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DeFi is communicating traditional finance through interest rate agreements, synthetic assets, and asset chaining.
Original title: “Taihe Observation丨How to make TeFi better integrate into DeFi”
Author: Taihe Capital
DeFi is composed of interconnected and composable financial components. These components are interconnected and built on top of each other, forming a very interesting financial innovation ecosystem, which improves the existing financial system and changes the rules of the game. However, DeFi is currently quite separate from the traditional world. Most of the assets on DeFi are native assets on the chain, and the main users are also players on the chain. At present, the volume of DeFi cannot be compared with CeFi (centralized finance), but in fact, DeFi and CeFi are not completely opposed. The real goal of DeFi should be to use the advantages of decentralization to provide solutions for the financial market and provide people Solve practical problems in reality.
The traditional financial market has always been an important component missing from DeFi. Only by opening up the bridge between DeFi and the real world can DeFi expand the scope of economic activities covered by DeFi, bring more free and convenient services to CeFi, and at the same time release more possibilities of DeFi, so as to realize the parallel development of DeFi and CeFi in the future. I personally believe that if the traditional market wants to enter DeFi, the first consideration is compliance, followed by relatively stable income. (Currently, the annualized rate of return on traditional bank savings is about 0.06%)
We classify according to the current major traffic entrances into DeFi in the traditional financial market:
The figure below (Figure 1) shows the USDC historical deposit and borrowing rate data on Aave (the yellow line is the borrowing rate and the green line is the deposit rate). From the overall picture, the deposit and borrowing interest rates on Aave fluctuate greatly, especially during the bull market, when the USDC borrowing interest rate has soared to more than 50%. For example, on March 8, USDC deposit and borrowing rates were 20.165% and 57.252%. In contrast, in recent days, the USDC interest rate has fallen to 2.01% for deposits and 3.11% for borrowings. (Picture 2, Picture 3)
Figure 1, Source: aavewatch
Figure 3. Source: Aave
At present, most lending agreements on DeFi use floating interest rates. When the asset utilization rate in the fund pool is higher (asset utilization rate = loaned funds/deposited funds, for example, there are 100,000 USDC in the fund pool, and 60,000 USDC is borrowed. Then the utilization rate of this pool is 60%), that is, the fewer the remaining borrowable assets, the higher the deposit interest rate will be used to attract users to provide more funds for the pool.
The closer the utilization rate of funds in the pool is to 100%, the greater the risk of a run. In the interest rate model, Aave (the formula is shown in Figure 4 and the interest rate model curve is shown in Figure 5) sets an optimal utilization rate Uoptimal. When the utilization rate U in the pool is less than the optimal utilization rate, that is, more deposits and less borrowing, and the utilization rate And interest rates are relatively low; and when the capital utilization rate starts to increase and is greater than the optimal utilization rate, the interest rate will become very high, and APY can even reach more than 50%. High interest rates encourage users to return loans or attract deposits, thereby dynamically adjusting fund utilization and deposit and borrowing interest rates. As for Compound, its interest rate model also uses a piecewise function. When the utilization rate exceeds a certain set value (optimum), the interest rate increases rapidly as the utilization rate increases.
Figure 4. Source: Aave
Figure 5, Source: DeFi Rate
The high volatility of floating interest rates prevents users from knowing whether they can earn the current interest level in the future. For both borrowers and lenders, the uncertainty of future interest rates is actually a potential risk, because the capital utilization function will lead to large changes in interest rates and is very sensitive to market cycles.
Fixed interest rate
The fixed interest rate will not change in the short term and can be regarded as a stable future cash flow, but the interest rate can still be adjusted according to the market in the long term. For traditional users who are new to DeFi, stable income is more attractive. In addition, compared to the DeFi methods of mortgage lending and liquidity mining, the learning threshold for fixed interest rates is also lower.
DeFi fixed-rate track has no leading projects yet
At present, DeFi also has many fixed interest rate projects, such as Barnbridge, Notification, yield and so on. Compared with the leading loan agreement, the volume of these projects is very small. Since users have chosen to take on the high risks of DeFi, they will naturally pursue higher returns. The fixed interest rate attracts few deposits and the amount of lock-up is small, so there are fewer borrowers, which in turn leads to fewer deposit users, which is a vicious circle. In an active market, fixed interest rates have lower revenue expectations and higher opportunity costs. This is precisely the disadvantage of fixed interest rates compared to floating interest rates.
