Circular Bond

A core use case where users deposit a volatile asset (e.g., ETH) as collateral to mint a stablecoin-denominated bond. The stablecoin is then deployed into a yield-generating strategy (e.g., a liquidity pool). The generated yield is automatically used to buy back and burn the bond tokens, paying down the debt over time without requiring additional capital from the user.

• Key Mechanism: Yield from external protocol pays the loan.
• Example: Using ETH as collateral to mint a USDC bond, then supplying that USDC to a lending protocol like Aave. The interest earned repays the bond.

DAOs and protocol treasuries use Circular Bonds to generate liquidity against their native token holdings without immediate dilution. By bonding a portion of the treasury's native tokens, the protocol can access stable capital for operations (e.g., funding grants, providing liquidity). The protocol then uses its revenue (e.g., protocol fees) to automatically service and repay the bond.

• Key Benefit: Unlocks capital from idle assets.
• Outcome: Creates a sustainable funding loop where protocol revenue directly retires its debt.

This transforms passive collateral into an active repayment engine. Instead of a user manually selling assets to make payments, smart contracts are programmed to execute a predefined strategy. Common strategies include:

• DCA (Dollar-Cost Averaging): Periodically selling small amounts of collateral.
• Yield Harvesting: Using rewards (staking, liquidity mining) as the repayment source.
• Option Selling: Generating premium income by selling covered calls against the collateral.

The bond's smart contract autonomously manages this process, reducing user intervention and liquidation risk.

Circular Bonds differ fundamentally from standard overcollateralized loans (e.g., MakerDAO, Aave).

• Standard Loan: Requires active management; user must manually repay or risk liquidation. Debt is static unless the user acts.
• Circular Bond: Debt is dynamic and self-repaying. The system automatically uses generated yield or scheduled sales to reduce the principal.
• Liquidation Risk: Both carry risk, but Circular Bonds are designed to amortize debt over time, potentially reducing the outstanding loan-to-value (LTV) ratio automatically, whereas in a standard loan, the LTV is purely a function of collateral price movement.

The core vulnerability of a circular bond is its reflexive collateral loop. The bond is issued against collateral (e.g., a token), and the proceeds are used to buy more of that same asset, artificially inflating its price. This creates a positive feedback loop where:

• Bond issuance increases demand for the collateral asset.
• The rising price increases the perceived value of the collateral backing the bond.
• This enables further bond issuance, repeating the cycle. A price decline triggers the opposite, negative feedback loop, leading to rapid devaluation and potential insolvency.

Circular bonds are highly susceptible to liquidity crises and manipulation. Since the bond's health is tied to a single asset's market depth, a large sell order can collapse the price, triggering margin calls or liquidation events on the bond's collateral. This structure is attractive for pump-and-dump schemes, where insiders can artificially inflate the collateral price before the bond is marketed, then exit, leaving holders with devalued assets. The concentrated liquidity required to maintain the loop is a critical point of failure.

The valuation of the collateral asset is typically determined by an oracle (e.g., Chainlink, Uniswap TWAP). This creates a single point of failure. An attacker could:

• Manipulate the price feed on a DEX with low liquidity.
• Exploit a flash loan to create a temporary price spike or crash.
• Trigger an oracle attack to falsely report a high collateral value, enabling excessive borrowing, or a low value to force unjustified liquidations. The bond's solvency is only as reliable as its most vulnerable oracle.

Circular bond structures often exist in a regulatory gray area. They may be classified as unregistered securities by bodies like the SEC or FCA, leading to enforcement actions. The self-referential nature can be seen as a form of market manipulation or a Ponzi scheme, where returns for early participants are paid by capital from new entrants. This exposes issuers and potentially large holders to significant legal liability, including fines, asset seizures, and civil lawsuits.

Beyond economic design, circular bonds inherit all standard DeFi smart contract risks. The bond's smart contract, the collateral vault, and the underlying asset's contract (e.g., an ERC-20 token) are all potential attack vectors. Vulnerabilities could include:

• Reentrancy attacks on the bond minting/burning logic.
• Governance attacks if the system uses a token for upgrades.
• Integration risks with lending protocols or oracles. A bug in any component of the interdependent stack can compromise the entire structure.

Due to their leveraged and interconnected design, a failure in a major circular bond can cause systemic contagion. If the bond is widely held or integrated with other protocols (e.g., as collateral in a money market), its collapse can lead to:

• Cascading liquidations across connected lending platforms.
• A loss of confidence in similar structured products.
• A liquidity drain from the broader ecosystem as participants flee to safety. This magnifies the impact from a single point of failure to a network-wide event.

A Circular Bond is a mechanism where a protocol uses its treasury assets (like LP tokens or stablecoins) to mint a bonded stable asset. The protocol then uses the revenue from its own operations (e.g., fees, yield) to buy back and burn the bonded asset, creating a circular flow of value. This is distinct from algorithmic stablecoins that rely on external arbitrageurs.

• Treasury Backing: The bond is minted against assets the protocol owns and controls.
• Buyback & Burn: Protocol revenue is programmatically used to repurchase bonds from the open market.
• Price Support: This creates a built-in buyer, providing a price floor and reducing volatility.

The Olympus (OHM) protocol pioneered the circular bond model with its (3,3) game theory. Users bond assets like DAI or LP tokens to the treasury in exchange for discounted OHM, vesting over time.

• Protocol-Owned Liquidity (POL): Bonded assets grow the treasury, which owns its own liquidity pools.
• Staking Yield: Staked OHM (sOHM) earns rewards from treasury revenue (bond sales, LP fees).
• Circularity: Revenue from bonds and fees is used to back OHM's value and fund staking rewards, creating a reflexive system.

The design aims for sustainable native yield and reserve-backed stability, but introduces specific risks.

• Objectives:
  • Yield Source: Generate yield from protocol activity rather than external incentives.
  • Treasury Growth: Accumulate assets to increase intrinsic value per token.
  • Reduced Dilution: Control token supply expansion through bonding schedules.
• Key Risks:
  • Ponzi Dynamics: Reliance on new bond sales to fund staking rewards.
  • Death Spiral: If sell pressure exceeds buyback capacity, the backing ratio falls, undermining confidence.
  • Complexity: Difficult for users to assess true risk-adjusted returns.

Understanding circular bonds requires familiarity with these specific terms:

• Bonding: The act of selling an asset (e.g., DAI, ETH) to the protocol treasury at a discount in exchange for the protocol's native token, delivered on a vesting schedule.
• (3,3) Game Theory: A cooperative Nash equilibrium where all participants are incentivized to bond and stake, rather than sell, for maximum collective benefit.
• Backing per Token: The value of treasury assets divided by the token's circulating supply, a key metric of intrinsic value.
• Risk-Free Value (RFV): A conservative accounting method valuing treasury assets, often excluding the protocol's own LP positions to assess core solvency.

The core model has evolved into several variants, adapting the circular mechanics for different goals.

• Liquidity Bonds: Focus on acquiring LP tokens to build Protocol-Owned Liquidity, reducing reliance on mercenary capital.
• Stablecoin Bonds: Protocols like Frax Finance use bonding to help stabilize its algorithmic stablecoin, FRAX, by accumulating collateral.
• Revenue Bonds: Directly bond protocol revenue (e.g., fee streams) to buy back and burn the native token, creating a deflationary flywheel.
• Cross-Chain Bonds: Protocols like Stake DAO use bonds to accumulate assets across multiple chains into a unified treasury.