Episode 413

Notional Finance – The Fixed-Rate Lending Protocol

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Notional is a protocol on Ethereum that facilitates fixed-rate, fixed-term crypto asset lending and borrowing. The core concept of Notional is fCash, a zero-compound bond defined by a currency type and maturity date. Notional’s liquidity pools are built by liquidity providers who contribute cTokens and fCash and act as counterparty to the lenders and borrowers that are active on the protocol.

We were joined by co-founders Teddy Woodward and Jeff Wu to chat about the benefits and tradeoffs of fixed rate interest borrowing, how Notional operates, and comparisons to other lending protocols in the space.

Topics discussed in the episode

  • Teddy and Jeff’s backgrounds and how they got into crypto
  • The benefits of a fixed rate over a variable interest rate loan
  • The product from a user perspective
  • The role of liquidity providers in the protocol
  • Tradeoffs of using Notional as opposed to other lending platforms
  • Lender and borrower obligations
  • How Notional maintain security
  • The ERC1155 token standard which is implemented on fCash
  • The maturity parameter and how it’s determined
  • The Notional governance model


Sebastien: Hi Teddy and Jeff, thanks for joining us today.

Teddy: Thanks for having us, Sebastien.

Jeff: Yeah, thanks for having us.

Sebastien: So, before we get started and dive into Notional Finance, tell us a bit about your backgrounds and how you became interested in crypto?

Teddy: Okay I’ll start. I started my career working in banking. I was an interest rate swap trader, and basically, I started there for about four years at Barclay’s and I really liked trading, but kind of hated working for a bank. It seemed to me that it was very much the way of the past.

So, I was trying to figure out what the new thing in finance was going to be. Cryptocurrencies just seemed like an obvious next step. Whereas, because I was working in the post financial crisis and all these regulations were making it almost impossible to do anything new or interesting or creative, which there’s a reason why those regulations were in place.

But it was a lot more boring to work in that environment and so I saw cryptocurrencies, which is a completely new thing. Just like, and it just seemed to me to just be super exciting and intellectually interesting.

I wanted to be a part of it and I left my job to trade crypto for the family office in 2018, and then towards the end, towards the end of that, end of 2019, I wanted to get into DeFi and I started Notional with Jeff in January of 2020. So that’s me.

Friederike: Jeff, what about you and how did you guys meet?

Jeff: My background is more in tech, so I started my career in the Bay Area, working for a tech company, doing data science and working with distributed systems. In around like 2011, that’s when I started my career and back then kind of the hot new distributed system was Hadoop, which maybe some people remember, but that was the beginning of big data movement. Right.

I spent a lot of time doing data science, data engineering, and that type of work. In 2016 and 2017, one of my co-workers introduced me to Bitcoin and I just naturally became fascinated with the technology. Really at that same time, it felt like the early days of big data again. This is like a cool new distributed system.

It works at a much larger scale. It kind of got me excited again about something new. It didn’t really click for me as to why someone would want to use blockchain or crypto until I started reading about MakerDAO and that’s when I was like, okay, this is, there’s a natural product market fit here with financial products.

Like this really makes sense to me. In 2018, I left my job and I took a new job at Splunk as the product manager for their blockchain team. Splunk is a data analytics firm here in San Francisco. I worked looking at the blockchain crypto industry in general.

Looking for business opportunities for Splunk. in the course of that in late 2019, I met Teddy, actually at a Cosmos Hackathon here in San Francisco. Where actually, we met Sunny, so this is.

Sebastien: I was at the Hackathon too. I was just walking around taking pictures and like putting stuff on Twitter. I wasn’t actually doing anything, but I was there.

Jeff: Oh awesome. It was a surreal experience because I had been listening to Epicenter a lot and I was having trouble with that Cosmos SDK and Sunny sat down next to me and started helping me. I was like, oh, wow, this is kind of surreal. Teddy, I met there just actually very serendipitously.

We just, I had wanted to do, we had both seen Compound come out like that very recently then. We were both just wanting to do a fixed rate, fixed term version of that, because we felt like that was, I was like variable rates are cool, but a fixed rate product is something that is more compelling to a mainstream audience.

I also think, from when we first met at the hackathon within the first 10, 15 minutes, we just hit it off. We have a really good rapport in terms of the skills and expertise we bring and that they complement each other really well. We also get along really well on a personal level.

Sebastien: Were you guys building anything at that hackathon?

Jeff: Yeah, we built a very early version of Notional. Is a fixed rate thing, using the Cosmos edge SDK. We took first prize there and that encouraged us to keep going, so.

Sebastien: Okay, cool. So then you switched over because you were building it originally. I mean the prototype or like proof of concept was on Cosmos. Then what made you decide to pursue it on Ethereum?

Jeff: That was late 2019, at the time, DeFi was still quite young then, and all the activity was on Ethereum. This seemed like a natural fit for us.

Sebastien: Okay, cool. Actually, this t-shirt I’m wearing now, and I got from the conference and I like my daily water bottle is the water bottle from that Hackathon. I like lots of swag from that conference for some reason.

