Written by: Kira Sun and Ruby Wu, partners of blockchain investment agency Incuba Alpha
YFI announced the merger of Pickle, Cream, Cover, Sushiswap and other well-known DeFi agreements in the short term, which attracted the attention of the entire market. We can’t help but worry, when industry first movers start to use mergers/acquisitions to consolidate their market position, does it mean that the DeFi track is becoming crowded, or the growth rate is slowing, and the market has entered a pattern of giants sharing their shares. ?
Does the DeFi market have the possibility of continuing to change? We are very optimistic about the answer to this question. The reason why we are optimistic has to start with the real change brought by DeFi.
The world of value exchange that the blockchain hopes to build is most thirsty for assets, and the explosive development of DeFi responds to this desire. For the first time, “credit” is introduced as an asset to the blockchain world.
The so-called credit refers to the debt-debt relationship based on the demand for funds. Credit is the cornerstone of the financial market, and the rapid progress of the financial market has always been inseparable from the expansion of credit and the accumulation of leverage. Whether in the traditional financial market or the DeFi market, any financial institution or DeFi agreement that occupies a core position in the market has successfully answered this question without exception: they have either introduced or created a new kind of credit as a basis Assets promote the process of credit expansion; either it is the creation of a certain financial product or trading market, which provides a more efficient way to increase leverage for credit expansion.
The concept of “introducing credit as an asset” is still in its infancy for the DeFi world. We look at DeFi’s worldview and investment logic based on the two directions of “introducing new credit” and “creating a leveraged approach”. With reference to the development path and market ecology of the traditional financial market, we can find some that are suitable for the DeFi market. The possibility of changing meaning.
The process of credit expansion and leverage accumulation
The ecology of the traditional financial market is rich and complex, including a variety of credit and dazzling leverage tools:
The financing needs of the country are packaged into sovereign debt; the financing needs of the private sector such as residential purchases, car purchases, medical and education consumption, or the financing needs of the corporate sector such as operating capital and capital expenditure are packaged into various debts-these credits constitute The cornerstone of the financial market, financial institutions create bonds (such as treasury bonds), loans (home mortgage loans, credit card loans) and other financial assets based on these credits, and continuously increase leverage through various derivatives.
The result of credit expansion and leverage accumulation is the continuous expansion of the balance sheets of all participating entities in the entire business chain of the financial market.
Taking the most radical era of financial liberalization before 2008 as an example, we can observe from the business path of the subordinated debt CDO (Collateralized Debt Obligation) how all participants in the entire financial market are connected through balance sheets. Since the structure of the financial market is very complex, we only abstract the core part in the above figure for reference.
Individuals have a need to purchase houses, and their assets have bought real estate or land, and they need funds to make up for the gap, so credit is generated on the debt end; commercial banking departments issue loans or purchase bonds on their assets end to support individual house purchase financing, on the debt end All types of bond assets are packaged and securitized. Non-bank financial departments purchase structured products with a credit rating. After the bank receives the funds, it can still continue to issue mortgage loans, thus completing the step of increasing leverage.
The entire process of credit expansion and leverage accumulation can continue to run until credit sinks (a large amount of debt owed by people who are actually incapable of repayment) and leverage breaks (a large number of subordinate debt defaults, the price of collateral plummets, and insolvency leads to insolvency of debt Obtained liquidation), resulting in a financial crisis. When the financial crisis is approaching, the central bank will print money out of thin air on the liability side and buy various debt assets on the asset side to bail out the market—that is, through quantitative easing, the central bank’s balance sheet will expand and pay for the collapse of the entire system. The CDO example can well describe the path of credit expansion, leverage accumulation, and balance sheet expansion in each link of the system.
DeFi market has formed a primary financial system
The DeFi market can learn from the world view of the traditional financial market, but there are also very significant differences in market structure.
The DeFi system is very simple. We can regard Maker as the central bank of the decentralized financial world (+Repo market), regard lending agreements such as Aave and Compound as commercial banking departments, and regard some income aggregation agreements as non-bank financial institutions to construct a simple analysis Framework to explore the possibility of the next development of the DeFi market in comparison.
