Introduction

It’s well-documented that the DeFi money markets are essential to the continued growth and adoption of DeFi. The idea of permissionless, decentralised, and censorship-resistant lending and borrowing of crypto assets is strong and enables a frictionless and seamless user experience as compared to its TradFi counterpart.

TradFi’s slow, boring and dull… The prospect of pseudonymous and borderless opportunities for lending and/or borrowing value in an instant is pretty appealing. Sure, builders (arguably) need to up their game when it comes to developing clean front ends/user interfaces. I’m sure we’ll get there in due time. However, the pressing matter is that of a lack of innovation in the sector of late.

Since the rise of Aave and Compound (although they work as intended), we haven’t really seen new ideas brought to the table all that often. Seldom do I come across innovative lending protocols these days. That’s sad! Unfortunately, the rule book seems to state that simply fork a working model on a new and upcoming blockchain and call it a day. In itself, that isn’t evil or wrong, however, to progress further with this whole DeFi thing, I’d argue we need to try to push the boundaries as often as possible. After all, we’re building on the bleeding edge, right?

The truth is that almost all crypto-native products are still fighting to establish and find product market fit. As such, it’s paramount that we as an industry look toward innovative solutions and be on the hunt for products that really make a change in the real world. For that to happen, we need to promote up-and-coming, innovative protocols that intend to spin the wheel on its head and bring something new to the table. Sure, many things may break, and we’ll encounter failures – that’s part and parcel of the process. However, with all the capital infusion by the VCs, smart minds working toward a common goal and a drive to develop unique solutions, I’m certain that great things will transpire. Or at least it’s my hope. This future keeps me motivated during this bear market.

Well, I’m glad to announce that it’s not all doom and gloom. Thankfully, the chads at Silo Finance are in the deep end and are bringing novel solutions to the DeFi money markets. Silo Finance is creating risk-isolated money markets on Ethereum and Arbitrum. In this article, I will explain what Silo is, how the protocol works, what XAI is, and much more. Strap in, folks, it’ll be a wild ride!

What is Silo Finance?

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Well, on the surface, Silo Finance is a DeFi lending and borrowing protocol. However, it isn’t your generic Aave or Compound fork. Silo brings novel solutions with it. Silo Finance creates permissionless and risk-isolated lending markets.

Importantly, the protocol isn’t upgradable – meaning the smart contracts are immutable and cannot change once deployed. Trust me, in the current era when DeFi rug pulls and exit scams are widespread, you want to be sure of the fact that a deployed contract that you’re interacting with cannot be changed/updated on a whim. It eliminates a major attack vector.

Essentially, Silo Finance is a second-generation decentralised lending protocol that operates without the need for custodians or permissions, allowing users to borrow any crypto asset while utilising any other crypto as collateral. This innovative approach is facilitated through the establishment of distinct, isolated lending markets, referred to as “silos.”

Within each silo, there are only three components: a unique token, Ethereum (ETH), and the newly introduced stablecoin XAI. ETH and XAI serve as essential bridge assets that interconnect individual silos, enabling seamless interactions between different lending markets. Don’t fret, continue reading as I explain exactly how it all works and how it’s different from traditional lending protocols as we know them.

Let us break down the component parts first.

1. Lending Markets: In lending markets, participants can lend and borrow various crypto assets. While banks have traditionally fulfilled this function in the world of conventional finance, decentralised finance (DeFi) introduces an alternative approach. Protocols like Silo Finance empowers users to take on these lending and borrowing roles without depending on a centralised authority, fostering a more decentralised financial ecosystem in the process.
2. Permissionless: A silo can be created for any token or asset. Both individual users and project teams can suggest the establishment of new markets, which the token holders then vote to determine whether they should be implemented or not. Furthermore, the protocol itself is accessible all around the world without the need to disclose your identity.
3. Isolated Risk: Lenders contribute their funds to a segregated lending market that exclusively contains Token A and a bridge asset. In the event that Token B suffers from a security breach or exploit, the lenders of Token A remain unaffected, as the risks are confined within the Token B market. This ensures that each market’s potential vulnerabilities do not impact other markets within the ecosystem.

While decentralised lending markets are not a novel idea, with platforms like Aave and Compound having blazed the trail in the lending space, Silo Finance seeks to become the premier lending protocol by addressing and improving upon the fundamental limitations of its predecessors. By doing so, Silo aims to provide a more robust and efficient lending solution for users within the DeFi ecosystem. Yeah, I’m all for it!

