Dion Chu is the Founder and CEO of Term Finance.

In this Quick Hit, we review a new fixed rate auctions protocol on Ethereum, launching today (August 1st) on Ethereum.  DeFi is known for its volatile variable interest rates. Term offers a new non-custodial fixed rate lending and borrowing protocol for a maturing DeFi markets that demand more predictable fixed rates, like those we find in traditional finance. With Term Finance, borrowers and lenders are matched through a unique recurring auction process, poised to usher in enormous growth for DeFi this next bull run!

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Timestamps

00:00 - Intro
07:33 - Background on Dion and origin of Term
14:55 - How Term Finance works
18:19 - Why fixed vs variable rates
22:19 - How auctions work
26:25 - Term repo tokens
27:28 - Guarded launch and results so far
29:59 - What's needed for multi-year term loans
33:12 - Closing

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🔗 Guest Links 🔗

► Dion on Twitter: https://twitter.com/dionchu
► Term Labs on Twitter: https://twitter.com/term_labs
► Learn about Term Finance: https://term.finance/
► Links to Term Discord, Telegram, and Medium: https://linktr.ee/term.finance

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🙏 The Edge Podcast is produced by 4RC Labs. If you're a DeFi/Web3 builder, contact our team at: https://fourthrevolution.capital/

All opinions expressed by hosts and podcast guests are solely their own opinions and not necessarily those of Fourth Revolution Capital. Podcast guests and 4RC may have positions in the assets or other matters discussed in this podcast. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Do your own research. This is not a recommendation or endorsement to buy any token(s) related to any platform(s) discussed.

So, you know, we've heard from a lot of default yield farmers, sometimes they can't sleep at night because they don't know what's going to happen.

Horror stories of people being on airplanes, not being able to reach their hardware wallet by the time they landed, liquidated.

You know, by giving you a fixed rate for a fixed amount of time and allows people who borrow to sleep a lot at night and not have to worry about, you know, what if a black swan event happens and it...

Hey everyone, welcome to the Edge Podcast.

I'm DeFi Dad from Fourth Revolution Capital, and I'm here with my co-host from 4RC Nomadic.

In this episode, we'll review a new non-custodial fixed rate lending and borrowing protocol launching soon on Ethereum called Term Finance.

DeFi is known for its volatile variable interest rates.

Term offers a next-generation solution for a maturing DeFi market that demands more predictable fixed rates like those we find in traditional finance.

With Term, borrowers and lenders are matched through a unique recurring auction process called term auctions.

Borrowers submit sealed bids and lenders submit sealed offers that are used to determine an interest rate that clears the market for participants of that auction.

Participants who bid more than the clearing rate receive loans and participants willing to lend below the clearing rate make loans.

We will dissect how all of this works and help you as DeFi users understand what's necessary to become a borrower or lender on term.

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All right, in just a moment, we'll introduce Dion Chu, the founder of Term Labs.

Dion attended Cornell and later Harvard where he became a teaching fellow and taught the principles of micro and macro economics.

He went on to have an extensive career in traditional finance working on trading desks on Wall Street such as Jeffries and Capula.

He would eventually start a small family office called Orthogonal Asset Management.

In 2022, he founded Term Labs, which is building the protocol Term Finance, a non-custodial fixed rate liquidity protocol for digital assets on Ethereum.

Today, we'll be talking to Dion all about his new venture at Term Labs and how Term aims to match borrowers and lenders through a unique recurring auction process, common in traditional finance, but rebuilt and re-imagined here in DeFi.

Term represents a sector of DeFi that we've been active in and following the last few years.

You know, if you want to classify it as like fixed income or fixed interest DeFi, And this is a sector of DeFi that we've always been very bullish on at 4RC, but I would argue we've yet to see real product market fit.

And so I'm hopeful that this is a part of the next major cycle in crypto and DeFi.

But Dion, you have an extensive background trading on Wall Street.

Can you tell us why that career in traditional finance led you here now to DeFi?

As you mentioned, my career on Wall Street was primarily as a government bond trader, trading US government bonds.

And when I started my own family office, for the most part, I stayed within the realm of traditional finance.

I think it was around the time of COVID when interest rates went down to 0.

And I started hearing about these double digit yields and DeFi that I started doing some more research, looking into what was going on.

