Summary

• The programmable layer on FIL, namely FVM, allows the construction of a trustless market;
• This requires a market that currently exists off the chain, that is, bringing FIL loans to the chain, retail FIL holders pledge their FIL, and miners borrow FIL from the fund pool;
• FIL lending is essentially to obtain cash in advance through the accumulation of miners' future rewards, so that FIL mining is more capital-efficient;
• In protocol design, there is a clear trade-off between centralization, capital efficiency, and security;
• The market size of borrowing FIL has decreased over time, but factors such as the introduction of stablecoins can unlock opportunities to build unique projects on top of these protocols;

Preface

Launching a programmable layer on top of a battle-tested blockchain is often exciting. When the Bitcoin blockchain launched Stacks (STX), a new paradigm of thinking emerged in the community built around it.

A similar scenario also happened when Filecoin launched FVM. The strong Filecoin community can now see its vision through a completely different lens. Many of the difficult problems with the ecosystem are now resolved. Creating a trustless marketplace through programmability is a key part of this.

Liquidity staking on Filecoin was the first "Request-for-build" released by the Protocol Labs team, and it received a lot of attention. To understand this, let's first understand how Filecoin's economics work.

How Filecoin incentives work

Unlike validators in Ethereum, there is no one-time pledge in Filecoin. Whenever miners provide storage space to customers, they need to use FIL as a pledge token. This pledge amount is to seal the storage block and save the sealed storage block in the miner's equipment. This structure ensures that miners will store data for clients for the duration of the transaction they agree to, in return for being incentivized. Incentives are distributed through PoSt (Proof of Space-time), and miners are rewarded by proving that they have stored correct customer data.

Miners are elected through a leader selection mechanism called DRAND. DRAND selects a leader based on some initial requirements and a percentage of the network's raw byte power controlled by the miner.

Miners must continuously increase their Raw Byte Power to be elected as leaders to mine blocks and receive rewards. This helps miners subsidize their storage costs.

While there are many factors that constrain the supply of these incentives, for storage providers/miners to maximize their profits they must strive to maximize RBP and attract more (and continuation of past) transactions .

This creates a positive feedback loop for the Filecoin network.

Economics of miners

While miners receive block rewards, those rewards are not liquid. Only 25% of the rewards are liquid, and the remaining 75% of the block rewards are unlocked linearly over 180 days (about 6 months). This creates problems for miners. What was supposed to be a reward for the miner's operating income is now a pending payment, which can only be unlocked after the miner attracts (or continues) the transaction.

Let's take a look at the top miner balances in the network (as of August 6, 2023).

As you can see from the graph, only about 1% of miners' rewards (or operating income) are actually liquid. If the miner now wants to do any of the following:

• Pay operating income
• Upgrade hardware
• Pay for maintenance
• or attract/renew deals

He will have to borrow fiat currency or borrow FIL tokens from a third party to make up for these "delayed" payments.

Currently, many storage providers (miners) in the network rely on CeFi borrowers like DARMA Capital, Coinlist, etc. Since these are loan products, storage providers must go through KYC and a strict audit process to borrow FIL.

When we look at the map below, we can see the high concentration of Filecoin miners in the Asian region, while the centralized service providers are mainly concentrated in the West. It is difficult for them to provide Asian miners with FIL loans on favorable terms, and most Asian miners/storage providers do not have access to these providers.

Not only does this prevent new miners from participating, but existing miners can only scale to the size of the FIL pools of these CeFi borrowers.

So why not borrow fiat currency from the bank? Due to the volatility of FIL, this creates additional capital management challenges for borrowing miners.

In order to solve this problem, a market needs to be established for FIL borrowers (miners) and lenders (which can be FIL holders).

Filecoin Staking

With the launch of FVM, this market idea became a reality. FIL lenders/pledgers can now put their FIL tokens to work, and miners can borrow from this pool (permissioned or permissionless), all managed by smart contracts.