Think of each silo as a standalone Uniswap liquidity pool. Every token is basically paired with the bridge assets i.e. ETH and XAI (Silo’s overcollaterlised stablecoin) – this allows for all silos to be linked with each other. Each token is confined to its own liquidity pool, helping in mitigating risk.

Protocol Mechanism

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It is imperative to get a working understanding of the protocol mechanism – if you’re interested in knowing all about the protocol and how things work.

Silo Finance enables the formation of distinct, isolated lending markets known as “silos.” The protocol is structured to accommodate two classifications of assets: Unique Tokens and Bridge Assets. Unique Tokens possess liquidity within their dedicated silos, with each token having its own individual silo. On the other hand, Bridge Assets (currently Ethereum (ETH) and the stablecoin XAI) are connected with every Unique Token throughout all the separate silos, serving as the link between them.

Within a siloed lending market, the three assets can be utilised both as collateral and for loans. This means that when a user lends Token A, they can only borrow the bridge assets (ETH, XAI, or both) against it. These bridge assets can then be employed as collateral in another silo to borrow Token B. Consequently, users can borrow any token using any form of collateral while confining the risks associated with the collateral token to a single pool. This structure ensures that potential risks do not spill over into other markets within the ecosystem.

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In contrast, first-generation lending markets such as Compound and Aave consolidate all collateral into a single, shared pool. As a result, the consequences of exploits, such as price manipulation, can be significantly more severe. This vulnerability has been exploited by hackers on several occasions, with the lending platform Cream serving as a notorious example. Additional disadvantages of the original shared-pool design encompass constraints on listing new assets, high costs for maintaining parameters, an unwieldy collateral listing process, and suboptimal capital efficiency.

Silo Finance aims to address and mitigate these systemic risks and limitations, ultimately unlocking the potential for long-tail assets to be more effectively lent and borrowed within the DeFi ecosystem.

An additional unique feature of Silo Finance is its permissionless approach to listing new collateral. As per Silo’s documentation, any individual can propose the introduction of new asset silos to the protocol, provided that a price feed (oracle) is available. At present, the core team takes responsibility for setting up and initiating the on-chain votes necessary to deploy new silos. Nevertheless, a guide is available that outlines the process, enabling anyone with the appropriate technical expertise to deploy a new silo for community voting.

Liquidation Process

Managing liquidations in an efficient and foolproof manner is paramount for the success of a lending protocol. Let’s explore how Silo ensures the protocol doesn’t incur any bad debt.

When a borrower’s Health Factor drops to 0%, a liquidation event is triggered, signaling the borrower’s position for liquidation. This enables liquidators to take the borrower’s collateral, sell it, and repay the outstanding debt while earning a liquidation fee.

Silo currently utilises a full-collateral liquidation approach. In this case, when a position is marked for liquidation, a liquidator claims ALL of the borrower’s collateral to cover their borrowed position. After the liquidation process is finished, the borrower retains only the amount they initially borrowed.

This liquidation technique is well-suited for long-tail assets that might have limited liquidity and experience significant slippage during the liquidation process.

Workflow:

1. You have $1,000 wstETH and want to borrow ETH.
2. You go to the wstETH-ETH Silo, which has the following borrowing factors:

1. Max LTV: 85%
2. Liquidation Threshold: 90%
3. Max Liquidation Fee: 10%
4. You deposit $1,000 wstETH and borrow $850 ETH, which is the maximum amount you can borrow given the Max LTV(Max LTV = 85% = 850/1000).

Imagine a scenario where the value of your borrowed ETH has risen to $910, while the value of your wstETH collateral stays unchanged. In this case, your borrow-to-collateral ratio becomes 91% (Total Borrows/Total Collateral = 910/1000). Since the Liquidation Threshold for wstETH is 90% and your Health Factor has dropped to 0%, your position is now flagged for liquidation.

4. A liquidator seizes your collateral ($1,000 wstETH)
5. The liquidator sells your collateral (wstETH) for your borrowed asset (ETH)
6. The liquidator repays your outstanding debt ($910 ETH) and keeps your remaining collateral ($90 wstETH)
7. As the borrower, you keep your borrowings ($910 ETH) but lose your collateral ($1000 wstETH)
8. The Liquidation Fee paid to the liquidator is 9.89% (Liquidator Reward/Outstanding Debt = 90/910)

Learn more about how liquidations work here.

XAI Stablecoin

XAI is an overcollaterlised stablecoin with a soft peg to the USD. In the Silo lending protocol, XAI functions as a secondary bridge asset, working alongside ETH. Users can collateralise and borrow XAI, paving the way for cross-asset lending and unlocking new applications, such as leveraging, shorting, and borrowing for yield farming within each silo. This expanded range of use cases enhances the versatility and appeal of the Silo lending ecosystem.

