Fixed Income Protocols — The Next Wave of DeFi Innovation
Originally published on Messari
Disclaimer:
- The above reflects the views of the investor and should NOT be construed as investment advice, financial advice or legal advice.
- This information is purely educational and is NOT meant to be taken as a recommendation to buy or sell any product or service. Please do your own research before making any decisions.
- Where relevant, direct quotes & passages have been taken from the sources, whitepapers, and blog posts cited.
Credit is the cornerstone of every financial ecosystem. It enables non-zero-sum wealth creation by allowing those with surplus assets to lend them to borrowers who have a productive or investment use for those assets.
The global credit market in aggregate is about three times the size of the global equity market. The overall size of global fixed income markets is approximately $128.3 trillion as of August 2020, according to the ICMA. In addition, the interest rate derivatives market is the largest derivatives market in the world. For the first half of 2019, the total notional amount outstanding for contracts in the interest rate derivatives market was an estimated $524 trillion according to data from the Bank for International Settlements (BIS).
While most of the trading in equity markets happens electronically, nearly all of the trading in the U.S. bond market takes place between broker-dealers and large institutions in decentralized over-the-counter (OTC) markets. Fixed income markets are thus inefficient and ripe for disruption, and DeFi is perfectly positioned to rapidly innovate on efficiency, liquidity, transparency, and accessibility for the largest financial market in the world.
“The interest-rate market is becoming the hottest topic in the DeFi world recently. The potential market size of interest rate market may be more than 10 times larger than the underlying credit market.” — Incuba Alpha Labs
There were two major pathways that traditional financial institutions took to create new credit instruments: i) new forms of credit through new underlying issuers/ assets (eg. treasury bonds, corporate credit, municipal bonds, mortgage backed securities), and ii) new derivatives on existing forms of credit (eg. interest rate futures & swaps, collateralized debt obligations, credit default swaps).
DeFi has done a fantastic job of innovating around lending (MakerDAO, Compound, Aave), trading (Uniswap, Sushiswap, Curve), aggregation (yEarn, Rari, 1inch, Matcha), synthetics (Synthetix, UMA), and insurance (Nexus Mutual, Cover) protocols. However, so far there has primarily been only one form of credit in DeFi — over-collateralized crypto backed loans with variable rates. The playing field is wide open on the fixed-rate lending side and the interest rate derivatives side, with no clear winners having emerged yet.
In this article we’ll highlight the three main emerging buckets of fixed income protocols, along with some of their most promising implementations:
- Fixed Rate Lending (Yield Curves): Yield Protocol, Notional Finance, UMA’s yUSD
- Interest Rate Markets (IRS): Horizon Finance, Benchmark, Swivel
- Securitization/ Tranches (CLOs): BarnBridge, Saffron
Fixed Rate Lending: Zero Coupon Bonds & Yield Curves
Fixed rate lending is by far the most common type of lending in traditional finance. For instance, of the $15.3 trillion dollars of debt outstanding in the US corporate debt and mortgage markets in 2018, 88% of it was in fixed rate terms, according to data from Lending Tree. Fixed rates allow participants to lock in a predetermined rate, without having exposure to interest rate volatility.
As an increasingly popular alternative to the variable-rate lending protocols that have gained significant market share, fixed-rate lending zero-coupon protocols permit users to borrow, against crypto collateral, tokens that can be redeemed at maturity for a face value.
“The types of derivatives & complexity reduction in financial planning you’ll be able to structure and implement with the existence of fixed yield in smart contracts will be mind blowing to traditional financial markets.” — Barnbridge
Through over-collateralized lending, users can borrow yield tokens against their collateral deposited, with a commitment to pay it back at face value (say $1). Should these borrowers want to lock in a fixed rate, they would sell their yield tokens immediately at a discount (say $0.85), knowing that at maturity they can buy it back for the $1 face value, and repay the loan. On the other hand, buyers of the yield token essentially lend their $0.85 of capital, knowing that it will always be redeemable for the $1 face value at maturity, and effectively locking in a fixed rate of return.
Dan Robinson’s seminal paper, The Yield Protocol: On-Chain Lending With Interest Rate Discovery, laid the theoretical groundwork for the creation of on-chain zero-coupon bonds and yield curves. UMA launched the first yield dollar token (yUSD-SEP20) which was essentially a zero-coupon bond redeemable for $1 at expiry, and tradable against USDC through an Automated Market Maker (AMM) pool on Balancer.
Yield Protocol took this concept one step further and created a specialized AMM equation that accounted for the upward price drift inherent in zero-coupon bonds, allowing LPs to deposit capital without exposing themselves to impermanent loss (IL) and continuous arbitrage.
As Messari previously wrote about here, “since Yield Protocol provides a number of varying expiration dates, we can construct a yield curve similar to the U.S. Treasury curve used by fixed-income analysts across the world.”
As you can see below, most of the activity has been on the short-end of the curve, with the long-end staying relatively stable.
Notional Finance has also just come out with a fixed rate borrowing/ lending protocol via a novel financial primitive called fCash. fCash are transferable tokens that represent a claim on a positive or negative cash flow at a specific point in the future and are tradable against the underlying currency (eg. DAI) within its native AMM-enabled liquidity pools. Lenders buy fCash and lock in a rate that represents the amount of the underlying currency that they can claim for their fCash upon maturity. Borrowers mint fCash and can sell it to receive the underlying currency, in exchange for the obligation to repay a fixed amount of the underlying currency at a specific future time. fCash tokens are always generated in pairs — assets and liabilities always net to zero across the Notional system.