Jeff: I was going to wear the t-shirt but I couldn’t find it.

Sebastien: I had a question for you, Jeff, about your past experiences, something that I often find myself thinking about, because I’m not at all familiar with the big data industry or like that ecosystem. I wonder if there’s anything that you know, what are the things that you took away from that experience working in that industry that apply to crypto?

Because in many ways are similar, but in many ways are also different, like the types of infrastructure on which blockchains operate, it’s totally different from the types of things you were mentioning earlier. What’s the parallel there? How does that apply in the crypto space for you?

Jeff: One is just, they’re both distributed systems, big data computing is distributed across a cloud environment. But the general principles of state across multiple machines, message passing, consensus. They’re applied in similar ways. There’s like a lot of, low level technological analogies between the two.

That’s one. I do think from an engineering perspective, working in blockchain is both fun and frustrating. If you’re in the big data space, you always have, at your fingertips, unlimited computers and unlimited storage endlessly. But on the blockchain, like that’s not the case.

Every bite you use costs money and there is a lot of congestion. So flipping from like one endless supply to very limited supply, it’s an interesting engineering challenge. It’s quite fun. I would say that’s the big difference. Yeah, for sure.

Friederike: Cool. Let’s talk about Notional. You already alluded to it. Notional is a fixed rate lending and borrowing protocol. Maybe let’s talk about this at a high level first. Why is the fixed rate something that’s desirable for customers?

Teddy: The fixed rates are really desirable because they give people stability and certainty and the ability to plan for the future. You can sort of, if you look at traditional financial markets, you see that the amount of fixed rate debt compared to variable rate debt is just overwhelming.

Something like 90% of the US debt market is fixed rate as opposed to variable rate, which shows that empirically, it shows the importance that both borrowers and lenders place on stability and certainty.

Just like if you think about it, it’s very challenging to do anything beyond a very short-term time horizon if you’re working exclusively with variable rates. If you want to take out a loan, you can just use an example from your everyday life.

If you want to take out a loan to buy a car, and the rate of interest that you’re paying on your loan fluctuates between 2%, one month and 10% the next month. It’s very difficult for you to plan and you know if you can afford that. Right.

If you extrapolate that forward to like, if your rate of interest fluctuates that much every day or every month, or it has the potential to, it’s very difficult to commit to, I’m going to borrow something for five years.

Take out a loan that’s like a five-year maturity. Just because you have no idea. It’s very difficult to do anything but something that’s extremely short-term.

I think that fixed rates beyond just bringing in a more user base that values certainty and stability can also just really expand like the capability of the DeFi system to enable use cases that are more long-term and just like enable new kinds of behavior. That’s what we’re really excited about.

Friederike: Teddy, can I ask something about legacy financial systems? Basically, I totally see that for consumers, having fixed rate loans is highly desirable just because loans that people typically have to satisfy often a significant portion of the money they have to spend. Right?

But what you’re doing in essence is that you’re buying insurance, or you’re buying some financial product that gives you a fixed borrowing rate. Whereas if you actually got the borrowing rate, that was just the borrowing rate over the day, you would probably on average pay slightly less. Right?

Basically, if you say 90% of all loans are fixed rate, is that consumers, or is that also companies? Because basically if I’m a big company that operates on that level, I can take larger financial risks and shave off like a couple of tenths of a percent somewhere. Right?

Teddy: That’s actually not necessarily the case. Your assumption here is that essentially by fixing your borrowing rate, you’re paying away some expected value, right, in return for getting this certainty.

Friederike: Exactly, that’s exactly what my assumption would be. Is that wrong?

Teddy: Well, it is not necessarily, it depends I guess. If we’re going to get like super trading about this, it depends on the aggregate who values the certainty more – borrowers or lenders. Right. It’s possible that for example, the lenders may value the certainty more than the borrowers.

And then theoretically, anyway, they would be willing to pay away some expected value in return for the certainty. And so, it’s not necessarily, but I think that in reality it’s just, it doesn’t quite work like that. You know, like for example, the ability to borrow at a fixed rate is not just a, it’s not just a bet on where the variable rate is going to be over the terminal loan.

Because, for example if you borrow, if what your fixed rate on your borrowing is, it gives you the freedom to pursue perhaps a certain type of investment that you feel like only might generate this amount of return.

The fact that you’re able to fix your financing costs gives you the confidence and the minimal aggregate risk such that you will pursue that course of action. Right? It’s less of a given amount that I’m going to borrow anyway, and should I borrow variable or fixed?

This is also why I want to borrow fixed because that will allow me to take on this other investment opportunity which maybe has a capped upside return. I’ll know that because my borrowing rate is fixed, my profit is going to be positive. Or like I’ll have a reasonable expectation.

It’s honestly just more complicated than just you’re speculating on what the variable rate is going to be over the duration of the loan. It’s just more complex.

Sebastien: Walk us through the product. I’d like to start with what the product looks like from the user perspective, and then maybe we can dive into the more technical aspects. But first actually, I’d like to ask you how much liquidity is on Notion?