So, you know, a crypto backstory about Bitcoin, a long time ago back in 2012, was very much a Bitcoin maxi.

But when I saw what was going on in DeFi, the ability to swap tokens, borrow and lend, it was just super interesting to me.

So as part of that journey, I started devising various projects, both on the NFT side and on the DeFi side.

And 1 of those advisory roles was serving as a Dow Treasury manager.

I think it was in that role where I started to notice the lack of fixed income product in DeFi.

Right, as a former bond trader, fixed income products, largest market, largest financial market in the world, And the fact that it didn't exist in the DeFi space was just really puzzling to me.

As part of that process, I started looking at some of the existing protocols that had attempted to do both borrow-lend and the fixed-rate space, but found that the product was suffering from scalability issues.

If you look at all of the existing protocols, at its core they rely on an AMM model.

So kind of like a DAX pool, where LPs are required to deposit idle capital that sits in the pool waiting for a transaction to show up.

And in between it generates no income, so the average return to LPs is quite low.

And from the borrower's perspective, the way it works is a borrower deposits collateral into a smart contract, but rather than getting loan proceeds from that transaction, all they get is an ERC-20 token, where they then have to take the additional step of selling that token into the DEX in order to realize any stable coin loan proceeds.

So it's a two-step process, and in that second step, because it is a DEX, you know, they have the typical issue of contending with slippage.

So, you know, in practice, if you try to borrow something like more than $2 or $3 million at a time from these fixed rate protocols, the interest rate quickly jumps from, say 5% to 6% or 7%.

So it's not really scalable from an institutional perspective.

I think the key insight that I had, largely drawing from my experience as a former government bond trader, is the need to draw a distinction between primary markets and secondary market trade.

So you know in crypto language primary market is like an ICO.

You're selling a token for the first time there's a lot of supply.

In secondary markets is what happens after a TGE event.

Once a token is issued, you can trade them on exchange, trade them on DEX.

DEXs were designed for trading volume on the margin, but not for selling large quantities of token at a single point in time.

And we think that matching borrowers and lenders in a fixed rate space is much more like a primary market activity than it is like secondary market trading.

And so finding a mechanism that's more suited to that was what was needed to make this model work.

So thinking back to my days as a government bond trader, I had participated in hundreds of U.S.

Treasury holds 6 bond auctions, selling at a time up to 50, 60 billion of treasury notes in a single go.

And every G7 country to this day still issues government bonds in the first instance through an auction process.

So the idea was to take that model and bring that on-chain.

And so that's what we created, an on-chain auction where at regular frequency, maybe once a week, borrowers and lenders can come together, submit levels of where they're looking to borrow or lend.

And then at a single point in time, you know, we'll close all bidding and the smart contract will determine a single market clearing rate where any borrower that's willing to pay at or above that rate will receive a loan.

And any lender willing to lend at or below that rate will make a loan, in both cases at that market claim rate.

So even if you're willing to pay 10%, the market comes out at 4, you only have to pay 4.

So nobody sees the rate that you're willing to pay until after the auction closes, so people are incentivized to bid their true valuation.

The long run vision here is that at steady state, there will be a token maturing every week, every month, going out to 1 year.

And the idea is this would serve as a benchmark DeFi interest rate for, you know, where does, you know, where do loans at DeFi trade at every point in time going out to 1 year?

So what you described sounds to me like a net new DeFi primitive with this new element of auctions.

So something that you've done in your past over many years, it sounds like, and you're now bringing that to DeFi as a way to match up lenders and borrowers that currently doesn't exist.

I think it's a new way of making markets or bringing people together to transact and DeFi.

Up to now, we've seen the DAX model standing liquidity, which is great because you can access liquidity at any time that you're looking for it, but it is very capital intensive and is not the most efficient use of capital for LPs.

We've seen attempts at order book models, which, you know, the, there are some scalability issues on chain to be able to accommodate true order books in a decentralized manner.

And options are sort of a nice middle ground.

It is like an order book, but it happens in batches at a single point in time.

So it actually is like a nice kind of compromise between the 2 opposing models of full border book and fully on-chain DEX.

And I think a nice benefit of that is when, especially when you're trying to match large volumes in auction, have been proven theoretically to be 1 of the most efficient mechanisms of doing that.

Deon, can we start to talk through term finance?

