Optim Liquidity Bonds — A New Cardano Primitive

Marco_112358
10 min readDec 13, 2022

has created and launched to Cardano Mainnet a new DeFi primitive, specific to Cardano, the new Liquidity Bonds!

Introduction

Anyone in the Cardano ecosystem that self-custodies knows that staking your ADA could not be easier. ADA itself is inherently ‘liquid staking’ — meaning that you can stake you ADA up until the exact moment you transfer it out of your wallet. However, you do need to choose your SPO (Stake Pool Operator). Choosing your SPO is a difficult, subjective choice. And on top of it, there are many SPOs that run multiple stake pools. There is nothing inherently wrong with that. Though the more Single Pool SPOs (SPOs that only run 1 pool not multiple pools) there are validating the Cardano Network, the more decentralized the network will be. But a Single Pool SPO really needs to get their delegation over 1M ADA to start to consistently mint blocks and get a smoother staking reward stream, which matters to delegators.

(This is all some background for why Liquidity Bonds make all of Cardano a more decentralized ecosystem).

Liquidity Bonds

Liquidity Bonds are a new Cardano primitive. They allow lenders to lend their delegation rights and staking rewards to borrowers, for a fixed interest rate. That’s it! A lender is entering into a delegation rights/staking rewards swap with the borrower. The lender is swapping their floating ADA staking rewards (and the right to choose which SPO the ADA is delegated to) for a fixed interest rate. The borrower is swapping (paying) a fixed interest rate for the right to choose the delegator of the ADA and receive the staking rewards from that ADA delegation. I view it as a fixed rate/floating rate ADA yield swap (with delegation rights). Lenders ‘pay’ the floating rate (ADA staking rewards that are variable) and ‘receive’ the fixed rate (the interest rate of the bond).

Here is the team’s simple writeup on Liquidity Bonds.

But why do we need liquidity bonds?

Use Cases

  • SPO Bonds — SPO Bonds are the current Optim Liquidity Bonds live on Mainnet. SPO bonds allow SPOs (the borrower) to increase their delegations. SPOs can use the SPO bonds to pay a fixed rate to get access to ADA delegation for a fixed period of time. An SPO can view the cost of borrowing as marketing expenses, or ever cost of customer acquisition for a fixed period of time. Single Pool SPOs may find this really attractive. As a Single Pool SPO, having over 1 Million ADA in your stake pool really helps you mint consistent blocks, which leads to more consistent staking rewards, and a better delegator experience. So the cost to issue a Liquidity Bond may really be worth the delegation for a fixed period of time. And on top of that, an SPO can use the ADA staking rewards to offset the fixed interest rate they pay.
  • IBO Bonds — My personal favorite use case. IBO bonds are ways for protocols to raise assets and distribute their tokens in a similar process to an ISPO. However, instead of the protocol running their own SPOs (and in some cases multiple SPOs), the protocol can borrow ADA delegation through a Liquidity Bond. The protocol borrows the ADA delegation and can delegate to potentially many different SPOs (say they raised 50M, instead of having one 50M ISPO pool, they could give 1M delegation to 50 different Single Pool SPOs). The protocol can pay for this ADA delegation through their own tokens, through fixed rate ADA, or both! And by delegating to many different Single Pool SPOs, the protocol is contributing to the decentralization of Cardano staking!
  • ISO Bonds — ISO bonds give you a way to lever yourself into an ISPO. Borrowers get access to ADA delegation to delegate into a current ISPO. They are essentially paying fixed interest to ISO lenders in order to delegate to ISPOs and gain access to more of the ISPO protocol tokens than the borrower current has. The borrower is essentially betting that the value of the excess ISPO tokens they receive will be greater than the fixed interest costs they pay in ADA for the bond.

What are the Risks?

  • Smart Contract Risk — Any time you are using any dApp (properly constructed), you are usually sending tokens to a non-custodial smart contract. This is great because you are not taking counterparty risk (like you would in CeFi, which requires you to trust that the counterparty actually has your tokens). However, there are risks that the smart contracts were not properly coded and designed, and could be hacked and drained. This is a risk you take anytime you interact with any dApp, its common across all of DeFi.
  • Opportunity Cost — If you think you can earn better returns, or better yield, by doing something else with your ADA versus locking it up for a max known period of time in a liquidity bond, that is your opportunity cost. You can try and measure this before you enter into the liquidity bond, but you will only know if you were right or wrong after the fact (ex-post).

