Euler Finance: Servicing the Risk-On DeFi Market

Euler Finance is a truly permissionless lending protocol with an impressive line-up of features aimed at risk-on lending.

Euler is a non-custodial DeFi protocol built on Ethereum that allows users to lend and borrow a wide array of digital assets. Euler comes packed with a series of new features that enable truly permissionless borrowing and lending of long-tail crypto assets, potentially servicing an entirely unnoticed market sector in the DeFi space. 

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What Problem Does Euler Solve?

To understand why Euler is the subject of today’s blog post, we must understand the unique set of problems that Euler solves, and to do this we have to take a look at the landscape of lending protocols in the DeFi space.

As it stands today, DeFi is dominated by two widely-known decentralized lending protocols: Aave and Compound. As of this writing, they collectively rake in nearly 50% of the total market share, with Aave holding $6.89 billion in total value locked (TVL) and Compound holding $3 billion in TVL, according to DeFi Llama.

Compound and Aave both have a limited scope on their capability for lending and borrowing, because they both focus predominantly on less risky, “short-tail” assets. Neither of these protocols were designed for handling all of the risks that come with the higher volatility cryptocurrencies on the market.

Instead, these protocols choose to negate this risk by relying on a permissioned listing system where any new tokens that want to be listed for borrowing or lending must be approved through voting of their governance tokens.

While it’s obviously desirable for a decentralized lending protocol to err on the side of being risk-averse, and not load up on potential liquidity issues to serve a distant fringe of the market — it does leave a major, potentially quite profitable section of the lending market entirely unserviced.

Enter Euler Finance; a truly permissionless money market protocol that opens up lending and borrowing for risk-on digital assets that would never be listed on protocols like Aave or Compound. When using Euler, users can choose to list and make available for borrowing and lending any ETH liquidity pair on Uniswap V3. 

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How Does Euler Work?

According to the Euler Finance Whitepaper, Euler was specifically designed to handle the risk that comes with lending more volatile, risk-on cryptocurrency assets. Since launching in December 2021, Euler has expanded its protocol to support 74 different assets and currently holds $215 million in TVL.

While permissionless markets are a practical concept and they work to benefit the industry, it’s worth noting that they also come with a healthy dose of risk. This is why Euler introduced the following features to dampen these associated risks:

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1) Robust Asset Classification System

Euler’s first notable feature is its unique asset classification system that aims to mitigate the risk of “domino-effect” style liquidations that could spread debt-contagion across lending pools by classifying assets according to their risk profiles. Assets are divided into three main tiers: isolation-tier, cross-tier, and collateral-tier.
The assets classified as ‘isolation-tier’ can’t be used as collateral, nor can they be borrowed from the same account alongside any other assets. ‘Cross-tier; assets, which have a higher risk for being a potential loss, can’t be used for collateral, but they can be borrowed alongside other cross and collateral-tier assets. Finally, ‘collateral-tier’ assets are, you guessed it; are the only assets that can actually be used as collateral.
When an asset is initially listed on Euler, it is immediately classified as ‘isolation-tier’. The asset’s tier can be changed through a governance vote. Currently, there are 59 isolation-tier markets, 11 cross-tier markets, and 7 collateral-tier markets.

By isolating the riskiest assets and restricting their use as collateral in lending, Euler can allow permissionless listing and safely facilitate money markets without endangering the entire protocol. Other lending protocols such as Aave and Compound can’t do this because a potential liquidation deluge in one market could potentially spill over into another and jeopardize the entire protocol’s debt-rating. Their listing requirements are therefore stricter and more centralized.

Another feature that Euler uses to minimize downside risk is harnessing Uniswap V3’s Time Weighted Average Price (TWAP) oracle solution. This means that Euler uses a decentralized oracle to source its price feeds instead of relying on centralized oracle providers like Chainlink.
The benefits of this are two-fold, namely Uniswap’s TWAP is on-chain, which means that no centralized authority needs to intervene when a new market is created on Euler. Second, trying to exploit the TWAP oracle is highly capital-intensive for potential hackers, which means that the protocol is far more resistant to price manipulation exploits than any of the other, more-centralized alternatives.

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2) Risk-Adjusted Borrowing Capacity

Beyond simply identifying which assets are the riskiest and automatically classifying them, Euler attacks liquidations with a dual-pronged approach that also assesses the risk profile of borrowed assets or liabilities. This mitigates the inherent risks associated with the permissionless borrowing and lending of risk-on digital assets. 

The major issues with other decentralized money markets is that lenders really struggle to verify whether or not borrowers are legitimately creditworthy, one of the main reasons why borrowing in DeFi leans towards being overcollateralized.
The main lending protocols like Aave generally rely on metrics known as “collateral factors” that determine the amount users can borrow based on the risk profile of their collateral assets. When the loan-to-value ratio drops below a certain threshold, and starts approaching a point where it becomes insufficient to cover the borrowed amount, the position is marked for liquidation.

While this may work really well for the more stable assets, Euler has introduced a system that weighs “borrowing factors” alongside collateral factors to reduce the chance of unnecessary liquidations, allowing users to safely borrow and lend risk-on assets.

Even if a borrower is liquidated — where “traditional” DeFi lending protocols offer a fixed percentage of the borrower's collateral for liquidations —  Euler runs “Dutch auction” liquidations which offer more reactive responses to borrower-side liquidations. 

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Euler’s Small But Powerful Innovations

In addition to these core features, Euler also brings a smaller subset of innovations to the table that make the lending protocol a legitimate, long-term provider for risk-on lending. These smaller features include protected collateral, deferred liquidity checks, fee-less flash loans as well as its own, in-house transaction builder.

By offering deferred liquidity checks, Euler allows its users to execute a range of transactions across complex positions without being constrained by rigid collateral conditions. Where the other permissioned lending protocols check an account’s liquidity at the beginning of operations, Euler users can ensure the protocol checks at the end of the operation. 

Deferred liquidity checks have the benefit of allowing users to execute fee-free loans, which in turn allows experienced traders to continually build up leveraged positions and take advantage of arbitrage opportunities across the DeFi space, all while executing complex trades. 

In a final show of efficiency and user-focused development, Euler offers its own, in-house transaction builder, that allows its users to batch transactions and submit them all at once. This means that users aren’t hit with enormous gas fees when they execute high volumes of transactions. The transaction builder also simplifies the user-side process of taking on additional leverage. 

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Conclusions & Predictions

In a market dominated by conservative lending protocols that shy away from long-tail assets due to valid fears of debt-contagion, Euler has developed a robust system of risk-hedges that positions it well to service an underserved market sector.

Through truly permissionless lending, combined with its sober risk-assessment strategies, Euler stands out as a frontrunner of next-generation, decentralized lending protocols in the DeFi space. Euler’s current early-usage data also shows strong signs of growing organic demand for such this product, even in the midst of DeFi’s year long downturn.

Ultimately, Euler isn’t what you would call a “superior” product to lending protocols like Aave and Compound. It’s a fundamentally different protocol that fills a gap in the lending market that other protocols seem to have missed or avoided. With that being said, Euler’s automated & permissionless, risk analysis technology is an impressive and expedient innovation in the new wave of DeFi projects. 

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Buy / No Buy Recommendation

If you think that Euler has sufficiently managed its risk and can sustainably service a major section of the digital asset market: buy.

If you think that Euler isn’t glossing over risks or that the long-tail market won’t ever see wide margins, skip it.