Vertical expansion of DeFi: Interest rate agreement will bring new changes in the world of decentralized finance

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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”.

Written by: Kira Sun and Ruby Wu, partners of Incuba Alpha, a blockchain investment institution

In the short term, YFI announced the merger of well-known DeFi agreements such as Pickle, Cream, Cover, and Sushiswap, which attracted the attention of the entire market. We can not help but worry, when the industry began to use first mover mergers / acquisitions, to consolidate market position, does that mean DeFi track is becoming crowded, or growth is slowing, the market is carved up into a giant share of the pattern ?

DeFi market as well as the possibility to continue to change it? We are very optimistic about the answer to this question. The reason why we are optimistic has to start with the real changes brought by DeFi.

The world of value exchange that the blockchain hopes to build is most eager for assets. The explosive development of DeFi responds to this desire, and for the first time ” credit ” is introduced as an asset to the blockchain world.

The so-called credit, is based on credit and debt funding needs arising, credit is the cornerstone of the financial markets, and financial markets plunging hurricane has always been inseparable from the cumulative expansion of credit and leverage. Whether in the traditional financial markets or DeFi market, any market to occupy a central position in the financial institution or DeFi agreement, without exception, successfully answered this question: they are either introduced or create a new credit as a basis assets, and promote the process of credit expansion; or is the creation of a financial product or market, providing a more efficient path to increased leverage for the expansion of credit.

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 ”. Referring 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:

Financing needs of the country is packaged as sovereign debt; the financing needs of the private sector, such as the financing needs of residents purchase, car, medical education consumption, or as working capital, capital expenditures and other corporate sector is packaged for all types of debt – these constitute credit 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.

Credit expansion and leverage the cumulative result is that all financial market participants in the balance sheet continues to expand across the entire business chain.

2008 years ago to the most radical financial liberalization era, for example, we can observe from subordinated debt CDO (Collateralized Debt Obligation) service path to the entire financial market participants is how all linked through the balance sheet. Since the structure of the financial market is very complex, we only abstract the core part in the above figure for reference.

Individuals with housing needs, end its assets bought land or real estate, you need money to make up the gap, so have the credit balance in the end; the commercial banking sector loans at the end of its assets or buy bonds to support financing the purchase of a personal, end in debt various types of bonds will be packaged assets, and securitization, purchase credit rating of structured products by the non-bank financial sector, the bank got the money can continue to serve mortgages, thus completing the link plus leverage.

Overall credit expansion and leverage cumulative process can continue to run until the credit sink (not actually a lot of debt repayment ability of the population) and the lever rupture (a large number of subordinated debt defaults, collateral prices plummeted, insolvency can not lead to debt obtain liquidation), resulting in financial crisis. In the dawn of the financial crisis, the central bank printing money out of thin air at the end of the debt, buying assets at the end of various credit assets bailout – that is, through quantitative easing, to achieve the expansion of central bank balance sheet, 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 think of Maker as the central bank of the decentralized financial world (+Repo market), Aave and Compound and other lending agreements as commercial banking departments, and 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.

Vertical expansion of DeFi: Interest rate agreement will bring new changes in the world of decentralized finance

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 the first to introduce a dollar credit linked by dollars legal tender, thus creating an expansion of mortgage credit lending USDT BTC to meet the trading needs. Similarly, Maker issued DAI by collateralizing ETH, forming an embryonic financial market similar to the currency issued by the central bank.

Once laid the foundation of credit expansion, the market will need more efficient ways to increase leverage and path, Aave, Compound and other similar commercial bank loan agreement forms began to appear.

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. ; at the end of the loan agreement liabilities, such as YFI, Pickle, Harvest and other income aggregation protocol began to absorb more capital, improve circulation efficiency leveraged funds.

On the current core business logic DeFi credit expansion of the market, in less than three years, DeFi market has formed a relatively complete basic financial system: based on BTC / ETH / collateral underlying asset creation (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 , all aspects have developed a relatively leading head the project.

We believe that the current top projects in all links 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. inside it bears the possibility of DeFi market next phase of change.

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.

DeFi next step in the development of the urgent need to expand throughout the first ecological balance sheet, which means that the emerging agreement requires further release of DeFi credit expansion potential of the current DeFi ecology, and find more new asset base can be expanded credit served.

To release the potential for credit expansion, you can start with the credit ratings of different assets. In traditional financial markets, we can see that the public sector, commercial bank part, the Bank corporate sector and the private sector, naturally occurring self-reliance to a weak credit rating. Credit currency, as a central bank’s liability, 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.

