BarnBridge: Risk-Adjusted Exposure to Decentralized Finance
[Freelance Project]
Intro
Cryptocurrencies surged to relevance in the wake of the monetary and fiscal responses to COVID-19. While traditional financial circles began considering Bitcoin’s role as an inflation hedge, another subset of blockchain-enabled applications also found product-market fit. Referred to as “DeFi,” short for decentralized finance, this subset of cryptocurrencies relies on smart contracts to pool capital and execute financial logic. To date, over $75 billion in assets have accumulated in these applications, drawn in primarily by a) higher baseline interest rates available in crypto-native money markets, and b) return profiles that resemble elements of both venture capital and private debt markets.
Largely built on top of the Ethereum blockchain network, DeFi applications now run the gamut from lending services to peer-to-peer exchange to derivatives - all without the need for a coordinating bank entity. The only prerequisite for accessing any of these applications – like market leaders Uniswap and AAVE – is an internet connection and an Ethereum wallet.
While the appeal of double digit lending yields and composable modularity across applications is undeniable, significant caveats remain. Fraud runs rampant and even the most successful applications experience stomach-churning volatility, both among their deposits and their own affiliated assets. More fundamentally, we have yet to see industry standards emerge for rating the technical and economic risks associated with a given smart contract. Survivors of this wild west have been rewarded handsomely, but, for DeFi to become “Fi,” we will need active efforts to bridge the gap between cryptocurrencies and the legacy financial system.
BarnBridge is one such effort. Built on Ethereum, it is a risk tokenization protocol; that is, BarnBridge allows users to access the yields of other supported DeFi applications but with varying degrees of risk exposure. Its first application, SMART Yield, allows for users to mitigate interest rate volatility on dollar-backed cryptocurrencies like USDC or USDT. Two future applications, SMART Exposure and SMART Alpha, will allow users to mitigate portfolio concentration and asset price risk respectively. The underlying insight powering these solutions is that blockchains allow for the tokenization of structured products, encapsulating their financial logic – once reserved for bespoke client offerings – in liquid wrappers. BarnBridge can thus provide a risk-adjusted onramp to DeFi for newcomer individuals and financial entities in spite of the fog of war that lingers over the sector.
This paper will provide a basic overview of the DeFi ecosystem today and a deeper explanation of BarnBridge. It is intended to serve educational purposes and should not be taken as financial advice.
DeFi: How Did We Get Here, and Where is Here?
DeFi is made possible by Ethereum. Launched in 2014, the Ethereum blockchain network allows for users to deploy executable code (known as “smart contracts”) to its shared storage that can then be verified and used by others. It is the shared system that powers and connects all DeFi and other cryptocurrency applications. If Ethereum is the internet, then smart contracts are the websites.
Its developer community has codified a number of important standards that allow for composability between smart contracts, unlocking network effects as applications build upon one another. While certain aspects of Ethereum make it ill-suited for retail internet applications (e.g. congestion fee pricing, low throughput, long block times), it offers rapid settlement on financial activities relative to traditional banking solutions. Its suitability for capital formation has played an irreplicable role in the growth of cryptocurrency as an asset class.
The term DeFi was first coined in August of 2018 as the earliest such applications emerged, primarily for peer-to-peer exchange and lending. The ongoing bear market at the time allowed for quiet development through 2019, culminating in Compound Finance’s June 2020 decision to introduce subsidies, denominated in its self-issued governance token, for users borrowing and lending on its platform. This practice was termed “liquidity mining” and quickly became standard across similar applications. It precipitated a flood of liquidity into the vertical: total value locked (“TVL”) in DeFi has grown from $1 billion on May 31st, 2020 to $62 billion on April 15th, 2021.
While a variety of DeFi use cases have gained traction, all rely on the following design principles:
Pooled Capital: Ethereum smart contracts can take custody of users’ assets while keeping track of who has a claim on what. This allows for the seamless aggregation of user assets with no friction from scaling (so the marginal cost for every additional deposit into the smart contract is zero).
