DeFi Showdown: DAO-Based vs. Permissionless Asset Pools
DeFi has the potential to revolutionize finance with its innovative mechanisms that challenge traditional systems. Among these innovations are DAO-based and permissionless asset pools. In this blog, we’ll explore the differences between these two types of asset pools, using the Euler and Fuse protocols as examples to dive into their functionalities, advantages, and challenges.
Primer on Lending Pools
Understanding Lending Pools
Lending pools are platforms where borrowers and lenders interact financially. Liquidity providers (lenders) deposit their tokens into these pools to earn interest. Meanwhile, borrowers can borrow funds or take out flash loans from the pools by putting up their crypto as collateral. Lending pools have become a cornerstone of DeFi protocols, enabling a range of financial services in a decentralized and trustless manner.
DAO-Based Asset Pools
Decentralized Autonomous Organizations (DAOs) run on smart contracts and community governance. DAOs manage rules, governance tokens, and decision-making through proposals and voting, all executed on blockchains.
How DAO-Based Pools Operate
DAO-based pools are all about community-driven decisions for managing resources and engagement. These pools offer transparent and efficient asset management. Governance token holders vote on new tokens proposed for the lending pool, ensuring minimal smart contract, counterparty, and market risks. This process often includes third-party or internal audits to prevent exploits.
The Shared-Pool Approach
Unlike the usual two-token pairs on DEXs and other platforms, DAO-based pools aggregate all deposited token liquidity into a single pool. This leads to higher utilization rates, more capital efficiency, and predictable interest returns for lenders.
Challenges of the Shared-Pool Approach
However, this also means liquidity providers face systemic risk. An exploit of a single token in the pool can jeopardize all other tokens in the pool. To mitigate this, protocols implement strict vetting systems alongside their governance structures. Governance allows token holders to vote on whether to support or deny newly proposed tokens for the lending pool.
Risk Management in DAO-Based Pools
Maintaining proper risk management in a DAO-based, shared-pool approach is crucial. Including highly volatile and improperly vetted assets has led to significant losses for some protocols. For instance, in May 2021, the Venus Protocol, a BSC-based shared-pool lending platform, suffered a critical exploit. Severe price manipulation of the $XVS native token resulted in $100 million worth of bad debt for the protocol.
Complexity in Asset Listing Frameworks
DAO-based asset listing frameworks differ across lending protocols, adding complexity to creating debt markets for a wider array of tokens. Both Aave and Compound use third-party audit services for initial risk assessments, whereas Maker internalizes the entire audit process. These approaches come with high upfront costs and time expenditures. Notably, most risk assessments are one-time tasks — only market-related metrics are continuously monitored in most DAO-based pools.
Asset Listing Process for Lending Protocols
Rigorous vetting and governance whitelisting provide security and stability for lenders in shared-pool lending platforms. However, they offer little support for listing long-tail assets and limit creating pools aligned with specific projects. This limitation highlights the robustness of permissionless pools as an alternative to the standard approach taken by Aave and similar lending platforms
Permissionless Asset Pools
The Concept of Permissionless Lending Pools
Permissionless lending pools allow anyone to create a pool, provide initial liquidity, and set up a borrowing market for virtually any token. This process requires no whitelisting or governance and opens debt markets to any long-tail assets.
Advantages of Permissionless Pools
Permissionless pools make debt market liquidity available to anyone, including DAOs and many protocols’ native tokens. This setup enables users to align interests with specific projects by binding tokens to a pool that is protocol-specific.
Tradeoffs in Permissionless Lending Pools
Permissionless lending pools come with their own set of tradeoffs. The lack of governance oversight and rigorous vetting means users risk losing all their collateral value for less robust tokens. Stricter individual due diligence is necessary when interacting with these pools. Lenders also face additional risks as their provided liquidity may sharply fall in value, depending on the supplied token’s nature.
Isolation of Permissionless Pools
Most permissionless pools are isolated, meaning each pool only holds liquidity for the specific collateral/borrow token pair. If an exploit occurs, similar to the Venus case, only that distinct pool would be affected, leaving the rest of the protocol safe from bad debt and further exploitation.
Case Studies
Euler Protocol
Euler’s Permissionless Listing System: Euler is non-custodial, giving users full control over their funds. It focuses on lending for long-tail assets, which are lesser-known and less liquid than major cryptocurrencies. Users can create their own lending markets without needing approval, offering flexibility and inclusivity for niche assets.
Reactive Interest Rates Model: Euler uses a dynamic interest rate model with a Proportional-Integral-Derivative (PID) controller to adjust rates based on market conditions. This model improves sensitivity and accuracy in interest rate pricing. Unlike traditional models that accrue interest per block, Euler compounds interest on a per-second basis, providing more precise interest calculations and potentially higher returns for lenders.
Dutch Auction Liquidation System: Euler replaces the fixed discount percentage liquidation system used by platforms like Compound and Aave with a Dutch auction system. This method auctions off a borrower’s collateral, starting at a high discount that decreases over time, incentivizing faster liquidations. This system reduces the risk of priority gas auctions (PGA) and miner extractable value (MEV) exploitation, offering a fairer and more efficient liquidation process.
Multi-Collateralized Stability Pool: Euler expands the stability pool model to allow for multi-collateralized support. Borrowers can provide liquidity to a stable pool in each borrowing market, facilitating immediate liquidations without relying on third-party exchanges. This approach reduces transaction costs for liquidators and improves the protocol’s overall efficiency.
Fuse Protocol
Fuse’s Permissionless Market Creation: Fuse allows anyone to create their own lending market, making it highly accessible and inclusive. Users can set parameters for collateral, interest rates, and risk management, tailoring the market to their specific needs and preferences.
Diverse Asset Support: Fuse supports a wide range of assets, including niche and long-tail assets that might not be listed on more restrictive platforms. This inclusivity promotes innovation and provides liquidity for a broader array of tokens.
Flexibility and Innovation: Fuse’s user-driven approach enables the creation of customized financial products. This flexibility allows users to manage risk more effectively and align their financial activities with their specific goals.
Security and Safety: Fuse implements rigorous security measures, including regular audits and insurance coverage, to protect against smart contract failures and other vulnerabilities.
Liquidation Mechanisms: Fuse uses Dutch auctions for liquidations, similar to Euler, offering a more efficient and fair process. Additionally, it provides options for self-liquidation, allowing borrowers to minimize losses by managing their own liquidation process.
Community Governance: Fuse incorporates DAO principles, enabling decentralized decision-making. Users with governance tokens can vote on important protocol changes and new asset listings, ensuring that the community has a direct say in the platform’s evolution.
Conclusion
By examining the Euler and Fuse protocols, we can see how DAO-based and permissionless asset pools offer unique advantages and challenges in DeFi. DAO-based pools, with their community-driven governance and stringent risk management, provide security and stability. In contrast, permissionless pools offer greater inclusivity and flexibility, allowing for rapid innovation and broader asset support. Understanding these differences helps users navigate the evolving DeFi landscape and leverage the opportunities these innovative financial mechanisms present.
Joule Finance’s Approach
Joule Finance has designed to create and deliver permissionless pools in addition to the native pools. This will improve liquidity for long-tail assets and provide DAOs and protocols with a minimum liquidation option for users to access borrowed liquidity.