XAI is accepted as collateral across all silos, similar to ETH. Furthermore, the SiloDAO can extend credit lines of XAI into any silo.

How Does It Work?

SiloDAO serves as the sole controlling authority over XAI. Through executive proposals, SiloDAO can decide to mint an unlimited amount of XAI and deposit it into any number of silos. Likewise, the DAO has the power to burn XAI that has been allocated to silos through governance proposals. As the DAO mints XAI and adds it to a silo, it effectively establishes the backing for XAI. Conversely, when the DAO burns XAI within a silo, it alters the backing for XAI accordingly.

Let’s look at an example to get a better understanding.

Imagine a scenario where SiloDAO mints XAI and deposits it into the bridge silo (XAI-ETH silo). By taking this action, the DAO opts to back XAI solely with ETH. If SiloDAO later decides to mint XAI and place it into the USDC silo, it effectively expands XAI’s backing to encompass both USDC and ETH. On the other hand, if the DAO chooses to burn the XAI that was minted and added to the USDC silo, this move alters XAI’s backing, reverting it from a combination of ETH and USDC to being exclusively supported by ETH.

In brief, the DAO sets the backing of XAI by controlling two functions:

1. Credit Extension: This function identifies token assets that can serve as collateral for borrowing XAI, effectively bringing the XAI into circulation (existence).
2. Credit Retraction: The function that removes XAI credit lines from silos by burning XAI out of circulation.

Executing both functions necessitates that the DAO determine the quantity of XAI to be minted or burned. Possessing the capability to carry out these functions enables SiloDAO to adapt to market conditions rapidly and efficiently.

Peg Stability

Stablecoin depegging is more common than I’d like it to be. As such, a stablecoin is as good as its peg stability. XAI is an overcollateralized stablecoin that maintains a loose peg to the US dollar. As a result, its value is generally anticipated to remain close to one dollar most of the time. In order to borrow XAI, users are required to provide more than the necessary amount of tokens as collateral. This overcollateralisation acts as a stabilisation mechanism, helping to mitigate the effects of price fluctuations in the collateral token.

When the collateralised positions approach a state of under-collateralisation, a liquidation event is triggered. This event safeguards the protocol against accumulating bad debt by liquidating positions that no longer meet the required collateralisation ratio. By maintaining an overcollateralised position, the protocol ensures the stability of the XAI stablecoin and minimises the risk associated with lending and borrowing.

The protocol treats XAI as equal to 1 USD to allow arbitrageurs to come in if the price deviates from the peg.

• Users have the ability to borrow and repay XAI at a fixed rate of $1. If the market price of XAI falls below $1, borrowers can take advantage of arbitrage opportunities by purchasing XAI at a lower cost and using it to repay their loans.
• When the market price of XAI exceeds $1, users can borrow additional XAI, bring it into circulation, and sell it on the market. After the price of XAI has dropped, they can use the proceeds to repay their outstanding loans, further capitalizing on the fluctuating price of the stablecoin.

Furthermore, SiloDAO exercises control over the borrowing interest rate for XAI throughout all silos, thereby effectively managing the circulating supply of XAI. This is achieved by adjusting the borrow interest rates either upwards or downwards as needed.

Protocol Revenue

Finally, XAI also acts as a catalyst for increasing protocol revenue. Any interest generated from borrowed XAI is directed to the SiloDAO treasury. This creates a new source of income that expands in relation to the overall quantity of XAI borrowed within the Silo protocol.

Shared Tokens (sTokens) & Debt Tokens (dTokens)

sTokens are ERC-20 tokens that signify a claim on a deposited asset within the Silo protocol. For example, when a lender deposits LINK into Silo, they receive sLINK in return. sTokens also accumulate interest based on the token’s respective interest rate.

Silo offers an innovative feature that allows lenders to decide if others can borrow their deposits, or if they prefer to “protect” their deposits, which prevents others from borrowing those assets. By choosing to protect the token, the lender relinquishes the opportunity to earn interest. sTokens represent assets available for borrowing, while spTokens represent protected deposits. It is possible to have both types of deposits for the same asset (e.g., 40% of the token is borrowable, and 60% is protected). spTokens can still be utilised as collateral for borrowing other tokens.

The naming convention for bridge assets (ETH or XAI) is slightly different: sBridge-ABC, where ABC denotes the silo in which ETH or XAI is deposited. For example, when depositing the bridge asset ETH into the LINK silo, the lender receives either sETH-LINK or spETH-LINK in return.

