# Convertible Notes Explained This is the advanced Academy page. Before reading this, make sure you understand [staking](https://docs.ethstrat.xyz/academy/staking-and-liquid-staking), [leverage and liquidation](https://docs.ethstrat.xyz/academy/leverage-and-liquidation), and the [treasury accumulation model](https://docs.ethstrat.xyz/academy/treasury-accumulation-model). *** ## What Is a Convertible Note? A convertible note is a loan that can be "converted" into equity instead of being repaid in cash. They're common in traditional finance — MicroStrategy, Tesla, and Uber have all raised billions through convertible bonds. Here's the basic structure: ``` Traditional Convertible Bond ━━━━━━━━━━━━━━━━━━━━━━━━━━━ Investor gives: $1,000 cash Issuer gives: A bond that pays X% interest annually + The right to convert the bond into shares at a predetermined price (the "strike") At maturity (if not converted): Investor gets their $1,000 back Before maturity (if converted): Investor exchanges the bond for shares (profitable if share price > strike price) ``` The investor accepts lower interest because the conversion option has value. The issuer gets cheaper borrowing because they're paying partly in optionality rather than cash. *** ## How ETH Strategy's Notes Work ETH Strategy takes the convertible bond concept and decomposes it into **two separate, composable DeFi tokens**: | Component | Token Type | What It Represents | | -------------------------------- | ---------------------- | -------------------------------------------------------------- | | **CDT** (Convertible Debt Token) | ERC-20 (fungible) | \~$1 of protocol debt. Tradeable, usable as collateral | | **NFT Option** | ERC-721 (non-fungible) | Your conversion rights: how much STRAT and esETH you can claim | In TradFi, these two components are bundled into a single instrument. In ETH Strategy, they're separated. This is important because: * **CDT can be sold immediately** — giving the bonder instant liquidity (like borrowing) * **The NFT can be held independently** — preserving upside exposure without holding the debt * **To convert, you reunite them** — burn CDT against the NFT to receive STRAT or esETH This separation turns a single illiquid bond into two liquid, composable primitives. *** ## Why Zero Interest? This is the question everyone asks. Why would someone lend money at 0% interest? The answer: **because the conversion option is the compensation**. Think about it as a trade-off: | | Regular Bond | Convertible Bond | | ------------------- | ------------------------------- | ---------------------------------------------------------------------- | | Interest rate | 5-10% | 0% (or very low) | | Upside exposure | None — just get your money back | If the underlying asset rises, conversion is worth more than repayment | | Downside protection | Get your money back at maturity | Same — get your money back at maturity | The bonder gives up interest income. In exchange, they get a **call option** on STRAT — the right (not the obligation) to convert into STRAT at a price fixed at bonding time. If STRAT appreciates significantly, the conversion right could be worth far more than 4 years of interest payments. ### The Option Payoff The conversion option has a classic "hockey stick" payoff: ``` Profit ↑ │ ╱ │ ╱ │ ╱ ← If STRAT price rises well │ ╱ above the conversion rate, │ ╱ profit grows linearly │ ╱ │ ╱ │ • ← Break-even (STRAT price = conversion rate) │───────────────┤ │ │ │ ← Maximum loss is the forgone interest │ (you still get $1 back per CDT at maturity) └───────────────────────────────────→ STRAT Price ``` **If STRAT goes up:** Convert to STRAT, capture the upside. The higher STRAT goes, the more profitable the conversion. **If STRAT goes down:** Don't convert. Hold CDT to maturity and redeem for the USD notional value (\~$1 per CDT, paid in esETH). Your loss is limited to the interest you could have earned elsewhere. This asymmetric payoff — limited downside, unlimited upside — is why bonders accept zero interest. The option itself is the payment. *** ## The Bonding Process Convertible notes are USD-denominated — the buyer is purchasing a note with a specific USD notional value. The smart contract accepts ETH for convenience, but prices everything in USD via an ETH/USD oracle. Think of it as: you're buying a $200,000 note, and you pay with 100 ETH. Here's what happens in a single transaction: ``` 1. User sends ETH as payment → 100 ETH at $2,000/ETH ($200,000 USD notional) 2. Protocol prices the note in USD → ETH/USD oracle determines notional (say $25 per STRAT conversion rate) 3. Protocol calculates entitlements → STRAT: 200,000 / 25 = 8,000 esETH: based on NAV per STRAT 4. Protocol acquires ETH for treasury → Wraps into esETH, split between: • Encumbered (reserved for conversion) • Unencumbered (protocol's free capital) 5. Protocol mints CDT to buyer → 200,000 CDT (~$1 per token) 6. Protocol mints NFT to buyer → Encoding: 8,000 STRAT entitlement, X esETH entitlement, 200,000 CDT owed, expiry (~4.2 years), timelock (~6.9 days) ``` The bonder now holds two tokens — CDT and an NFT — and can do whatever they want with either one. *** ## Conversion Pricing: The PCF/GCF Formula How does the protocol decide how much STRAT a bonder gets per dollar bonded? This is the conversion rate, and it's computed from two governance-controlled parameters: **PCF (Premium Control Factor)** — scales a "premium" based on how much CDT is outstanding. More outstanding debt → higher premium → fewer STRAT per bond. **GCF (GAV Control Factor)** — scales the treasury value (Gross Asset Value). Higher treasury → higher conversion rate → fewer STRAT per bond. The formula: ``` Conversion Rate ($ per STRAT) = (Treasury Value × GCF + CDT Supply × PCF) / STRAT Supply ``` ### Why This Formula Matters The pricing formula protects existing STRAT holders from excessive dilution: * **When the treasury is large**, the conversion rate is high → each bond gets fewer STRAT → less dilution per dollar bonded * **When CDT supply is high** (lots of outstanding debt), the premium pushes the rate higher → discouraging excessive bonding during high-debt periods * **Governance can tune PCF and GCF** to make bonding more or less attractive without changing the underlying formula ### Worked Example Protocol state: * Treasury: 10,000 esETH at $2,000 = $20M GAV * STRAT supply: 1,000,000 * CDT supply: 5,000,000 * PCF = 1.0, GCF = 1.0 ``` Conversion Rate = ($20,000,000 × 1.0 + $5,000,000 × 1.0) / 1,000,000 = $25,000,000 / 1,000,000 = $25 per STRAT ``` A buyer purchasing a $2,000 note (sending 1 ETH at $2,000/ETH) gets: * **STRAT entitlement:** $2,000 / $25 = 80 STRAT * **CDT received:** 2,000 CDT If the same person purchased a note when ETH was at $4,000 (treasury doubles to $40M): ``` Conversion Rate = ($40,000,000 + $5,000,000) / 1,000,000 = $45 per STRAT STRAT entitlement = $4,000 / $45 = ~89 STRAT ``` Higher treasury value → higher conversion rate → fewer STRAT per dollar. This is dilution protection in action. *** ## The Two Exercise Paths After the \~6.9-day timelock and before the \~4.2-year expiry, a note holder can convert by burning CDT: ### Path 1: Convert to STRAT (Bullish) Burn CDT → receive newly minted STRAT. Choose this when you believe STRAT will appreciate. You're exchanging a debt claim for equity in the protocol. The STRAT amount was fixed at bonding time — it doesn't change with market conditions. When STRAT is minted through conversion, the corresponding esETH moves from encumbered to unencumbered holdings, freeing it for the protocol to lend and generate yield. So conversion is actually good for the protocol's revenue capacity. ### Path 2: Convert to esETH (Risk-Off) Burn CDT → receive esETH from the treasury. Choose this when you want to exit into ETH-denominated value. The esETH amount was also fixed at bonding time, based on the NAV per STRAT at that moment. ### Partial Exercise You don't have to convert all at once. Burn some CDT now, keep the rest for later. Entitlements decrement pro-rata: ``` If you hold a note with 10,000 CDT owed and 400 STRAT entitlement: Burn 2,500 CDT (25%) → receive 100 STRAT (25% of 400) Remaining: → 7,500 CDT owed, 300 STRAT entitlement ``` You can mix paths across partial exercises — convert some to STRAT and some to esETH at different times. *** ## After Expiry: Redemption If the note reaches expiry (\~4.2 years) without full conversion, the remaining CDT can be redeemed: * **If the protocol is solvent** (treasury value > total CDT obligations): each CDT redeems for \~$1 worth of esETH * **If the protocol is underwater**: CDT redeems pro-rata — everyone gets a proportional share of available esETH Redemption is permissionless — anyone can trigger it for an expired note. *** ## Three Ways to Use a Convertible Note Different users bond for different reasons: ### 1. Non-Liquidatable Borrowing **Goal:** Get liquidity without selling ETH and without liquidation risk. ``` Purchase note (send ETH) → receive CDT + NFT Sell CDT on market → instant liquidity Hold NFT → preserve conversion rights (upside) ``` This is economically similar to borrowing, but with no margin calls, no variable rates, and no liquidation. The "cost" is the forgone interest on the CDT and the risk that conversion rights expire worthless. ### 2. Leveraged ETH Exposure **Goal:** Amplified exposure to ETH via STRAT. ``` Purchase note (send ETH) → receive CDT + NFT Hold everything → wait for STRAT to appreciate Convert NFT → receive STRAT at the fixed conversion rate ``` If STRAT appreciates beyond the conversion rate, the note's STRAT entitlement is worth more than the original USD paid for the note. This is leveraged exposure without liquidation risk. ### 3. Downside-Protected Positioning **Goal:** ETH exposure with a defined floor. ``` Purchase note (send ETH) → receive CDT + NFT If ETH rises → convert to STRAT or esETH (capture upside) If ETH falls → hold to maturity, redeem CDT for ~$1 each (floor) ``` The floor is the CDT's redemption value at maturity. As long as the protocol remains solvent, you get your dollar value back. The ceiling is unlimited (STRAT can appreciate indefinitely). *** ## Key Differences from TradFi Convertible Bonds | Feature | TradFi Convertible Bond | ETH Strategy Note | | ---------------- | ------------------------- | ------------------------------------- | | Components | Single bundled instrument | Two separate tokens (CDT + NFT) | | Tradability | OTC, illiquid | Both components tradeable on-chain | | Partial exercise | Usually all-or-nothing | Arbitrary partial amounts | | Settlement | Cash or shares | STRAT or esETH (two paths) | | Interest rate | Low (0.5-3%) | Zero | | Term | 3-7 years typical | \~4.2 years | | Callable | Often callable by issuer | Not callable — the term is guaranteed | The non-callable property deserves emphasis. In TradFi, issuers often call their convertible bonds early — forcing conversion when it benefits the company, not the investor. ETH Strategy's notes cannot be called. The \~4.2-year term is guaranteed on-chain. No governance vote, no multisig, no protocol decision can force early conversion or change the terms. *** ## What to Read Next You now have the conceptual foundation for the full protocol documentation: * [Convertible Notes](https://docs.ethstrat.xyz/core-mechanics/convertible-notes) — the technical specification with all smart contract details * [Conversion of Notes](https://docs.ethstrat.xyz/core-mechanics/conversion-of-notes) — conversion and redemption mechanics in full detail * [CDT](https://docs.ethstrat.xyz/core-mechanics/cdt) — the debt token's role in the system * [STRAT Economics](https://docs.ethstrat.xyz/tokenomics/strat-economics) — how all of this translates to STRAT value accrual