Term Finance: On-chain Lending Protocol with Fixed Interest Rates, Fixed Terms, and Non-Redeemability

Author: defioasis

Since its online launch over two months ago, the fixed-rate liquidity protocol Term Finance has processed $23.8 million in tenders, including $11.9 million in deposits and $11.9 million in loan requests. Of these, $6 million in loans were successfully matched through Term Finance’s unique recurring auction model. The average transaction size in auctions has steadily grown to $350k over the past four weeks. Term Finance completed a $2.5 million financing round led by Electric Capital in February of this year, with participation from Circle Ventures and Coinbase Ventures, and underwent an audit by Sigma Prime in May.

As early as mid-September, BitMex founder Arthur Hayes shared insights on the interest rate differences between Term Finance and mainstream DeFi protocols. With its fixed-rate auction model, Term Finance is able to offer comparatively lower borrow rates. For example, the 4-week USDC borrow rate on Term is 3.495%, whereas the average borrow rate on Aave V2, Aave V3, and Compound is 5.72%. Similarly, the 4-week ETH borrow rate on Term is 2.395%, compared to the average borrow rate of 3.19% on Aave V2, Aave V3, and Compound.

(Source: https://x.com/CryptoHayes/status/1703554481823293646?s=20)

Tri-Party Repo

Term Finance is an on-chain, non-custodial fixed-rate lending protocol built on the traditional financial (TradFi) tri-party repo model.

(Note: Tri-party repos generally consist of traditional tri-party repos and General Collateral Finance (GCF) repos, but unless specifically mentioned, tri-party repo in this article refers to the traditional tri-party repo.)

The tri-party repo model is a common form of repurchase agreement (Repo) in the financial markets, involving three main parties: the lender, the borrower, and a third-party agent. In a repurchase agreement, one party (usually a financial institution or government, i.e., the borrower) nominally sells assets (usually fixed-income assets like government bonds) to another party (the lender) with an agreement to repurchase them at a specific price on a future date. The third-party agent is responsible for managing all aspects of the transaction, including asset clearing, collateral management, and settlement upon loan maturity. At the end of the loan, the borrower repurchases the assets at the agreed-upon repurchase price and pays the corresponding interest. The third-party agent takes care of all this, ensuring the smooth completion of the transaction.

The tri-party repo model has various applications scenario in traditional finance, most commonly serving as a means for banks and other financial institutions to obtain short-term liquidity. It can also serve as a tool for central banks to conduct money market operations, manage collateral through a third-party agent for risk management purposes, or for hedging strategies. For example, say Bank A needs short-term liquid funds to meet its immediate liabilities. It can use the government bonds it holds as collateral to obtain funds from Bank B through the tri-party repo model, with a trust company serving as the third-party agent responsible for handling transaction details and collateral custody.

Combining On-Chain Finance with Tri-Party Repo

In Term Finance, borrowers and lenders are matched through a Term Auction cyclical recurring process. In this auction, borrowers submit sealed bids, and lenders submit sealed offers, which are used by the protocol’s smart contracts to determine the clearing rate. The clearing rate is the interest rate set to balance supply and demand. Borrowers who bid above the clearing rate and lenders who offer below it will be matched. Borrowers thereby receive loans, while lenders extend credit and receive Term repo tokens, which serve as a voucher for destroying to redeem principal and interest at the end of the loan term. On the other hand, borrowers who bid below the clearing rate and lenders who offer above it will be sidelined. The allocation process will prioritize lenders with the lowest cost of funds and borrowers most willing to pay interest. The decentralized Term Finance protocol effectively acts as the third-party agent in traditional finance; collateral assets from borrowers are locked in a smart contract (Term Repo Locker) that can be verified in real-time by both parties and is monitored by the Term Finance protocol for collateral health and liquidation handling. Additionally, borrowers who win the auction match are required to pay a loan service fee to the protocol, annualized at 0.3%-0.5%.

Term Auction is essentially a call market that includes sealed bids, second-price sealed-bid auctions, single auctions, and single-price double auctions. Regardless of the type, matching is done according to the clearing rate. By processing multiple orders within a predetermined time frame, double auctions increase liquidity and reduce transaction costs. Worth mentioning is that, for lenders, this can be seen as submitting offers to buy Term repo tokens.

Term Repos combine the advantages of both DeFi and TradFi. Once bilateral auction matching is achieved, the agreements not only have fixed rates but also fixed terms and are non-redeemable before maturity. This differs greatly from mainstream DeFi protocols like Compound and Aave, which feature variable rates, indefinite terms, and redeemable at any time. In Term Finance, all agreements are short-term loans, with current terms mainly for 1 week, 2 weeks, and 4 weeks. Borrowers must repay the loan on the maturity date or within the repurchase window (12–24 hours after maturity). Early repayment is not allowed, which means lenders cannot redeem their assets before the maturity date or repurchase date. Additionally, borrowers have the option to roll over or extend before the repurchase date expires.

(Note: In the upcoming new version scheduled for mid to late November, Term Finance will introduce early repayment options for borrowers, allowing them to unlock collateral by paying the full term’s interest, all without any cost to the lender.)

Similar to mainstream DeFi protocols, Term Finance also adopts an over-collateralized model and currently only supports mainstream assets like USDC, USDT, sDAI, WETH, and wstETH. Thus, it’s worth noting that although borrowers cannot repay loans before the maturity date, they can still withdraw over-collateralized collateral; they can also add more collateral to avoid triggering liquidation. In the auction instance of Term Finance 4W-USDC(wstETH)-Nov 16, the collateral is wstETH, and the lending asset is USDC, with an initial collateral ratio of 150% and a minimum collateral ratio of 125% (falling below this value will trigger liquidation).

According to the fixed term, liquidation could happen under two scenarios: one is within the term, where the borrower fails to maintain sufficient collateral value and triggers liquidation; the other is post-maturity, where the borrower cannot repay the loan within the repurchase window and thus incurs a default liquidation. Regardless of how liquidation is triggered, the liquidator repays the borrower’s debt and takes possession of it, but has to pay a part of the debt amount to the protocol as a default penalty.

Continuing with the example of the 4W-USDC(wstETH)-Nov 16 auction (initial collateral ratio of 150%, minimum collateral ratio of 125%), assume user A collateralizes $1.5 wstETH to borrow $1 USDC. Due to a decline in the price of ETH, the original $1.5 wstETH is now worth only $1.2, falling below the minimum collateral ratio. A liquidator steps in for the liquidation, repays the $1 USDC debt, and obtains $1.2 wstETH in collateral. However, a default penalty fee based on a certain percentage of the debt amount, say 2.8%, has to be paid to the protocol, amounting to $0.028. Thus, the net profit for the liquidator is $1.2 wstETH — $1 USDC debt — $0.028 default penalty = $0.172.

Based on the tri-party repo model, Term Finance introduces features in DeFi that are uncommon in existing mainstream lending protocols, such as fixed interest rates, fixed terms, and non-redeemability. These features have their pros and cons. For instance, fixed interest rates provide both borrowers and lenders with protection against interest rate risks, especially in the highly volatile cryptocurrency world, enabling investors to manage their capital more precisely. However, fixed rates also mean that investors cannot earn on risk premiums in highly volatile markets. Moreover, the inability to redeem early means that there is reduced flexibility in the use of funds.

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