Like What are the major moving parts or like the mechanisms that you need to understand?

I think so far you've clearly laid out we have borrowers and we have lenders, we have an auction price, and we have an auction process that is coordinated on chain.

All of this is automated by smart contracts.

A lot of the benefits here of DeFi that I want to say we somewhat take for granted, it's really powerful here because you're taking a fairly complex, middleman intensive mechanism in traditional finance and you're bringing it on chain.

So maybe you could start to talk us through what does it look like for us as users, if I'm a borrower or if I'm a lender who's approaching using term finance in the future?

Yeah, I think a key thing to understand to start is that in early days, we will focus on over-collateralized loans.

You have to put up significant collateral in order to borrow from the protocol.

And the collateralization ratios will be very similar to what you'll find on variable rate protocols like Aave and Compound.

I think along with that, the liquidation mechanism is also based largely on Aave and Compound, where your collateral is held in a smart contract.

And if you fall below the margin requirement, then your tokens will be instantly liquidated.

The liquidation mechanism is also very similar.

Liquidators are provided with the liquidation incentive where they will be able to purchase your collateral at a discount, in consideration for repaying a portion of your loan.

1 unique feature that we implemented is that we have liquidation limits.

So a liquidator can only liquidate you to the point where your collateral returns to a healthy factor plus a little bit of buffer.

So you won't get fully liquidated as a result of a minor infraction.

A second interesting difference is that unlike the variable rate protocols, where all of the collateral is held in a large single commingled pool, the collateral and the term contracts will be segregated by matured.

Then the collateral there is separate from all of the other loans that may have been, you know, deployed in the past.

And so that provides a little bit more, you know, diversification of risk on the lending side.

And as with all of these over collateralized loans, the rates are very low, so it's great for the borrower.

And as a lender, it's really targeted towards people who are concerned with capital preservation.

You know, if you're looking for D-Gen yields, this is not where you go.

But if you are worried about preserving your capital, then, you know, we want to be there along with Compound and Aave as a safe place to put your capital.

Who are your target users with this sort of arrangement?

And then I think it's important just to kind of key in on the variable rate versus fixed rate a bit more.

So obviously, Compound Aave have a floating interest rate.

What you're bringing to the market is a fixed interest rate.

Maybe outline some of the benefits and I guess some of the dangers in certain kind of like black swan events where a floating interest rate can really sort of harm a borrower or lender.

Yeah, you know, I think 1 of the, you know, important features that we're trying to bring is this fixed rate concept.

You know, there have been many attempts at it.

And for the most part, variable rate product has worked very well in DeFi.

But we have seen episodes, you know, around tail risk events or black swan events, as you briefly mentioned, where you have these liquidity squeezes in DeFi, where interest rates on these floating rate protocols will spike for, you know, up to a couple of days through 60, 70, 80% per annum APY.

And when you are subject to that kind of borrowing costs, in the worst case, you might get liquidated.

And even if you don't get liquidated, it could ruin whatever yield farming arbitrage trade that you had on.

So, we've heard from a lot of default yield farmers, sometimes they can't sleep at night because they don't know what's gonna happen.

Horror stories of people being on airplanes, not being able to reach their hardware wallet, and by the time they've landed, it's liquidated.

By giving you a fixed rate for a fixed amount of time and allows people who borrow to sleep a lot at night and not have to worry about, you know, what if a black swan event happens and it, you know, throws everything out of whack.

So, you know, I think that's a very important feature of fixed rate borrowing.

And even for individuals who maybe you just want to borrow against your Bitcoin, your long-term holder, but you want to make a home improvement, you want to fix your kitchen, you know, it's nice to be able to borrow at a fixed rate for 6 months, whatever it is, and know exactly what it's going to cost you at the end of the day.

It makes it much easier for people to plan their expenses and how much you need to save up to repay the loan once they're ready to do so.

So I think for both institutions and individuals alike, having the certainty and predictability of a fixed rate makes it a lot easier.

I think that's the key there is the certainty and predictability is a part of DeFi maturing.

You know, as much as we're all grateful for the volatility and the excitement when the space is growing, the pie is growing and there's a positive sum experience to that.

But in order for DeFi to mature into the next generation of its growth.

We need this predictability and certainty.

And this is why we were particularly excited when we first learned about what you're building with Term.

