Introduction

In the DeFi lending market, loan interest rates can be divided into two categories based on whether they fluctuate: variable interest rate lending and fixed interest rate lending. The variable interest rate lending sector is already well-developed. In contrast, projects that offer fixed interest rates started much later, and this domain is currently in its early stages. Most users’ funds are still concentrated in the variable interest rate market. However, DeFi lending projects often have significant interest rate fluctuations, leading to unstable user returns and creating uncertainty. As a result, there’s a growing demand in the market for fixed interest rates. If future lending protocols can reach a certain scale and there are already mature, financially secure, and large-scale platforms in the market, users’ preferences for lending platforms can differ considerably. For instance, during downturns when overall interest rates are low, borrowers prefer variable interest rate platforms because they can pay less interest. At the same time, lenders might lean towards fixed interest rate platforms. Conversely, when the market is bullish and overall interest rates rise, borrowers tend to favor fixed interest rate platforms, while lenders gravitate towards variable rate platforms.

Currently, fixed interest rate protocols can be categorized into three main camps: zero-coupon bonds, yield redistribution, and interest rate swaps. The most basic foundational logic belongs to zero-coupon bonds. A zero-coupon bond does not offer interest payments. It’s traded at a price lower than its face value and repaid at face value upon maturity. The operating logic is as follows: Lenders purchase zero-coupon bonds at a discount, which acts like a fixed interest rate deposit. They can then collect the bond’s face value upon its maturity date. Borrowers, on the other hand, can pledge assets to borrow zero-coupon bonds and sell them at a discount for cash. To retrieve their collateral, they need to repay the face value of the zero-coupon bond at its maturity date. The difference between the bond’s face value and the cash they get from selling it represents the interest on the loan. Since the cost of borrowing via zero-coupon bonds is essentially the deposit’s earnings, a balance can be achieved through market supply and demand.

Notional Finance falls under the fixed interest rate protocol using zero-coupon bonds. It has introduced a derivative token called fCash to establish a fixed interest rate. This article will elaborate on the product’s business logic, with a focus on its interest rate model and liquidation model, and provide an analysis of the protocol’s token model and its current state of development.

Notional Finance Overview

Notional Finance is a fixed-interest rate lending protocol built on Ethereum. It draws inspiration from the zero-coupon bond model in traditional finance. Depositors purchase tokens at a discount and redeem them on a 1:1 basis upon maturity. Borrowers are required to over-collateralize to obtain loans. The protocol introduces the fCash token to achieve a fixed interest rate. fCash represents a claim to positive or negative cash flows at a specific future point in time and can be traded in its native AMM-supported liquidity pool.

The product officially launched in January 2021. After two version updates, version 2 (v2) was launched in July of the previous year, integrating with the Compound protocol. Subsequently, in September, they released a new product called the Leveraged Vault. The team continues to enhance and refine the product experience. In April 2022, they secured $10 million in Series A funding, and version 3 (v3) is expected to launch in the third quarter of this year.

Basic Logic

The primary participants in Notional Finance’s lending system include lenders, borrowers, and liquidity providers. The protocol achieves fixed interest rate functionality through the fCash token. fCash is an ERC-1155 token, representing an obligation relationship without a specific maturity date. For depositors, +fCash represents the right to redeem the corresponding token at a 1:1 ratio, acting as an asset. For borrowers, -fCash signifies the obligation to pay the corresponding token at a 1:1 ratio, acting as a liability.

Image source:：https://docs.notional.finance/notional-v2/fcash/what-is-fcash

The fundamental operating logic of Notional products is: depositors simply buy +fCash at a discount and can achieve a fixed return by redeeming it at a 1:1 exchange rate on the maturity date. Borrowers only need to collateralize a certain amount, mint +fCash, and then sell it to get a loan.

For instance, liquidity providers supply cToken to Notional’s liquidity pool and receive nTokens as a receipt. This receipt has no expiration date and can be redeemed at any time. nTokens are ERC-20 assets, representing Notional’s share in the total liquidity of a specific currency. A portion of the deposited cToken is used to purchase fCash. Thus, the liquidity pool consists of cToken and fCash.

If a depositor wishes to provide a loan of 100 DAI to the Notional platform at a fixed interest rate for a year, they first convert their 100 DAI to cDAI. They then deposit cDAI into the Notional liquidity pool, receiving 105 fDAI, with a loan maturity date of December 1, 2021. On the maturity date, depositors can redeem their 105 fDAI for cDAI and then convert cDAI into 105 DAI.

For borrowers, after over-collateralizing with ETH, they can mint a certain amount of fDai. The system sells it for cDai, retrieving Dai from Compound to achieve a fixed-rate loan. The difference between Dai received by the borrower during the transaction and the minted fDai represents the fixed interest the borrower needs to pay upon maturity. As illustrated below, borrowers collateralize ETH into Notional, choose a maturity date of December 1, 2021, mint a pair of fCash tokens, and sell the positive fCash token to its liquidity pool in exchange for the base currency loan.

