Decentralized Money Market
VeradiVerdict - Issue #140
Pantera Capital recently led the seed round of Parallel Finance, a decentralized money market for the Polkadot blockchain. Other investors include Polychain Capital, Lightspeed Venture Partners, Breyer Capital, 8 Decimal Capital and Hypersphere Ventures.
Parallel Finance is a new decentralized money market for the Polkadot and Kusama blockchains. The protocol supports two key functions: lending and borrowing.
To lend assets, users can deposit capital into any of Parallel’s asset pools (currently DOT, xDOT, and USDT). Users earn interest on these assets based on their proportional ownership of the pool and how much that specific pool contributes to the total supply of the protocol.
To borrow assets, users must over-collateralize their loans by depositing some assets as collateral, with a value greater than the amount they intend to borrow. Users can then borrow from any of Polkadot’s asset pools, paying an algorithmically determined interest rate.
One key limitation of DeFi on Proof-of-Stake blockchains like Polkadot is that users must generally choose between staking their tokens (to earn a block reward from validating new blocks) and lending their tokens (to earn interest from a money market). This produces a tension between the blockchain’s overall security (which requires enough tokens to be staked) and the capital efficiency of its DeFi protocols (which requires a sufficient supply of tokens).
Parallel Finance enables users to simultaneously stake and lend their assets, allowing them to support the security of the network, participate in DeFi, and earn higher rewards, all at the same time. Users can deposit the blockchain’s staking token (e.g. DOT) into Parallel’s account, which Parallel stakes on their behalf; Parallel then pays out any block rewards to the user. In exchange, users receive a voucher token (e.g. xDOT, a futures token that can be redeemed 1:1 for DOT in the future) which can then be supplied to Parallel’s money markets, allowing them to also earn interest on the same assets they have staked.
Parallel’s decentralized governance is centered around the protocol’s native token: PARA. PARA holders have the ability to propose referendums, protocol upgrades, parameter adjustments, etc. and also vote on governance actions proposed by others. The specifics of PARA distribution will be announced prior to the launch of mainnet, but the protocol intends to allocate tokens in a way that encourages the long-term security, stability, decentralization, and maintenance of the protocol.
With the rising popularity of Ethereum, users of Ethereum-based DeFi suffer more and more from prohibitively high transaction fees, making DeFi on alternative chains an interesting area for exploration. By fusing a decentralized money market with a delegated staking mechanism, Parallel Finance enables users to simultaneously reap block rewards and interest from their tokens, creating a huge incentive for DOT/KSM holders to participate in DeFi on Polkadot and Kusama. Ultimately, this helps draw in new sources of liquidity, positioning Parallel Finance to be one of the key players in the ever-growing DeFi ecosystems of Polkadot/Kusama.
What is Parallel Finance?
Parallel Finance is a new decentralized money market for the Polkadot and Kusama blockchains. The protocol aims to bring more liquidity into the Polkadot/Kusama ecosystem, particularly as more dapps are built on these alternative chains and Polkadot/Kusama asset (e.g. DOT/KSM) holders encounter higher demand to borrow and lend their assets. The protocol’s testnet is currently live here.
At a high level, the protocol supports two primary functions: lending and borrowing.
To lend assets and to earn interest, users can deposit capital into any of Parallel Finance’s three lending pools: DOT, xDOT, and USDT. Each pool accrues interest based on an asset-specific interest rate, which is algorithmically determined based on how much each pool contributes to the protocol’s overall supply and liquidity for borrowing. The aggregate interest earned by a pool is then distributed to the pool’s suppliers, based on their proportional ownership of the pool.
To borrow assets, users must first over-collateralize their loans by depositing some assets as collateral to the protocol, with a value greater than the amount they intend to borrow. This sets the “borrow limit” for the user, or the maximum amount the user can borrow from Parallel Finance, which is algorithmically determined based on the loan-to-value ratio of the asset pool that they wish to borrow from. Users can increase their borrow limit by repaying their debt to the protocol or by depositing more collateral. They can then borrow from one of Parallel Finance’s three asset pools (DOT, xDOT, and USDT).
As assets prices fluctuate, loans may become undercollateralized, threatening the protocol’s short- and long-term financial solvency. To control for this, when the value of a user’s collateral drops below the amount they have borrowed, Parallel Finance offers to sell their collateral at market price with a liquidation discount, incentivizing a prompt purchase by arbitrageurs. This helps efficiently eliminate the borrower’s exposure in the protocol and the protocol’s overall risk of hitting a loan-to-value ratio below 100%.
