Payoffs
Overview of borrower/lender payoffs for ZLLs on MYSO
Borrower Logic
From a borrower's perspective, a Zero-Liquidation Loan can be seen as a swap between the borrower and the lender vault, in which the borrowers pledges some collateral token, receives some amount of loan tokens, and is allowed to reclaim their previously pledged collateral (net of fees) if they pay a pre-determined repayment amount prior to the expiry of the loan.
This can be seen as a call option that gives the borrower the right to "buy back" collateral tokens from the vault for a set repayment amount.
When a borrower holds underlying collateral themselves, they participate in a 1:1 value change of the asset over time. After a loan is taken out, the borrowers holds a call option on their collateral as well as the loan amount. This means that the borrowers retains upside participation in the collateral while being protected from any downside risk, i.e., if the collateral price falls below the some strike price K then the borrower doesn’t have any incentive to repay and will leave the collateral in the pool.
Lender Logic
From a lender's perspective, funding a Zero-Liquidation Loan can be seen as a swap in which the lender provides some amount of loan token to their lending vault, receives some amount in pledged collateral, and writes a call option that gives a borrower the right, but not the obligation, to repay their loan and receive their collateral back.
Before a borrower accepts a given loan quote, a lender simply holds their funded loan vault amount, which is independent of the underlying price of the collateral. After a borrower accepts their given loan quote, the lender's position turns into an in-the-money covered call - this means that they're long in the underlying collateral but also short an in-the-money call option.
If at expiry of the loan the underlying collateral price is above some strike price K, then the borrower is naturally incentivized to repay, and the lender will be able to claim the repayment amount. Otherwise, if the underlying price falls below the strike price, then the borrower naturally will not repay and the lender will retain the posted collateral.
Now, let’s describe a theoretical loan:
Assume 1 ETH = $2000 USDC
Lender sends out a loan offer where they agree to lend out USDC against wETH collateral at 80% LTV with a 1 year tenor
Lender sets a 12.50% interest rate on this loan
A borrower arrives and finds these terms attractive — they agree and pledge 1 wETH and borrow $1600 worth of USDC.
The borrower has entered a Zero-Liquidation Loan and they have the right, but not the obligation, to reclaim their 1 wETH collateral if they repay ~$1800 USDC. In this case, a rational borrower would repay if the price of 1 wETH doesn’t fall by more than ~10% — else, it would make sense to not repay and walk away with the loaned USDC.
Scenario #1 - At expiry of the loan, the value of the wETH collateral has increased by 20%. It is rational for the borrower to repay the loan and recoup their collateral. In this case, the lender will earn their desired 12.50% interest.
Scenario #2 - At expiry of the loan, the value of the wETH collateral has fallen by 15% to $1700
The value of wETH is still above the loan taken ($1600 USDC at 80% LTV) — however, it is not in the borrower’s best interest to repay the loan since the fixed repayment amount of $1800 USDC is worth more than potentially recouping $1700 worth of wETH.
In this scenario, the borrower would default, but the lender would still earn a nice yield (~6.25%) as the value of the defaulted wETH is above the original loan amount ($1700 worth of wETH > $1600 worth of loaned USDC).
Scenario #3 - At expiry of the loan, the value of the wETH collateral has fallen by 30% to $1400 Since the value of wETH is now below the value of the loan taken out ($1600 USDC > $1400 wETH), a rational borrower would default on the loan and choose not to repay.
The lender would be left with the defaulted collateral — however, at an 80% LTV, there is a buffer for the downside and the lender is left with a 12.50% loss.
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