Teddy: Right now, we’ve had fluctuating liquidity, like right now we’re in the order of 10 million TBL. What we’ve been doing as a company. I’ll give you a bit of background. We launched Notional V1 in January of this year and we’ve had between 10 and $20 million of TBL since the launch.

And what we’re doing right now is kind of got our heads down, building Notional V2, and we’re just getting set to launch that. Notional V2 is going live in three to four weeks.

Fingers crossed. But that’s going to be, that’ll be a big step up from the protocol because we’re making some significant changes to the protocol, as well as launching our token and our public liquidity mining program. We anticipate that this set of changes is going to really be a big step forward for Notional.

Sebastien: Cool. Then walk us through the product. What can I do as a user of this product? If I’m a lender or a borrower what does it look like for me? And maybe contrasting that to what people may already be used to, which is Aave or Compound or some of these other lending platforms.

Teddy: Sure. Basically, like the core concept in Notional is what we call fCash. That is a zero coupon bond. In that it is defined by a currency type and a maturity date. For example, December 1st, 2021, USDC is an fCash token that matures on December 1st, 2021. Okay.

This fCash token is transferable, it’s tradable. On December 1st, 2021, it can be redeemed for one USDC on Notional. Effectively, December 1st, 2021 USDC, represents USDC at that specific future date. Okay? The way we enable fixed rate borrowing and lending is by allowing users to trade between USDC today and USDC in the future as represented by this fCash.

If you’re a lender, you can sell your USDC today and purchase USDC on December 1st, 2021. And the exchange rate at which you make that trade between USDC today and USDC on December 1st, implies a fixed interest rate over that period of time.

That’s like the basic way that this works and the way we facilitate that trading is we have liquidity pools on-chain where we have USDC on one side and December 1st, 2021 USDC on the other side. And you can trade between them. And we have liquidity pools for different currencies and different maturities.

We have USDC December 1st liquidity pool, a USDC March 1st, 2022 liquidity pool, for example. So we have, as a user, you have multiple options. You can borrow and lend DAI in USDC at several different maturities.

Friederike: In a way you’re not actually, so the protocol doesn’t fix an interest rate, but market mechanisms do like they would in traditional financial systems.

Teddy: That’s correct. The way I think about it and for everybody listening, I am a trader, so it’s probably not the way that everybody else thinks about it. But I think about it less as borrowing and lending, than buying and selling cash in the future.

That’s the way that I think about it. Yes, it is market determined. We have these liquidity pools as people borrow and lend, they move to prevail.

Friederike: Do you guys have basically liquidity providers or market makers that emulate what a currency market would look like on a legacy system?

Teddy: I suppose. It’s interesting to compare this to the traditional financial system, but yes, we do have liquidity providers. The system relies on liquidity providers to put their capital into these liquidity pools, so that borrowers and lenders can actually use the protocol.

Friederike: And the liquidity providers. What’s in it for them?

Teddy: Basically, and I’ll talk a bit about Notional V2 here, because we’ve changed the way, we’ve changed the way this works a little bit. But basically, the liquidity provider earns interest on the capital that they put into the system. In Notional V2, liquidity providers actually provide C tokens instead of the underlying token like DAI, they’ll put in C-DAI.

They earn interest on their capital plus trading fees. Anytime someone borrows or lends, they pay a transaction fee that goes to the liquidity providers, very similar to Uniswap. The liquidity provider is going to earn interest on their capital via compound.

They’ll earn transaction fees from borrowers and lenders on Notional. They’ll also earn in Notional V2 anyway, liquidity incentives in the form of our governance token.

Friederike: Okay, maybe let’s talk about the governance token in a bit, but does that mean that the borrowers and lenders effectively get the same rates? Basically, maybe because there’s no spread?

Teddy: There is a spread and the spread

Friederike: Okay, but that’s a one-time thing. Right?

Teddy: That’s correct. It’s like a true market rate and borrowers and lenders get the same market rate, as opposed to something like a Compound, where there’s structurally a spread between the lending rate and the borrowing rate. That is not the case in Notional. There’s like one interest rate that both borrowers and lenders get.

Sebastien: There must be trade-offs to using Notional as opposed to another lending platform, what would you consider those trade-offs to be?

Teddy: Okay, so, I would compare it to something like Compound or Aave. And the trade-offs, from my perspective, that the most significant trade-off is going to be just the fact that Compound and Aave have been around for a while and they are lower risk therefore. Right?

I think that smart contract risk is just an undeniable thing that anybody has to reckon with in DeFi. If you’re launching a big ambitious new platform like Notional V2, people need to think about smart contract risk. I think that Compound and Aave have, is that they’ve been around for a while.

This most recent thing with Compound notwithstanding, they have built a very strong track record of security. I would say that’s probably the most significant trade-off that I would see.

Jeff: I just want to add a couple of things here. One misconception that we’ve seen a lot with Notional is that, even if you’re like lending or borrowing fixed on Notional for three or six months, you’re not locked into that for the duration of the term. Right.

