Core Contracts

Summary
This report identifies a critical financial risk within the protocol: a mismatch between assets and liabilities due to the application of linear interest for depositors and compound interest for borrowers. This imbalance can lead to insolvency, jeopardizing the protocol’s ability to meet withdrawal demands and ultimately resulting in user fund losses and protocol collapse.

Vulnerability Details

The protocol’s current interest structure consists of:

• Linear interest for depositors: Deposits grow at a simple, fixed rate over time.

• Compound interest for borrowers: Borrowed amounts grow exponentially over time.

Consider a depositor and borrower over a two-year period:

• Depositor: Lends 100 USDC at 10% linear interest.

  • Year 1: 100 * (1 + 0.10) = 110 USDC.

  • Year 2: 100 * (1 + 0.10 * 2) = 120 USDC.

• Borrower: Borrows 100 USDC at 10% compound interest.

  • Year 1: 100 * (1 + 0.10)^1 = 110 USDC.

  • Year 2: 100 * (1 + 0.10)^2 = 121 USDC.

At the end of two years:

• The protocol owes 120 USDC to the depositor.

• The borrower owes 121 USDC.

• If the borrower defaults, a 1 USDC shortfall emerges. Over time, such shortfalls accumulate, increasing insolvency risks.

Impact

While this design simplifies lender-side calculations, it creates a fundamental imbalance. Over time, this discrepancy leads to liabilities (depositors’ balances) lagging behind assets (borrowers’ debt), increasing the risk of insolvency. Beyond financial concerns, this issue can severely impact user trust, a crucial factor in decentralized finance (DeFi) protocols.

The disparity between asset and liability growth can lead to severe consequences:

1. Insolvency Risk

   • If liabilities (depositor funds) outgrow available assets (borrower repayments), the protocol may fail to meet withdrawal demands.

   • Example: If withdrawals exceed the protocol’s reserves due to faster-growing borrower debt, the protocol becomes insolvent.

2. Loss of User Funds

   • Depositors may be unable to recover their funds in the event of insolvency.

   • Borrowers could face higher fees or penalties as the protocol struggles to cover deficits.

3. Erosion of User Trust

   • Perceived Unfairness: Depositors may feel disadvantaged as their returns lag behind borrower repayment obligations.

   • Lack of Transparency: Unclear communication regarding interest mechanics can lead to mistrust.

   • Fear of Insolvency: Concerns over insolvency can trigger mass withdrawals, further destabilizing the protocol.

4. Regulatory Scrutiny

   • Regulators may investigate the protocol for mismanagement, leading to legal consequences, financial penalties, or forced shutdowns.

Tools Used

Recommendations

To address the imbalance, prevent insolvency, and maintain trust, the following strategies are recommended:

1. Align Interest Calculation Methods

   • Apply compound interest to both lenders and borrowers to ensure synchronized growth of assets and liabilities.

   • This promotes fairness and enhances protocol sustainability.

2. Establish a Reserve Buffer

   • Allocate a portion of borrower interest payments to a reserve fund.

   • This reserve acts as a safeguard against borrower defaults or financial imbalances.

3. Implement Dynamic Interest Rates

   • Adjust interest rates based on the protocol’s financial health.

   • Example: Increase depositor rates or lower borrower rates to balance asset and liability growth.

4. Frequent Rebalancing

   • Regularly assess and rebalance asset and liability levels.

   • Automated mechanisms or manual interventions can prevent financial drift.

5. Enhance Transparency and Communication

   • Clearly explain the interest calculation methods to users.

   • Publish regular financial health reports to foster trust and awareness.

6. User Education Initiatives

   • Provide educational materials on interest mechanisms and financial stability.

   • Use simulations to illustrate risks and benefits to users.