THORChain Lending: Revealing the Shadow of Terra LUNA

Author: Yilan, LD Capital

Introduction

In-depth exploration of the new lending module launched by Thorchain on August 22 reveals the shadow of Terra LUNA, with the similarity to LUNA primarily reflected in the fact that the collateral deposited by users is exchanged for RUNE. In reality, the fluctuations in the RUNE-collateral exchange rate determine the inflation and deflation of RUNE, meaning RUNE absorbs the volatility of the RUNE-collateral exchange rate through inflation and deflation, just as LUNA absorbed the volatility of UST.

However, the forms of expression (RUNE participates in lending, with destruction and minting occurring during loan opening and closing, while LUNA participates in stablecoin anchoring, with destruction and minting occurring through arbitrage when UST is unpegged) and the underlying risk dimensions (LUNA has unlimited minting, while RUNE has inflation and deflation limits, and only 50% of the collateral for synthetic assets is RUNE) differ. Additionally, the lending protocol has implemented strict risk control and risk isolation measures, therefore the overall risk is relatively small, and it will not generate systemic risks similar to Terra LUNA, even if a negative spiral occurs, it will not affect other functions of Thorchain.

I. Understanding Thorchain's Lending Mechanism

The characteristics of Thorchain's lending lie in the absence of interest, no liquidation risk, and no time limits (initially, the minimum loan term is 30 days), for users, it essentially involves shorting USD while holding collateral in BTC/ETH; for the protocol, it essentially involves shorting BTC/ETH while holding collateral in USD. Debt is denominated in TOR (the USD equivalent of Thornchain), so users are akin to purchasing an OTM call option on BTC with a gold standard.

Opening a new loan will have a deflationary effect on $RUNE assets, while closing a loan will have an inflationary effect on $RUNE assets. BTC collateral will first be exchanged for RUNE, then destroyed, and finally, RUNE will be minted to exchange for the required assets. In this process, the difference between the value of the collateral and the debt, minus fees, corresponds to the net destruction value of RUNE.

If the collateral appreciates at repayment, while the RUNE price remains unchanged, more RUNE needs to be minted to exchange for the required assets, leading to inflation; if the RUNE price rises, it is ideal not to mint as much RUNE; if the RUNE price falls, inflation will be more severe. If the collateral depreciates at repayment, with the RUNE price unchanged, the user may choose not to repay (resulting in no minting).

If the value of RUNE relative to $BTC remains unchanged during loan opening and closing, then $RUNE will not generate a net inflationary effect (the amount destroyed equals the amount minted minus exchange fees). However, if the value of the collateral relative to RUNE increases between loan opening and closing, then the supply of $RUNE will experience net inflation.

To address the inflation issue, lending control measures are in place—if minting causes total supply to exceed 5 million RUNE, there is a circuit breaker design. In this case, reserves will intervene to redeem loans (instead of further minting), and the entire lending design will stop and exit use, but other aspects of THORChain will continue to operate normally.

Thus, the entire lending process has a significant impact on the inflation and deflation of RUNE, but under the condition of a relatively low overall lending cap, both inflation and deflation are capped. When the RUNE-collateral exchange rate rises indefinitely, the maximum deflation is currently capped at the largest opening amount, which is 15 million * 0.33 (0.33 is the lending lever, might change), i.e., 4.95 million (which may increase in the future). In the case of an indefinite decline in the RUNE-collateral exchange rate, inflation is also controlled by the circuit breaker to remain below 5 million.

Specifically, if a user over-collateralizes 200% to borrow 50% of the required assets, the other 50% at redemption will be minted based on the RUNE-collateral exchange rate. This step is essentially similar to LUNA, but under the Thorchain Lending mechanism, since the portion backed by RUNE is only 50%, the product capacity is also smaller, thus the overall risk is relatively small, and it will not generate systemic risks similar to Terra LUNA. This risk is isolated, and even if a negative spiral occurs, it will not affect other functions of Thorchain.

1. How to understand the design of lending as a deep out-of-the-money, resettable strike price call option for users

When Alice provides 1 BTC, she also receives 50% cash (with a CR of 200%) and the opportunity to purchase 1 BTC with this cash.

If at repayment (assuming one month later) BTC has risen, Alice repays the debt (i.e., the equivalent of 50% of the BTC value from a month ago), spending the BTC price from a month ago to purchase this one BTC. If it drops significantly, exceeding 50%, Alice may choose not to repay, and the protocol will not generate minting of RUNE leading to inflation (for Alice, her long position fails).

2. How to understand the absence of borrowing interest

It can be seen as users paying multiple swap fees instead of an interest rate; it is essentially a CDP product. If borrowing interest were charged, the attractiveness of this product to users would be diminished.

The entire lending process is as follows:

Users deposit native asset collateral (BTC, ETH, BNB, ATOM, AVAX, LTC, BCH, DOGE). In the initial phase, collateral is limited to BTC and ETH. The amount of collateral each debt position can accept (debt position cap) is determined by a hard cap (15 million), lending lever, and pool depth coefficient. Over-collateralization generates debt, and the proportion of debt obtained is determined by CR.

