Which risks are you exposed to?
Lending generates a yield by taking risk. Before providing liquidity to lending pools, it’s important to fully understand the risks associated.
These are the risks that liquidity providers may be exposed to:
When you provide liquidity in a pool you’re taking credit risk from the borrowers of that pool. It is possible that a borrower or multiple borrowers default, which could result in a loss for the pool. Pool delegates review and approve borrowers that may participate in a pool, so liquidity providers should review and be comfortable with the underwriting process and results of different pool delegates when choosing which pool to add BTC funds.
Unlike CeFi lenders, Zest Protocol has a built in mechanism that can help reduce credit risk:
- Pool cover: Each lending pool has a pool cover which is used as first-loss capital (gets hit first in the event of default). Pool delegates are required to add funds to the pool cover as a representation of their skin in the game. The size of the pool cover for each individual pool is publicly visible.
Borrowers enter a Master Loan Agreement (MLA) during onboarding which enables legal enforcement in case of default. Liquidity Providers should be fully aware and comfortable with the risk of default and potential inability to recover their funds.
Zest Protocol trades-off counterparty risk of CeFi lending for smart contract risk. Bitcoin funds are held in escrow by Clarity smart contracts on Stacks. All smart contracts are in theory vulnerable to exploits. Unlike counterparty risk, smart contract risk slowly scales down close to zero over time as contracts become more battle-tested. Zest addresses smart contract risk through:
- 1.Two smart contract security audits from leading cybersecurity firms [to be posted here when published].
- 2.Use of Clarity smart contracts instead of Solidity smart contracts: Clarity is a programming language designed by scientists from Princeton and MIT in response to the many hacks of Solidity smart contracts. Clarity trades-off some of Solidity’s expressiveness for safety, enabling developers to build dapps with the safety requirements of financial use-cases in mind (learn more).
- 3.Slowly scaling up: Zest Protocol won’t allow liquidity providers to drop hundreds of millions of BTC into freshly audited contracts at once. Zest Protocol will slowly scale up the pool capacity for pool delegates until the contracts are fully battle-tested.
The Zest pool contract is a smart contract on Stacks, which means that an attack on the Stacks network is a potential risk (but only while BTC is escrowed in a pool).
Under the hood, Zest Protocol pegs incoming BTC into sBTC as an escrow mechanism. When the BTC is borrowed an sBTC for BTC peg-out occurs under the hood. When BTC funds are escrowed in a pool, they exist as sBTC. sBTC is a 1-to-1 backed tokenised version of BTC on the Stacks layer. The BTC backing sBTC is held in a threashold-signature script on the Bitcoin blockchain. The open-membership threshold signers are participants in Stacks consensus (stakers of the Stacks layer’s native token STX).
Zest Protocol's unique technical design limits Stacks attack vector risks only to the portion of BTC that is escrowed in a pool in the form of sBTC waiting to be borrowed (when Zest Protocol pegs the sBTC out to BTC). Pool delegates are incentivised to keep the amount of sBTC in their pools as low as possible: the longer the sBTC sits idle in their pools, the lower the yield in their pool will be. Based on analysis of lending protocols with a similar design to Zest, we expect a utilisation rate of 90-95% of BTC capital - leading to only a 5-10% of BTC funds to be held in escrow as sBTC at any given time
Since all funds are in BTC, liquidity providers are exposed to potential attacks on Bitcoin.
- 1.Is a liquidity provider exposed to counterparty risk from pool delegates? No. Pool delegates have no direct control over the BTC assets in their pool. When authorizing loans, pool delegates call a function in Zest Protocol in order to make a loan from the pool to a whitelisted borrower.
- 2.Can withdrawals be frozen? Unlike CeFi lending, there is no ability to freeze withdrawals. Neither the pool delegates nor the DAO can freeze withdrawals.
Disclaimer: Pool delegates review and approve Borrowers that may participate in a Pool, so Liquidity Providers should review and be comfortable with the underwriting process and results of different Pool Delegates when choosing which pool to provide liquidity to.