In the world of blockchain, the most basic asset is BTC. The creation of stablecoins, especially USDT, made the blockchain world begin to have credit and made DeFi possible. USDT is the first to introduce US dollar credit by pegging to US dollar legal currency, thus creating a credit expansion that collateralizes BTC and lends USDT to meet transaction needs. Similarly, Maker issued DAI by collateralizing ETH, forming an embryonic financial market similar to the currency issued by the central bank.
Once the foundation for credit expansion is established, the market will need more efficient ways and paths to increase leverage. Loan agreements such as Aave and Compound begin to appear in the form of commercial banks.
The rise of lending agreements has also expanded the path of credit expansion. On the asset side of lending agreements, more ERC-20 tokens have begun to be used for lending, and the explosive development of liquidity mining has spawned strong lending demand. ; On the liability side of the loan agreement, income aggregation agreements such as YFI, Pickle, Harvest, etc. began to absorb more funds to improve the efficiency of leveraged capital circulation.
In the current core business logic of credit expansion in the DeFi market, in less than 3 years, the DeFi market has formed a relatively complete basic financial system: the creation of basic assets based on BTC/ETH/mortgage (such as Maker and Synthetic Assets)-Oracle (ChainLink)-DEX trading platform (Uniswap, Balancer, Curve)-Loan agreement (Aave, Compound)-Aggregator (YFI, APY)-Wallet (MetaMask, Trust Wallet) has formed a complete business chain , Each link has developed a relatively leading head project.
We believe that the current top projects in each link have occupied the ecological high position, the market structure is very unfriendly to competitors who enter the market later, and the existing track is obviously crowded. However, comparing the CDO product examples mentioned above, we can clearly find that the DeFi business model is still very rudimentary compared with traditional finance. There is still a very large gap in terms of the richness of credit and the complexity of the leverage path. There is the possibility of the next stage of transformation in the DeFi market.
Where does the next high ecological opportunity come from?
The ecologically high opportunity of DeFi lies in providing the market with the highest quality credit and a more efficient path to leverage.
The next step of the development of DeFi first urgently needs to expand the balance sheet of the entire ecosystem, which means that the emerging DeFi agreement needs to further release the credit expansion potential of the current DeFi ecosystem and find more new basic assets that can expand credit investment.
To release the potential for credit expansion, you can start with the credit ratings of different assets. In the traditional financial market, we can see that the public sector, the commercial bank sector, the non-bank corporate sector, and the private sector naturally have subject credit ratings from strong to weak. Credit currency, as a liability of the central bank, needs to be supported by the safest national debt and other assets on the asset side. If it is necessary to further expand the currency supply, it needs lower-level MBS and other qualified collateral.
As a decentralized protocol, DeFi does not have a credit rating based on the subject itself, but it has gradually formed a credit rating of assets during business development. Observing the balance sheet of Maker as the “central bank”, DAI, as Maker’s liabilities, needs to be issued with qualified collateral. The highest credit rating on Maker’s asset side is ETH and BTC, followed by stable currencies such as USDC. If the DeFi market needs to rely on the additional issuance of DAI to achieve expansion, Maker needs to expand its own balance sheet. The first possibility and limitation is the lack of qualified collateral in the DeFi market.
We believe that in the overall balance sheet of the DeFi market, BTC and ETH play a role similar to gold or national debt, and stable currencies such as USDC and DAI are in the second tier in the form of foreign exchange reserves or central bank liabilities; while yToken and atomic ( aUSD), ctoken (cUSD), stoken (sUSD) and utoken (uUSD) are in the third tier in the form of similar commercial bank liabilities; Altcoins, other LPToken and similar corporate liabilities are in the fourth tier of credit.
The current DeFi market has the most potential for credit expansion to release the second layer (stable currency) and the third layer (revenue certificate Token), such as interest-bearing stable currency uUSD, yToken, aToken, cToken and other assets with future income characteristics can be included Collateral, or packaged into debt derivatives for financial innovation, the circulation of these income certificates can release more liquidity to increase the leverage level of the entire system.
