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CryptoEconomic Research

Mars Protocol: Decentralized Lending and Borrowing on Terra

Mars is a decentralized credit protocol built on Terra that is designed to be non-custodial, algorithmic, and community-governed.
by David ShuttleworthMarch 11, 2022
Mars Protocol Profile

Summary

The core function of the Mars protocol is to operate like a traditional bank in the sense that it attracts deposits, enables lending, manages illiquidity and insolvency risk, but does so all in a fully decentralized, on-chain capacity. One of its key differentiating features is that it allows fully permissionless lending and borrowing as well as pre-approved, permissioned lending to whitelisted entities without requiring collateral. The latter is a novel mechanism which expands the market demand for deposits and helps create a positive feedback loop for all ecosystem participants. Ultimately, the goal of Mars is to allow a pathway for borrowing and lending virtually any Terra-based digital asset and create strong mechanisms that properly incentivize optimal rates of utilization.

Overview

Traditional credit infrastructure is wrought with inefficiencies, misalignment of incentives, and a rigid imbalance of benefits. For instance, loan origination fees can be quite costly to the borrower, fund disbursement can take several weeks, and there is often a requirement of significant collateral or credit for approval, all of which can serve as high barriers of entry. Moreover, traditional banks commonly offer a “high-interest” savings account of 0.5% to depositors that quickly transforms a user’s deposit into an outbound loan with a yield that is several orders of magnitude greater than the yield given to the user. Under this scenario, the bank captures most of the benefits of the loan. Decentralized projects in the space have been developing pathways that the attempt to correct this imbalance, perhaps most notably Anchor, a decentralized lending protocol on Terra that offers users upwards of 19% APY on their deposits. A key difference here, however, is that Anchor functions as a “Saving-as-a-Service” protocol with predictable rates, while Mars functions as a credit protocol with dynamic rates. Moreover, Anchor relies on yield from Proof of Stake assets to generate fixed-income, whereas Mars can use any Terra asset as collateral, which shifts yields to be centered on the protocol’s actual utilization rates. Finally, an issue with similar credit protocols in the space is that they typically require collateral in order for a user to access a line of credit. Therefore, borrowers on such protocols are also lenders; there are no outright borrowers since collateral is a perquisite.

Mars is a fully decentralized, on-chain credit infrastructure that enables both permissionless and permissioned lending as well as lending without collateral. Moreover, interest rates are continuously priced algorithmically based on reserve utilization. That is, as the supply and demand of Mars deposit reserves changes over time, the prevailing interest rates for loans will adjust automatically. Over time, this feature is handed off to Mars governance, and token holders will have the power to fine-tune interest rates. The goal here is to democratize the protocol and enable the community to determine the best path forward and allow for potentially greater responsiveness and capital efficiency.

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Overall there are four key agents within the Mars ecosystem: lenders, collateralized borrowers, uncollateralized borrowers, and governance. In the most general sense, users can interact with the protocol to deposit their digital assets (specifically CW20-based) to earn dynamic interest through lending or borrowing against the collateral they have deposited. In addition, whitelisted projects can borrow from Mars in the form uncollateralized loans. Mars governance ultimately approves which projects can participate and sets the standards by which potential projects can become whitelisted.  

Digging a bit deeper, the Mars Red Bank is a feature of the protocol that enables non-custodial, permissionless lending and borrowing. Users deposit funds into the protocol which are effectively added to Mars liquidity pools. In return, the user receives $maAssets which represent their share of the liquidity pool and allows fee sharing. In addition, users can choose to borrow from the protocol by utilizing their deposit as collateral. As the utilization rate changes (i.e. total deposits vs. total outstanding loans), the protocol algorithmically adjusts the interest rate paid to lenders and paid by borrowers. This mechanism helps ensure capital efficiency while mitigating insolvency risk by incentivizing lending when reserves are low and curbing borrowing. Red Bank lending, therefore, serves the dual purpose as a yield generator and as collateral that can be borrowed against. 

One useful feature that helps prevent insolvency is Mars’ liquidation mechanism. While not novel, this establishes a predetermined maintenance margin by which loans can be liquidated against when their collateral falls below a certain value relative to their outstanding debt (i.e. loan-to-value ratio). An additive feature is that anyone can repay a fraction of a borrower’s debt; the repayment does not have to come from a specific wallet address. Mars incentivizes this behavior by providing such users with an equivalent amount of the borrower’s collateral plus a bonus. Users then have the choice to receive either liquidity tokens (which are transferred from the borrower) or receive the underlying assets (which triggers the borrower’s liquidity tokens to be burned). This incentivizes capital infusion in the event of market volatility and allows opportunistic participants the chance to earn considerable rewards when timed correctly.