How is the protocol specifically optimized for the Polkadot ecosystem?
One key difference between Polkadot and Ethereum (which hosts the vast majority of DeFi protocols today) is that Ethereum uses Proof-of-Work (PoW) consensus to secure its network while Polkadot uses Proof-of-Stake (PoS) consensus. In PoS consensus, block validators must “stake,” or essentially lock up, the chain’s token (e.g., DOT) to be eligible to validate new blocks. Generally, validators’ chances for being elected to validate the next block are proportional to the amount they have staked.
In exchange for validating blocks, validators earn a block reward from the network. In this sense, staking can be viewed as a sort of investment: validators invest (or stake/lock-up) assets in order to earn a yield (block rewards). These staked assets can generally not be used for anything else, making them effectively illiquid. This produces a sort of competition between lending protocols and staking in PoS blockchains. Based on the current block reward and interest rates, token holders must decide whether to stake their assets and earn block rewards or whether to supply them to a lending protocol like Parallel Finance and earn the interest rate. In turn, fluctuations in the block reward and interest rate can threaten the network’s overall security (if the block reward is lower, token holders are incentivized to unstake and lend their assets instead) and liquidity (if the interest rate is lower, token holders are incentivized to stake their assets, reducing the overall amount of liquidity on the chain).
One of Parallel Finance’s key features is that it allows token holders on Polkadot and Kusama to simultaneously stake and lend their assets. To do so, token holders can deposit their assets into Parallel’s account and receive a “voucher” in exchange. For example, a DOT holder might deposit DOT into the protocol and receive xDOT (essentially a “futures token” that can be redeemed 1:1 for DOT at some point in the future) in exchange. Parallel then essentially stakes the user’s assets, on their behalf, nominating their own validators, and pays out the block rewards accordingly. At the same time, users can supply their xDOT tokens to Parallel’s xDOT lending pool, enabling them to simultaneously earn interest on their asset as well. This makes Parallel an extremely compelling option for users that are looking to stake or lend assets (as they can now do both), and also paves a path towards bringing more liquidity into Polkadot/Kusama while ensuring the underlying blockchains remain secured.
How is it governed?
The core of Parallel’s decentralized governance structure is the Parallel native token, referred to as PARA. PARA holders can propose various governance actions (including referendums, network upgrades, council member elections, & parameter adjustments) and also vote on proposed governance actions. The entire supply of PARA tokens will be minted prior to the launch of mainnet, with an allocation strategy that encourages long-term network security, stability, decentralization, and maintenance.
The protocol also maintains a “Treasury,” which is overseen by the council (a set of governing members elected by PARA token holders). Parallel charges a small fee on each loan they execute, which channels into its Treasury fund. Various teams can make spending proposals about how to use the funds (e.g. establish a new market, upgrade some aspects of the protocol, etc.), which are then approved or rejected by the council.
As Ethereum becomes increasingly oversaturated, prohibitively high transaction fees and ridiculously slow transaction times make it particularly difficult for mainstream users and new crypto enthusiasts to participate in Ethereum-based DeFi, making DeFi on alternative chains an interesting area for exploration. These chains are often more interoperable (like Polkadot) and specialized (like those of Kusama), expanding the range of financial use cases that DeFi protocols can capture. Unfortunately, these newer chains often suffer significantly from a relative lack of liquidity, making it extremely difficult to build and sustain capital efficient DeFi protocols on top of them.
Parallel Finance offers one of the most compelling solutions to bring more liquidity into the Polkadot/Kusama ecosystem. The protocol fuses a decentralized lending protocol with a delegated staking mechanism, enabling users to simultaneously stake and lend their assets to earn both the network’s block reward and the protocol’s interest. Ultimately, this creates a massive incentive for DOT/KSM holders to participate in DeFi on Polkadot and Kusama, since they can effectively double their earnings by doing so. As the DeFi ecosystems on these chains continue to evolve, Parallel Finance will be instrumental in bringing in new swaths of liquidity, setting the protocol up to be one of the key players in the cross-chain DeFi of the future.
- Paul V
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Hi, I’m Paul Veradittakit, a Partner at Pantera Capital, one of the oldest and largest institutional investors focused on investing in blockchain companies and cryptocurrencies. I’ve been in the industry since 2014, and the firm invests in equity, early stage token projects, and liquid cryptocurrencies on exchanges. I focus on early-stage investments and share my thoughts on what’s going on in the industry in this weekly newsletter.