Composability: Common standards allow for smart contracts to plug into each other, similar to how APIs have come to dominate Web2.0 architecture. The two most common are ERC-20, which provides a one-size-fits-all solution for issuing tokens with a given supply on top of Ethereum, and ERC-721, the standard for non-fungible (i.e., 1-of-1) tokens. In addition to these standards, common open source libraries for smart contract development have grown battle tested over time, increasing the learnings and inter-functionality of coins since these libraries creations.
Programmed Logic: Tying it all together, smart contracts capable of custodial work (pooled capital) and interfacing with one another (composability) should, critically, also be able to execute their intended function(s). For a lending contract, this might mean determining an interest rate based on how much asset supply exists versus how much of that supply is lent out. Importantly, once a smart contract has been deployed, its code cannot be changed - once a user has confirmed there are no backdoors or known vulnerabilities, they can be certain of what processes the contract will carry out.
These three principles are the foundation of an ecosystem of “money robots” that are modular in nature. Together, these robots (protocols) provide many of the financial services found in traditional finance.
To get a better sense for what is meant by financial services, consider some of the following applications:
Uniswap | Exchange: Uniswap facilitates peer-to-peer exchange of Ethereum-based cryptocurrencies. It relies on two primary actors, liquidity providers and traders. Liquidity providers deposit two assets into the Uniswap smart contract in exchange for a proportional share of the 0.3% transaction fee levied on all trades involving those two assets. As traders interact with this pairing, the Uniswap smart contract is actively routing liquidity and updating quoted prices. This method gets around the latency issues that make running traditional order book market making impractical on Ethereum. While relatively capital inefficient, this “automated market maker” (AMM) design has unlocked liquidity for a long tail of assets and growing interconnectedness between DeFi applications stands to introduce yield-bearing opportunities for excess liquidity going forward.
Compound / AAVE | Lending: Both Compound and AAVE serve as money markets where users can deposit supported assets as collateral for secured loans. Different assets have different collateralization factors (i.e., what percentage of the a deposit can count toward the user’s credit line) and interest rates are determined variably as supply and demand for each supported asset fluctuate. Neither AAVE nor Compound require users to provide credit scoring: margin calls are enforced via open auctions that occur as a user’s collateral value falls below the value of their borrowed assets. As these processes are coordinated via smart contracts, any Ethereum user can audit any loan issued and verify the solvency of either platform.
Yearn Finance (YFI) | Asset Management: All actions taken on the Ethereum network are charged a variable congestion fee (called “gas”). These fees are determined by the complexity of the smart contract executing the action, rather than the value being transacted, meaning that it would cost the same to deposit $10,000,000 into any of these applications as it would $1. Thus, economies of scale emerge when one is able to aggregate assets and automated strategies across different smart contracts. YFI is the leading such aggregator, providing users automated yield-bearing strategies for depositing coins while minimizing the relative cost of gas fees.
Smart contracts provide the modular functionality necessary for Ethereum applications to provide composable financial services. But where does value accrue in such a system? The communities behind these applications can issue cryptocurrencies that confer governance rights, as well as rights to cash flows generated by the applications. Distribution of such “governance tokens” plays a significant role in the outsized yields found throughout DeFi, as the secondary markets for token subsidies provided to users can reflect venture capital-style return profiles. Users are rewarded these governance token subsidies for providing services deemed valuable for the application, such as providing liquidity, driving volume, or participating in community votes. As more skeptical readers will be sure to have questions regarding this final element, caveats regarding today’s norms in DeFi will be addressed later in this paper.
BarnBridge: A Measured Means of Entering DeFi
For the many who do not consider themselves crypto-native, volatility – and their inability to tame it – remains a significant barrier to entry. What they need is a layer of applications built on top of existing smart contracts that provide the ability to calibrate their cryptocurrency investment with their non-cryptocurrency risk profile. Whereas the existing smart contracts for DeFi applications provide raw functionality, such auxiliary protocols can offer the alpha necessary for mainstream adoption.
