DeFi credit forms mainly revolve around over-collateralization with variable interest rates, and the potential of fixed-rate loans and interest rate derivatives has not yet been released.
Original title: “Messari 丨 Fixed Income Agreement Will Be the Next Wave of DeFi Innovation? 》
Written by: Rahul Rai, Managing Partner of Gamma Point Capital Translator: Davida
This article is a guest post from the Messari community. Rahul is currently the managing partner of Gamma Point Capital, a hedge fund focusing on digital assets and decentralized finance. He used to work for Morgan Stanley’s foreign exchange hedge fund team and graduated from the Wharton School of Business with a bachelor’s degree in economics.
Credit is the cornerstone of every financial ecosystem. It allows those with surplus assets to lend these assets to borrowers who have production or investment uses for these assets, thereby achieving non-zero-sum wealth creation.
The total size of the global credit market is approximately three times the size of the global stock market. According to ICMA data, as of August 2020, the overall size of the global fixed income market is approximately US$128.3 trillion. In addition, the interest rate derivatives market is the world’s largest derivatives market. According to data from the Bank for International Settlements (BIS), in the first half of 2019, the total notional amount of contracts outstanding in the interest rate derivatives market was estimated to be US$524 trillion.
Source: Swap.Rate
Although most transactions in the stock market are conducted electronically, almost all transactions in the US bond market are conducted on the distributed over-the-counter (OTC) market between brokers and large institutions. Therefore, although the fixed income market is mature, its efficiency is low. DeFi is fully capable of innovating quickly in efficiency, liquidity, transparency and accessibility for the world’s largest financial market.
“The interest rate market is becoming the hottest topic in the DeFi world recently. The potential market size of the interest rate market may be more than 10 times that of the basic credit market.”-Incuba Alpha Labs
There are two main ways for traditional financial institutions to create new credit instruments: one is to create new forms of credit through new basic issuers/assets (such as treasury bonds, corporate credit, municipal bonds, and mortgage-backed securities); Create new derivatives in the form of credit (such as interest rate futures and exchanges, mortgage debt, credit default swaps).
DeFi’s innovations around lending (MakerDAO, Compound, Aave), transactions (Uniswap, Sushiswap, Curve), aggregation (yEarn, Rari, 1inch, Matcha), synthesis (Synthetix, UMA) and insurance (Nexus Mutual, Cover) protocols Very well done. However, so far, there is only one form of credit in DeFi-over-collateralized crypto-backed loans with variable interest rates. The competitive environment for fixed-rate loans and interest-rate derivatives is very open, and there is no clear winner yet.
In this article, we will focus on the three emerging parts of fixed income agreements and some of their most promising implementations.
Fixed-rate loans (yield curve): Yield Protocol, Notional Finance, UMA’s yUSD
Interest Rate Market (IRS): Horizon Finance, Benchmark, Swivel
Securitization/Partial (CLOs): BarnBridge, Saffron
Fixed-rate loans: zero-coupon bonds and the yield curve
Fixed-rate loans are currently the most common type of loans in traditional finance. For example, according to data from Lending Tree, 88% of the $15.3 trillion outstanding debt in the U.S. corporate bond and mortgage market in 2018 was on fixed-rate terms. Fixed interest rates allow participants to lock in a predetermined interest rate without having to bear the risk of interest rate fluctuations.
As an alternative to the increasingly popular variable-rate loan agreement, the zero-interest fixed-rate loan agreement allows users to borrow tokens based on encrypted collateral, which can be redeemed at the corresponding face value when they expire.
“With the existence of a fixed rate of return in smart contracts, you will be able to construct and implement financial planning in which the type & complexity of derivatives is reduced. This will be a huge impact on traditional financial markets.”-Barnbridge
With over-collateralized lending, users can borrow revenue tokens with their deposited collateral and promise to repay it at face value (for example, $1). If these borrowers want to lock in a fixed interest rate, they will immediately sell their earnings tokens at a discount (such as $0.85), because they know they can buy it back at the face value of $1 at maturity and repay the loan. On the other hand, buyers of yield tokens basically lend their capital of US$0.85, knowing that they can always be redeemed at the face value of US$1 at maturity, and effectively lock in a fixed yield.
Dan Robinson’s seminal paper “The Yield Protocol: On-Chain Lending With Interest Rate Discovery” laid a theoretical foundation for the creation of zero-coupon bonds and yield curves on the chain. UMA launched the first yield USD token (yUSD-SEP20), which is essentially a zero-coupon bond that can be exchanged for 1 U.S. dollar after maturity, and can be exchanged for USDC through the automatic market maker (AMM) pool on the Balancer Trading.
Source: UMA
“Yield Protocol” takes this concept a step further and creates a special AMM equation to explain the inherent price drift of zero-coupon bonds, allowing limited partners not to be exposed to short-term losses (IL) and continuous arbitrage Deposit capital.
As we wrote here before, “Since the yield agreement provides many different maturities, we can construct a yield curve similar to the U.S. Treasury curve used by fixed income analysts around the world.”
As shown in the figure below, most of the activities are on the short end, and the long end remains relatively stable.
Source: Roberto Talamas
Notional Finance has just launched a fixed-rate lending agreement through a new type of financial primary product called fCash. fCash is a transferable token that represents claims on positive and negative cash flows at a specific point in the future . Its native support AMM liquidity pool for transactions against the base currency (such as DAI). Lenders buy fCash and lock in an interest rate, which represents the amount of the relevant currency they can claim for their fCash at maturity. Borrowers mint fCash and can sell fCash to obtain base currency in exchange for the obligation to repay a fixed amount of base currency at a specific time in the future. fCash tokens are always produced in pairs – the assets and liabilities of the entire nominal system always have a net value of zero.
