Introduction

Euler Finance is an Ethereum-based lending platform striving for comprehensive risk mitigation without sacrificing capital efficiency. Novel features include asset tiers, risk-adjusted liability value, feeless flash loans, and much more. Euler has many ambitious products in development as well, such as its own AMM, a decentralized in-house oracle solution, and a secondary permissionless pool layer.

Anyone can list new assets, and Euler uniquely categorizes assets into risk-based tiers to decide how they can be used in the protocol. With this robust approach, borrowers and lenders get more protection with no major compromises. Euler has over $450 million in TVL today (includes borrows) and has drawn investors like Coinbase Ventures, Uniswap Labs Ventures, Jump, Paradigm, and more. It saw explosive growth in 2022 and shows no signs of slowing anytime soon.

The Problem

Lending protocols today have design flaws when it comes to containing the risk of bad debt from volatile assets, especially when it comes to liabilities. Not to say that these protocol designs are “bad”, but rather they are not comprehensive. Protocols use blanket risk control tactics like only listing assets approved by governance, absolute asset isolation, or static risk parameters.

Borrowers are generally restricted based on the risk of their collateral, but the risk of their liabilities is never controlled. This can lead to dangerous situations like what we saw just a few months ago with the $CRV short on Aave, resulting in nearly $2 million in bad debt for Aave (now fully paid off!).

The Goal

Euler is a lending market that implements more extensive risk methodology to safely offer a larger selection of borrowable and lendable assets. Asset listings are totally permissionless, so new tokens do not need governance approval before they’re added.

Assets are voted into different tiers by Euler governance. These tiers determine how assets can be used based on their risk, like being used as collateral or being borrowable alongside other assets. Euler introduces plenty of other improved risk parameters like adjusting the value of liabilities based on their risk, reactive interest rates, optimized liquidations and close factors, and much more.

How Does it Work?

At its core, Euler works like Compound or Aave. Assets listed on Euler can be lent and borrowed, and borrowers must have deposited collateral in order to borrow from the protocol. Suppliers get interest-bearing eTokens representing their deposit, and borrowers get interest-accruing dTokens to represent their debt.

Unlike Aave or Compound, asset listings on Euler are permissionless. The only requirement to add a new asset is that it has a WETH trading pair on Uniswap v3. By supporting a broader range of assets, permissionless money markets generally create greater risk that is difficult to mitigate.

This risk is largely reduced by Euler ranking assets into categories with different risk-specific restrictions. Euler governance ranks assets into three unique tiers:

• Isolated is the default tier (new listings start as isolated). An isolated token can be lent and borrowed, but cannot be used as collateral. More specifically, isolated assets cannot be borrowed together with other assets. This is to mitigate liability risk, since liquidation cannot be buffered with “safer” assets.

• Cross is the next tier up. A cross-tier token can be borrowed and lent, and similarly cannot be used as collateral. Unlike isolated assets however, cross assets can be borrowed alongside other non-isolated assets.

• Collateral is the highest tier. Collateral assets inherit all the same features of cross assets, except they can be used as collateral to borrow other assets.

Users that are borrowing isolated assets against their collateral will not be able to borrow anything else on the same account. Rather than making users open a new position(s) from a completely separate wallet, users can open new positions in an Euler sub-account from the same wallet. Each wallet can create up to 256 sub-accounts.

The risk and volatility of assets being borrowed is ultimately never accounted for by major lending protocols, and this can create systemic risk just like collateral assets can. Paired with the common collateral factor (a.k.a collateral ratio), Euler introduces its original “borrow factor” concept. While collateral factors limit borrowing based on the collateral asset’s risk, borrow factors limit borrowing based on liability risk (the asset being borrowed).

Inspired by Aave’s original concept, the release of Euler’s High Efficiency Mode (e-Mode) allows Euler governance to specify unique collateral or borrow factors for certain collateral/liability pairs. Mentioned in the initial proposal:

“An E-mode is a specific LTV applied to a specific trading pair. While a conservative LTV makes sense for lending USDT to borrow WETH, it would make sense to increase LTVs specifically for USDT/USDC given high correlation between these two assets.”

