowed tokens in the pool, they can redeem their share of the underlying assets at any time. Borrowers can withdraw liquidity from the fund pool when needed and must return the funds with interest.

For borrowers, Euler introduces a yield-bearing token dToken for tokenized debt, minted when borrowing funds and burned upon repayment. The accrued interest is determined by an algorithmically set interest rate for each asset.

Furthermore, Euler relies on Uniswap V3's decentralized time-weighted average price (TWAP) oracle to assess users' creditworthiness, with WETH as the reference asset. If a borrower's risk-adjusted liability value exceeds the collateral value, liquidation may occur.

Currently, Euler has completed smart contract audits conducted by Solidified, ZK Labs, and blockchain security firm Halborn, with no critical vulnerabilities found. Next, we will explore Euler's features and innovations.

Permissionless Listing Mechanism

The Euler lending market will primarily rely on assets with WETH trading pairs on Uniswap V3, categorizing these assets into three tiers: isolated layer, cross-layer, and collateral layer, each with different risks and returns.

Isolated layer assets: Used for general lending but cannot be used as collateral. Additionally, borrowing different assets requires using different accounts on Euler.

Cross-layer assets: Usable for general lending but also cannot be used as collateral; however, multiple cross-layer assets can be borrowed using one account.

Collateral layer assets: Usable for general lending and cross-borrowing, and can also be used as collateral. Cross-borrowing refers to users pledging assets in one account to borrow multiple collateral layer assets.

Of course, collateral layer assets have the highest capital efficiency, allowing both lenders and borrowers to flexibly utilize their assets in the lending market, but they also face greater liquidation risks. Additionally, EUL holders can upgrade isolated layer assets to cross-layer or collateral layer assets through governance.

Optimized Liquidation Mechanism

In terms of liquidation, Euler considers the value of the borrower's liability assets, customizing the liquidation threshold by combining collateralization and borrowing rates. It also utilizes Dutch auctions and discount acceleration mechanisms for liquidity providers to limit MEV during liquidation. Furthermore, it has established multi-collateral stable pools for liquidators to conduct low-cost liquidations directly.

Customizing Liquidation Thresholds by Combining Collateralization and Borrowing Rates

Like similar lending protocols, Euler requires users to ensure that the value of their collateral is always higher than their liability value, i.e., over-collateralization, excluding the period when liquidity checks are delayed. Regarding how to achieve over-collateralization, Compound determines the borrowing ratio based on collateralization limits, but this method only adjusts for risks related to the decline in the value of the borrower's collateral assets, without considering the growth factors of the borrower's liability asset prices.

In light of this, Euler considers both the risks of collateral asset depreciation and the appreciation of the borrower's liability asset prices. While introducing collateralization rates, it also introduces borrowing rates (borrow factor), with each borrower's liquidation threshold tailored to their specific risk conditions related to the assets they borrow and use as collateral. This means that when a borrower's risk-adjusted liability value exceeds the collateral value, liquidation may occur.

Anti-MEV Liquidation

Another notable feature of Euler is its anti-MEV liquidation mechanism, which uses Dutch auctions and discount acceleration mechanisms for liquidity providers to limit MEV extraction during liquidation. In Compound and Aave, liquidation incentivizes liquidators by offering the borrower's collateral at a fixed percentage discount, but this approach has the issue that potential liquidators can only compete for liquidation opportunities through priority gas auctions (PGA), which is unfriendly to large borrowers and fails to incentivize small liquidations.

To address this issue, Euler allows the discount that liquidators can obtain to increase as the difference between the borrower's risk-adjusted liability value and collateral value increases after the borrower reaches the liquidation threshold. Additionally, Euler will provide liquidity providers with a discount booster mechanism, enabling them to profit in Dutch auctions before miners and frontrunners (without boosters).

Using Internal Multi-Collateral Stable Pools for Liquidation

Euler draws on the stable pool model pioneered by the Liquity protocol and expands it into a multi-collateral stable pool format, allowing lenders to support liquidations by providing liquidity to the stable pools of each loan market.

Liquidity providers in the stable pool earn liquidation collateral rewards by depositing eTokens. When a liquidation occurs, liquidators use liquidity from the stable pool to repay the borrower's debt and proportionally reward the stable pool with the obtained liquidation collateral shares. This means that lenders can ultimately passively exchange their tokens for liquidation collateral assets during the liquidation process.

The advantage of this mechanism is that when a borrower reaches the liquidation threshold, liquidators can immediately liquidate using internal liquidity sources without needing to exchange assets from third-party exchanges, significantly reducing transaction costs.

Additionally, Euler's interest rate model is similar to the dynamic interest rate model designed by the Delphi Digital team. When utilization exceeds (or falls below) target utilization levels, a PID controller amplifies (or suppresses) the rate of change of interest rates, producing responsive interest rates that adapt in real-time to the underlying asset market conditions, thereby effectively improving capital efficiency. Furthermore, according to Euler's official documentation, platform interest rates are calculated with compound interest on a second-by-second basis.

Summary

In summary, Euler considers the needs of both lenders and borrowers, as well as liquidators, to meet different roles through a permissionless listing mechanism, optimized liquidation mechanisms, and dynamic interest rate models, while replacing collateral auctions with multi-collateral stable pools, allowing lenders to ultimately passively exchange their tokens for liquidation collateral assets.

Euler's multiple innovations and its operational model, which borrows and optimizes from other lending protocols, may significantly enhance capital efficiency while opening new perspectives in the lending sector. However, the low liquidity of long-tail assets with WETH pairs on Uniswap and the feasibility of the Euler mechanism are also worth noting. Additionally, Euler will issue a governance token EUL, which can be used to vote on parameters such as asset tiers, collateralization rates, and borrowing rates.