Introduction

Security incidents are common in DeFi lending. A single asset may cause systemic risk stability (barrel effect) in spite of its enhanced liquidity and capital efficiency offered by the shared pool model. Silo Finance is a lending market deployed on Ethereum and Arbitrum. The product features a risk isolation mechanism designed to meet the transaction needs of long-tail assets. It also launched an over-collateralized stablecoin $XAI in the ecosystem. This article will discuss how Silo works, the logic of the $XAI stablecoin, the token model, the current development, and the competitive environment.

About Silo Finance

As a champion project in the Ethereum Hackathon competition in 2021, Silo Finance is focusing on building a DeFi lending protocol that is more resistant to systemic risks. It was officially launched on the Ethereum mainnet in August 2022 and deployed on Arbitrum in February 2023.

In DeFi lending protocols, incidents of manipulating collateral prices and over-lending other relatively stable assets to make profits often take place. Since most lending protocols adopt the shared pool model, the entire protocol will reveal the risk exposure of the asset when the protocol supports using certain risky assets as collateral. Therefore, the protocol needs to strictly control the quality of the collateral, thus limiting transactions of long-tail assets.

Silo Finance is designed to meet the high requirements for collateral and improve the efficiency of the risk control mechanism. It achieves this goal by using independent currency markets to isolate risks and reduce the systemic risk caused by a single asset, thereby increasing the application scenarios of long-tail assets.

How Silo Works

Silo Finance is unique because it introduces silos and bridging assets. Its lending pool is composed of several independent silos, each of which contains two assets, namely, independent tokens and bridging tokens (ETH). The silos are connected by bridging assets. With this mechanism, it is possible to isolate risks between different tokens, which helps to build a long-tail asset trading market.

When a user wants to stake asset A to lend asset B, the lending will actually be divided into two steps:

1. Deposit the collateral asset A in silo A and lend out the bridging asset.
2. After the bridging asset is lent, it will be deposited into the B silo as collateral to lend asset B.

Source: https://medium.com/silo-protocol/introducing-silo-secure-money-markets-for-all-crypto-assets-73cecc479fa6

With this risk isolation mechanism, asset B borrowed by the borrower is secured by the liquidity of the bridging assets. If the price of asset A is manipulated by hackers and continues to rise, hackers can lend the equivalent loans of inflated asset A under normal mortgage lending but can only lend at most all bridge assets in the silo under the mechanism of Silo. However, there is a problem with this model: if a single loan is divided into two deposits and loans, the capital utilization rate will be reduced. For example, up to 50% of the funds can be lent in a single loan, but only a maximum of 25% of the funds can be lent if the bridging assets are used for conversion.

Stablecoin $XAI

Launched by Silo Finance, $XAI is an over-collateralized stablecoin pegged 1:1 to the U.S. dollar. As a bridging asset after ETH, $XAI is also voted and governed by SiloDAO. The price stabilization mechanism of $XAI works by using market arbitrage to affect supply and demand. Specifically, when the price of $XAI is higher than $1, arbitrageurs can deposit collateral (such as ETH) to mint new $XAI and sell it on the market to make a profit. As a result, the increase in the supply of $XAI in the market will pull the price back to $1. On the contrary, when the price of $XAI is lower than $1, arbitrageurs can buy $XAI at a low price in the market and repay the loan to redeem the collateral for making a profit, thus driving the price up by reducing the market supply of $XAI.

By now, $XAI hasn’t been widely used. The team launched related liquidity mining activities to increase the initial liquidity, in which users can obtain $XAI by adding liquidity in the silo as well as get a certain rate of return. Users can also directly buy $XAI in the $XAI/FRAX fund pool on Curve and deposit the acquired $XAI, FRAX, and USDC into the Curve pool to obtain the corresponding LP tokens. Then, they can stake LP tokens into Convex to increase their revenue by obtaining token rewards. However, since the current usage scenarios of $XAI are few and the demand for tokens is low, there is a challenge for the liquidity of the stablecoin $XAI. The crucial point of future development is how the team can expand the application scenarios of $XAI to improve liquidity.

Source: Official file

Current Development

Analyzing lending protocols in the market, we can see that most DeFi users currently prefer to use mainstream assets and stablecoins which have high liquidity and are highly recognized by the market. Compared to altcoins, they have smaller price fluctuations and lower liquidation risks. According to the data in March 2023, the lock-up volume of the Silo Finance protocol is about $32 million, which is conducive to the construction of a long-tail asset trading market under the risk isolation mechanism. However, in terms of capital composition, most funds are still put into stable coins and mainstream assets and, actually, long-tail assets only take up a limited proportion.

Source: Official Website

Security attacks such as price manipulation often occur in mortgage lending development. Since most protocols adopt the shared liquidity pool model which reveals the risk exposure of all assets supported. Therefore, many protocols have taken risk isolation into their product design. However, compared to stablecoins and mainstream assets, long-tail assets have greater price fluctuations, which makes the risk isolation mechanism more conducive to long-tail asset transactions. Silo Finance has other DeFi lending protocol competitors, for example, Aave, the top lending protocol, also introduced an isolation mode in its v3, allowing unlicensed token listings but setting a debt ceiling for new assets.

Token Model

The total supply of $SILO tokens is 1 billion. In February 2021, the initial coin offering (ICO) was held on the Gnosis platform, and a total of 100 million $SILO tokens were auctioned, accounting for 10% of the total supply. In its distribution, 45% of the tokens are allocated to the community vault, 6.75% to early contributors, 21.75% to founding contributors, 6.35% to early investors and advisors, 10% to future community contributors and advisors, and 0.2% to community rewards.

In February 2022, Silo launched an airdrop campaign for early participation. Silo, a non-custodial lending protocol, has launched an airdrop, reported by BlockBeats (source: theblockbeats.info).

SILO will be released within four years, the timeline can be seen in the next graph.

Source: Official File

The interest fees obtained by lending $XAI will go into SiloDAO. The team plans to use part of the revenue to repurchase $SILO tokens every month from this year, with the monthly repurchase ranging from $25,000 to $35,000. In the past two months, the team has repurchased a total of 906,118 tokens, accounting for 0.09% of the total supply.

Conclusion

As a DeFi lending protocol, Silo Finance achieves risk isolation by introducing silos and bridging assets, which is conducive to meeting the transaction needs of long-tail assets. However, it will also lead to low capital utilization. The over-collateralized stablecoin $XAI also faces a liquidity test as a bridging asset. The focus of the team on its future development will be expanding the application scenarios of $XAI and increasing demand.

In terms of the current composition of the capital pool, funds are mainly put into stable coins and mainstream assets, and long-tail assets actually take up a very limited proportion of assets, which may spoil the core competitiveness of the project. Seen from the fundamentals, Silo Finance has growth potential to some extent. However, the current lock-up situation indicates that the team needs to carry out incentives such as liquidity mining in the early stage to attract more funds and users.