A new approach to crypto loans is emerging, offering borrowers protection from liquidation risks.
MYSO Finance has developed a unique protocol that allows users to take out crypto-backed loans without worrying about sudden liquidations. But how do these Zero-Liquidation Loans (ZLLs) actually work?
Understanding Crypto Loans and Their Importance
Crypto loans play a significant role in the digital asset market, much like Lombard loans do in traditional banking.
With over $15 billion in Total Value Locked (TVL) as of October 2022, platforms like Maker, Aave, and Compound have become dominant in the decentralized lending space.
These platforms operate on a simple principle: borrowers deposit crypto assets as collateral and borrow another crypto asset in return.
If the value of the collateral drops significantly, it gets liquidated, meaning it is auctioned off to repay the loan. Borrowers also have to pay a liquidation penalty fee in the process.
However, Zero-Liquidation Loans (ZLLs) change this entirely. Unlike traditional crypto loans, ZLLs do not expose borrowers to liquidation risks.
Even if the value of the collateral decreases drastically, it will not be forcibly sold. One of the first projects to introduce this concept in DeFi is MYSO Finance, short for Million Yield Structuring Opportunities.
MYSO Finance started as a hackathon project in October 2021 and later secured $2.4 million in seed funding in early 2022. This funding was used to develop a liquidation-free, fixed-rate, and oracle-free crypto lending protocol.
Why Liquidation Risks Matter in Crypto Lending
Recently, DeFi lender Aave, the largest lender for Ethereum, had to temporarily halt lending for 17 tokens after incurring $1.6 million in bad debt due to a major loan liquidation involving CRV (Curve Finance’s token).
This incident highlights the difficulties of managing liquidation risks and how unexpected market movements can impact even well-established protocols.
According to Aetienne Sardon, founder of MYSO Finance, such incidents prove that liquidation risks should not be taken lightly.
While liquidation mechanisms are meant to protect lenders, they do not eliminate credit risks. That’s where Zero-Liquidation Loans (ZLLs) provide a safer alternative.
How Do Zero-Liquidation Loans Work?
ZLLs function similarly to traditional crypto loans, where a borrower deposits a crypto asset (e.g., Bitcoin) as collateral and borrows another asset (e.g., stablecoins).
However, the key difference is that borrowers do not face liquidation risks. Even if the collateral price drops, the borrower can still reclaim their collateral as long as they repay a pre-agreed amount within the loan term.
The only way a borrower risks losing their collateral is if they fail to repay on time. In such cases, the collateral is then transferred to lenders.
This entire process is handled autonomously through smart contracts, eliminating the need for intermediaries or third parties.
Why Zero-Liquidation Loans Are a Game Changer
The introduction of ZLLs can bring greater stability to the crypto market. Traditional liquidation-based loans carry several risks, such as:
- Market Contagion: One liquidation can trigger a chain reaction, leading to multiple forced liquidations, similar to what happened with Three Arrows Capital (3AC), Celsius, and FTX. Studies show that between 2019 and 2021, over $800 million in collateral was liquidated.
- Network Congestion: If the blockchain network becomes overloaded, liquidations may not be executed in time, causing lenders to suffer losses. This happened in early 2020 when Ethereum’s network congestion prevented Maker Protocol’s liquidation transactions from going through.
- Oracle Manipulation: Traditional crypto loans rely on price oracles to determine when liquidations should happen. However, these oracles are sometimes vulnerable to attacks and manipulation, which can force unnecessary liquidations.
- Maximal Extractable Value (MEV) Issues: Liquidations contribute significantly to MEV, a controversial practice where traders exploit transaction ordering to extract profits, leading to centralization risks.
By eliminating forced liquidations, ZLLs provide a safer and more resilient lending structure for both borrowers and lenders.
How Zero-Liquidation Loans Operate Without Oracles
One of the most unique aspects of ZLLs is that they do not rely on oracles for price tracking. Instead, they use liquidity pools, which are set up with a fixed maximum loanable amount per unit of collateral.
For example, a pool might allow users to borrow a maximum of 800 USDC per 1 ETH deposited as collateral.
This parameter is set when the pool is created and does not change, regardless of ETH’s market price. Lenders manage their liquidity manually, reallocating funds if the asset price drops below the lending threshold.
This mechanism functions similarly to an order book system, where lenders decide the price points at which they are comfortable lending.
This approach removes reliance on price oracles, making ZLLs more decentralized and resistant to manipulation.
Will Zero-Liquidation Loans Boost Confidence in DeFi?
According to Aetienne Sardon, ZLLs could increase confidence in DeFi by:
- Simplifying the borrowing process, making it more accessible to newcomers.
- Attracting institutional and risk-averse investors who prefer structured financial products.
- Providing safer lending opportunities, where lenders can earn stablecoin returns without exposure to volatile crypto assets.
MYSO Finance has already launched a public testnet, allowing borrowers and lenders to experiment with ZLLs before the protocol’s full launch.
Are There Any Risks with Zero-Liquidation Loans?
Despite their advantages, ZLLs are not risk-free. Some key risks include:
- Lender Financial Risks: If the collateral’s value drops too much, borrowers may choose not to repay the loan, leaving lenders with potentially worthless collateral. This is similar to a covered call option strategy in traditional finance.
- Smart Contract Risks: DeFi platforms are always at risk of hacks and vulnerabilities in smart contracts. To minimize these risks, MYSO Finance has partnered with ChainSecurity, a respected Swiss security auditor, and plans to launch a bug bounty program.
Although uncertainties exist, over time, increased usage and audits should help in improving the protocol’s reliability.
Will DeFi Replace Traditional Banks?
Sardon believes that DeFi and banks should coexist rather than compete. The goal is to make financial services more accessible, transparent, and fair.
While DeFi offers decentralized solutions, banks provide essential services that many people still rely on. In the long run, banks may integrate DeFi technologies into their operations, leading to a hybrid financial system.
How Should DeFi Be Regulated?
With regulations like the European “Markets in Crypto-Assets” (MiCA) framework, DeFi could face increased scrutiny in the future. However, Sardon argues that hasty regulation could hinder innovation. Instead, regulators should:
- Coordinate internationally to avoid regulatory loopholes.
- Recognize that many DeFi services already fall under existing laws.
- Focus on improving financial literacy to help users make informed decisions.
Rather than rushing into strict regulations, a balanced approach is necessary to protect investors while fostering innovation in DeFi.
Final Thoughts
Zero-Liquidation Loans offer a revolutionary approach to crypto lending by eliminating forced liquidations.
They provide borrowers with greater security, lenders with alternative investment opportunities, and the overall market with increased stability.
While challenges remain, ZLLs represent a major step forward in the evolution of decentralized finance.
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