Liquidity Bond Market

If you’ve been around the Cardano ecosystem for a while, you might have participated in an ISO or Initial Stake Pool Offering. ISOs consist of delegating ADA to a stake pool run by a project building on Cardano or a project’s SPO partner, then getting compensated in the project’s governance tokens for doing so. Another aspect of staking familiar to those in the Cardano ecosystem are community initiatives aiming to support small and single pool operators that ensure the decentralization and resilience of the network. These two paradigms are at the core of our first product which centers around staking and delegation.

Optim’s Liquidity Bonds are a novel DeFi instrument that allows for low-risk provision of ADA to specific stake pools. Borrowers never actually gain full custody of lenders’ funds, but are able to ‘borrow’ ADA to delegate and lock into selected stake pools from which they derive a direct benefit. Lenders are able to accrue interest on their ADA while benefiting from a smart contract having custody of lent funds rather than an individual.

All loans are for ADA with interest paid in ADA. There are two use cases for which we are structuring our initial Liquidity Bonds. The first are ISOs (Initial Stake Pool Offerings), which will enable borrowers to delegate larger amounts of ADA to ISO pools thus earning more of a project’s governance tokens. The second are SPOs (Stake Pool Operators), which will allow new and small SPOs to borrow enough ADA to consistently mint blocks and bootstrap liquidity into their stake pool.

Our Liquidity Bond Market is not a pooled lending model, but rather an order book. Anyone can submit and post an order to either take out a loan or issue a loan at a fixed interest rate for a fixed duration. In an eUTxO model, order book systems are not only easier to implement in the network but this design actually works to the advantages of the Cardano blockchain. The EUTxO model provides a very unique challenge, namely the fact that each transaction must specify every UTxO it takes as input.

An Initial Stake Pool Offering is a novel method for investors to support new projects building on the Cardano blockchain. Commonly referred to as an ISO or ISPO, this innovative new fundraising mechanism leverages Cardano’s native Proof of Stake system by having participants delegate to specific Stake Pools for either a complete, fractional or no amount of their staking rewards in exchange for the future return of the protocol’s own governance token.

The idea was first envisioned by a SundaeSwap community member and has since become a standard start-up capital pooling method within the Cardano ecosystem. In July of 2021, MELD officially became the first project to utilize an Initial Stake Pool Offering. Over the next few months, over 600 million ADA was staked into the MELD ISO with a value at the time of over $1 billion USD. Its more than 40,000 participants contributed $10 million of staking rewards that was directly used to develop the MELD protocol. Similar models have been successfully adopted by projects such as Genius Yield and Maladex.

Despite serving its intended purpose of raising capital, it has also sparked some criticisms in the Cardano community as the demand for participation has siphoned delegators from other Stake Pools. This not only centralizes the network but limits the financial viability of small pool operators to remain in business as well.

In response, Minswap pioneered the concept of a Fair ISO, or FISO, by randomly selecting 25 small stake pools to support and not requiring delegators to forfeit any of their ADA staking rewards at all. At its peak, the Minswap FISO accumulated a value of 200 million ADA in stake, while SundaeSwap, which used a similar model, saw the staggering participation of 310,000 delegators with an accumulated value of 6.8 billion ADA staked across various pools.

Initial Stake Pool Offerings have proven to be extremely lucrative. For perspective, about 40,000 ADA staked in the MELD ISPO would have resulted in a reward of around 80,000 MELD tokens, currently valued at 10,300 ADA. Comparatively, the same amount of ADA would have only yielded about 1,000 ADA of staking rewards in an equivalent timeframe.

ISOs as both a fundraising and token distribution model will likely continue as the Cardano ecosystem expands in the coming years. Many ADA holders who want exposure to new projects can simply swap staking rewards for a project’s tokens without selling their underlying holdings. However, the challenge remains for those who want large exposure to a project but lack the ADA necessary to participate to the degree they desire.

