The Two-Market Model
Today's leading lending protocols work on this concept of a Utilisation ratio. The way this works is that if there is $100 deposits, and $75 are lent out, then the interest proceeds paid on the $75 (let's say 4%) are used pay the $100 of lenders (i.e. $75 x 4% / $100 = 3%). This mechanic produces a wide spread, or a wide bid-offer between the rate that borrowers pay, and the rate the lenders receive. As such, Utilisation, and its usefulness in a fast-moving, institutional environment is limited.
At Infinity, we have built a two-market model, that emulates 'real world' mechanics taken from institutional finance, and in particular, the interbank lending market. While in TradFi, this market is very well understood and used. In DeFi, however this concept alongside the historical (and preferred?) use of Liquidity Providers, makes for a more complicated set of mechanics that we term the 'Two Market Model'. In this model, there are two markets: The Reference Market, and the Subscription Market.
Imagine there is a large, but equal number of Lenders and Borrowers who agree to pay, or receive respectively, a Reference Rate, no matter how that rate is determined. This market always operates at 100% utilisation, so much in fact, that the concept of Utilisation is not used - rather, we simply say that the # of Lenders matches the # of Borrowers. If there are $100mm of Lenders, there are exactly $100mm of Borrowers -- if there are $10mm Lenders, there are $10mm Borrowers.
Let's look at how these participantes get into or out of this market.
In the Reference Market, or Reference Rate Market, there is a smaller, and likely uneven number of participants actively switching their positions between one of the three states: Lending, No Position, and Borrowing. The supply, demand, and dynamics of trading behavior in this market influence the Reference Rate, that the Subscription market ultimately adheres to.
Participants may be involved in one or two of these markets, looking to add capital, remove capital, or do nothing. The supply and demand of participants entering or exiting the markets adjusts the reference rate and in order to move in or out of the Subscription market, one must be paired with a participant who has the opposite position. That is:
- A Potential lender could be matched with a potential borrower, causing the size of the Subscription market to increase
- A Potential lender could be matched with a current lender (who wants to exit their position), causing no change to the subscription market (i.e. they're just switching positions).
- A Potential borrower could be matched with a current borrower (who wants to exit their position), causing no change to the subscription market (i.e. they're just switching positions)
- A Current borrower (who wants to pay back their loan) could be matched with a current lender (who wants to redeem their loan), causing the size of the Subscription market to decrease
To catalyse liquidity, we employ a liquidity-provider (LP) incentive program that pays market participants to actively switch their positions in exchange for a share of protocol fees. LP positions are a DeFi-native representation of an attempt to build depth around an order book. Within the FX markets, an LP provider switches their positions between two currencies, for example, ETH and USDT.
In the Interest rate market, the LP providers switch their positions between Lending, No Position, and Borrowing:
- The Lending LP position switches their positions between Lending, and Not Lending (i.e. No Position) and is considered a Long position.
- The Borrowing LP position switches their positions between Borrowing, and Not Borrowing (i.e. No Position) and is considered a Short position.