One thing about Notional is that you can lend some money. If you need to withdraw that money, you can sell that fCash back into the markets and get your money out, and you’ll be able to sell it at the current market rate at that point in time. That’s one thing that we’ve heard with Compound.

Oh, like Compound, I can always get my money out. Well, that’s similar to Notional as well. I also say one trade-off on the downside here with Notional is that, since you are going through a liquidity curve, both on lending and borrowing, the lending, the gas fee on the lending side is going to be similar to the borrowing side. Right.

On both sides, the gas fees will be a little bit higher. On compound, since you’re just wrapping C tokens, it’s cheaper on the lending side. But for us the action is similar on both sides. You’ll pay a bit higher gas fee. But those are the main differences.

Sebastien: And what happens at the maturity date? Like are you expected to have paid off your loan by the maturity date, and if you haven’t, what happens? You get liquidated or what happens then?

Teddy: Yeah. Okay. Basically, and just for your listener’s clarity here, so I’m going to be talking about Notional V2, okay? Given that we’re launching this pretty quick or pretty soon rather, and we’ve changed a few things.

In Notional V2, if you’re a lender and you reach maturity and you haven’t rolled your loan forward, what’s going to happen is that, immediately upon maturity, you’re going to switch from earning a fixed rate to earning the variable rate. Okay. Immediately upon maturity, you’re no longer earning say 6% fixed.

Now you’re just earning the variable compound lending rate on your cash. Okay. There’s no action necessary. That’s what happens as a lender. Now as a borrower, it’s so basically the way Notional works. It is very important in order for us to ensure that lenders can pull their money out when they’re entitled to taking their money out.

We have to make sure that borrowers essentially make good on their obligations, and pay their debts by the time that they say they’re going to pay their debts. If you’re a borrower and you borrowed until March 1st, 2021 or 2022 rather, and you can roll your debt forward if you don’t want to actually repay your debt. Let’s say it’s April 1st, you can decide, okay I’d really rather keep my debt open.

I’m going to roll my March 1st debt into March 1st, 2022 or 2023 rather. You can roll your debt forward. Now, if maturity does come and you haven’t paid your debt, what’s going to happen is that a third party can roll your debt forward three months on your behalf.

Essentially, you will be forcibly auto rolled forward by three months at a penalty interest rate. That’s like at the moment, we’ve decided upon 250 basis points. That’s a two and a half percent penalty to the current market interest rate.

If the three month interest rate was 6%, your debt would be rolled forward at eight and a half percent. There’s like a bit of a penalty that you’re paying for not paying on time, but you are not going to get liquidated. Your collateral is not going to be seized

Sebastien: That’s pretty interesting. That’s quite different from the experience, say, of a typical lending protocol where you borrow the money and you just pay the interest for as long as you’re there. If you pay it back, whatever you’re paying the interest on the principal.

When this happens, who are these third parties that get to carry over your loan for the next three months? And are they, is there some incentive mechanism here for them to do this, or?

Teddy: Yep, that’s correct. It’s like a liquidation function. Like we would expect the same people who are going to be doing liquidations are going to be doing this rolling forward. The incentive is so we said that there’s, you’re borrowing at this penalty interest rate.

Two and a half percent over the market interest rates. That settlement penalty is the liquidator’s incentive. They essentially lend to you at a two and a half percent premium to the market rate. Then the expectation is that they would lend to you and then immediately sell that fCash that they got from you on the on-chain market and just capture that spread.

Friederike: Okay. I see. You already talked about the fact that everything is collateralized. Can you talk about the choice of collateral and what the collateralization ratio is?

Teddy: Sure. This is going to be something that will change and on an ongoing basis. But we are going to launch with, so we’re launching with the same four currencies that we have live on Notional V1. Eth, wrapped Bitcoin, USDC, and DAI.

And all four of those currencies are going to be lendable and borrowable, and they’re all going to be eligible as collateral to collateralize a loan in any one of those currencies. And the initial collateralization ratio for like a USDC debt collateralized by Ether for example, we’re going to start off conservative.

We’re starting off with a collateralization ratio that is roughly 150%. It’s a slightly more conservative collateralization ratio, but that reflects the fact that this is we’re launching a brand new protocol and we want to get comfortable before we start making that ratio a bit more aggressive.

For the actual collateral types, we’re launching with those four, but the collateralization framework on Notional V2 is very flexible. We will have the ability to deploy new collateral types and we very much intend to do that.

That’s going to be from a business standpoint, we expect to launch a new batch of collateral types, pretty close following the launch of Notional V2. We will definitely continue to add support for new collateral types that fit within the risk framework of the protocol.

This stuff, we do a lot of this risk work in-house and it’s something that we put a significant emphasis on as a company, and we want to put an emphasis on as a community, risk management of the protocol. So that these collateralization ratios and new collateral types these things are going to be fluid.

We definitely intend to make Notional as capital efficient as can be without sacrificing the integrity of the protocol. We want to enable people to borrow against as wide a variety of collateral types as we can safely onboard.

Friederike: Okay. Maybe let’s talk about the governance and how to add collateral types a bit in the frame, basically in the context of the token also, but just for wrapping this up. What happens if my loan is underwater?