What about default risk/credit risk? This is an important risk of all traditional bonds.

Optim Liquidity Bonds do not have default risk because borrowers need to maintain an interest buffer (denominated in epochs). Currently, the SPO bonds have a minimum interest buffer of 6 epochs. This means that the SPO borrower must have prepaid, at a minimum, 6 epochs worth of interest into the bond. If for some reason the SPO no longer wants to maintain the bond or fails to continue to prepay the interest, anyone can come and close the bond. This effectively gives lenders a ‘put option/provision’ (also called put bonds) to close the bond early. The lenders then would get all of the accumulated interest plus the leftover prepaid interest buffer (up to 5 epochs worth of interest!). The borrower loses the prepaid interest left in the bond.

The prepaid interest feature makes these bonds even more attractive for lenders. There is a table below that shows if the bond is closed early (because the minimum interest buffer is not maintained), lenders actually receiver a higher annualized yield than the stated interest rate (because the bond matured early and they captured up to 5 extra interest payments).

How does a Liquidity Bond Work?

Lender’s Perspective

Liquidity Bonds are pretty simple from the perspective of the lender. As a lender, you are putting your ADA into a smart contract that holds the ADA in there for (at a maximum) the term of the loan. The smart contract allows the borrower to choose which stake pool to delegate the ADA to. The borrower never actually has access to the ADA, the ADA itself stays in the smart contract.

The actual mechanics are as follows:

  1. I want to buy a bond, but I don't have the 1M ADA needed to fill the bond myself. So I decide to place 1000 ADA into the Bond Pool. The Bond Pools allow multiple users to pool their ADA together to get to the needed 1M ADA. I receive 10 EQT Tokens for my deposit (1 EQT = 100 ADA deposited). Also I can remove my ADA by returning the EQT tokens anytime while the pool is filling up to 1M ADA.
  2. Once the pool is filled, I can convert my EQT tokens into BT (Bond Tokens). I will 10 BTs that represent my 1000 ADA, plus the interest as it accrues over time.
  3. I can then monitor the bond. This allows me to make sure that the borrower keeps the required amount of prepaid interest in the bond. If the borrower does allow the prepaid interest to fall below the minimum, anyone can close the bond.
  4. Finally, once the bond matures, I can redeem my ADA and the interest.

Also note that bond tokens can be traded on secondary markets. So there may eventually be liquidity for bond tokens (i.e. you could sell your bond token on the market before maturity). Also, these bond tokens may be used in different DeFi applications as collateral. Optim announced a partnership with

where Liquidity Bonds will be able to be used as collateral in Liqwid Money Markets. Optim Liquidity Bonds are composable!

Here is a live SPO Bond, the PSB bond.

So as a lender, what yield will I get? It really depends on when the bond closes (i.e. if the borrower does not keep up with their required prepaid interest buffer). Below is a quick example (of a live bond currently being pooled) showing what will happen to the lenders’ annualized yield if the bond closes at different times. This bond takes 1 epoch to get fully funded, then starts at the beginning of epoch 2. You can see if the bond closes at the beginning of epoch 10 (i.e. at the beginning of epoch 10, the prepaid interest falls to 5 epochs worth, below the 6 epoch threshold), then the annualized yield is 7.71%. However, if the bond goes to the beginning of epoch 74 (the full term of 72 epochs), the annualized yield is 5.26%. (Note this is slightly less than the 5.34% because it took a full epoch to fully fund the bond, so we account for that 1 epoch funding period).

Example of Interest Received by Lenders at different epochs
Annualized yield that lender receives based on the bond closing (potentially early due to necessary prepaid interest limits)

Borrower’s Perspective

Liquidity Bonds are a great tool for borrowers to get access to ADA delegation rights for a fixed cost. This cost could be seen as marketing expenses or cost of customer acquisitions (fixed term and cost) for an up and coming SPO. Or the cost of leverage for ISO bonds. Or the cost of raising capital and distributing your protocol’s tokens for an IBO bond.

