Gearbox improves capital efficiency within DeFi through a novel DeFi primitive, Credit Accounts, which are isolated smart contracts with predefined, whitelisted parameters such as liquidation thresholds and approved tokens. Credit Accounts contain both the user funds and the borrowed margin funds, are deployable on any DeFi protocol, and are non-custodial so users never relinquish ownership of their assets. All operations go through the Credit Accounts which gives users a way to easily traverse the DeFi ecosystem and leverage-interact with whichever protocol they choose.
Currently there are many areas within DeFi that lack composability and this presents a significant bottleneck to capital efficiency. Since protocols in the space are largely not composable with one another there ends up being an abundance of idle assets and underutilized capital, as users cannot easily move assets across chains and dApps. In addition, user-side over-collateralization presents a significant limitation to capital efficiency, which has been a driving force in the emergence of new credit instruments focused on undercollateralized or collateralless loans.
Gearbox enables users to access leverage and interact with external DeFi protocols in a composable way. This is achieved through the advent of Credit Accounts. This new DeFi primitive acts as collateral for different leveraged operations and lets users execute financial orders without actually accessing funds on it. This approach is similar to obtaining leverage on a centralized exchange in which users borrow funds for margin trading within the platform, but the key difference is that Gearbox’s protocol functions cross-platform. So, for instance, rather than gaining access to leverage on BitMEX by borrowing funds on BitMEX, a user can interface with Gearbox, create a Credit Account, and then use this smart contract to perform leveraged interactions on Uniswap, Sushiswap, and potentially any other applicable protocol.
How it works
Users interested in obtaining leverage can access the Gearbox protocol to initiate a Credit Account. They can choose the assets they are interested in using, determine different whitelisting parameters such as liquidation thresholds, and then deposit funds to the Credit Account to activate it. These funds are then used as collateral for the user's debt and enable the user to control them by sending financial orders to their Credit Account and instructing it what to do, such as engage in margin trading on Uniswap or leveraged farming on Yearn. Overall, the Credit Account functions as an isolated smart contract that binds together the user funds and the borrowed funds. There are several parameters built in to the structure of each Credit Account to help mitigate risk, include liquidation thresholds, a list of approved tokens, as well as a list of approved protocols. Setting predefined parameters and whitelisting specific protocols helps preserve network integrity and protect against malicious actors.
Once the user is finished with their Credit Account, they can close it by either repaying the debt and withdrawing all funds from the Credit Account to their wallet or they can use the default swap function in which case the funds are applied to repay debt, with any remaining funds being returned to the user.
The primary agents in this protocol are lenders and borrowers. In general, lenders function as liquidity providers who seek additional yield and have a higher risk tolerance, while borrowers are users (e.g. traders or yield farmers) that seek to increase their positions by borrowing liquidity from the protocol, for which they pay an interest rate. Lenders can provide liquidity by depositing a variety of different assets, such as $DAI and $WETH and earn yield on it, while borrowers utilize these pools for composable leverage.
One of the most critical components of Gearbox is its liquidation mechanism. The protocol employs a metric that continuously evaluates all outstanding Credit Accounts and determines their respective health. Once that metric falls below a score of 1, then the Credit Account can be liquidated by anyone. In this case, the liquidator earns a fee for liquidating the Credit Account and ensuring the integrity of the network. The liquidated funds are transferred to the protocol treasury, and any remaining balance is returned to the Credit Account’s originator. This design helps incentivize market participants to constantly look for unhealthy positions, thereby adding an additional layer of risk mitigation.
The native token of Gearbox is $DIESEL, which serves as the protocol's LP token. Like other LP tokens, users deposit liquidity into one of the given pools and receive $DIESEL. In return, $DIESEL token holders begin to accrue interest through the capital that they have provided into the liquidity pool, which is used to power Credit Accounts. Token holders also collect a portion of protocol fees proportional to their share of the given pool.
There are several protocol fees that help incentivize market participants, namely liquidity provider fees, borrower fees, and APY spread fees. Liquidity provider fees are centered around the fees charged when a liquidity provider withdraws funds from the pool. So when a liquidity provider decides to withdraw, they are charged a fee of 1%. This helps keep pools sufficiently funded and discourages liquidity providers from frequently moving their funds around. Borrower fees are tied to a penalty that is attributed to a Credit Account that is liquidated. Upon liquidation, a portion of the fees are distributed to a third-party liquidator who proactively liquidated the account and a portion of the fees are distributed to the Gearbox treasury. Current, liquidators can earn 5% of the Credit Account's value, while Gearbox receives 2%. This adds an extra layer of security as participants that can spot an unhealthy account stand to gain a financial reward just for monitoring the network. Finally, the APY spread fee is the fee that the protocol takes between the APY that liquidity providers earn and the fee that Credit Account users pay for borrowing assets.
Gearbox has created a very novel DeFi primitive which facilitates cross-chain composability and blends together many different protocols within the space. While the Gearbox is currently integrating with some of the larger TVL protocols such as Uniswap and Aave, it will be interesting to see how comprehensive and broadly applied Smart Accounts ultimately become and whether they are interoperable with relatively smaller projects in the space.
Since launching towards the end of 2021, Gearbox's TVL has remained quite low. While the protocol is still in the earlier stages of bringing composable leverage to Web3, additional use cases for this primitive along with more cross-chain composability could help expand TVL quite considerably.
A key issue here is that pool providers may not be sufficiently incentivized to provide liquidity on Gearbox. For instance, a user depositing $USDC earns less than 1% APY. That same $USDC could earn significantly more yield in numerous protocols in the space. Perhaps more problematically, if the user attempts to withdraw their funds on the protocol, they encounter a 1% withdraw fee. So in order to earn a positive yield on a $USDC deposit, the user would need to lock their assets in Gearbox for well over a year. This is not the most optimal investment for most potential liquidity providers. As the demand for composable leverage grows, however, this could serve as a catalyst for increasing pool yields and thereby incentivizing more liquidity into the protocol.
One other general concern is the ability of Gearbox to effectively manage massive liquidations without suffering from “outages” like other centralized exchanges have been know to do in the past. One potential way around this is to continue to ensure that participants are sufficiently incentivized to diligently act as liquidators and help maintain the overall health of the network. Gearbox's Credit Account health metrics will also play a pivotal role here and could theoretically prevent cascading liquidations by being able to react ahead of time in a more proactive manner.
Further Reading and Sources
Cryptofunds, market makers, and trading desks can engage in DeFi and Web3 with MetaMask Institutional
MetaMask Institutional offers unrivaled access to the DeFi ecosystem without compromising on institution-required security, operational efficiency, or compliance requirements. We enable funds to trade, stake, borrow, lend, invest, and interact with over 17,000 DeFi protocols and applications.
Found this research useful? Connect with the Consensys Cryptoeconomic Research team at [email protected]
Disclaimer: Consensys Software Inc. is not a registered or licensed advisor or broker. This report is for general informational purposes only. It does not constitute or contain any individual investment advice and is made without any regard to the recipient’s objectives, financial situation, or means. It is not an offer to buy or sell, or a solicitation of any offer to buy, any token or other investment, nor is it intended to be used for marketing purposes to anyone in any jurisdiction. Consensys does not intend for any person or entity to rely on any facts, opinions, or ideas, and any financial or economic commentary expressed in this report may not be relied upon. Consensys makes no representations as to the accuracy, completeness, or timeliness of the information or opinions in this report and, along with its employees, does not assume any responsibility for any loss to any person or entity that may result from any act or omission based upon this report. This report is subject to correction, completion, and amendment without notice; however, Consensys has no obligation to do so.