Teddy: If your loan is underwater, basically, if you have become under collateralized, you are eligible for liquidation. What a liquidator can do is they can purchase a portion of your collateral and deposit the currency that you owe.

If you are taking out a USDC loan collateralized by Ether, your liquidator can purchase some of your Ether and give you USDC in exchange for that Ether. Basically, by doing that, they’re going to reduce the risk of your account and re-collateralize your account.

Friederike: What’s the penalty?

Teddy: The initial penalty we’re going for, so basically the liquidation penalty is going to vary by currency. Now, the liquidation penalty for Ether, the initial penalty we’re going forward is 8%. That is the liquidation penalty.

Jeff: We’re talking about collateral here. So one thing I wanted to mention, I think Teddy can describe this better than I can, but one thing about Notional which is different from Compound and Aave is that in Notional, your collateral can also be liquidity provided into Notional fCash markets.

Like Teddy mentioned, Eth is both a tradable in these fCash markets. You could deposit Eth, that’d be wrapped into C-Eth as your collateral, but you can also deposit Eth and have it turned into liquidity, which has been provided on those Eth markets.

You’ll be earning additional yield on your Eth while it’s being provided as collateral. One thing about Notional, which I know we’re talking about at a very high level here, but there’s a lot of depth in terms of the collateralization framework, which allows people to collateralize not only liquidity, but also lending rights.

You can be lending Eth out at six months and be borrowing against it. There’s just a lot of ways to, there’s actually, beyond just the currency types, there’s also like different sub categories of each currency of how it can be represented as collateral. I don’t know. Teddy can probably explain this.

Teddy: Yeah. I’ll just kind of like to follow on that a bit. Thanks, Jeff, for bringing that up. But yeah, so if you want to take out a USDC loan, and you’ve got Ether as collateral, you can just deposit the Ether into Notional and borrow against it.

Or like Jeff seid, you can earn yield on your collateral while you’re using it to borrow against. Right. If I’ve got my Ether, I can actually lend it at a fixed rate on Notional and then use that loan to borrow against. I can lend it; I can also provide liquidity on Notional.

We haven’t talked about this yet, but in Notional V2, we have this thing called nTokens, which is our version of Notional liquidity tokens. You can mint nTokens from your Ether, so you can provide liquidity to Notional and then borrow against that liquidity you’ve provided.

You can earn liquidity fees. You can earn note incentives and then borrow against it. Right. We think that this is, it took a lot of work and adds like a lot of code to make sure that this works.

But we think that this is a pretty killer feature, because essentially what it means is that you are giving up nothing as a user. There is no dead weight from your capital. Like your collateral can always be earning an attractive rate of interest.

You never have to, just put up capital and not earn anything on it. We think that is pretty critical. It’s something where it’s like if you look at the decentralized OTC lending businesses in crypto, they don’t give you any. When you borrow USDC and collateralize that with Ether or wrapped Bitcoin, they just take your Ether.

They don’t give you any interest in it. On Notional, this is an objectively better thing because you are earning all the possible interest and returns that come from your collateral at the same time as you’re using it to collateralize your loan. We think that’s pretty cool.

Friederike: That is cool. Capital efficiency is something that is notoriously important to DeFi users. This brings me to a question for Jeff. Jeff, in terms of security, so basically, this is often a criticism that’s levied against DeFi. Basically, it’s a house of cards.

As soon as one card falls, the entire house collapses. We’ve seen that even tried and tested protocols such as Compound and Compound had a huge bug last week and it wasn’t catastrophic and it paid out too much in fees. So basically it wasn’t a catastrophic failure, but it was a pretty severe bug. How do you go about mitigating this risk for your protocol and your users?

Jeff: Yeah, so I would say just like broadly the way we think about Notional, the product and everything we do, our number one is security. Number two is capital efficiency. Number three is user experience. We evaluate everything we do in that framework.

So security, especially in DeFi it’s sort of, it’s just software quality at the end of the day. And software quality, that’s the highest level that you can like to achieve. That comes like critical components of good software quality, or are well-known it’s good documentation.

It’s naming your variables cleanly. It’s like being a really good conscientious programmer, first and foremost, and then it’s testing. It’s just like exhaustive testing in different scenarios. Then even beyond that and a lot of issues that are ongoing, but at the same time, it’s one place where users and developers all value security very highly. Right.

You don’t see that in the more traditional software space security tends to be something on the back burner. So it’s nice that users actually value this and pay attention to the audits and care about those things. Along those lines it’s not just testing, but it’s audits and it’s also like adopting new technology. Right.

We’re working with <inaudible> on formal verification and some of the newer fuzzing tools coming out, which expand the capability of testing beyond just what we’re writing right off the bat. We’re always looking for ways to just get more confidence around the code and just ensure that it is doing what we intended to do.

Friederike: Okay. Basically if I step back one step, if you look at each individual module at each DeFi Lego brick, even if each individual Lego brick is structurally sound and well engineered and has clear APIs and inputs and outputs and no intrinsic bugs.