Image source:：https://docs.notional.finance/notional-v2/liquidity-pools/liquidity-pools

The interest rates available to borrowers and depositors depend on the ratio of cToken to fCash in the liquidity pool. The underlying idea is the more cToken in the pool, the lower the interest rate; the more fCash in the pool, the higher the interest rate. The exact figures are determined by the Notional AMM interest rate model.

Notional AMM Interest Rate Model

The team used the Logit function curve to design the AMM algorithm. The exchange rate and interest rate pricing formula between fCash and the underlying asset is as follows:

In the pricing model mentioned above, both the scalar and the anchor are initial parameters that can be modified through governance. The scalar determines the sensitivity of the curve: a smaller scalar value results in a steeper curve, leading to greater slippage within a specified range and hence increased volatility in interest rates due to trading. The anchor determines the curve’s position on the xy plane, influencing the range of interest rates generated: a lower anchor value shifts the curve vertically, resulting in a lower starting interest rate.

Image source:：https://docs.notional.finance/traders/technical-topics/notional-amm

The horizontal axis in the figure represents the proportion of fCash in the total pool. When a transaction occurs, the ratio of +fCash in the pool changes. For instance, when a user deposits Dai, the amount of Dai in the liquidity pool increases and +fCash decreases. As a result, the proportion drops, causing the exchange rate to decrease. Therefore, with subsequent transactions, the rate users receive will also decline.

Given the differences between fixed and floating interest rate protocols, there exists a maturity date. Depositors must ensure they can redeem the underlying assets at a 1:1 ratio upon this date. Therefore, in the design of the interest rate curve, it’s imperative to ensure that, even in the absence of any transactions, the exchange ratio between fCash and the underlying asset gradually approaches 1:1. Notional sets the scalar as a function of time. This ensures the parameter increases as the maturity date draws closer, allowing the interest rate curve to dynamically adjust as the maturity date nears.

Image source:：https://docs.notional.finance/traders/technical-topics/notional-amm

Liquidation Model

Notional introduces the concept of collateral value, which can be understood as the total asset value users hold in Notional, exceeding the value discounted by a specified risk coefficient. When the collateral value in a user’s account falls below zero, the user is subjected to liquidation.

For the liquidation process, Notional draws inspiration from Compound’s liquidation mechanism. Any third party can act as the liquidator by invoking the smart contract to purchase the debtor’s collateral at a discount. For USDC and Dai, the liquidator can receive a 4% discount. For ETH and WBTC, the available discounts are 6% and 7% respectively. Liquidators are required to purchase a minimum of 40% of the assets being liquidated.

Token Model

NOTE is the governance token for the Notional Finance protocol with a total supply of 100 million tokens. Out of these, 50% are allocated for a four-year liquidity incentive plan.

The team introduced the NOTE token staking feature in March of the previous year. Users can stake their NOTE tokens in the Balancer’s NOTE/WETH liquidity pool and, in return, receive sNOTE tokens. sNOTE serves as a Balancer LP token, earning rewards, and also provides protection for Notional users. sNOTE can be exchanged at any time for a certain proportion of LP tokens from the pool. As the pool’s rewards grow, sNOTE can be exchanged for an increasing number of LP tokens.

Image source:：https://docs.notional.finance/notional-v2/governance/note-staking

The platform charges a protocol fee of 0.3% on every loan amount. From this fee, 80% is used to build a reserve fund. This fund acts as a buffer to repay in case of bad debts. The remaining 20% is channeled towards rewards for LPs as part of the liquidity incentive.

Current Development Status

Based on official data, Notional Finance currently has a Total Value Locked (TVL) of approximately 30 million USD, an accumulated trading volume of 770 million USD, and a cumulative active user count of 1,632.

Image source:：https://info.notional.finance/

Image source:：https://info.notional.finance/

According to statistics on Dune, the number of users on the Notional platform has been steadily increasing over the past year. Following the introduction of the NOTE staking module, there was a rapid surge in the number of depositors. As of now, there are 883 depositors and 374 borrowers.

Image source:：https://dune.com/PierreYves_Gendron/Notional-V2-Dashboard

Conclusion

The fixed interest rate segment is still in a very nascent stage of development. Its trajectory in the short term remains unclear, but from a long-term perspective, there’s potential for growth. Notional Finance’s overall product design is commendable, utilizing its proprietary AMM algorithm to create liquidity pools. Its performance metrics are fairly competitive within similar protocols, indicating a sound foundational base. The team is also consistently iterating and enhancing the product experience. With the imminent launch of the v3 version and the expansion of product functionalities, the future development of Notional Finance looks promising.