At a high level, BarnBridge achieves this by aggregating user funds, depositing them into an underlying market, and disproportionately distributing the outcome to risk tranches. Users enter either as “seniors” or “juniors” depending on their risk appetite, with seniors receiving a fixed rate in exchange for reduced performance and juniors receiving a variable rate. Because the seniors are only eligible for yields or asset performance up to a certain threshold, outperformance beyond that threshold entitles juniors to additional returns, compensating them for the risk they take on should the underlying market underperform. These derivative positions themselves are codified as tokens like any other Ethereum-based cryptocurrency would be, meaning they can freely trade in any secondary market unlike traditional structured products offered by investment banks.
BarnBridge will initially have two applications capable of implementing such logic: SMART Yield and SMART Alpha. SMART Yield launched in March 2021 and allows users to mitigate interest rate risk in money markets like Compound and AAVE; SMART Alpha is slated for an end of Q2 launch and will allow users to mitigate asset price volatility with prioritized returns and secured principals.
SMART Yield
The following is an example of how SMART Yield functions in practice:
User Determines Which Originator Market to Enter: BarnBridge offers users the ability to enter into dollar money markets hosted on Compound and AAVE where their deposits are then lent out by the underlying smart contracts. BarnBridge supports both dollar-backed “stablecoins” (e.g. USDC, USDT) and dollar-pegged cryptocurrencies (e.g. DAI, sUSD). Different stablecoins on different money markets have different supply and demand curves and thus exhibit heterogeneity among their interest rates.
User Determines Whether to Enter the Junior or Senior Side: As the user deposits, they’ll see what the originator’s current annualized variable yield is; the highest possible senior fixed rate that could be minted given current market conditions; and the variable annualized rate juniors are earning at that moment. The creation of new seniors is limited by existing junior liquidity, meaning that the greater the proportion of juniors over seniors, the larger a principal can enter into a fixed rate senior close to the current market rate.
BarnBridge Smart Contracts Deposit Funds into Originator Markets: BarnBridge smart contracts know where to deposit users’ assets, the exact amount necessary to cover senior holders’ principals and fixed yields, and the percentage penalty juniors need to pay for exiting their positions prior to the average maturity date of all outstanding seniors. With these guardrails in place, senior holders can be assured that they will receive their fixed interest payment upon maturity, even if underlying rates were to collapse or mass redemptions occurred on the junior side.
User Assets Accrue Money Market Yields in Real-Time: DeFi applications allow for interest rates to accrue and compound on a per-block basis; with Ethereum, these updates occur on average every 13 seconds. During periods where the originator market’s annualized rate comes out higher than the weighted-average fixed rate of outstanding seniors, the excess yield is distributed to junior holders. Conversely, when the annualized originator rate comes in lower, a commensurate portion of the yield being earned by the juniors is allocated to the seniors.
Juniors Holders are Subsidized for Their Risk-Taking: Every junior holder’s position is represented by fungible tokens indicating their association with the originator market. For example, Compound’s USDC market is designated by the derivative cUSDC token; the token indicating a junior deposit through BarnBridge into it is designated as bb_cUSDC. Because this token is tangible on Ethereum, it can be further deposited into any other ERC-20 standard-compatible smart contract. All of this is to say, it is possible to verify who has deposited into the juniors and to incentivize such positive behavior. The BarnBridge community currently provides a BOND token-denominated subsidy to junior holders, similar to how early startups award early adopters. The value of the BOND token is completely determined by supply and demand on secondary markets.
Users Redeem Their Principals and Accrued Yields: The redemption processes for juniors and seniors differ significantly. Seniors can be redeemed for their principal and quoted yield upon the maturity date, or at any point thereafter (the principal earns yield for all other depositors until redeemed). Juniors can be redeemed for their principal and earned yield at any point, but must pay a redemption fee depending on how far out the average maturity date for all outstanding seniors is, and the current disparity between junior and senior capitalizations. It does not matter whether the redeeming user was the one who minted either the senior or junior in the first place, allowing for secondary markets to form for both.
With this process flow in place, a natural see-saw phenomenon plays out. Juniors are initially attracted to enter a given originator market due to levered yields in a mature state of the system, and by BOND subsidies in earlier days. Their growth outpaces that of the less liquid, lower yielding seniors, but eventually there will come a point where the liquidity provided by juniors and a contemporary spike in market rates will attract users looking to lock in an attractive fixed rate. This injection of senior capital effectively raises the floor of how many juniors could be supported by the system sans subsidies. What is compelling about this model is that it does not force either camp to alter their risk profile: the risk-averse users are subsidized by the risk-on ones, and their interaction unlocks a natural flywheel for capital accumulation through BarnBridge.