If you combine enough Lego bricks together, you can still get a structurally unsound system. Right? Basically, and to me, that’s also a systemic risk that we, as an ecosystem, need to think about how to go about this.

And how to protect the users even despite the fact that maybe each individual brick is fine, but if you actually stack them in a certain way, it ends up being very much not fine. Do you have any measures in place or any thoughts on how we as an ecosystem should address that?

Jeff: Yeah, that’s a great question. I would say what happened with Compound, was, for me it was an eye-opener because we were integrating with Compound. It’s a dependency here. And unlike some software dependencies where you can hard fix the version, Compound’s going to change.

It’s a dynamic dependency. So it’s something that we, at least for me, the, my takeaway was that I need to be paying more attention to what’s happening there and what they’re doing on their side in governance. Right. That’s true of a lot of protocols, which depend on Compound.

And I think at the end of the day as we become more interconnected, and it’s sort of, it’s in our best interest to make sure that Compound is working well and working healthy, we depend on Uniswap for people to be able to trade out of positions during liquidation.

Jeff: That’s another thing that we’re going to do, we’re going to monitor the liquidity pools on Uniswap and Curve and make sure that they’re deep enough for liquidations. Yeah, we just need to be vigilant as a community in a system. Right. Because yeah, I totally agree. We’re all dependent on each other.

Sebastien: I’d like to ask you about the fToken or fCash token. I read that you guys have built a token standard, or you’re leveraging an existing tokens center called the ERC1155. I had never heard of this token standard. What does it do exactly and how is it different from other tokens we may be familiar with?

Jeff: Most people are familiar with the ERC20 token standard. So something about the ERC20 token standard, which is nice and makes it easy to develop against and understand, is that something like USDC is always going to be USDC.

It’s never really going to change. We can pass it around to all of us. It’ll sort of, it’s going to remain USDC. One unique characteristic of fCash is that it matures. On a particular day, December 1st, 2020, 2021, it’s going to convert from a promise to actual redeemable USDC. Right.

So it doesn’t adhere to the expectations that you would have of an ERC20 token, because it changes at a very distinct point in the future. In addition, one thing that we want to do with Notional and one important piece of Notional is the ability to trade and create fCash at different maturities.

We have the three and the six month and the one year. One thing we haven’t talked about and is available Notional is the ability to actually lend and borrow at dates that are in between those different points in time. You can actually lend in OTC markets at nine months or eight months, if that’s a product that people want. Right.

A really cool part about Notional is that we can actually value that and value those fCash assets and let you borrow against them. But the scalability issue of creating ERC20 tokens for each one of those dates and having different token contracts from a technical perspective becomes really cumbersome.

That’s why we chose the ERC1155 standard, which we think fits the nature of the token much better. The key thing about an ERC1155 token is that it’s identified by an ID. So each identifier will be like the currency and the date that identifies the fCash asset.

Basically you can call that contract saying I would like to transfer December 1st USDC fCash, and it’ll be able to locate it properly and transfer it. What that does is it gives the developer a single contract, single point of entry for transferring all different types of fCash assets.

It makes programming and understanding systems a lot better. One analogy for this, that helps make it more clear, is that, in traditional finance, if you’re going to trade something like an equity, you go to the stock market. Right.

If you’re going to trade something like a bond, something with a fixed term, fixed interest you go to different markets. You go to OTC desks, or you go to, you just go to different markets. They’re not intermixable in the same standards. Right.

That’s something very similar here. This is a different type of asset. So it requires a slightly different standard to make a good experience for the developer.

Sebastien: It creates a token which has properties that were where you have common properties, but there’s like a non-fungibility between different characteristics of the same token. It’s like a one contract to manage different fungible tokens that are not fungible amongst each other. Is that a good way of describing?

Jeff: That’s great. Great way to describe. So USDC on December 1st is fungible with all other USDC on December 1st, but USDC on January 1st is not fungible with USDC on December 1st. Right? That way you have these stacked maturities that are going out. They’re fungible within themselves, but not between.

Sebastien: Talking about maturity, who defines these maturity periods? I suspect it’s governance. Maybe we can talk about that a bit and how all these maturity dates get defined?

Jeff: Yep. Again, this is in Notional V2. In Notional V2, one thing about Notional is that when you provide liquidity, it gets distributed across the different fCash markets. So that has the effectives fragmenting liquidity across these different pools.

One thing that we didn’t want to have happen is have it get fragmented across too many pools. What we’ve done with Notional V2 is we sort of, hard-coded like fCash market cadence that will go from three months to six months to one year to two years to five years to ten year and then to twenty years.

That’s the defined cadence of the fCash market’s going out in the future. Governance will enable us to turn them on as we go forward. We’re going to start with the first three months, six months and one year. That’s what users will be able to lend to borrow on the liquidity pools.

As I mentioned, with the actual token standard underneath there, there is the ability for OTC trading, direct trading between two parties at dates in between those liquidity pools. I don’t know, Teddy, if you want to add anything to that.