There are already many players in the ecosystem who are building this market and preparing to launch it in the next few months.

Although such a market is called a pledge agreement, in terms of business nature, it is closer to a loan agreement.

The basic features of such FIL loan products include:

1. The lender pledges the spare FIL tokens to obtain "liquid pledge" tokens.

2. Borrowers (miners) can borrow from the pool based on the collateral (basically the initial pledge amount + locking rewards) in the miner smart actors (actors).

3. The borrower will pay the interest by transferring the miner's "OwnerID" to the smart contract every week or other specified time period.

4. Lenders will earn interest (deducting protocol fees) as an annualized rate of return (APY), which can be obtained by resetting tokens or accumulating tokens.

Existing participants in the system include:

Different liquid pledge agreements have different ideas when it comes to borrowing:

Over/Fully Collateralized vs. Undercollateralized

In overcollateralized or fully collateralized models, the debt-to-equity ratio is always less than or equal to 100%. This means that if my miner balance is 1000 FIL, I can only borrow up to 1000 FIL (also depends on the protocol rules). This can easily be coded into smart contracts with default risk built in. Both provide greater transparency and provide security to the stakers (lenders). Another advantage of this model is that it also allows permissionless borrowing. In this case, the product is more like Aave/Compound than Lido or RocketPool.

In the undercollateralized model, the lender bears the risk, and the risk is managed by the protocol. In this model, risk modeling is a complex mathematical calculation that cannot be embedded in smart contracts and needs to be done off-chain, which sacrifices transparency. But because of the leverage involved, the system is more capital efficient for borrowers. The more permissionless the leveraged system is, the more risk lenders take on, which will require a very robust dynamic risk management model run by the protocol developers.

The trade-offs are:

• Capital efficiency and staker risk
• Capital efficiency and transparency
• Lender risk vs borrower access to the system

Single Pool vs Multiple Pools

The protocol can also choose to build a multi-pool model, where lenders can choose to stake FIL tokens in different pools with different risk parameters. This enables on-chain risk management, but at the cost of decentralized liquidity. In a single pool model, risk would have to be managed off-chain. Overall, the tradeoffs will still be the same as those mentioned above.

The trade-off: liquidity diversification vs risk management transparency

risk

In the over-collateralized model, even if the miner is slashed multiple times, once the debt-to-equity ratio reaches 100%, the miner will be liquidated and the staker will be relatively safe.

In an under-collateralized model, a borrower may be penalized if it fails to attest to storing a block. This is more common in Filecoin than PoS type models. This will affect mortgage values and increase leverage for borrowers. In this model, liquidation thresholds must be set very carefully.

Filecion's Miner Penalty (90 days)

MARKET PLAYERS COMPARISON

**So what about Ethereum staking/lending protocols coming to market? **

In the Filecoin ecosystem, unlike Ethereum, the responsibilities of nodes (miners/validators/storage providers) go far beyond typical uptime. They need to market themselves to be selected as Storage Providers (SPs), regularly upgrade hardware to support more storage, archive, maintain and retrieve data. For SP, Filecoin storage and reward mining is a full-time job.

Unlike validators in Ethereum, there is no one-time pledge in Filecoin. Whenever a storage provider offers storage to a client, they need to stake certain tokens. This pledge is to seal the storage block and save the sealed storage block in the miner's equipment. Provisioning storage on Filecoin is a very capital-intensive process, which discourages many new miners from participating in the network, and discourages existing miners from staying and contributing to the network.

Since participants on the borrow side are limited to miners, building trust on the borrow side will also be an energy-consuming process for newcomers in the Filecoin ecosystem.

With Filecoin's mechanism alone, Ethereum's pledge and even lending protocols cannot be easily deployed on FVM.