Fixed high-yield products are not sustainable
Anchor is a fixed interest rate savings agreement launched in Terra ecology, which can increase the annualized rate of return of UST (Terra ecology’s stable currency) to about 20%. A fixed annualization of 20% is enough to attract people’s attention, so the question is whether the annualization is sustainable?
Unlike other lending platforms, deposits on Anchor cannot be used as collateral. Depositors deposit UST with UST interest, while borrowers need to mortgage bAssets such as bLUNA to lend UST. The depositor’s interest is composed of two parts, one is the UST interest paid by the borrower when making the loan, and the other is the block reward obtained by the bAsset under the PoS mechanism that the borrower pledges. Anchor achieves an anchor interest rate of about 20% by dynamically adjusting the incentive income to borrowers and depositors. Most PoS chain block rewards come from transaction fees and token inflation (the release of native tokens). If the price of PoS chain native tokens falls; on the other hand, there will be fewer transactions on the chain in a bear market. All aspects of income will decline. In the long run, it is difficult for Anchor to maintain the promised fixed income of about 20%.
In May of this year, someone on the Anchor forum calculated that if the price of LUNA drops by 50% (at the current price), or the amount of deposits on the Anchor increases by five times, in both cases, the UST in the Anchor reserve wallet (the reserve at the time) The wallet has 5.7 million UST) can only last for 5.9 and 0.4 months respectively. Based on this problem, the official team received a grant of approximately 70 million UST from Terraform Labs on July 14 to support the fixed annualization of the agreement for the next 1.5 years. The current Anchor reserve wallet balance is 71.9 million UST. We recalculate according to the current Anchor deposit amount, reserve wallet balance and LUNA price:
In the current Anchor agreement, the deposit amount is 536 million UST. Assuming that the deposit APY is 18%, the agreement pays a total of 96.48 million UST to depositors as interest.
In the current Anchor agreement, the value of the collateral, namely bLUNA, is 549 million UST (bLUNA current price is $7.04). Assuming that the APY of staking on the Terra chain is 10% (but in fact, the APY of staking on Terra is now 7.54%), the income generated by these collaterals is 54.9 million UST.
In the current Anchor agreement, the borrowing amount is 175 million UST. Assuming that the borrowing APR is 12% unchanged (the current borrowing APR is 12.17%), the borrowing interest income on the Anchor is 21 million UST.
The theoretical Anchor’s net income is 54.9 million UST + 21 million UST-96.48 million UST = 20.58 million UST.
If other conditions remain unchanged, and now $LUNA falls by 50%, the value of the collateral will be halved. With the mortgage rate unchanged, the amount of borrowing will also be halved, and the interest income from borrowing will be halved. If the rest remains unchanged, the net income of Anchor at this time is -55.53 million UST;
Similarly, if other conditions remain unchanged, the deposit amount in the Anchor now increases five times, and the interest payable by the Anchor increases five times, and the rest remains unchanged, then the net income of the Anchor at this time is -407 million UST.
In this model, the price of LUNA, the amount of deposits, the income of PoS staking, the interest rate of borrowing, etc. are all variables-the price of LUNA decreases (which will also lead to the decrease of staking income), and the increase in deposits will cause the Anchor to provide its own funds to support This promised benefit. When the UST in the reserve wallet is used up, the high fixed interest rate given by Anchor cannot be sustained at all. (So Anchor received 70 million UST grants from Terra a few days ago to increase reserves)
DeFi project’s attempt to meet the traditional world
Concerns about traditional financial access to DeFi
Although the high returns of DeFi are attractive enough for traditional fields, there are several reasons why traditional funds have been slow to enter DeFi.
First of all, DeFi needs to bear high risks while having high returns, and for traditional users, liquid mining, on-chain mortgage lending, etc. have certain learning thresholds; secondly, DeFi has anti-censorship properties, which is exactly the same as traditional institutional users. The considered compliance and regulatory requirements are inconsistent. In addition, for security reasons, most institutional users use high-security multi-signature wallets instead of web-side plug-in wallets such as Metamask. Previously, institutions could only enter the market through custodians or brokerage companies such as retail or Coinbase, and DeFi entry channels were very limited.