Euler will also use reactive interest rates. Like other protocols, rates rise and fall with a pool’s utilization rate (how much of the pool’s supply has been borrowed). Except rather than rising and falling at a constant rate, rate change on Euler markets can be sped up or slowed down to closely track utilization. This ensures that spikes in utilization of any size can be met with the appropriate interest rate.

Each market on Euler collects reserves in the event that bad debt is created by borrowers. Reserves are like an insurance fund for lenders, since any bad debt incurred will be paid with whatever reserves are available. Reserves are market-specific, so a percentage of interest paid by borrowers of a market is used to grow its reserves. This percentage (reserve factor) is decided by Euler governance and varies by market.

Liquidations on Euler are optimized too. Static discounts on collateral encourage competition between liquidators known as “Priority Gas Auctions” (PGAs). This is like a race to pay the highest gas fee in order to get a transaction executed first, and as such be the liquidator of some collateral. This is not to mention how fixed fees discourage larger borrowers (5% fee on $10,000 vs 5% on $10,000,000). Euler improves this with its custom Dutch collateral auction model. Rather than static fees, collateral discounts increase as a position becomes more and more under-collateralized.

Unlike Aave, Euler’s dTokens are transferrable. This gives liquidators much more flexibility since they have two different ways to liquidate:

• Absorb a position by depositing the amount of collateral needed to make a position healthy again. This transfers the remaining collateral (eTokens) and debt (dTokens) to the liquidator who takes on the position.

• Close a position by paying off a position’s debt, seizing the collateral, and liquidating it on some exchange

With that said, Euler uses soft liquidations. The amount of collateral that can be liquidated from an under-collateralized position is determined by “close factors”. Usually these are fixed, and this can result in more collateral being liquidated than really necessary for borrowers who are barely below a healthy ratio. Euler will instead use dynamic close factors which limit liquidators to liquidating the minimum amount of collateral necessary to make a position healthy again.

Users can enjoy a simple UI with an abundance of useful features. Since lending markets are go-to outlets for going long and short on assets, Euler makes this easy with both its Long/Short tool plus the Mint tool for leveraged borrowing. These tools’ usefulness are best exemplified with liquid staking derivatives like wstETH and cbETH. Euler is the only onchain market where these LSDs can be longed/shorted, and holders can use the Mint feature to leverage up their staked ETH. Euler only plans to keep expanding and support more liquid staking derivatives.

Euler also offers a Transaction Builder tool for users to bundle transactions and save on gas. The Transaction Builder can notably be used to execute feeless flash loans with the “Defer Liquidity” option. This option allows a user to perform a series of actions (borrow, liquidate, etc.) and only checks they have the proper liquidity to do so by the very end of the series of actions. Users only have to pay gas.

How Does it Work? Eulerswap

Eulerswap will be a pool-based DEX which leverages its own custom-built oracle solution. The first audit is expected this month (February) and launch is expected by the end of Q1. This will be one of many features anticipated in Euler v2.

Since the Merge greatly reduced the cost of manipulating oracles (especially TWAP), there is a widespread need for truly decentralized and tamper-resistant oracles that provide reliable price data.

Median Oracles will strive to be just that, and they can eventually be integrated into the main Euler market as a primary oracle solution. Median Oracles will mimic Uniswap’s TWAP functionality and be built into Eulerswap, but they will offer substantially more protection against price manipulation. Rather than standard mean pricing, Eulerswap oracles will favor weighted median prices to significantly increase the cost of manipulation.

Eulerswap’s AMM design will be a hybrid between Uniswap v3 and Curve, and it will be the first-known AMM leveraging a dynamic invariant. This would likely be the ability for a pool to modify its invariant curve in response to changing market conditions. Rather than a static AMM formula shared by all pools, pools can instead adapt their curves specifically to their market.

