WTF is…Element Finance?


If you’ve ever been on the lookout for fixed income in crypto you may already know of Element Finance. The DeFi primitive, which launched their testnet in May and on the Ethereum mainnet in July, has become the leading fixed rate marketplace. While fixed rates might not seem as sexy as a 10x lever on some shitcoin they are sort of the oil in the engine for mature financial markets. In the normie world the interest rate swap market does trillions of dollars in volume annually as institutions look to lock in a fixed rates to hedge risk, or speculate on variable rates to turn a profit. IRL, this massive market transacts pretty much entirely via exclusionary Over The Counter (OTC) trading. Conversely, Element’s primitive introduces a trustless and permission-less marketplace for a number of assets. How does Element work and what is it bringing to the DeFi space? Down the rabbit hole we go, anon.

Brass Tacks

Element Finance provides a trustless and permissionless market to trade interest rates. Element’s markets leverage custom Balancer pools to trade the yield on certain whitelisted Yearn vaults. These vaults include base assets such as DAI and USDC as well as more exotic ones such as stETH, MIM-3POOL and Curve’s TriCrypto. Users can interact with Element Finance in a couple ways, the most straight forward of which is simply buying assets at fixed rates via the Element dAPP. These principal tokens (PT tokens in the Element nomenclature) represent a fixed rate earned over the stated term; you are effectively buying the future rights to these assets at a discount.

So for example, if you purchased the steCRV principal token you’d lock in a 6.74% annualized fixed rate over the term ending on January 28th, 2022. Though the rate may be annualized you will only realize the pro rata yield of that, given the expiration. When the term is up you simply redeem your PT tokens for the underlying asset. Rinse, repeat. Rumor has it the gigabrains at Element are working hard on an auto-rollover feature that will make managing these terms a lot easier. But don’t worry, anon, if you do need liquidity before the term expires you can always sell your principal tokens on the Element AMM.

For those who consider themselves more of a “power user” Element also allows you to mint principal and yield tokens from supported underlying assets. Minting these tokens allows users to take one of these variable rate Yearn vault positions and split the principal from the yield, leaving the user with two tokens. As we mentioned before the PT token will always be redeemable at face value at the end of term. The YT tokens, on the other hand, are redeemable for the average interest accrued over the term thus representing a tokenized variable rate.

This splitting of yield from the principal creates greater capital efficiency when speculating on variable rates. Users who want to speculate on increases in the variable rate can mint the PT and YT tokens, sell the PT token and repeat the process known as yield compounding. Our frens at Component have even made a tool for all the degens out there. For the less degen among us Element also allows users to become market makers, providing liquidity on the principal or yield token to earn additional yield via trading fees.

Spotlight: Treasury Management

One of the more exciting use cases for Element’s fixed rates is in treasury management. The team wrote about this initiative back in August 2021. Since then companies such as Gnosis Safe, Drift, and ChainSafe have all started leveraging the Element protocol as part of their treasury management strategy. Additionally, there is an active governance proposal on the ENS forums to allocate a portion of their treasury to fixed rates. Why does this matter?

When you’re managing tens, if not hundreds, of millions of dollars in assets for a protocol with thousands of users you have a responsibility to take a more risk-off approach to managing said assets. Recall the Messari report from May which revealed most top protocols were massively over indexed in their own native token. We saw first hand how this can have large negative implications for a protocol as the DeFi bubble started to deflate and some protocols experienced exploits. Rari Capital, for example, saw their token price fall by around 50% following their exploit, and pretty much all DeFi protocols are well off all time high status.

Through smart treasury management, such as asset diversification and yield hedging, protocols can better insulate themselves from both normal market variance and black swan events. This is where Element can be leveraged to ensure the stables or just plain ETH a treasury has can still be deployed as productive assets while locking in a fixed income on some portion of those assets. This leads to more predictable revenue streams for protocols and DAOs, ultimately making operations run much more smoothly.

Looking Forward

Big things are on the horizon for Element finance! If you’ve spent any amount of time in the Element Discord you will know that the most commonly asked question is “wen L2”. Good news on that front: the Element Finance team announced a partnership with Aztec! Aztec is a zkRollup based Ethereum Layer 2 that brings privacy and scalability to the Ethereum ecosystem. Depending on the term and asset the Element team estimates that trading principal tokens on Aztec can bring down gas costs by as much as 40x. The partnership will initially launch with DAI as their only asset but Element will be working closely with the Aztec team to determine which additional assets and user actions to onboard.

Finally, Element will be launching governance for the protocol, as they mention in their blog. The team has spoken about their governance primitive at conferences such as EthCC and written about its implementation. I highly encourage you to check Element smart contract developer and general gigachad Paul Vienhage’s talk on the governance contracts if you haven’t already. This is an excellent primer for how these governance primitives can be leverage to usher in an exciting new era in on-chain governance.

Anyone interested in participating in the DAO should pop over and say hello in the #governance channel in the Element Discord, where team and community members will be happy to answer any questions. Additionally, you can browse through the contracts on GitHub if you want to see how the sausage is made.

Wrapping Up

While fixed rates might not have the sex appeal of the degen ponzi box du jour, I hope we have shown how in mature and stable financial markets fixed rates play a crucial role. As the entire crypto ecosystem moves towards less volatility Element is well positioned to be a foundational Lego piece. Protocols, DAOs, and users can hedge risk or speculate on variable rates while the primitives themselves can serve as a platform for the next wave of builders. Add to that the imminent move of the DAI markets to a zkRollup-based L2 in Aztec, the progress being made on rolling out governance, and the teased Elfiverse and I’d say there is plenty to get excited about.