In addition, it is to further expand the inclusion of assets in the form of the fourth layer (corporate liabilities), such as introducing financial assets such as real-world supply chains or consumer finance into the DeFi ecosystem, such as Naos.Finance, based on off-chain asset mortgages to achieve borrowing; introducing gold Or the synthetic assets of stocks, such as Synthetix and Mirror Protocol; or try to explore credit lending without collateral, such as TrueFi, by introducing new credits to achieve the purpose of expanding DeFi.
Vertical expansion: helping the DeFi market increase leverage
If credit creation and balance sheet expansion are the “horizontal expansion” of DeFi, then the tools and methods for enriching the DeFi market to increase leverage are a kind of “vertical expansion”: as the underlying assets become more complex, the asset side of the DeFi agreement There will be more and more fixed-term and fixed-rate credit requirements. Correspondingly, the debt side of the DeFi agreement will also have requirements for debt cost, duration management and risk management, thus forming a “vertical expansion” based on the interest rate dimension. As a result, it brings a new dimension of DeFi market capacity and more possibilities with huge imagination. At this latitude, the development of the DeFi interest rate market deserves the most attention.
The interest rate market is becoming the hottest topic in the DeFi world recently.
As discussed above, our perspective on the DeFi world is to answer the question “how to more effectively achieve credit expansion and leverage accumulation in the financial market”. More diversified credit will be introduced into the blockchain as an asset to drive a new credit expansion, which belongs to the “horizontal expansion” of the DeFi balance sheet expansion; the core issue of the interest rate market is to help the DeFi market improve the efficiency of increasing leverage. This belongs to the “vertical expansion” of the DeFi market. We believe that a new dimension of market expansion will bring more interesting possibilities to the DeFi market.
Although the form is different from traditional financial institutions, the core of the DeFi agreement as a carrier for financial business is the management of its own balance sheet. The balance of the capital cost on the liability side is deducted from the income generated on the asset side and retained as profit. From a business perspective, this is not substantially different from the profit model of financial institutions, which provides the most basic business logic for constructing the DeFi interest rate market.
At the same time, with the continuous expansion of the DeFi ecological balance sheet, more and more assets will put forward fixed-term and fixed-rate credit requirements, and will also put forward more leveraged financial tools and trading market demand, which will make DeFi The agreements will generally face the pain points of capital cost, duration management and interest rate risk management on the asset and liability side. Similar to the traditional financial market, these pain points will give rise to a large number of DeFi agreements that assume similar positions as “non-bank financial institutions” (such as investment banks, insurance companies, asset management companies, etc.). We see that some very innovative interest rate, insurance, risk management and derivatives agreements are emerging in the market at this moment. The interest rate market is a new track with a new ecological layout. Undoubtedly, these innovators will be born that can rival Uniswap, Maker, and Aave. A new market leader of the same level.
Understanding the DeFi interest rate market: making leverage more efficient
However, the concept of “interest rate” seems simple, but if it really focuses on the landing of the DeFi interest rate market, its difficulty is not less than that of the decentralized derivatives track.
In the concept of traditional finance, interest rates are the benchmark for key factors in the pricing of large categories of assets, and the term structure of interest rates can also reflect people’s expectations for future interest rates.
The interest rate itself is a very complex system. The central bank can set policy interest rates, including benchmark interest rates, excess savings rates, interest rates for various monetary policy instruments, etc.; the money market has Libor, repurchase rates, etc.; the credit market has deposit and loan interest rates; bonds The market has interest rates such as treasury bonds, interest rate bonds, and credit bonds. Different bonds have different ratings, different credit ratings, different maturities, and different interest rates.
Similarly, Maker’s interest rate policy includes stable rates and DSR (DAI Savings Rate), Aave and Compound’s interest rates include deposit rates and loan rates, and Curve and other liquid mining or other DeFi agreements provide expected APY rates. These interest rates are obviously of different credit ratings. They are all floating interest rates, with no fixed term, and have a strong centralizing influence on interest rate pricing.
When we discuss interest rates in the context of DeFi, the real issue that needs to be discussed is
- What interest rate market will be constructed at different credit levels?
- What kind of interest rate products are created to serve the increased leverage demand?