SMART Exposure and SMART Alpha
In the coming months, the BarnBridge core team will be releasing the smart contracts for two additional applications: SMART Exposure and SMART Alpha. SMART Exposure will focus on addressing concentration risk by allowing users to tokenize a self-executing portfolio strategy that maintains a specific ratio between two Ethereum-based assets. For example, consider a user looking to maintain 80:20 exposure to Ether and USDC; depositing into SMART Exposure would provide them with a liquid token that grants them with proportional withdrawal rights to an automated pool of assets buying into and selling Ether for USDC to maintain the ratio as its price fluctuates. This application does not require a junior-senior structure.
SMART Alpha will require a junior-senior structure to provide users with asset price risk mitigation. Whereas SMART Yield users enter into existing DeFi markets, SMART Alpha users contribute a given asset to a BarnBridge-hosted pool. Senior users receive a claim on a bounded range of dollar-denominated value determined by the size of their principal relative to existing junior user liquidity. This allows senior users to sell the theoretically-unlimited upside of a given asset to junior users in exchange for downside protection on their principal. While juniors are the first to take losses in the case of underlying asset price downturn, this structure provides them collectively with a levered upside position once the price surpasses the average upper bound of all existing senior positions. Because of the composability of BarnBridge-issued tokens, such junior positions could be coupled with negatively-correlated assets in SMART Exposure pools to mitigate their overall downside risk. Moreover, senior positions of popular assets like Ether can further serve as collateral for debt issuance throughout the wider DeFi ecosystem.
The BarnBridge DAO and the BOND Token
BarnBridge exists entirely on top of the Ethereum network - it has no association with any incorporated entity or nonprofit organization. Instead, it is governed by what is referred to as a Digital Autonomous Organization, a co-op coordinated by holders of the BOND token. DAO members are able to vote on what smart contracts are to be deployed, as well as how fees generated by BarnBridge applications are to be allocated.
The following is a timeline of how the DAO came to be, how the SMART Yield application was launched, and what the DAO has voted on to date:
September 2020: BBDAO Seeded for Core Team Development
Co-Founders Tyler Ward and Troy Murray raised $1,000,000 in private seed funding that was deposited into a multi-signature wallet on Ethereum to fund the core team’s runway.
Spending of these funds was coordinated by the Launch DAO, a miniature governance implementation that allowed for oversight of expenditures.
October 2020: BOND Token Distribution Period Begun
From the end of October through the beginning of April, 32,000 BOND tokens were distributed weekly through a “proof of capital” smart contract; users who deposited dollar-backed/-pegged cryptocurrencies into the smart contract were rewarded for the opportunity cost of doing so, despite their deposits sitting otherwise inert.
A secondary market for BOND tokens was incentivized by awarding users who provided liquidity to the BOND-USDC pairing on Uniswap a proportional share of 20,000 BOND weekly; these rewards will persist through October 2023.
February 2021: BarnBridge DAO Launched
The BarnBridge DAO, consisting of an architecture of interacting smart contracts, was deployed on top of the Ethereum network.
These smart contracts allow BOND holders to deposit their BOND into the DAO to gain voting power, with users who choose to lock their BOND receiving expanded voting power, up to a 2x multiplier for those who lock for a whole year.
Proposals to execute on-chain actions, like allocating treasury funds or deploying new smart contracts for applications or subsidization programs, pass if 40% of total voting power participates in the vote with 60% approval.
March 2021: SMART Yield Smart Contracts Deployed
The SMART Yield application soft-launched with an unsubsidized integration with the Compound Finance USDC money market.
Two weeks later, the first DAO vote was held in order to introduce BOND token subsidies for the junior side.
This single originator received over $50M in deposits during its first month; Compound Finance’s market for the dollar-pegged, Ether-backed DAI currency is now live, and multiple originators from the AAVE platform will be supported by the end of April.