DeFi agreement as to the center, itself based on the main credit rating does not exist, but gradually formed a credit rating of assets in business development. As observed “central bank” of Maker’s balance sheet, DAI Maker as liabilities, need to rely on eligible collateral to issue, at the end of assets the highest level of credit is the Maker of ETH and BTC, followed by USDC and other stable currencies. If DeFi need to rely on the market to achieve additional expansion of DAI, the Maker need to expand their balance sheets, the possibility of the first to appear and also the limitations that: DeFi market shortage of qualified collateral.

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), etc., in a similar form of commercial bank liabilities in the third layer; form Altcoins, other LPToken and other similar corporate debt in the fourth layer of credit.

Vertical expansion of DeFi: Interest rate agreement will bring new changes in the world of decentralized finance

DeFi most current market potential release credit expansion is that the second layer (stable currency) and the third layer (income certificates Token), such as interest-bearing stable currency uUSD, yToken, aToken, cToken future earnings and other assets with characteristics can be incorporated collateral, or packed into debt derivative financial innovation, these gains credentials circulation can release more liquidity to increase the leverage of the entire system.

There is also the further expansion into the assets of the fourth layer (corporate debt) in the form of, for example, the real-world supply chain, consumer finance and other financial assets or the introduction of DeFi ecology, such as Centrifuge and Naos.Finance, based on asset-backed loans under the chain to achieve; introduction gold stocks or synthetic assets, such as Synthetix and Mirror Protocol; or try to explore without having collateral credit lending, for example TrueFi, to achieve the purpose of expanding DeFi table by introducing new credit.

Vertical expansion: helping the DeFi market increase leverage

If the credit expansion table creation and the balance sheet is DeFi of “horizontal expansion”, so rich DeFi increase market leverage tools and methods belong to a kind of “vertical expansion”: With the increasing complexity of the underlying assets, assets end DeFi Agreement credit demand will face a growing number of fixed term and a fixed interest rate, the corresponding liabilities end DeFi agreement will also demand the cost of liabilities, long-term management and risk management appear to form a rate based on the dimensions of “vertical expansion.” 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 of your credit will be introduced as an asset block chain, drive new credit expansion, which is a DeFi balance sheet expanded table of “horizontal expansion”; the core issue of the interest rate market is the need to help DeFi increase market leverage to increase efficiency, 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.

While the forms of traditional financial institutions differ, but DeFi agreement as a vehicle to carry out financial business, its core is on its own balance sheet management, deduct the difference liabilities end cost of capital as profit surviving revenue generated from the asset end, a simple 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 derivative agreements are emerging in the market at this moment. The interest rate market is a new track that lays out a new ecosystem. These innovators will undoubtedly be born that can rival Uniswap, Maker, and Aave. level other new market leader.

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.

Interest rate itself is a very complex system, the central bank interest rate policy could be developed, including the benchmark interest rate, the excess reserve rate, interest rate and other various monetary policy tools; money market Libor, the repo rate and so on; the credit market deposit and lending 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 interest rates include deposit interest rates and loan interest rates, and Liquid mining such as Curve or other DeFi agreements provide expected APY interest 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.

Vertical expansion of DeFi: Interest rate agreement will bring new changes in the world of decentralized finance

When we discuss interest rates in the context of DeFi, the real issue that needs to be discussed is

  1. Build what the market interest rate at different levels of credit?
  2. What kind of interest rate products are created to serve the increased leverage demand?
  3. 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 Treasury bond yield curve is the benchmark for pricing all fixed-income products. The interest rate pricing process requires:

  1. Formed by zero-coupon Treasury benchmark yield curve, with the benchmark yield curve, DeFi interest rate market interest rate pricing in order to have an anchor;
  2. Form a yield curve based on the benchmark yield curve and risk premium through various fixed income products;
  3. According to the spot rate curve estimated forward rate curve, and then the formation of swap yield curve, so for all types of forwards, futures, swaps and other interest rate derivatives provide pricing curve, and ultimately can achieve the full path to release the product in the CDO market DeFi , To achieve the improvement of the entire interest rate market system.

Vertical expansion of DeFi: Interest rate agreement will bring new changes in the world of decentralized finance

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. Take the creation of zero-coupon bonds of ways, such as Yield of ytoken, UMA’s uUSD and Notional Finance, these agreements are issued with a way to take mortgage ETH stable currency zero-coupon bonds, fixed term (such as yETH-DAI-3month), The most intuitive product form is an interest-bearing stable currency with a fixed term. Implied interest rates are 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, while 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, and build the lowest and most benchmark spot income for the DeFi market Rate curve.

