Lending for the Long Tail: Silo Finance
Memecoins are out of control. A sceptic would be looking to short this latest wave of dog tokens.
But where can one short such shitcoins? Until recently, nowhere.
Enter Silo Finance .
Systemic vs. Siloed
Aave was DeFi’s first successful lending protocol, allowing users to deposit a supported asset as collateral to borrow any other supported asset. The variable borrow and lend rates are calculated as a function of the amount borrowed versus the amount supplied, ramping up quickly as the utilization rate approaches 100%.
This system, while over-collateralized, is quite capital efficient, as:
However, it also comes with a major downside.
Let’s say token XYZ is supported on Aave and suffers a hack, resulting in its price dropping 90%. The XYZ deposited to Aave as collateral is now near-worthless. Borrowers can walk away with borrowed money instead of redeeming it for worthless collateral. And now all lenders, no matter what token the lent, share in this loss due to the fact that all assets are commingled — this is considered a socialized loss. Note that this could also happen due to oracle failure or manipulation for a single token as well.
So one bad apple spoils the bunch.
And Aave’s model, while working well as a money market for major assets, runs into difficulty scaling horizontally to accommodate the long tail of assets. The protocol has to be very picky on what it allows as collateral.
This is where Silo Finance comes in.
Siloed Risk & The Long Tail
Silo aims to cater to the long tail of assets, allowing anyone to create a lending market for any asset.
Quite simple in its design, Silo separates lending assets into two-sided pairings. The token asset is paired with a bridge asset — the same bridge asset that is paired with other token assets in other silos.
As an example, let’s say we have the following silos, with USDC as the bridge asset.
Given that the PEPE meme token is highly volatile and speculative, it is unlikely to be supported any time soon by Aave.
But on Silo, I may be able to borrow PEPE anyway using ETH as collateral.
I simply deposit ETH into the ETH pool to borrow the bridge asset USDC, and then deposit that USDC into PEPE pool to borrow PEPE.
Now, if PEPE suffers a catastrophic drawdown, ETH depositors in the ETH pool are unaffected. The losses are limited to the PEPE and USDC depositors in that single pool.
In time, we might imagine the sprouting of lending markets for thousands of token assets.
By extension, Silo could enable the shorting of thousands of assets.
And once you can short, market makers can hedge and perpetuals and deeper liquidity can follow.
Loss of Capital Efficiency
This all sounds great, but is there a catch?
While I can now borrow a token that was not available on Aave markets, I am not able to borrow as much given the fact that I was required to use the proceeds from an over-collateralized loan to over-collateralize my PEPE loan.
Let’s say that every asset required a collateral ratio of 200% (or a loan-to-value of 50%).
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In the Aave example, I could have deposited $2000 of ETH to borrow $1000 WBTC.
However, if I borrow PEPE on Silo, I deposit $2000 of ETH to borrow $1000 of USDC, which I deposit to the PEPE pool as collateral to borrow $500 of PEPE.
A side note, but we have previously explored how the term “capital efficiency” is often used in place of “leverage”.
Silo And Short-Tail Assets
Interestingly, if you own a major asset, like LINK, and would like to earn interest on it, the choice about where to lend is not necessarily Aave.
If there is demand from long-tail asset holders to borrow ETH (though unlikely in most scenarios), you may still earn a decent rate on Silo.
But, to reiterate, if you want to borrow another major asset against your WBTC, Aave is the more efficient choice.
In summary, the market benefits from both of these products as they provide distinct value propositions to lenders and borrowers.
Llama This, Llama That
The llamas are taking over the crypto market.
And a Silo fork, Silo Llama, recently launched with crvUSD as the bridge asset, providing a dedicated lending market for crvUSD. And it changed the game for Silo in terms of TVL.
And despite Arbitrum getting some traction, the Llama edition has driven the vast majority of fees:
This is notable given that if you want to borrow long tail assets, using crvUSD is now potentially the best way to do so. It’s a win-win for Curve and Silo.
And yet at the same time, it’s a great example of how much room there is for new lending products in DeFi.
Is The Market Wrong?
Silo currently sits at a ~$60M fully diluted valuation, while Aave sits at a ~$1.8B FDV - around 30x that of Silo.
Why isn’t Silo TVL greater? The market is currently saying there is very little demand for long tail lending.
Given that Aave has captured around 50x the TVL (total value locked or amount deposited), perhaps this is a fair valuation, but given that the long tail will likely end up being much larger than the top couple of assets, this is a token I will be keeping an eye on.
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