Understanding the Risks
As we have introduced a number of new concepts throughout this paper, we would be remiss not to address some of the common questions and concerns that users raise when first interfacing with DeFi applications.
What fundamental value, if any, do governance tokens have?
In general: The term “governance token” has admittedly been overused and applied across a wide spectrum of implementations (in many ways, no two governance tokens act alike). How do you classify a governance token if a company with an equity structure or a foundation is leading application development? What legal recourse, if any, do holders of such a token have against the issuer? Does such a token necessarily need to accrue value generated by its associated application? Or are voting rights value enough? All of these questions, while drawing heated opinions from different camps, remain unanswered despite multiple unicorn valuations, and even one decacorn. It is our view that the clearest value propositions lie with governance token implementations that reflect value structures similar to traditional co-ops. They provide an alternative to the corporate-driven status quo of both the Web2.0 internet as well as that of the traditional financial system.
For BarnBridge: BarnBridge does not exist as a legal entity in any jurisdiction. Its original development work was funded through private contributions to a treasury address hosted on Ethereum. The smart contracts associated with BarnBridge applications have been all deployed by the community-governed DAO, to which all protocol fees are directed (e.g., junior depositors are charged 0.5% on their principal upon entry, senior depositors pay 5% of their fixed income). BOND token holders are the sole entities capable of launching new smart contracts or allocating funds held in the DAO treasury. Only 22.5% of the capped BOND supply was set aside to vest for insiders, and so community participation is required to effect any such DAO proposal.
Are these applications sustainable without subsidies?
In general: Equilibrium rates in crypto-native money markets are naturally higher than those found in traditional analogues. Crypto-native money markets have more efficient cost structures thanks to the capital and time efficiency of smart contracts; higher willingness to pay for leverage given the continued outperformance of the asset class; and a general appreciation for the risk associated with investing in a nascent space. That said, the double and even triple-digit annualized yields present across many DeFi applications is the result of an ongoing bull market creating secondary liquidity for governance token subsidies. Teams building without this in mind will struggle to maintain product-market fit once the market cools off.
For BarnBridge: BarnBridge’s SMART Yield product currently relies on subsidizing deposits into the junior side to create liquidity for the senior side. As readers who have been involved with the launch of new financial products or two-sided marketplaces can attest, such a practice is par for the course in bootstrapping liquidity. What matters is that the money markets upon which SMART Yield relies have shown organic borrow demand even without subsidization, and that demand for yield-bearing dollars would presumably increase during a period of secular decline for DeFi ecosystem valuations. Subsidy schedules for SMART Exposure or SMART Alpha have not been discussed yet amongst the community, but the value of automated portfolio rebalancing and mitigated downside in such an environment is self-evident.
How can one assess smart contract risk?
In general: Ethereum smart contracts are written in the Solidity programming language (developed specifically for the purpose of smart contracts). As a result, best practices and industry standards have, since 2014, been forged through trial, codified through open source resources, and become working tradition passed on from one developer to the next. And now the industry has measurably matured, with the value settled via Ethereum-based smart contracts ($1.5 trillion in Q1’21 alone) far outpacing the value lost to contemporaneous exploits (sub-$100 million during the same period). Such exploits can be either technical or economic in nature; technical exploits are those that lose funds due to shortcomings in the code, while economic exploits are those that result from incorrect assumptions about user behavior. Smart contract auditing has grown into a cottage industry, boutique firms offer economic modeling of the assumptions underpinning application designs and bug bounties rival or even surpass those offered by leading technology companies. On the user side of the equation, enterprise-grade options for asset custody currently hold hundreds of billions in value, while easy-to-onboard interfaces for retail participants are widely available.
For BarnBridge: Any BarnBridge-associated smart contract that accepts user deposits is audited by leading providers (e.g., Open Zeppelin, Quanstamp, Hacken) prior to deployment. Its proof-of-capital distribution contract alone saw nearly $1 billion in unique deposits over the course of six months without a single exploit. Best practices, like time-weighted averaging of originator market rates and asset price feed integrations with the Chainlink service, ensure that its applications can weather brief bouts of volatility without being hamstrung.