Introduction

DeFi lending markets have become quite mature, with Maker, Compound, and Aave being the main hubs for capital. They have experienced steady development and continuous expansion in various ecosystems. Looking back at their development history, the first lending platform, ETHLend (now AAVE), used a peer-to-peer lending model, where borrowers or lenders would place orders and fill in details such as collateral type, loan interest rate, amount, and collateral ratio, and the demand side would take the order.

Although the peer-to-peer lending model allows users to set various parameters, the differences in borrowing and lending demands can lead to low matchmaking efficiency. Therefore, Compound introduced the concept of peer-to-pool, and Aave also adopted this model. Borrowers and lenders interact through a pool of funds to complete lending operations, which improves the utilization of funds and effectively matches the demands of both borrowers and lenders. The peer-to-pool model has also become the mainstream lending model.

The peer-to-pool model meets the majority of lending needs, but it also has issues such as interest rate fluctuations and interest rate differentials between borrowers and lenders. As a result, fixed-rate protocols have gradually emerged. In comparison, the fixed-rate field started later, with most projects emerging in the second half of 2020. Currently, it has not yet formed a significant market size. Most protocols attract users through leading projects that offer floating-rate lending, but these users are not necessarily true existing users. Additionally, they rely on liquidity mining incentives for sustainability, and once the incentives decrease, users are quickly withdrawn. Although the fixed-rate field is still in its early stages of development, there is still demand in the market, especially for institutional investors who need deterministic and predictable income products to manage their assets. Term Finance is one of the few auction-based lending protocols that fixes the final loan interest rate through hidden bids from both borrowers and lenders. Its main features are fixed rates and interest rate smoothing. This article will provide a detailed explanation of its product logic and analyze the current development status of the project.

What is Term Finance?

Term Finance is a fixed interest rate lending protocol deployed on Ethereum. It facilitates matching between borrowers and lenders through an interest rate auction mechanism. Each auction has fixed collateral and loan assets, and the interest rate is determined by the bid of the lenders and borrowers during the auction. The official website product was launched on Ethereum on August 1, 2023. The team completed a seed funding round at the end of February this year, receiving $2.5 million in funding support. Currently, no tokenomic model has been introduced.

Source: https://docs.term.finance/protocol/term-repos

To capture market demand, the official website currently focuses on offering lending pairs such as wstETH-USDC, wstETH-WETH, sDAI-USDC, etc. These pairs are primarily used to increase leverage for wstETH, boost wstETH mining rewards, and enhance sDAI deposit earnings. The total locked value in the liquidity pool is close to ten million US dollars. The team has expressed their commitment to introducing more trading pairs in the future to meet market demand.

Product Experience

Term Finance protocol holds regular (four-week) loan auctions to match transactions, with corresponding collateral assets and lending assets. As shown in the figure below, borrowers can see on the Term official website that there will be a loan auction for lending USDC against collateral wstETH, with a loan duration of four weeks.

Source: https://app.term.finance/

Borrowers click to participate in the auction and enter the quantity of USDC to borrow as well as the quoted interest rate. The Term contract is responsible for matching, similar to peer-to-peer trading.

Source: https://app.term.finance/auctions/

Auction Mechanism

The auction of Term Finance is divided into announcement dates, auction window, and disclosure period. One week before the official start of the auction, information about the collateral, loan assets, and other relevant details will be made public. During the auction window, borrowers and lenders hide their bids using a hash algorithm until the settlement of interest rates, thus ensuring secret bidding. At the end of the disclosure period, the bidding results of both parties are revealed on the blockchain, and the final settlement interest rate is determined through the on-chain algorithm. The core of the on-chain algorithm is to find a supply-demand balance point in the interest rate bids of both parties, maximizing the loan amount.

Other Mechanisms

Extension

Borrowers have the option to extend their loans by using the same collateral and loan assets, thereby extending the repayment date. Similar to auctions, borrowers are required to submit an amount and bid rate. Although extensions simplify the borrower’s operational steps to some extent, the process still occurs every four weeks, which is more cumbersome compared to traditional lending protocols like AAVE. There is also a possibility of an increase in settlement rates but a failed extension. If the extension fails, users may face liquidation due to difficulty in repaying the debt.

Liquidation

When the borrower’s collateral ratio falls below the minimum required collateral ratio for the loan, liquidation will be triggered. Anyone can initiate liquidation by calling the liquidation contract. The liquidation penalty ratio is 8%, with 2.8% allocated to the protocol and 5.2% allocated to the liquidators.

Service Fee

The protocol’s current sources of income are derived from liquidation penalties and service fee revenue. When borrowers successfully bid and obtain loans, a service fee will be automatically deducted from the loan amount. The service fee is collected from borrowers in the form of an annualized interest rate, usually ranging from 0.3% to 0.5%.

Development Status

Term Finance launched its products on the Ethereum mainnet in August this year. The amount of locked funds has been continuously increasing. Leveraging the popularity of the LSD race, it first introduced trading pairs such as wstETH-USDC and wstETH-WETH, focusing on increasing leverage returns for wstWTH. The total amount of locked funds has exceeded $12 million at its peak. Currently, the locked funds in the liquidity pool are approximately $10 million.

Source: https://defillama.com/protocol/termfinance

Conclusion

Term Finance achieves fixed interest rates within a specified period through an auction mechanism, where both lenders and borrowers hide their quotes and use algorithms to determine the final lending rate, maximizing the matching of loan amounts. The overall business logic is relatively straightforward, with fixed interest rates that flatten the interest spread. However, this also brings about the problem of low efficiency. Term loans typically have a four-week repayment period, meaning that the interest rate fluctuates every four weeks. This makes it cumbersome for borrowers to extend their loans, and there is a possibility of extension failures.

Currently, there is limited demand in the market for fixed interest rates. Lenders and borrowers are more inclined towards safety and long-term interest rate stability. The overall attractiveness of the current fixed interest rate in the project is not significant. In terms of flattening the interest spread, the auction settlement rate is the rate agreed upon by both parties, eliminating the interest spread similar to a peer-to-peer mechanism. However, this leads to lower interest rates and difficulty in forming a relevant competitive advantage. The project has not yet launched a token economic model and is continuously introducing relevant lending trading pairs to capture market demand.