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The Field of Mars feature of the protocol allows certain whitelisted addresses to borrow funds without collateral. This can be thought of as a pre-authorized, permissioned lending service. Part of the novelty here is that it enables dApps to be built on top of the Red Bank, such as leveraged yield farming and liquidity-as-a-service. In general, most credit protocols only offer collateralized loans. This limits capital efficiency (low loan-to-value ratios) and targets only a small market of users since the end result is a lender that also wants to borrow. As a result, the interest rates offered to users end up being relatively low. By enabling whitelisted, uncollateralized loans, Mars expands the market to non-depositor borrowers which in turn increases both borrower demand and utilization rates.

Ultimately, lenders receive much higher yields than otherwise would be possible with strictly collateralized lending. While whitelisted entities can borrow without collateral, Mars mitigates its risk exposure through the provision of liquidation logic that ensures that a given borrow has the ability to repay regardless of market conditions. This framework is monitored and approved by governance. Allowing dApps to access Mars’ liquidity increases its composability and creates more demand for deposits. This creates a positive feedback loop in which this added demand for liquidity will keep constant pressure on utilization rates, thereby increasing the yield paid to lenders and further tapping into their overall willingness to lend their capital.

Tokenomics and Mechanism Design

$MARS is the protocol’s native token and is used primarily for fee sharing and governance. In short, users can stake their $MARS tokens to receive $xMARS tokens. $xMARS tokens then enable holders to earn a share of protocol interest rate revenue and grant voting and proposal rights. Governance on Mars is expansive and decisions include asset listing, risk parameters, treasury spending, and whitelisting new wallets.

One interesting aspect of Mars governance is the concept of incentivized voting. In short, voters are be directly impacted by the outcomes of their decisions, both positive and negative. Positive outcomes will be rewarded with $MARS tokens, while negative outcomes could result in up to 30% of staked tokens being sold in the case of shortfall events. This mechanism helps guide well-reasoned decisions to the forefront and mitigates malicious or wasteful proposals, since voters will be financially harmed by voting for such proposals.

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Source: https://docs.marsprotocol.io/mars-protocol/protocol/welcome-to-mars/protocol-risks

Another novel mechanism of Mars is that it has created an incentivized safety fund comprised of reserve assets in the event of a shortfall. In general, a shortfall occurs when the value of a borrower’s debt exceeds the value of their collateral, resulting in a deficit for lenders. While common in any form of lending, these events can lead to infrastructure collapse if not properly accounted for. Mars approaches this problem by incentivizing $xMARS holders to contribute to a pool of reserve funds and earn fees for staking their tokens there. In the even of a shortfall event, these stakers are at risk to have up to 30% of their stake sold to help keep Mars solvent. With proper risk management and sufficient inflow of lender capital, this can be a net positive position for users with more risk appetite.

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Source: https://docs.marsprotocol.io/mars-protocol/protocol/mars-token/tokenomics

In terms of token value flow, 80% of interest payments are distributed amongst lenders; 10% is distributed amongst safety fund participants; 10% is distributed amongst $xMARS stakers. There is a total supply of 1,000,000,000 tokens, with distribution as follows:

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Source: https://docs.marsprotocol.io/mars-protocol/protocol/mars-token/tokenomics

Macro View

While the protocol is still in its early phase, there is approximately $235M in TVL, which puts Mars within the top 10 in terms of TVL on the Terra ecosystem.

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Source: https://defillama.com/protocol/mars-protocol
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Source: https://defillama.com/chain/Terra

Currently, however, only $14M of outstanding loans exist, which represents about 6% of TVL. This should make borrowing relatively cheap, given the surplus of reserves and low utilization rate. It will be interesting to see how utilization rates change over time as well as how interest rates adjust to incentivize borrowing.

One particularly risky aspect of the protocol is the enablement of collateralless lending. While Mars’ approach is a novel in its own right and serves to boost yields to lenders, one potential shortcoming is its liquidation logic. Developers of whitelisted accounts are free to choose their liquidation logic and while this is subject to the approval by Mars governance, this assumes that those voting on a particular decision have the requisite knowledge to adequately vet a given proposal. If the majority of voters do not possess such knowledge then the protocol becomes exposed to significant counterparty risk. The result is that loans without collateral could be whitelisted without sufficient liquidation logic in addition to the prospect of whitelisting the wrong counterparties.

Moreover, the aspect of risk-reward voting has several implications that may impact and ultimately limit governance participation. For instance, voters may be more prone to abstain from voting for fear of being associated with a proposal that leads to an unexpectedly bad outcome. While this does help curb proposals that are deliberately harmful to the protocol’s health, it could also dissuade votes from an otherwise beneficial proposal for fear of financial penalty.

Sources and Further Reading

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