Borrowing: Alice deposits 1 BTC, which will first be exchanged for RUNE in the BTC-RUNE swap pool. These RUNE enter a V BTC pool, where they are destroyed while being converted into a derivative asset Thor.BTC. The collateral for synthetic assets is constant product liquidity, always 50% of the asset, with the remaining 50% being RUNE. The derivative asset Thor.BTC is then sent to an internal module, where a dynamic CR (collateral ratio) determines how much loan can be obtained, and additionally generates Thor.Tor (similar to USD) tokens as a bookkeeping method for the loan. The steps that occur here are solely for internal accounting purposes, subsequently generating USDT loans for Alice to use.

Repaying the loan: When Alice repays, she sends all USDT or other Thorchain-supported assets to the protocol, which are converted to RUNE. RUNE will mint Tor, and the protocol checks whether the user has repaid all loans denominated in Tor. If fully repaid, the collateral will be released and converted to derived collateral (Thor.BTC), and then this derived asset will be re-minted into RUNE, which will then be swapped back to L1 BTC. RUNE is minted during this process.

It is important to note that these swap and convert processes incur fees (at least 4 swap fees for a single loan), so the total repayment amount needs to be slightly higher than the actual amount to cover these swap fees. Although there is no interest, the collection of these multiple fees can effectively be seen as a substitute for interest. Although the wear and tear are significant, the RUNE generated as fees is destroyed, which is a tangible form of deflation.

3. How to understand the absence of liquidation and no repayment time limits

Since the debt denominated in TOR stablecoins is fixed, borrowers can choose to repay with any asset, but in reality, they will all be exchanged for RUNE in the market. Liquidity providers and depositors do not directly lend their assets to borrowers. The pool merely serves as a medium for exchanging between collateral and debt, making the entire process a betting behavior, which is the reason for the absence of liquidation.

The protocol needs to use RUNE to repay enough TOR (for full repayment) to help users reclaim their collateral. If the price of the collateral drops significantly, users may choose not to repay (and the corresponding RUNE will not be re-minted, resulting in net destruction). In fact, the protocol does not wish for users to repay; if the price of the collateral rises while the price of RUNE falls, user repayment will lead to inflation.

4. How to understand the deflationary and inflationary role of RUNE as a trading medium

First, the total cap of all lending pools is determined by the RUNE Burnt portion in the gray area of the diagram multiplied by the lending lever, and the 15 million RUNE Burnt is the result of the protocol previously burning non-upgraded BEP2/ERC20 RUNE. Therefore, it can be seen that the protocol currently has a space of 15 million before reaching the maximum supply of 500 million RUNE.

The previous text also introduced the role of RUNE in the entire borrowing process (which can be reviewed in the mechanism section above). Opening a new loan will have a deflationary effect on RUNE assets, while closing a loan will have an inflationary effect on RUNE assets.

If the collateral appreciates at repayment, while the RUNE price remains unchanged, more RUNE needs to be minted to exchange for the required assets, leading to inflation; if the RUNE price rises, it is ideal not to mint as much RUNE; if the RUNE price falls, inflation will be more severe. If the collateral depreciates at repayment, with the RUNE price unchanged, the user may choose not to repay (resulting in no minting).

If the value of RUNE relative to BTC remains unchanged during loan opening and closing, then RUNE will not generate a net inflationary effect (the amount destroyed equals the amount minted minus exchange fees). However, if the value of the collateral relative to RUNE increases between loan opening and closing, then the supply of RUNE will experience net inflation.

To address the inflation issue, lending control measures are in place—if minting causes total supply to exceed 5 million RUNE, there is a circuit breaker design. In this case, reserves will intervene to redeem loans (instead of further minting), and the entire lending design will stop and exit use, but other aspects of THORChain will continue to operate normally.

If calculated with the parameters in the diagram, currently all debt position pools combined amount to only 4.95 million RUNE in total. That is, all debt positions can accept collateral equivalent to 4.95 million RUNE.

Source: GrassRoots Crypto

The total RUNE Burnt in the entire Reserve serves as the buffer for all debt positions and the last resort for inflation. The total amount of RUNE Burnt * Lending lever of 4.95 million (currently) will be allocated according to the depth of each debt position pool. The deeper the pool, the more reserve buffer allocated. For example, if the BTC Lending pool depth is twice that of the ETH Lending pool, then the value of RUNE Burnt * Lending lever * depth coefficient in the reserve is the maximum collateral cap that this lending pool can bear. Therefore, when the price of RUNE rises, the collateral that this pool can accommodate also increases. It can also be seen that the lending lever and the price of RUNE jointly determine the upper limit of collateral that the lending pool can accommodate.

The THORChain protocol and all RUNE holders are the counterparties for each loan. The RUNE destruction/minting mechanism means that RUNE condenses/dilutes during the opening and closing of debt (among all RUNE holders). When the RUNE-collateral exchange rate drops, inflation occurs, and conversely, deflation occurs.