Teddy: No, that’s pretty good. There’s like we have this predefined maturity cadence, which references a reference time that rolls forward every three months. Basically you might have January 1st. Let’s see, what would it be? It would be, I suppose it would be December 1st, March 1st and December 1st, 2022.

Those might be your liquidity pools. Then once you get to December 1st, those dates would roll forward. They would all roll forward. Then you’d have March 1st, June 1st and June 1st, 2022. Every three months the active maturities for the liquidity pools are going to roll forward three months.

Friederike: When do you plan to introduce the longer cadence ones? Because these would be also super interesting to see how people gauge the future of the ecosystem. Basically if you’re going to buy a 20 year fixed loan on a DeFi product, there’s so many externalities that go into this besides what you think money’s going to cost for the next 20 years. Right?

Teddy: Yeah. It’ll be a little while before we get to 20 years, if I’m being completely honest. Basically, our intention here is, there’s a lot of things to consider when we activate one of these longer date maturities. As Jeff seid, we’re launching within three month, six month and one year.

The next thing to turn on would be the two year. Right. When you turn that on, it’s very difficult to, and technically it might be impossible to turn it off, but basically it’s hard to go back on it. Right? And so once you turn it on, you need to support it in perpetuity pretty much. Now, because of that it’s not a decision that we take lightly.

The downside, where one of the downsides of turning on one of these longer date maturities is that you distribute the total liquidity amongst a greater number of liquidity pools. You’re fracturing liquidity. There’s like a very tangible downside to opening up one of these, one of these longer date maturities.

We want to be sure that people really want it prior to turning it on. The way we like to figure that out is by starting Notional V1, we had a three month and a six month maturity, and we saw that the vast majority of the activity was in the six month. This made us believe that people really want fixed rates. They want long durations.

That’s why we’re launching the one year at launch with Notional V2. So we’re going to go and see what happens. Like is the majority of activity going to be in the one year and are our users going to tell us that they want even longer date maturities? That a lot of it is just we’re extending the maturity horizon with Notional V2.

We’re going to see what people think, like listen to what they tell us. If they do want a two-year, and we’re satisfied that there’s going to be a decent enough amount of activity to justify putting liquidity in that two year, then we should be able to turn it on.

Friederike: That makes complete sense, but it leads me to my next question, who are we? Who decides what the governance looks like?

Teddy: Good question. Okay. We have in Notional V2, as I alluded to earlier in this podcast, we are issuing the protocols governance token, the note, and are the governance decision-making, so protocol upgrades and risk parameter changes, that’s all going to be subject to on-chain voting by note holders.

So we’ve pretty much forked Compound governance and maybe Jeff can say a little bit about exactly any differences between the way our governance module works and the Compound governance module works. Before we get there, I’ll just say a little bit about the token distribution.

Node holders are going to be making these decisions. We really believe that ultimately, we want Notional to be foundational infrastructure for this new financial system. We want to distribute the governance of the protocol and to decentralize control.

To that end, we have earmarked about 55% to 60% of the total token supply for the community to be distributed mainly through liquidity incentives, but also through a foundation that will support the community with ecosystem grants and development grants.

Basically, over the next few years, we plan to distribute that majority of the tokens to people that aren’t us basically. We plan to progressively decentralize the effective control of the protocol. Jeff, I don’t know if you want to say a little bit about our governance system from a technical standpoint.

Jeff: The governance system will work very similar to Compound in terms of voting and the way it can make changes to the protocol. This is an area I would say is there’s potential for us as a protocol, as a community to decide to upgrade and change that to, there’s tons of different governance models out there.

I would just say like where we’re starting is the starting point and we’ll see what the protocol needs to do from a governance standpoint to change that. One thing that the way we’re parameterizing it, I think this is kind of like maybe interesting is, so the compound currently has like a seven-day cadence. Everyone’s aware of this now of actually getting changes through.

One thing we’re keenly aware of is that this is a new protocol. As we go out , we want to be able to make some changes quicker. We’re going to shorten that time cadence for us to be about two and a half days in the beginning. As the protocol matures, as we feel more comfortable, we’ll elongate that time cadence. Just as a way to represent the maturity of the system. Otherwise, it works pretty similar to Compound.

Sebastien: One thing that I thought would be really cool here is if, like lots of people I’d say, have positions in Aave and they may want to move those positions into something like Notional to benefit. Basically, from a better interest rate or like at least a fixed interest rate.

Is there a way, or are there like products that you know of, or like without having to code your own flash loan contract, where basically you could say, okay, here’s my position on Aave, I want to move it over a Compound?

This is how much gas it’s going to cost, but it’s going to happen. I’m going to be able to move all of those positions there in one transaction? Because that’s something that I would like to use.

Jeff: Yeah, absolutely. I think <inaudible> this between Compound and Aave, although I’m not entirely certain, but we actually, as part of the code that we’ve open-sourced for Notional V2. There’s a flash loan contract that will move your Compound variable borrow into Notional, then essentially flip you from a variable rate into fixed rate borrow in a single transaction.