Our ISO Liquidity Bond Market allows people to borrow ADA for delegation to an ISO with no collateral. In place of collateral, the borrower simply pre-pays interest on the loan. This can be done safely as the ADA being borrowed is controlled by an Optim smart contract that ensures it can only be delegated to an ISO then returned to the lender. The borrower doesn’t have custody of the ADA to do whatever they please.

As mentioned previously, our ISO Lending Bond Market is not a pooled lending model, but rather an order book. Anyone can submit and post an order to either take out a loan or issue a loan at a fixed interest rate for a fixed duration. All loans are for ADA with interest paid in ADA.

For example, one might offer to loan out 100K ADA for 6 months at 8% annual interest.

A borrower sees this, deposits 4K ADA interest, and selects the stakepool they wish to delegate to. The borrower has 104K ADA staked in an ISO. At the end of the loan duration the 100K ADA is paid back to the lender along with 4K ADA interest.

In order to take advantage of time multipliers for ISOs in which users are offered a higher rate of rewards to incentivize longer participation, these Liquidity Bonds would be time locked for the full duration. However, in order to retain available liquidity in these financial instruments, Optim will support a secondary market to trade these bonds before the contract expires at discounts dependent on supply and demand.

Borrowers that purchase ISO Liquidity Bonds will be both those that support and have faith in a project as well as those who believe the value of the token earned will exceed the value of the ADA interest paid on the bond. There are risks associated with all investment decisions and users will always be responsible for conducting due diligence on ISO projects and affiliated stake pools. Borrowers have the ability to re-delegate to different pools during the bond’s duration.

Users who do not wish to participate in ISOs but are motivated to increase their ADA holdings by earning ADA interest can offer loans at what we expect to be above the risk-free staking rate. Whenever and opposite but equal motivations and incentives are identified in the market, it provides an opportunity for both parties to help each other further achieve their individual goals. One can do so by buying and selling ISO Liquidity Bonds.

Optim’s Liquidity Bonds have a wide variety of use cases across the Cardano ecosystem. The second product we’re designing around them is centered on SPOs. By using Optim’s Liquidity Bond market, stake pool operators will be able to purchase SPO Liquidity Bonds to bootstrap ADA delegation during the early stages of their stake pool operation.

Any stakepool that needs delegation can pay what we expect to be around 1.5% interest for a 1 million ADA bond. The staking rewards accrued by the bond purchaser (borrower) pool pass through to the bond issuer (lender) along with additional ADA interest that is prepaid but incrementally released. This allows the borrower to exit the loan without forfeiting their entire interest payment. A penalty might be paid to the lender as short-term staking rewards from small pools can be highly variable due to the luck factor. On the other hand, this also protects lenders who might need to withdraw their loan due to unjustifiably poor stake pool performance. We are currently exploring appropriate metrics and oracle feeds that can automate performance benchmarking. We’re also exploring decentralized, governance driven approaches to white listing stake pools that are qualified to purchase bonds. This should help mitigate any issues with stake pool performance and expected returns for the limited V1 release.

While a number of factors determine the economics of stake pool operations, the largest determinant of block production and thus rewards is delegation. This creates the biggest barrier to entry when spinning up a new stake pool, as operators need to bootstrap enough liquidity to mint blocks consistently, prove operational competence, achieve competitive APR, and then leverage this through marketing and community building into a sustainable pool. Eventually, the need to keep these bonds will decrease over the life cycle of the pool. SPO Liquidity Bonds could become a business expenditure that is more reliable than investing into marketing campaigns alone and can help supplement a pool’s marketing and community building efforts.

Optim Finance, much like other DeFi protocols in the Cardano ecosystem, is patiently waiting for CIPs 30–33 to provide the capabilities necessary for more complex dApps to run on chain. When presented with the unfortunate prospect of slowing progress for our flagship protocol, the Optim team decided to temporarily shift focus to building and releasing products around important features already running on the Cardano network.

Our Liquidity Bond Market is the first of these products, but it won’t be our last. If you’re curious to see what other novel ideas Optim is tinkering with, head on over to our Discord. We appreciate the amazing support we’ve received from the Cardano community and we’re looking forward to soon releasing our contributions to the ecosystem.

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