- How to set the fixed interest rate term and price it, that is, to form the term structure of interest rate (yield curve)?
Explain the three major directions of DeFi interest rate agreement in detail
In traditional financial markets, the national bond yield curve is the benchmark for pricing all fixed-income products. The interest rate pricing process requires:
- A benchmark yield curve is formed through zero-coupon Treasury bonds. With a benchmark yield curve, the DeFi interest rate market can have an anchor for interest rate pricing;
- Form a yield curve based on the benchmark yield curve and risk premium through various fixed income products;
- Calculate the forward interest rate curve based on the spot interest rate curve, and then form a swap yield curve, thereby providing a pricing curve for various forwards, futures, swaps and other interest rate derivatives, and finally realize the complete issuance path of CDO products in the DeFi market , To achieve the improvement of the entire interest rate market system.
At present, all types of emerging agreements dedicated to building the DeFi interest rate market cannot deviate from the scope of this fixed income product and pricing logic, and all DeFi interest rate agreements follow this logical line and make a single-point breakthrough at a certain upstream and downstream point. , Mainly formed three more typical directions:
1. Adopt the method of creating zero-coupon bonds, such as Yield’s ytoken, UMA’s uUSD and Notional Finance. These agreements all adopt the method of mortgage ETH to issue stable currency zero-coupon bonds with a fixed term (such as yETH-DAI-3month). The most intuitive product form is an interest-bearing stable currency with a fixed term, and the implicit interest rate is priced through trading or AMM for such bond tokens.
This form is simply to copy the traditional financial market’s form of constructing a benchmark yield curve from the literal definition. The traditional market needs to rely on the credit of zero-coupon treasury bonds with different maturities. In the DeFi market, ETH credit similar to treasury bonds can be used to issue bonds. As an approximate substitute for zero-coupon treasury bonds, the DeFi market builds the lowest and most benchmark spot income Rate curve.
2. Adopt token securitization methods with cash flow benefits, such as Barnbridge, Benchmark, and Centrifuge. These projects draw on the CDO product issuance method mentioned above. In essence, they create new fixed income products that can be based on Aave or Compound’s cash flow income is packaged, structured grading and asset securitization, priority Senior Token and inferior Junior Token are issued, and inferior investors bear floating interest rates, and priority investors can obtain fixed-term and fixed-rate income .
As the Token asset securitization model matures, this type of agreement can incorporate more cash flow from the underlying asset pool, issue more tranches (such as introducing mezzanine or more priority), allowing users to pass transactions, AMM or quotations To discover interest rates of different maturities, and construct a yield curve in the dimension of fixed income products. The yield curve of this dimension needs to be supported by the credit of the underlying asset cToken or aToken, which is similar to commercial bank financial bonds and is at the subordinate level of ETH-DAI bonds similar to national bonds in terms of credit rating.
3. Introduce interest rate swap financial derivatives, such as Horizon, Swap.rate, DeFiHedge, etc. Interest rate swap refers to two funds with the same currency, the same principal, and the same maturity, which are exchanged between a fixed interest rate and a floating interest rate. They are mature and large-scale financial derivatives in the traditional financial market. DeFi users can sign such Interest rate swap contracts, swap floating interest rates to fixed-term fixed interest rates to counterparties. The yield curve of this dimension is mainly based on observing the structure of the spot interest rate and the forward interest rate curve, and introducing financial derivatives to hedge, arbitrage or trade interest rate risks.
However, even if financial derivatives such as interest rate swaps are adopted, the ways in which different DeFi agreements construct fixed interest rates are quite different. DeFiHedge and Swap.rate use order books to trade interest rate swap contracts of different maturities, but the trading mechanism is slightly different, while Horizon adopts a combination of token asset securitization and interest rate swaps, allowing Priority users freely quote the fixed income interest rate they want to obtain, and inferior users bear the floating interest rate. After maturity, the cash flow of basic asset income is distributed in the order of the quoted interest rate from low to high, and the rate of return is formed through the game between users curve.
