DeFi Insight: Undercollateralized lending with Sentiment protocol

Sentiment, a liquidity protocol launching on Arbitrum, offers borrowers the ability to access up to 5x leverage for long/short tokens and deploy capital into integrated protocols such as Sushi, Curve, and Aave, with additional protocols on the horizon. Lenders provide capital and benefit from high capital utilization and competitive yields. Sentiment prides itself on its composable nature, allowing users to create new yield strategies based on composable leverage. Overall, Sentiment offers a robust and secure platform for both borrowers and lenders to access and benefit from the growing world of DeFi.

Authors: Valentin Kalinov, Christian Viehof

The challenge of undercollateralized lending

Undercollateralized lending in crypto is challenging due to the highly volatile nature of the market and the lack of reliable pricing data. Cryptocurrencies are known for their significant price fluctuations, and these swings can occur rapidly, leading to unpredictable losses for lenders. Without proper collateral, lenders are unable to secure their funds against market risk, making it difficult to offer loans without exposing themselves to a high degree of risk.

One example of the difficulties of undercollateralized lending is the collapse of MakerDAO’s collateralized stablecoin, DAI, in March 2020. During the market crash, DAI’s collateral became underpriced, leading to the automatic liquidation of the user’s collateral to maintain the peg to the US dollar. As the market continued to plummet, the automated liquidations created a downward spiral, ultimately leading to the system’s temporary collapse. This event highlights the challenges of maintaining stability in an undercollateralized lending system during a rapidly changing market.

The emergence of under-collateralized lending platforms like Sentiment and Gearbox marks a significant development in the cryptocurrency market, as investors are now able to access leverage for long and short positions without the need for over-collateralization. However, despite this new avenue of investment, minimum deposit requirements remain high, making these platforms inaccessible to the majority of retail investors. As such, Sentiment stands as the sole option for retail investors who want to start small.

While perpetual trading platforms such as GMX offer leverage for retail investors, they come with their own set of challenges, including high trading fees and the risk of a total loss of principal. As a result, traders on these platforms often end up losing more than they win. With the rise of under-collateralized lending platforms, however, investors now have a new option to leverage their positions and capture the benefits of the market’s growth potential without the need for traditional collateral. As we look ahead to 2023 and beyond, it is likely that leveraged lending platforms will continue to be an important investment narrative in the cryptocurrency market.

The Sentiment protocol

The two key user groups interacting with the protocol are Lenders and Borrowers. Lenders provide liquidity to the protocol, while borrowers create leveraged debt positions against their assets using the pooled funds from the lenders.

Figure 1: Total Value Locked in USD (source: defillama.com)

Accounts

All of the assets borrowed on the Sentiment platform are managed via a proxy contract which means the user never has custody of the loaned assets in their personal wallet. As the account functions as a proxy contract separate from the borrower’s EOA, the borrower is never in possession of the loaned assets, including the deposited collateral and borrowed assets. This delegated ownership model affords the borrower full control over how the assets are utilized while avoiding custody. This arrangement enables the protocol to maintain a primary right of ownership over the assets during the duration of the position, which is crucial in managing risk and facilitating liquidations if necessary. Withdrawal of assets from the vault only occurs if a borrower intends to take profits, decrease the position, or entirely close it.

Borrowing

Once a borrower opens a credit position, they have the ability to perform delegated actions on the loaned assets in their borrow account. Let’s assume a trader is bullish on ETH in and he wishes to bet on the price of ETH by opening a leverage position. The action would look like this:

1. Deposit 1 ETH of collateral at a spot price of $1,550
2. Borrow 3 ETH of USDC for $4,650
3. Buy 3 ETH at a spot price of $1,550 per token

The protocol sets a one-time 0.1% fee on all new borrows in addition to variable interest rates. A portion of the fees accrued will go toward a protocol insurance fund.

Figure 2: Borrow activity on Sentiment (source: dune.com)

Other borrowing strategies include:

• Leveraged LP farming
• Pair trading (going short one token and long another, capturing the spread in performance between the two)

Managing risk

To minimize risk for lenders, the risk engine of the protocol ensures all “accounts” have sufficient liquidity to meet their debt obligations. The risk engine computes and verifies the risk of each account and is also responsible for maintaining solvency at the protocol layer with respect to each lender. However, investors can quickly become subject to automatic liquidation by the engine. A small swing in the collateral’s value could liquidate any investor’s position and lead to principal loss.

The International Token Standardization Association (ITSA) e.V.

The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.

• The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
• The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to the market capitalization of classified tokens.
• ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.

Remarks

If you like this article, we would be happy if you forward it to your colleagues or share it on social networks. More information about the International Token Standardization Association can be found on the Internet, on Twitter, or on LinkedIn.

Valentin Kalinov is an Executive Director at International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He has over five years of experience working at BlockchainHub Berlin in content creation and token analysis as a project manager at the Research Institute for Cryptoeconomics at the Vienna University of Economics and token analyst at Token Kitchen. You can contact Valentin via valentin.kalinov@itsa.global and connect on Linkedin if you would like to further discuss ITSA e.V. or have any other open questions.

Christian Viehof is an Executive Director at the International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He completed his Bachelor in Economics at the University of Bonn, the Hong Kong University and the London School of Economics and Political Science with a focus on Behavioral Economics and Finance. Currently pursuing his Master of Finance at the Frankfurt School of Finance and Management, you can contact him via christian.viehof@itsa.global and connect with him on Linkedin, if you would like to further discuss ITSA e.V. or have any open questions.