2. Take tokens securitization have cash flow benefits, such as Barnbridge, Benchmark and Centrifuge, these projects draw on the CDO product distribution methods previously mentioned, in essence, it is the creation of a new fixed-income products, or may be based on Aave Compound cash flow income packaged, structured classification and asset securitization, issuing priority Senior Token and bad after grade Junior Token, bear a floating interest rate of bad-stage investors, priority investors can get fixed term and fixed-rate income .

As the Token asset securitization model matures, this type of agreement can incorporate more cash flows from the underlying asset pool, issue more tranches (such as introducing mezzanine or more priority levels), 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 dimensions of the yield curve need to rely on the underlying assets cToken or aToken credit to support, similar to the commercial bank financial bonds, government bonds in the secondary ETH-DAI similar bonds from the credit rating.

3. The introduction of interest rate swap derivatives, such as Horizon, Swap.rate, DeFiHedge and so on. 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 swaps, the floating interest rate swap counterparty a fixed interest rate fixed term. The yield curve of this dimension is mainly through observing the structure of spot interest rate and forward interest rate curve, and introducing financial derivatives to hedge, arbitrage or trade interest rate risk.

However, even if financial derivatives such as interest rate swaps are used, 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 the 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 building DeFi market interest rate path itself is not good or bad, because the location of the different rates of interest rate pricing agreement locate business lines vary, different markets and credit rating target rate, the creation of different financial instruments, even if 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 in the form of zero-coupon bonds, would take a lot of collateral, consisting of complex borrowing and liquidation of behavior, also need to rely Uniswap transaction or AMM to achieve price discovery in the market and lack of liquidity early stage, it is difficult to achieve for transactions 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 long-tailed ERC-20 currencies.

For securitization takes the form of tokens, you first need to find the pool of assets can generate income cash flow, which is apparently relatively limited choice, this type of agreement over the course of DeFi expansion of eligible collateral to obtain considerable development; In addition, if the priority Level tokens need to price interest rates in the form of transactions or AMMs, and they also have similar disadvantages as 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 interest rate swaps the form derivatives, such derivatives pricing relies on credible and forward curve spot yield curve, and the rate itself is downstream of pricing, the current yield curve in the absence and market DeFi 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 we compare the above-mentioned traditional financial markets in the path of the CDO issuance, in the current market DeFi currently only formed a part of the financing needs of the formation of mortgage assets, the follow-up:

  1. Form derivatives through asset securitization package;
  2. Conduct structured issuance and interest rate pricing;
  3. 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, this part of the market space is the sum of the three may be more underlying credit market more than 10 times higher, tokens securities, zero-coupon bonds, interest rate swaps and other derivatives DeFi rate agreements respectively can occupy a specific part of these, there are very large The opportunity to grow a new batch of DeFi market giants.

With the complete market interest rates, the demand for risk management will become more vigorous, such as insurance, risk management, asset liquidation DeFi agreement will also usher in the explosive growth opportunities.

Even build DeFi interest rate market there are still many great challenges, under the premise of objective laws to comply with financial services, DeFi has its own characteristics, we look forward to seeing more interest areas beyond the traditional financial thinking of new ideas.

Will interest-bearing stablecoins become 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 DeFi market interest rates have decentralized pricing of interest rate anchor, Aave such as loan agreements and Compound willingness to introduce long-term liquidity loans designed to improve its basic interest rate incentive model; Uniswap et DEX whether to release the funds in the pool Idle assets provide more liquidity to the market, thereby further expanding the multiplier of DeFi credit expansion?

When DeFi protocol encountered huge withdrawal, surge in demand for loans and other short-term liquidity gap, the willingness by way of issuing zero coupon bonds are lending between each other, to avoid a run or enhance the efficiency of financial leverage, thus forming a similar inter-bank A brand new market in the dismantling market?

Whether the emergence of new financial products will continue to stimulate the development of all types of investment banking, asset management business, which was born out of similar financial mixed operation times, like JPMorgan, super platform agreement with diversified financial services capabilities? 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.


Incuba Alpha is an emerging investment institution focusing on the blockchain field. Its investment philosophy is: “Believe that the essence of the world is information and computing, invest and empower pioneers who build the future digital world.”

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