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Convertible Notes Explained

This is the advanced Academy page. Before reading this, make sure you understand staking, leverage and liquidation, and the 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:

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:

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:

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

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):

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:

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.

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.

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.

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:

PreviousHow Treasury Accumulation WorksNextWhat is ETH Strategy

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