5. Is the CDP protocol a good on-chain capital accumulation model?

For Thorchain's Lending, it is a form of capital accumulation that uses RUNE as an essential medium in the borrowing and repayment process, increasing the scenarios for destruction and minting.

So is this capital accumulation model advantageous? Let's first look at some other capital accumulation models in different sectors.

CEX is the most obvious beneficiary of capital accumulation models, as it also acts as a custodian, and in many cases, these funds can generate more returns (the requirement for reserves to be public has significantly reduced these returns). How to protect the safety of user custodial funds is also something that regulatory frameworks need to clarify, as regulators usually expect exchanges to have full reserves.

The situation on-chain is entirely different.

DEX requires high incentives for LPs after capital accumulation, so the purpose of capital accumulation is to deepen liquidity and cannot directly utilize the "deposits" provided by LPs to generate profits, but rather forms a liquidity moat through a large reserve.

Pure Lending, like Aave or Compound, incurs interest costs for capital accumulation, and the entire model is not much different from traditional lending, such as requiring active management of borrowing positions and having repayment time limits.

In contrast, the CDP model for capital accumulation is a healthier model. Due to the high volatility of collateral assets, most over-collateralized CDPs in the current market involve users over-collateralizing a certain asset to obtain stablecoins/other assets. In this process, the CDP protocol effectively gains more "deposits." Moreover, there is no need to pay interest on these deposits.

Thorchain also belongs to this CDP model, so where is the collateral held? In fact, the collateral is exchanged for RUNE through liquidity pools. Therefore, no one is "holding" the collateral. As long as the THORChain pools are healthy and operating normally, any deposited collateral will be exchanged for RUNE, and then arbitrageurs will rebalance the pools as usual. This can be seen as the collateral being settled in the RUNE pairs against other currencies in Thorchain. Because collateral like BTC has entered the circulating market rather than being held in the protocol, although the generated debt is 100% collateralized, the difference in value between the collateral and the debt is determined by the value of RUNE, thus casting a shadow similar to Terra LUNA over the entire mechanism.

Capital sink may be one of the goals Thorchain Lending aims to achieve, using users' collateral assets to settle as liquidity in the swap pool. As long as users do not close their loans and the price of RUNE does not drop significantly, the protocol retains assets, RUNE generates deflation, forming a positive cycle. Of course, the opposite could lead to a negative spiral.

6. Risks

Since collateral like BTC has entered the circulating market rather than being held in the protocol, although the generated debt is 100% collateralized, the difference in value between the collateral and the debt is determined by the value of RUNE, thus casting a shadow similar to Terra LUNA over the entire mechanism. Since the RUNE burned when opening loans and the RUNE minted when closing loans may not be equal, both deflationary and inflationary situations can arise. It can also be understood that if the price of RUNE rises at repayment, deflation occurs, and vice versa leads to inflation. If the price of RUNE falls below the price multiplied by the lending lever at the time of opening, the circuit breaker will be triggered. Throughout the lending process, the price of RUNE plays a decisive role in inflation and deflation. When the price of RUNE declines, a significant number of users choosing to close loans poses a high risk of inflation. However, the protocol has implemented strict risk control and risk isolation measures, so the overall risk is relatively small, and it will not generate systemic risks similar to Terra LUNA, even if a negative spiral occurs, it will not affect other functions of Thorchain.

The lending lever, CR, and whether to open different collateral debt positions are the three pillars of Thorchain lending's risk control.

Additionally, Thorchain has a history of being hacked, and its code is quite complex, so Thorchain Lending may also have vulnerabilities that need to be paused or fixed.

II. Conclusion

The launch of the Thorchain Lending product generates network synergy benefits, additional trading volume, and higher pool capital efficiency, driving the system to generate real profits and increasing the total bonded amount, allowing Thorchain to gain potential upside by reducing the total circulating amount (when the RUNE-collateral exchange rate rises).

Capital sink (accumulation may be one of the goals Thorchain Lending aims to achieve) uses users' collateral assets to settle as liquidity in the swap pool. As long as users do not close their loans and the price of RUNE does not drop significantly, the protocol retains assets, RUNE generates deflation, forming a positive cycle.

However, in fact, reverse market trends leading to inflation and negative spirals are entirely possible. To control risks, the use of Thorchain lending is limited, with a smaller capacity. Overall, inflation and deflation, given the currently capped volume, will not fundamentally impact the price of RUNE (at most a 5 million RUNE impact).

Moreover, for users, the capital efficiency of Thorchain is not high, with CR fluctuating between 200%-500%, ultimately likely floating between 300%-400%. From a pure leverage perspective, it is not the best product. Additionally, although there are no borrowing fees, the multiple internal transaction fees incurred are not user-friendly.

Evaluating only the Lending product does not represent the overall development of the Thorchain DeFi product matrix. There will be a series of analyses on other Thorchain products in the future.