Protocol Economics

**Is there enough FIL in the market to supply loans? **

As of August 6, 2023, there are approximately 264.2 million FIL tokens in circulation. These tokens have not been pledged as pledges for storage blocks, or rewards to be released, and can be regarded as pledged by lenders to the pool. The total number of FIL tokens.

**Is there sufficient borrowing demand? **

While FIL borrowing is important to miners, what are they actually borrowing? In the over-collateralized model, they pay up front on locked rewards, while in the under-collateralized model, they pay up front on future rewards.

As can be seen from the chart above, the total locked rewards are about 223 million FIL tokens, and the supply can meet the demand. The ratio of demand to supply is almost 84%. This shows the power dynamics on both sides, neither can exert pressure on the other in terms of interest rates/annualized yields.

**What will the future look like? **

The estimate of the future FIL borrowing demand market is actually the number of FIL tokens released by future rewards.

Professionals from Messari performed 3-year and 50-year forecast simulations of FIL circulating supply using different scenarios.

According to the chart on the upper left, in a conservative case, if the addition of data is low and only 10% of the total transactions are renewed, then the new reward output in the next 3 years will be close to 100 million FIL tokens. And in the aggressive case, if the addition of data is high, 70% of existing transactions are renewed, and the additional reward output will reach about 200 million FIL tokens.

Therefore, it can be expected that the market size will be between 100 million and 200 million FIL tokens in the next 3 years. At the current FIL token price ($4.16 on August 6th), the total available market (TAM) for borrowing could be between $400 million and $800 million. This can be thought of as the TAM for the debit side of the product.

On the supply side, in a conservative estimate, roughly 300 million FIL tokens will be minted, while in a more aggressive scenario, the circulating supply is simulated to be about the same as it is today. why? Because if more transactions are absorbed and renewed, more FIL tokens will be locked in the pledge of storage blocks.

In more aggressive scenarios, demand will outstrip supply, and the interest charged could be higher in this competitive market.

If the demand for adding more data exceeds the growth in circulating supply, the price of FIL tokens will rise, creating more demand for borrowing in FIL tokens.

Possible future directions for this model

There is no need for a winner-take-all model among different designs. Intuitively, in the long run (in terms of total value locked in TVL), usually the most securely built protocol wins, just like Lido in the Ethereum ecosystem. Rather than optimizing for a 2-3% yield, I would prefer a safer structure, and I think holders of FIL tokens will also prioritize safety of capital over slightly higher yields.

This is after taking into account the amount of penalties miners pay for not being able to prove storage time.

From the perspective of borrowers (miners), miners can borrow from different protocols for different purposes. If miners already have a lot of collateral and don't need to leverage to pay operating expenses, then the safer over-collateralization model will work better because it is more secure. However, if I were a new miner and needed to stake a large number of storage blocks, I would probably be borrowing from an under-collateralized pool.

By studying the above model, we can see that:

In Filecoin, staking is important to fill the gap between supply and demand of FIL tokens in the ecosystem. The FVM has recently been released, allowing a lending market to exist. While the problem is real, the release of FVM may come too late for most FIL staking/lending protocols, as mining rewards gradually decrease, making it a niche market.

However, some fascinating use cases could arise on top of these staking protocols. With the introduction of stablecoins, rewards can be viewed as cash-forward contracts. Similar to the model Alkimiya built on Ethereum. This can inject new capital into the Filecoin ecosystem and increase the total value locked (TVL) of these protocols.

Ethereum and Filecoin have different technologies, different miners, different developers, and different applications, so the communities are also different. Especially for staking, since each miner is "non-homogeneous", driving demand requires business development, and its success is directly proportional to the reputation of the protocol in the community.

Filecoin's staking is a key solution that needs to get more miners into the system, put fractional funds into operation, create greater economic incentives, attract more developers as the ecosystem and build useful products to build positive positive feedback loop.

Summarize

There are still many unsolved problems in the Filecoin ecosystem, but we believe that the Protocol Labs team is working in the right direction to realize their vision of storing human data in an efficient system.