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Can we start to dive into just some of the nitty gritty as like a power user who might you know hop into term here once it's live on Ethereum mainnet?

So first I love the idea of being able to lock in a rate as a lender.

This is something that especially having just lived through a crypto bear market, a lot of those rates dropped.

And So we as lenders and stable coin markets, we would love to be able to lock in higher rates.

So if I'm willing to lend and I'm matched with a borrower through the auction process on term, I guess what decides programmatically what capital gets used to be lent to those borrowers?

What if there's an excess supply of capital?

Or on the flip side of that, we'd also like to talk about what if there isn't enough capital supplied and the loan is not going to be issued?

So, you know, now talking about the auction mechanics, you know, at the end of the auction, after everybody's submitted the amounts that they're looking to lend and the interest rates at which they're willing to do so.

We will find that market clearing price where supply meets demand, and we will assign fills based on the most willing to lend.

So people who are willing to lend for the cheapest and fill it going up, you know, in order and on the barn side, we will fill those who are most willing to pay first and then kind of downwards and then if there's access demand or supply at the marginal rate, then everybody who submitted a loan to lend at a certain, at the same price will be filled pro rata on the margin.

So if we get down to the final few, the last marginal rate, and there's only a hundred thousand of demand, but 200, 000 of supply, And each of the lenders will get 50% of an allocation versus relative to what they submitted to lend.

This is very common, same as it works in the U.S.

Now when it comes to these auctions and the terms for loans that are going to be auctioned off, Who decides that?

Is something there programmed in and do we like vote on that as a Dow?

Do we have folks full time who are, I guess, you know, figuring out and trying to model out like What are the best terms to offer in terms of those loans?

Is it the borrower that suggests that and requests a certain term?

Early days, it'll be determined by the core team.

We're in talks with all of our potential users.

But the idea is that in the long run, you know, we have a DAO.

The goal would be to allow new pairs, new terms to be deployed based on DAO governance.

But in the short term, as we're kind of bootstrapping, it will be determined by the core team.

But if anybody has ideas, love to hear your input because we're always trying to figure out, obviously, what has the most demand, right?

That's what the goal is at the end of the day.

Are these borrowers, are they over or under collateralized?

And if over collateralized, how much collateral do they have to put up for the loans that they take out?

Yeah, these are all over collateralized loan.

So just like Aave and Compound and the collateralization ratio is going to be identical to what you'll find on Aave and Compound as well.

So if it's say Ethereum or Rapps to ETH, we would require 125% for every dollar borrowed on the platform.

Dion, can you speak a bit to the term repo token and how that fits into the protocol and kind of like what functions does it serve?

Yeah, so what happens at the conclusion of an auction is the borrower will receive his loan proceeds directly from the protocol.

And lenders will receive ERC-20 tokens, they call them repo token.

They're essentially receipt tokens that the borrower or lender will use to redeem for principal plus interest at maturity.

They'll typically be normalized to be redeemable 1 for 1 with the underlying purchase token.

So the idea is it would trade like a discount note, you know, some fraction of a dollar converging to a dollar as you get closer to the maturity date.

And also 1 thing I want to clarify, I think sometimes a lot of people are confused about this.

So we need to do a better job of clarifying, but these loans are peer to pool.

So you're not lending and borrowing from a specific individual.

All the lenders are going to the pool and all the borrowers are borrowing from that same pool.

And so at the time that we're filming this, you're currently live on Ethereum mainnet in what you're calling a guarded launch I believe.

Are you finding like you're competitive with other borrowing platforms?

So, you know, we had run a testnet for about 12 weeks, make sure we ironed out all of the issues.

We launched this guarded launch on mainnet just to make sure that when you switch between testnet and mainnet, There's always some configurations that you forget to make.

So the first 2 options, we limited the size of the bids and offers allowable on the protocol to make sure, you know, if anything goes wrong, that, you know, it would be a manageable loss.

We held our first full-term four-week option 2 weeks ago, and the results are very interesting.

The first full-term auction cleared at 3.5%, So that's right around the midpoint of where Aave's supply and borrow rate is.

The lenders are getting paid a little bit more than what they would supplying, and the borrowers are paying a little bit less than what they would pay on a variable rate protocol.

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Term Finance: Pioneering Fixed Rate Loan Auctions on Ethereum