On the other hand, dTokens are ERC-20 tokens that symbolise a borrowed asset within the Silo protocol. They are created when an asset is borrowed and burned when the loan is repaid. Unlike sTokens, dTokens cannot be moved out of a wallet. For bridge assets, the borrowed token follows the dBridge-ABC naming convention (e.g., dETH-UNI), where ABC represents the silo associated with the borrowed asset.

Governance & SiloDAO

Silo’s lending protocol, Silo Finance, is owned and managed by SiloDAO. The governance token (SILO) grants holders complete control over the DAO and its lending protocol via voting and delegation rights. The core contributor’s team has established the groundwork for the protocol’s success, but it is the community’s responsibility to guarantee its evolution into the premier platform for secure money markets.

Silo adopts the OpenZeppelin Governor, a delegated voting governance model akin to the one used by Compound. This governance structure allows token holders to either vote on proposals directly or delegate their voting power to other community members who can then vote on their behalf.

The following aspects are decided by governance:

• Deploying new markets (silos) with all the parameters i.e. LTV, LT, Interest Model etc.
• Adjusting a market’s settings, including increasing/decreasing LTV, LT, changing interest model and replacing current price feed.
• Adding/removing bridge asset(s).
• Increasing token supply. This functionality is something the DAO might consider removing at any point and effectively place a perpetual hard cap on token supply.  
• Directing the protocol-controlled assets to where it’s beneficial to the growth of the protocol.

Silo’s governance model features a voting period of three days for proposals, with an additional two-day delay for on-chain proposals. This aligns with best practices and offers a reasonable time frame. A quorum requires 10M SILO tokens, equivalent to 5% of tokens in circulation (~180M SILO) or 1% of the maximum token supply (1B SILO).

To participate in on-chain governance, one simply needs to delegate SILO tokens to their wallet or a delegate. There is no vote-lock or staking mechanism currently in place. However, governance attacks via flash loans are mitigated through the delegation system, as new delegates cannot participate in votes that are already live when they invoke the delegate function. Furthermore, the team has previously expressed their intention to transition to a vote-escrowed tokenomics system, with the latest update coming in April 2022.

At present, there is no emergency function or admin with veto power to address potential attacks or issues. If a malicious governance action occurs, users can exit their positions within the 48-hour time-lock window.

SILO Token & Buyback Program

The SILO token acts as a governance and rewards token. As stated above, exposure to SILO grants the holder complete control over the DAO. Furthermore, sourced through the token buyback program, the SiloDAO has allocated 1.3M SILO tokens to incentivise lending and borrowing in certain markets.

The program lasts for 60 days from its start on March 13, 2023. Learn more about the incentives program here.

In terms of the token buyback, the SiloDAO earns income from various streams, and it’s anticipated that the annual revenue for 2023, will range between approximately $250,000 and $500,000, subject to market conditions. The plan is to use all realised revenue to buyback SILO tokens directly from the SILO/ETH balancer pool, amounting to roughly $25,000–$35,000 buys every month.

As mentioned above, tokens purchased in the buyback program will be used to incentivise users to use the Silo protocol.

Here it’s important to note that the liquidity incentives program is funded by real revenue and not token inflation. The thesis is that the token itself acts as a governance token. The protocol utilises the revenue to buyback SILO from the open market and then uses those tokens to fund the rewards program, thus ensuring sustainability.

Also, as mentioned above, the devs are contemplating allowing a vote-escrow mechanism that would allow staking and locking SILO for what I believe would be a share of protocol revenue, among other things. We know how it goes, eh?

As for tokenomics, the total supply is capped at 1 billion. In the first 6-months, around 102 million tokens will circulate. Find more details here.

Verdict

I’m super impressed with what I see with Silo. These gigabrains found a shortcoming in the existing DeFi lending space and built a novel solution that improves the user experience and furthers our cause. It’s our responsibility to bring innovative builders to the limelight.

Implementation of their own overcollaterlised stablecoin was a bold move but a necessary one, in my opinion. The unique minting and burning implementation whilst being able to maintain peg is especially praiseworthy.

Finally, make sure to review the resources to learn more about Silo. There’s a lot more to the protocol that I could cover in this article. I hope you found it informative and helpful nonetheless. Until next time!

Resources

Website: https://www.silo.finance/

Dapp: https://app.silo.finance/

Twitter: https://twitter.com/SiloFinance

Docs: https://silopedia.silo.finance/welcome/read-me

Dev Docs: https://devdocs.silo.finance/

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