Some important points to remember if you are a liquidity bond borrower.

  1. Make sure you continue to keep your prepaid interest up to date. If the prepaid interest falls below the epoch threshold (currently 6 for SPO Bonds), then the bond will be closed. This will cause your annualized net cost to be higher than it needs to be as you forfeit the prepaid interest.
  2. If for some reason you want to get rid of the bond, you could just forfeit the prepaid interest and let the bond mature early. Or you could sell you ownership of the bond as the borrower to someone else who wants the ADA delegation rights and staking rewards (the borrower’s rights are represented as an NFT).
  3. As the borrower, you get the ADA staking rewards from the ADA in the Liquidity Bond. You can use those staking rewards to offset the fixed cost. Fixed Cost minus ADA Staking Rewards = Net Cost.
Example of Interest Paid by Borrowers at different epochs
Annualized net cost (fixed cost minus the ADA staking rewards) that a borrower pays based on the bond closing (potentially early due to necessary prepaid interest limits)

Conclusion

Optim has really thought through a lot of use cases for Liquidity Bonds. The 3 described here are really just the start. Optim has also made these bonds composable and tradeable. I haven’t even spent any time on transaction chaining (an awesome scaling solution for Cardano that does not need batching); it took me seconds to send my ADA and receive my EQT tokens because of transaction chaining.

I look forward to participating in

Liquidity Bonds, receiving fixed yields for my ADA, using the Bond Tokens in other DeFi protocols within the Cardano ecosystem, and supporting Single Pool SPOs who need these bonds to bootstrap!

Appendix — Key Terms of the SPO bonds

SPO Pubkey — This is where the ADA will be staked to, once the Optim Bond Pool has sufficient liquidity, in the below example the target is 1M ADA. Assuming that this pubkey is owned by the borrower then standard ADA staking rewards would be given to the SPO.

Duration — Currently duration is fixed to 72 epochs (roughly 12 Months) this is to simplify the dApp during the initial launch, this will be amendable in the future as. This means that by default the maximum duration that the loan can be active is 1 year, assuming that interest payments are kept up to date.

Bond Amount — Select the number of bonds that you want to issue, all Optim bonds have a face value of 100 ADA. So issuing 10,000 bonds means 1M ADA.

Interest Rate — This is the annualized rate that you are willing to pay for the ADA, one thing to bear in mind is that if the pubkey attached to the bond belongs to the borrower then you could use this to pay towards the interest, for example if you set the interest to be 5.5% on a 1M ADA loan then you would have to pay approx. 750 ADA / epoch but if stake pool is able to achieve an average return on stake of 3.5% that same 1M ADA loan would earn you approx. 480, so you would essentially only pay roughly 2% for that loan.

Minimum Interest Buffer — Interest Buffer (prepaid interest) is the amount of interest that must always remain deposited for a bond to remain active, measured in epochs. SPOs must monitor and ensure a Bond always contains enough future interest to meet the Interest Buffer.

Premium — This is the initial interest paid for the loan, currently this is defaulted to 12 epochs, this premium will be distributed to the lenders once the bond closed.

In the below example given that the minimum interest buffer is 6 epochs and initial premium paid is 12 epochs, the bond would be closable on epoch 7 if no further interests payments were made, therefore the borrower would lose ADA equal to the value of 5 epochs interest.

Here is an example of issuing an SPO Bond

Thank you Joynul for the help!

About Marco

I am in the Kitty Farmer Committee for Minswap Labs. I am an active community member and Iporian at IPOR. I am also an active community member of Optim Labs. I am part of the Calculated Finance CALC Strategy DAO. I am a co-founder of Osmium DAO.

This is not Financial Advice!

I would love to hear your feedback/questions/comments. Reach out to me on Twitter… Marco_112358, or Discord… marco_112358 in Wonderland#2400

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Marco_112358

TradFi background (CFA/CFP), DeFi Degen. Love ETH, ADA, ATOM, KUJI, SOL, DOT, NEAR,