It could be speculated that $EUL holders will control Eulerswap pool gauges, and previous governance proposals suggest $EUL emissions are possibly being reserved for Eulerswap rewards. The Euler team has even hinted at potentially supporting borrowing and lending Eulerswap LP tokens on the main market.

How Does it Work? Baby Euler

Inspired by former champion protocol Rari-Fuse, Baby Euler will let users deploy their own lending pools with customizable parameters like interest rates, oracles, and collateral/borrow factors. It is expected to launch sometime in March or April 2023.

Permissionless pool lending protocols infamously experience the issue of fragmented liquidity, but Baby Euler will not suffer from this as markets will be created with eTokens. While each market and its risk on Baby Euler is isolated, all liquidity will be sourced from the underlying main Euler market.

Only eTokens can be used as collateral, and all assets being borrowed will come from lenders on the main market who opt to lend to Baby Euler pools. This improves overall liquidity on this secondary sublayer, and enables anything to be used as collateral to borrow any asset.

Partnerships

Although Euler only exists on Ethereum so far, the DAO is eager to expand the protocol’s presence to chains like Arbitrum and BNB Chain.

Euler recently announced an exciting partnership with FloorDAO. In this collaboration, Euler hosts markets for longing or shorting different NFT collections that FloorDAO has tokenized into ERC-20s.

IdleDAO has integrated Euler into its protocol to offer users various yield strategies tiered by risk (Perpetual Yield Tranches). The Spool Finance yield protocol allows users to incorporate Euler PYTs into their yield strategies.

Wonderland has released a new oracle design it has been working on and has reached out to Euler for a potential collaboration. The Euler Team mentioned the possibility of adding Wonderland’s Price alongside Uniswap and Chainlink as an oracle option for markets.

OlympusDAO has recently chosen Euler to host the first $OHM and $gOHM borrow markets where users can soon borrow these assets directly against collateral.

Tokenomics

$EUL Price: $6.17

Market Capitalization: $89,843,080

Circulating Supply: 14,533,469

Total Supply: 27,182,818

Fully Diluted Valuation: $168,038,890

Read more about token distribution here.

The $EUL governance token is used to vote on asset tiers, collateral/borrow factors for each asset, which oracle each asset uses (Uni v3 TWAP/Chainlink), reactive interest parameters, reserve factors, and any other relevant protocol decisions or changes. All of these risk parameters are ultimately decided by governance using various categories for assessing each asset’s risk.

The $EUL token is distributed through emissions mostly to lenders of the protocol, and this is currently planned for a total of 96 epochs. Each asset pool on Euler has a $EUL gauge and earns relatively more or less emissions depending on the gauge’s weight.

Users can use their $EUL to vote in governance, or it can be staked to different pools to increase their gauge weights. In this, lenders who hold $EUL can stake it on asset markets they supply in order to increase their $EUL rewards. Users can also stake select eTokens on Euler to earn $EUL rewards. Currently only eWETH, eUSDC, and eUSDT are supported.

Conclusion

Euler is a totally modernized money market using thoughtful approaches to mitigating risk, simplifying UX, and building other useful sub-products. It achieves a real balance between supporting as many assets as possible and controlling the systemic risk of doing so, and ultimately improves on almost all features of today’s top lending protocols.

It has an exciting product stack in the works including the Eulerswap AMM/in-house oracle as well as the Baby Euler submarket. This combined with Euler’s eventual multi-chain presence could propel the protocol to new heights, and there’s no doubt it will take the rest of DeFi with it.

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DISCLOSURE: I have no exposure to Euler or $EUL. I was not asked to write this article and have not been compensated in any way. The information provided in this article is solely for educational purposes and should not be considered as financial advice. The views expressed in this article are my own and do not necessarily reflect the official policy or position of any company or organization. Readers should always conduct their own research and seek professional advice before making any financial decisions.