Centralized and decentralized entities set foot in the traditional financial entrance market
Some time ago, Coinbase launched a product that allows users to obtain a 4% annual rate of return APY by lending USDC. However, “the lending of USDC is not protected and may be affected by the counterparty’s credit risk, which will result in total loss of funds.” Stable currency USDC The issuer of Circle also launched Circle Yield last month, which is regulated and available to companies and financial institutions. According to different maturities, the fixed income of deposits ranges from 4% to 4.15%. (USDC currently ranks seventh in market capitalization and is the second-most stable currency in market capitalization. Its issuing company, Circle, announced on July 8 that it will list on the New York Stock Exchange through a backdoor.)
Compound and Aave have also launched products for users of product institutions. Potential targets include new banks, financial technology companies, and even some family businesses, hedge funds, pension funds and other non-cryptographic companies and financial institutions. Compound launched “Compound Treasury” through cooperation with Fireblocks and Circle, allowing these institutional users to convert U.S. dollars into USDC and obtain a fixed interest rate of 4%. This 4% includes the proceeds of USDC deposits and liquidity mining in Compound. Aave launched “Aave Pro” in conjunction with Fireblocks, and introduced automated anti-money laundering and anti-fraud screening through the data security company Chainalysis, allowing whitelisted KYC users to enter DeFi while complying with compliance requirements. The Aave Pro pool uses the Aave V2 contract and is separate from other liquidity pools in Aave.
Looking at the above four products, the development prospects of Circle and Coinbase may be better. First of all, the problems faced by Compound Treasury will be similar to those of Anchor, because the 4% of the income that Compound promises comes from deposit interest and liquidity mining. As the market environment changes, generally speaking, the interest rate and yield of the DeFi protocol are decreasing; secondly, the income of liquid mining fluctuates greatly. If the price of COMP (Compound token) falls, the yield will also be based on the U standard. decline. Although 4% fixed income is not high compared to other liquid mining, it also has unsustainable risks. Although Aave can achieve compliance, at present, Aave does not seem to be a fixed income, but an Aave Pro for KYC users only. And Circle (if listed) and Coinbase, both compliant and endorsed to a certain extent, are more in line with the demands of the traditional market.
In contrast, Aave and Compound, as DeFi head lending agreements, are of great significance to the launch of these two products. They not only provide a DeFi entry for traditional institutions and users, but also allow more users in the traditional world to slowly contact and participate in DeFi. Opening up the traditional market to enter DeFi can not only introduce a large number of assets, but also connect CeFi and DeFi, bringing more possibilities to DeFi.
Before the emergence of synthetic assets, DeFi could not trade assets such as bulk, foreign exchange and stocks in the traditional financial market; while the emergence of synthetic asset projects such as Synthetix, UMA, Mirror, etc., made synthetic assets linked to real asset prices. From then on, people can On-chain transactions in the traditional financial market for bulk (such as gold, silver), foreign exchange (such as USD, EUR) and stocks (such as Tesla, Apple), etc. Synthetic assets have opened up the traditional financial market and the digital currency market, and are of great significance for cross-chain asset aggregation, outsourcing, and financial derivatives.
In Synthetix, users can obtain sUSD by staking the native token SNX (collateralization rate is 400%). sUSD can purchase synthetic assets (S assets) on Synthetix Exchange, gaining risk exposure but not holding the underlying assets (no dividends will be generated, etc.) In essence, it is just the anchoring of the asset price). S assets are directly generated on the chain, and prices are acquired through real-time oracles and not determined by market purchases, so there is no slippage in large transactions.
Mirror is a synthetic asset project in Terra ecology. With UST (minimum mortgage rate 150%) or LUNA, MIR, ANC (minimum mortgage rate 200%), synthetic assets such as stocks, futures, and exchange funds can be cast and traded. These synthetic assets You can trade on Mirror, Uniswap, etc.