These three paths for constructing the DeFi interest rate market are not distinguished by their own advantages or disadvantages, because different interest rate agreements target different positions on the interest rate pricing business line, target interest rate markets and credit ratings, and create different financial instruments. The same financial instruments such as interest rate swaps are used, and the pricing mechanism is different. Therefore, these DeFi interest rate agreements are not directly competitive, and they are also facing different objective constraints at this stage.
For example, the form of zero-coupon bonds requires a large amount of collateral, including complex lending and liquidation activities, and also needs to rely on Uniswap trading or AMM to realize price discovery. In the early stage of the market and the lack of liquidity, it is difficult to achieve the right through trading. Effective pricing of interest rates, the resulting benchmark yield curve may not reflect the actual interest rate structure, and this bond product is expected to be more suitable for BTC, ETH, and even aToken and cToken such high-credit-rated assets. , Unable to meet the financial needs of the long tail ERC-20 currency.
For the form of token securitization, it is first necessary to find an asset pool that can generate income cash flow. At present, it is obvious that the options are relatively limited. This type of agreement will develop significantly along with the expansion of DeFi qualified collateral; in addition, if priority is given Level tokens need to price interest rates in the form of transactions or AMMs, and they also have similar disadvantages to zero coupon bonds. If the agreement gives the agreed priority fixed interest rate, the pricing is not completely market-oriented, and it is difficult to call it decentralized.化.
For the form of interest rate swap derivatives, the pricing of such derivatives needs to rely on credible spot yield curves and forward curves, and it is in the downstream of interest rate pricing. At present, the yield curve in the DeFi market is absent. Under the constraints of insufficient liquidity in interest rate swap transactions, market transactions may not be active, and the pricing of such derivatives may have a greater deviation from the fair price, but relatively speaking, it is the most direct way to satisfy users to lock in interest rate fluctuations. A path to risk.
Interest rate agreement will give birth to a new batch of DeFi giants
If you compare the CDO’s issuance path in the traditional financial market mentioned above, in the current DeFi market, there is only a link in which financing needs are formed into mortgage loan assets. Follow-up:
- Form derivatives through asset securitization package;
- Conduct structured issuance and interest rate pricing;
- The establishment of interest rate risk hedging or speculative positions is still a blank.
Only by completing these three links can the construction of the DeFi interest rate market be regarded as a closed loop, and DeFi can be regarded as answering the proposition of “how to increase leverage more efficiently.”
However, the total market space of these three links may be more than 10 times higher than the underlying credit market. DeFi interest rate agreements such as token securitization, zero-coupon bonds, and interest rate swap derivatives can occupy specific links in each of them, and have very large The opportunity to grow a new batch of DeFi market giants.
With the completion of the interest rate market, the demand for risk management will become more vigorous. DeFi agreements such as insurance, risk management, and asset liquidation will also usher in explosive development opportunities.
Even if there are still many huge challenges in constructing the DeFi interest rate market, DeFi has its own characteristics under the premise of following the objective laws of financial business. We look forward to the emergence of more novel ideas in the interest rate field that go beyond traditional financial thinking.
Will interest-bearing stablecoins be the first use case to break through the zero-coupon bond model? Will they seize the share of stable currencies or form a native bond market?
When the DeFi interest rate market has a decentralized interest rate pricing anchor, will the lending agreements such as Aave and Compound be willing to introduce long-term liquidity lending design to improve their basic interest rate incentive model; whether Uniswap and other DEX release funds in the fund pool? Idle assets provide more liquidity to the market, thereby further expanding the multiplier of DeFi credit expansion?
When the DeFi agreement encounters short-term liquidity gaps such as huge redemptions and surge in loan demand, are you willing to use the issuance of zero-coupon bonds to borrow from each other to avoid runs or increase the efficiency of capital leverage, thus forming a similar inter-bank A brand new market in the dismantling market?
Will the emergence of new financial products continue to stimulate the development of various investment banks and asset management businesses, leading to the birth of a super platform agreement with diversified financial service capabilities similar to JPMorgan in the era of financial mixed operation? DeFi’s cutting-edge experiments have just opened the door to the interest rate market, and behind the door are endless possibilities.
Hell is empty, and all the devils are here.
The hell is empty, the demons are in the world.
