Perpetual debt and protocol mechanics


Here, we introduce Covenant: a collateral-agnostic, capital-efficient, market-driven lending protocol. Covenant is built on tradeable perpetual debt, a new DeFi primitive which enables an efficient method of pricing, buying, and selling debt on digital assets. The purpose of this document is to explain in a readable manner how the protocol works. If you have any questions after reading, please join the Discord.


Incumbent DeFi lending protocols are characterized by one or more of the following deficiencies:

  • Limited collaterals, e.g. focused on easy to price liquid tokens with continuous oracle data

  • Incorrect risk pricing, i.e. algorithmically constrained (e.g, pool utilization)

  • Expensive markets, i.e. wide borrow-lend spreads

Some of the above deficiencies are design tradeoffs. For example, utilization-based protocols like AAVE and Compound are characterized by wide borrow-lend spreads, a knock-on effect of prioritizing on-demand liquidity and having yields being the only market incentive.

We solve for these deficiencies with Covenant, such that hard to price and illiquid collaterals can be used to mint debt, where the risk of these collaterals is priced directly by the market, and where this is done through efficient low-spreads between borrowers and lenders.

This enables important synergies and use cases. One exciting example, in our view, is for protocols to mint debt against their liquid and illiquid tokens in ways that do not negatively affect the protocol's tokenomics. This is discussed in more detail in the Protocol Debt section.

Tradeable Perpetual Debt

The core component of Covenant is tradeable perpetual debt, or zTokens, which a user can obtain from on-chain guilds. Users can then swap zTokens on DEXs for money.

Borrowers swap collateral for zTokens through a Guild, and subsequently zTokens for money through a DEX. Lenders, on the other hand, swap money for zTokens. Over time, the value of these zTokens increases - implying an additional cost that borrowers need to pay to get back their collateral, and an interest that lenders earn by holding the zTokens. The various components of this system are explained below and illustrated in Figure 1.

Guild - Collateral vs zToken exchange

Guilds implement all functionality related to collateral management (what can be deposited or withdrawn) and debt management (mint, burn, liquidations). In essence, through a guild, a user can swap their collateral assets for a liquid zToken.

For this, Guilds are initialized with a base money unit (e.g., Eth) in which both collaterals and zTokens are valued. Collaterals are valued using external oracles, whilst zTokens keep an internal facePrice that tracks their full, non-discounted, face-value.

Each Guild has an LTV defined, indicating the maximum amount of zTokens that can be swapped for collateral, such that

zTokenFaceValue<=LTVcollateralValuezTokenFaceValue <= LTV * collateralValue

where zTokenFaceValue=facePricezTokenzTokenFaceValue = facePrice * zToken. When a user swaps collateral for zTokens, there is a specific amount of collateralValue that is locked, and only they can swap zTokens to get that collateral back (unless their vault is open to liquidations, at which time anyone can swap zTokens for the collateral).

Uniswap - zToken vs Money exchange

Users can swap zTokens on any DEX for money. In particular, their marketPrice is defined as the value of a zToken in terms of base money (as defined in the Guild).

Interest rates

The facePrice of zTokens continuously increases through time t at a rate determined directly from the marketPrice zTokens trade at on the DEX:

facePricet=facePrice0eratetrate=f(marketPrice)facePrice_t = facePrice_0 * e^{rate * t} \\ \, \\ rate = f(marketPrice)

Further details are contained in the whitepaper. Here we'll summarize by indicating that the effective APY of the zToken facePrice is inversely proportional to the token's marketPrice, specifically:

APYfacePricemarketPriceAPY \propto \frac{facePrice}{marketPrice}

In practice, the marketPrice is always at a discount to the zToken facePrice. The below table provides example APY's given a constant discount through the year:

marketPrice / facePriceEffective APY







In addition to the zToken facePrice increasing over time at this rate, the collateralValueLocked in each vault in a Guild goes up at the same rate, thus ensuring the total collateral value locked is always equal to the total zToken faceValue in circulation.

zTokens behave similar to existing real-world debt instruments. The price and interest rate are inversely related. If the marketPrice of a zToken goes down, the effective interest rate increases and vice-versa, if the marketPrice goes up, then the effective interest rate decreases.


Debt is perpetual, in that if the borrower meets all conditions of the Guild, their vault will never be open for liquidation. In practice, however, this will require the borrower to continually add collateral, or to pay back debt that has accrued (by swapping zTokens bought on the market to unlock collateral in their vault). Thus, debt is not perpetual per se, but continuously accrues interest till the liquidation conditions of the vault are met.

This flexible structure allows for various loan products: margin type loans (where the mark-to-market value of liquid collateral has to exceed a liquidation threshold of debt value before being open to liquidations), to illiquid asset type loans (where the value of the collateral is assessed once, and from then on that value is used as the watermark above which the debt value cannot exceed).

In the case of insolvency, meaning the available collateral value after liquidator fees does not cover the value of outstanding debt, then the face value of all zTokens are reduced proportionally to the value gap. In effect, the loss is passed proportionally to all zToken holders via a reduction in the facePrice of zTokens.

System Dynamics

While Covenant is similar in many ways to real world debt markets, its incentives diverge in important ways from incumbent lending protocols.

Borrower and Lender Incentives

Borrowers and lenders are both directly influenced by the current rate on zTokens. If the marketPrice is high (i.e. low interest rate), borrowers are incentivized to take out loans and lenders are incentivized to sell their zTokens. Conversely, if the marketPrice is low (i.e. high interest rate), then borrowers are incentivized to pay back their loans (if they can) and lenders are incentivized to buy but zTokens. In addition to yield incentives, a change in zToken price can make borrowers and lenders immediately realize some of their expected yield, creating a more reactive market to yield changes vs existing money market lending protocols.

LP Incentives

The DEX fees LPs earn on zToken pools can be considered a loan underwriting fee, given they are charged when borrowers swap zToken for money, or vice versa when repaying a loan. To maximize these fees, LPs are incentivized to strategically place their liquidity given the functionality of Uniswap v3 around the expected risk price of debt.

Additional questions

How is interest distributed to zToken holders?

Although Covenant debt is perpetual (ie, without a fixed maturity), it does have an end value it is anchored to: the value of the collateral backing it at the time it is liquidated. Borrowers, seeking to avoid liquidation, will make sure to swap money for zTokens on the DEX so as to reduce their debt burden; or liquidators will acquire zTokens when liquidating to lay claim to the liquidated collateral. Both of these mechanisms ensure the price of zTokens on the DEX keeps track of the value of the collateral backing the zTokens in circulation.

Why Uniswap V3?

While a Uniswap V2-style AMM could be used to swap zTokens for money, Uniswap V3 is currently a preferred option given its capital efficiency. Because zToken's marketPrice determines the interest rate on the underlying debt, we think it’s important for LPs to provide liquidity only at the interest rate considered appropriate for a given collateral type and liquidation mechanics (e.g., liquidation threshold). Additionally, it’s important for observers of such a market to have a view of potential interest rates given liquidity allocation.

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