Exploration of the Essence of DeFi: Analyzing the Design Concept of Collateral Operators

This article was published on the NEST public account, authored by Banach

1. From Linear Operators to Nonlinear Operators

Continuing from the last time (Lecture One), linear operators have their value, but they cannot yield a decentralized asset, meaning they cannot be securitized. Nonlinear operators possess self-enhancing properties (the larger the scale, the higher the value), and if this property is represented by tokens, it holds certain value, while linear operators cannot correspond to such tokens. We are committed to generating a new native asset based on an operator, rather than merely completing value transfer. To enable the securitization of linear operators, we have attempted to construct a compression mechanism, but the results have certain flaws: making linear operators gamified logically presents contradictions. Gamification requires that the larger the scale, the greater the value, but only a nonlinear structure can form barriers; otherwise, the choice of scale is indifferent. The essence of linearity is precisely to make it indifferent, so it cannot be deliberately gamified; otherwise, the result will resemble Fcoin.

2. The Scale Advantage of Compound Comes from the Nonlinearity of Collateral Operators

Linearity does not refer to whether the interest rate curve is linear or nonlinear, but rather that under equilibrium interest rates, the scale of borrowing does not affect the borrowing rate. Compound actually uses price oracles during collateralization, while the actual borrowing process requires interest rates; without equilibrium interest rates, the nonlinear operator determines the borrowing process through interest rate algorithms. The formula of Compound is nonlinear; the larger the scale, the higher/lower the interest rate, while the linear equilibrium interest rate is unrelated to scale. If it were purely linear, there would need to be an interest rate oracle. With both interest rate and price oracles, the entire borrowing process becomes linear. Assuming trading 10 ETH and 100 ETH is at a given price, this represents that the price has reached equilibrium. The nonlinear operator links price and scale.

3. MakerDAO Can Capture Value Because of Stability Fees

If we disregard liquidation risk, MKR can still capture some value without stability fees, as this value lies in the consensus around DAI (i.e., forming a liquidity premium). However, if the market is complete, meaning we do not consider so-called psychological dependencies, then MKR cannot capture value. The network effect of stablecoins is determined by use value, or other factors such as contract locking or the update costs when using stablecoins, but the intrinsic value is the same for both DAI 1 (single collateral DAI) and DAI 2 (multi-collateral DAI). If we consider liquidation risk, it becomes possible to capture value, which is the significance of insurance funds in parallel assets. The larger the insurance fund, the larger the scale, because it is related to stability fees, which do not have oracles. Use value is determined by protocol update costs; if the protocol updates automatically, using either DAI 1 or DAI 2 protocols would be the same, making these two contracts equivalent (disregarding liquidation risk). Stablecoins only have the lowest update costs for the entire network due to the difficulty of detecting contracts; conversely, if everyone executes the same development paradigm or structure, there may be no update costs. Writing a generic factory contract that generates DAI 1 and DAI 2 would eliminate update costs, making the development paradigm more open; as long as the collateral is the same, the output will also be the same. If we disregard liquidation risk and change the development paradigm, MKR becomes a simple collateral operator with no value.

4. Collateral Operators + Insurance Funds for Parallel Assets

Native assets are the foundational securities formed by decentralization on-chain, such as NEST and CoFi. Parallel assets do not require tokens to close the loop, hence they do not issue coins. Compound and Maker do not use oracles; essentially, their collateral assets are also a type of foundational security, but they are neither decentralized assets nor native assets, effectively introducing credit on-chain. Borrowing and stablecoins rely on insurance to guarantee value, rather than forming a game through nonlinear interest rate oracles. Interest rates should ideally be determined through trading pricing and require frequent large transactions, but since interest rate fluctuations are not that significant, many times they are simply set artificially or through simple algorithms: for example, the price of government bonds is determined through trading, while real estate interest rates may remain unchanged for a long time. The interest rate market is still too early, so currently, there are not many issues with something like Compound, because arbitrage is too difficult.

Currently, the demand for collateralized lending on-chain is not sufficient to generate pricing demand. I believe fixed interest rates are the insurance funds for parallel assets; all collateral operators must work in conjunction with insurance funds to form a complete loop, which is an improvement of parallel assets over Maker.

5. Collateral Operators from a Risk Perspective

Due to decentralization, involving both collateralization and liquidation processes, the collateral rate and liquidation line constitute the two core risks of the collateral operator: operational risk and liquidation risk. Operational risk refers to the duration until liquidation is triggered, while liquidation risk refers to whether assets can be liquidated at or above the collateral rate. Here we assume that price trends are generally effective in the long term, although there may be jumps in the short term, causing liquidation to not necessarily be completed; triggering operational risk occurs when the price reaches the liquidation line.

Time and Interest Rates

Assuming a person collateralizes a loan with a given interest rate of r, but once operational risk occurs, they receive interest income from the start of the loan until the operational risk time, after which they can only receive risk-free returns; if the risk-free return is 0, then under the given r, different collateral rates will yield different returns for the lender, which is the risk structure of the collateral operator, roughly represented by this graph (above), which is also a unique term structure.

Next, let's discuss liquidation risk. Whether collateral can be quickly traded during a liquidation period is influenced by 1) volatility, 2) asset liquidity, and 3) liquidation scale. Therefore, ideally, K and C should be dynamic, following volatility; however, once dynamic, it may affect user experience in product design: users may not remember the liquidation line due to potentially significant volatility changes. Thus, K and C should be designed to maintain a fixed ratio, such as differing by 10-20%. Liquidation may succeed or fail, leading to what is known as under-collateralization, or it may fail due to the overall liquidation scale being too large. Hence, insurance funds exist to address liquidation risk.

6. From Interest Rate Operators to Insurance Fund Operators

A portion of the stability fee is determined by the collateral rate, and another portion by the total collateral ratio; of course, volatility can also be considered (ideally for K and C), that is, the ratio of total ETH collateral to total circulation. Thus, insurance funds can achieve extremely high interest rates based on scale, naturally balancing this, still utilizing the nonlinear operator of interest rates. If oracles are used, then insurance funds do not care about the pool (the size of the pool does not make any difference in forming parallel assets and cannot solidify assets); without interest rate oracles, scale effects will form.

In fact, these interest rate operators are all operators of insurance funds. Pure interest rate operators (such as how to determine interest rates during lending) differ from insurance fund operators; insurance funds cannot hedge and bear the risk of market incompleteness, which may lead to losses. Whether Compound or Maker, to form self-enhancement, insurance funds are necessary; otherwise, the entire process becomes a mess, with collateral providers mutually bearing each other's liquidation risks without sufficient return compensation. Insurance funds are very clear.

7. DeFi is a Combination of Fundamental Operators

Trading operators, collateral operators, trigger operators (the specificity of smart contracts), random operators, recursive operators, insurance operators, interest rate oracles—DeFi is a combination of these fundamental operators. NEST has also been a completely original software engineering design in China over the years, from the internet to blockchain.