Then also on the flip side, actually, if you’re holding C-tokens and you actually just want to lend at a fixed rate, you can actually just deposit those into Notional and receive fCash in return. That you can actually flip your variable rate loan into a fixed rate loan directly.

With the Aave integration since we’re not using Aave as the underlying money market in Notional V2. Swapping from Aave is something that is possible. We’ll definitely look into it. It’s something that you, as Teddy alluded to, is part of building the community. Those are the types of things that the foundation would look to support through like development grants and things of that nature.

Friederike: Maybe let’s zoom out to the ecosystem a bit. In your view, what are the next milestones that we’ll hit in the DeFi system? This week we saw a French bank made a maker proposal. So basically Teddy, as someone coming from traditional finance, what do you think the next year is going to look like?

Teddy: Okay. That’s a really interesting question. First of all, let me just say that obviously I’m biased, but I do think that Notional V2 is going to unlock like some really cool stuff in DeFi that you haven’t been able to do.

I’m just going to say real quick first, because basically, to these fCash tokens that we’ve been talking about, they allow you to define and manipulate cash flows at specific future dates where you have guaranteed liquidity via the Notional infrastructure.

That’s something that you’ve never had before in DeFi. So you’re going to be able to create really cool fixed income products. For example, coupon bonds. Right? You could essentially bundle a number of these fCash tokens together, such that you could buy a bond that would give you fixed payments on a periodic case.

You can have, you could lend a hundred dollars for two years and you’d get fixed payments every quarter. Right. As opposed to taking the entire payment at the end. Right. That’s something that’s really cool. Obviously, a super popular product in traditional finance.

You can’t do it in DeFi today. And something like fCash allows you to do that. That’s just, okay. That’s just my little thing on Notional I had to say. Now, from a more macro perspective. This is going to be a really interesting year to come for DeFi.

Because I still talk to a lot of my friends in traditional finance and even some of the more conservative ones, they’re coming around to DeFi, they really are. It’s past the point now where we’ve hit the big numbers, and so we’ve gotten people to pay attention and we sort of proven out like some real product market fit here.

The longer we stick around and these things continue to work, just the more undeniably useful, this space starts to look to outsiders. Right. The absolute number one thing that has made more mainstream users wary about DeFi is the security risk. Right?

The idea of, because you just think about how weird it is. It’s like I’m going to take my money and I’m just going to put it in a computer program. Right. There’s nobody I can call if things don’t work as they’re supposed to. Right. It’s like a really weird thing. It’s like a psychological barrier that you need to get over.

The only way to make people comfortable with doing that is time. It’s time that these things are operating, and they’re operating correctly and people are getting their money back when they’re supposed to. Right.

When you’ve had time now where these systems have been operating safely and securely. Over the next year, that will continue and people will become more confident and less worried about smart contract risks.

I think that we’re also seeing innovations in the DeFi insurance space that are going to get people more comfortable, which is super interesting. Basically, the thing that’s the barrier to entry is risk. It’s smart contract risk, it’s regulatory risk.

Over the next year, you’re going to see a significant diminishment in both of those risks. Right? Like one just with additional time and new insurance solutions coming to market for DeFi, that’s going to reduce the smart contract risk. Then the other thing is lessening in the regulatory risk.

Because I saw a headline that the FDIC is looking to potentially ensure stable coin issuers. Or like offer insurance to stable coin issuers or to approved stable coin issuers. There is a recognition that DeFi is important.

Regulators in the US are going to be offering some actual clarity within the next year in this space. That’s going to make a lot of people more mainstream users, much more comfortable. That in the next year you’re going to see a lot of the risks and barriers to entry, significantly reduced.

That’s not even talking about, and I hadn’t mentioned, but the layer two solutions coming online. Like a year from now, you can see a lot less contract risk, a lot less regulatory risk and lower gas fees, because of layer two.

If you put all those things together, then DeFi is like a no-brainer and it’s subjectively superior to traditional finance. As it’s like a super exciting time.

Friederike: I totally agree on many parts of what you just said. The one issue where I feel like my personal feeling is more or less diametrically opposed to what you just said is regulatory. Right? Basically, to me, the feeling is that regulators, especially in the US, are not moving in a great direction.

Teddy: I think that it’s up for debate. I would say. People have obviously liked some of the stuff from some certain officials has like caused concern in the crypto space. That in the US which you’ve actually seen as significant pushback from people who are very pro-crypto and pro-innovation in the US.

There’s like a non-negligible number of politicians that are really on our side and that I find very encouraging. That there’s a growing recognition from what we’ve seen. Yes, there are people who are against crypto, but that there is a growing recognition that this space is going to be extremely important.

Just like this thing is growing extremely rapidly, this thing is going to be big. Right. There’s a growing recognition of that. There are a lot of people who want to make sure that the US has places at stake and places a flag there. I’m really actually pretty optimistic from that standpoint.

Friederike: Okay. That’s good to hear. It’s always nice to hear people be optimistic about the regulatory environment. Teddy, Jeff, when is Notional version 2 coming out?

Teddy: We’re targeting the first week in November. That’s what we’re targeting. I think we’ll do it. Again, I’m optimistic.



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