The emergence of synthetic assets has become a bridge for transactions, lowering the barriers for people to enter the financial market (for example, at the beginning of this year, many brokerages and platforms such as Robinhood restricted the opening of GME stocks, at this time people can use synthetic assets to trade these stocks) . It greatly broadens the current DeFi boundary and enriches the application scenarios of DeFi. It is a key window for encrypted finance to traditional finance, and a bridge from the crypto world to traditional financial markets.
Real assets on the chain
A few years ago, when the concept of asset tokenization was proposed, someone proposed to introduce real assets into the world on the chain. Now non-homogeneous token NFT can be used to correspond to any physical or virtual assets with economic value, and provide real assets on the chain. The conditions have also opened a door for DeFi to go out of the lap.
The first practice of real assets in DeFi lending
In April of this year, MakerDAO and Centrifuge issued the world’s first DeFi-based real asset loan. Centrifuge bridges invoices, real estate, royalties and other assets to DeFi, and uses NFT to mortgage physical assets in smart contracts; MakerDAO can provide credit lines for these assets. Aave’s governance forum also initiated a proposal to establish a real-world asset (RWA) mortgage lending market, that is, users can provide liquidity to the market, borrow these real-world assets and earn interest from the collateral.
Assets on the chain not only provide tickets for real assets to enter the DeFi ecosystem, but also have the advantages of improving the transparency of asset ownership information, simplifying transaction procedures, and reducing transaction costs. However, the actual assets on the chain have not yet been widely used, because there are many problems in infrastructure and legal warrants that need to be solved urgently. I personally think that until these objective conditions are perfected, they will not be widely used in the near future, and it is difficult to become an effective one. The flow interface that merges the traditional world into DeFi.
Several big mountains hindering real assets from being chained
First of all, a major problem faced by real assets on the chain is the disconnection of on-chain and off-chain trust. How to define the value of assets? Essentially, it still depends on off-chain data. How to ensure off-chain trust? Relying on the law and supervision. And when the world on the chain interacts with the off-chain world, risks and problems will also be faced-so a reliable and secure oracle is needed to provide accurate data in the casting, transaction and management links, and convert trusted data off the chain into Trusted certificates and trusted digital assets on the chain. In order to obtain financial services through traditional financial institutions or entering DeFi (decentralized finance).
Secondly, assets have advantages and disadvantages. As far as mortgage lending is concerned, if it is a high-quality asset, it can actually be supported by traditional financial institutions, and the interest and risk are lower than those on the chain; if it is a low-quality or junk asset, traditional institutions will not recognize it, and the risk of putting it on the chain will be further Expansion; for the remaining part of the assets, due to the lack of a unified asset evaluation plan, a third party is required to investigate, review and verify, which is contrary to the original intention of decentralization. In addition, the docking of the real economy will inevitably face technical and legal risks. For an asset, it is also difficult to judge whether there is an on-chain and off-chain offset.
Furthermore, if real estate, financial bills, accounts receivable, warehouse receipts, etc. are used as collateral, and they cannot be traded or have poor liquidity, it is difficult to obtain a reliable price feed. If it involves the liquidation of underlying assets, how to deal with these collaterals?
If these problems are not resolved, judging from the current development stage, due to the lack of infrastructure and middleware, technical means and legal procedures are incomplete, it is destined that real assets will not be able to achieve large-scale examples on the chain. Although both MakerDao and Aave are promoting mortgage lending of real assets, they can only stay in the experimental stage.
to sum up
Looking at the above as the entrances of traditional traffic, entities such as Coinbase and Circle have joined hands with DeFi projects to first meet the requirements of compliance. Compound and Aave, as native DeFi projects, bring stable income to the traditional market. They can be regarded as savings products. Compared with the various gameplays in DeFi, the learning threshold is lower.
Although synthetic assets are currently relatively large in these categories, there are certain thresholds for understanding and use. Therefore, the current synthetic assets are all users in DeFi, and it is difficult to introduce new incremental funds and users.
As for real assets on the chain, it can break through geographical boundaries, but it needs to improve the basics and supporting facilities, such as reliable oracles, unified asset appraisal schemes, mature custody and insurance systems, etc. Before the above-mentioned problems are solved, although the idea of real asset chaining is good, it is still difficult to get large-scale application.
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