Source: Notional Finance Docs
It is worth noting that, due to the fluctuating excess mortgage rate, high price fluctuations, and super-liquid collateral with superimposed risks, it is not easy to determine an accurate measure of the “risk-free” rate of return in the DeFi ecosystem. However, over-collateralized lending platforms such as MakerDAO and Compound can be considered as fair indications of risk-free floating interest rates, while collateral-backed yields such as UMA’s uUSD and Yield Protocol’s fyDai can give a risk-free rate of return. Fair indication of a zero-coupon fixed interest rate. A stable currency with a yield rate like yEarn’s yUSD will add more risks and should be appropriately compensated by the spread of risk-free interest rates.
Interest rate market
The ability to trade future rates of return as an asset/token is a very powerful idea. It increases the amount of credit and leverage in the ecosystem, improves price discovery, improves market efficiency, and allows market participants to speculate and hedge interest rate risks.
In view of the prevalence of floating interest rate yields in the DeFi ecosystem, interest rate swap (IRS) agreements have a huge opportunity to intervene , allowing lenders and LPs to swap floating yields and lock in fixed yields.
Source: Delta Exchange
Benchmark is a protocol that can realize the tokenization and transaction of future returns. It allows participants to divest the yield of the underlying asset and trade that yield separately as their own token. In this way, Benchmark enables holders of these assets to sell their rights to the (variable) rate of return by cash advance, thereby locking in a fixed interest rate for a fixed period of time. Buyers of these rights purchase yield tokens to obtain variable yield risk exposure in a capital-efficient way, without betting on collateral and worrying about liquidation.
Source: Benchmark
In addition, Benchmark has also developed a new AMM variant that takes into account the time decay (theta) of yield tokens. Since the yield token is designed to be worthless when it expires on a specific date, otherwise the price decay will cause the LP to lock in permanent losses on the traditional AMM platform.
Horizon is built on a similar concept, and solves the problem of limited interchangeability and liquidity of fixed-term income tokens , as well as the margin and AMM requirements related to such tokens. It uses game theory to form a decentralized interest rate market. By introducing interspersed auction markets with different periods (Horizon Mark), participants can compete in a fair and transparent competitive environment for priority payments in exchange for the upper limit of the rate of return.
Swivel Finance (formerly DeFi Hedge) is an agreement that establishes the infrastructure for the creation of algorithm-mandatory fixed-rate lending agreements and true trustless interest rate swaps. Users can create fixed-side or floating-side interest rate swap quotes for any Ethereum tokens provided by Compound or Aave. Then, the buyer can fill in the bidder’s terms and lock in the funds of the maker and the buyer until the agreed period is completed, at which point one party will return its capital and fixed rate of return, while the other party will return the remaining floating interest.
By using the CLOB system, Swivel avoids the need for AMM pools and completely avoids slippage. In addition, by running on top of larger lending agreements such as Compound and Aave, it does not have to guide both parties in the market.
Source: Swivel.Finance
Securitization and conversion
Without the infamous mortgage-backed securities that crashed the global economy in 2008, Wall Street’s legacy would be incomplete. If leverage is used irresponsibly, it will lead to an overestimation bubble and then a catastrophic correction. However, the basic innovation behind MBS and other convertible bonds is very powerful-dividing cash flow into different risk profiles to meet the needs of investors with different risk profiles and utility functions.
Source: Wikipedia
BarnBridge is a volatility derivative agreement that aggregates the yields of different agreements and aggregates them into high-yield and low-yield convertible bonds with different risk conditions. SMART Yield Bond (Structured Market Adjusted Risk Convertible Bond) aggregates and deposits collateral into a loan agreement or yield generation contract, and then bundles its yield into different convertible bonds and marks them. Therefore, the most senior convertible bonds have a lower yield and a safer risk profile, while the more junior convertible bonds have a higher yield but have additional risk exposure. SMART bonds essentially achieve free market pricing for yield risk trading.
This allows users not only to obtain a fixed interest rate of return, but also to centralize the return of many agreements in the entire ecosystem , creating greater efficiency by diversifying risks and smoothing the industry’s yield curve.
Saffron is another protocol that tokenizes the ownership of assets on the chain. By using the Saffron pool to select customized risks and returns, liquidity providers can gain greater flexibility and dynamic exposure.
Saffron tokenizes the future income stream of each asset and the net present value of the used principal. Based on the profit of tokenized holding, the corresponding distribution is made among all grades through the return waterfall. The initial application of the return waterfall utilizes two main convertible bonds: one is an “A” grade convertible bond with enhanced yield, and the other is a super high-grade “AA” grade convertible bond with reduced risk.
After the increased liquidity is removed, it is used to repay the initial principal of AA holders, and then pay the principal and interest of the enhanced yield A file. In exchange for this enhanced return, Participants in Grade A must use Saffron’s native token (SFI) as a bet to mitigate the failure of the underlying platform (such as Compound, Aave or Curve). In this case, the Saffron agreement acts as a custodial service for risk transfer between Participants in Part A and Participants in Part AA.
Overall, the DeFi market has huge potential for credit expansion. The migration of yields and yield-based derivatives from a less efficient centralized financial system to a more efficient decentralized financial system may be one of the largest wealth flows in human history. Take a look across fixed-rate loans How to intervene in the agreement on the interest rate market and the yield of convertible bonds to provide the market with the highest quality credit and the opportunity to effectively obtain leverage along the entire risk curve will be very interesting.