It’s worth noting that with variable over-collateralization rates, high price-volatility, and superfluid collateral with stacked risks, determining an accurate measure of “risk-free” yield in the DeFi ecosystem is not a trivial task. However over-collateralized lending platforms like MakerDAO and Compound can be considered a fair indication of the risk-free variable rate, while collateral-backed yield dollar tokens like UMA’s uUSD and Yield Protocol’s fyDai can give a fair indication of the risk-free zero-coupon fixed rate. Yield generating stablecoins like yEarn’s yUSD stack more risks and should be appropriately compensated through a spread over the risk-free rate.
Interest Rate Markets
The ability to trade future yield as an asset/ token is a very powerful idea. It increases the amount of credit and leverage in the ecosystem, improves price-discovery, increases market efficiency, and allows market participants to speculate on and hedge against interest rate exposure.
Given the prevalence of variable-rate yields in the DeFi ecosystem, there is a huge opportunity for interest rate swap (IRS) protocols to step in and allow lenders and LPs to swap out their floating yields and lock-in fixed yields.
Benchmark is a protocol that enables the tokenization and trading of future yield. It allows participants to strip away the yield from an underlying asset, and separately trade that yield as its own token. In doing so, Benchmark enables holders of such assets to sell their rights to the (variable) yield for up-front cash, thus locking in a fixed rate for a fixed period of time. Buyers of these rights purchase the yield tokens to gain exposure to the variable yield in a capital-efficient manner, without having to stake collateral and worry about liquidations.
In addition, Benchmark has developed a new AMM variant that accounts for the time decay (theta) of the yield token. Since yield tokens are designed to expire worthless at a specific date, the price decay would otherwise cause LPs to lock in a permanent loss on traditional AMM platforms.
Horizon builds on similar concepts, and addresses the problem regarding limited fungibility and liquidity of yield tokens with fixed tenors, as well as the margin and AMM requirements associated with such tokens. It uses a game theoretic approach to form decentralized interest rate markets, by introducing interspersed auction markets (Horizon marks) across various tenors where participants can compete for preferential payment in return for capping their yield, on a fair and transparent playing field.
Swivel Finance (formerly DeFi Hedge) is a protocol that establishes the infrastructure for the creation of algorithmically enforced fixed-rate lending agreements and truly trustless interest-rate swap. Users are able to create fixed-side or floating side interest-rate swap offers for any Ethereum token offered by Compound or Aave. Takers are then able to fill the offeror’s terms, locking in both the maker and taker’s funds until the agreed-upon term is complete, at which point one party is returned their capital and fixed yield, while the other is returned the remaining floating interest.
By using the CLOB system, Swivel circumvents the need for AMM pools and avoids slippage altogether. In addition, by operating on top of larger lending protocols like Compound and Aave, it doesn’t have to bootstrap both sides of the market.
Securitization & Tranches
The legacy of Wall Street would be incomplete without the infamous Mortgage Backed Securities (MBS) that took down the global economy in 2008. Leverage, when taken on irresponsibly, can lead to overvalued bubbles followed by disastrous corrections. However the underlying innovation behind the MBS and other tranched securities is very powerful — splitting up cash flows into different risk profiles, to cater to the needs of a wide variety of investors, with different risk profiles and utility functions.
BarnBridge is a fluctuations derivatives protocol that aggregates yield across different protocols and pools them into higher-yielding and lower-yielding tranches with different risk profiles. The SMART Yield Bond (Structured Market Adjusted Risk Tranches) pools and deposits collateral into lending protocols or yield generating contracts, the yield of which is then bundled up into different tranches and tokenized. So the most senior tranches have lower yields with much safer risk profiles, while the more junior tranches have higher yields with additional risk exposure. SMART bonds essentially enable free-market pricing for the buying and selling of risk on yield.
This enables users to not only get access to fixed-rate yield but also pools yield from numerous protocols across the ecosystem, creating greater efficiencies by spreading risk and smoothing out the industry yield curve. You can find the full spreadsheet model here.
Saffron is another protocol that tokenizes ownership of on-chain assets, giving liquidity providers access to greater flexibility and dynamic exposure by selecting customized risk and return profiles via the use of Saffron pool tranches.
Saffron separately tokenizes the future earning stream and the net present value of utilized principal in each tranche. Earnings, based on tokenized holdings, are distributed accordingly across all tranches via payback waterfalls. The initial application of the payback waterfall leverages two primary tranches: a yield enhanced “A” tranche, and a risk mitigated super-senior “AA” tranche.
Added liquidity, when removed, is used to pay back the initial principal of AA holders before paying the principal and interest of the yield enhanced A tranche. In exchange for this enhanced return, participants of the A tranche must stake Saffron’s native tokens (SFI) to mitigate against failures on the underlying platform (such as Compound, Aave, or Curve). The Saffron protocol in this scenario acts as an escrow service for the transfer of risk between A tranche participants and AA tranche participants.
Overall, there is huge potential to unleash credit expansion in the DeFi market. The migration of yield and yield-based derivatives from less efficient centralized financial systems to more efficient decentralized financial systems could be one of the largest movements of wealth in human history, and it will be interesting to see how protocols across fixed-rate lending, interest rate markets, and tranched yields step in to provide the market with the highest quality of credit and efficient access to leverage across the risk curve.
Sources
Analysis of Decentralized Interest-Rate Swap Models
Vertical Expansion of DeFi: decentralized interest market rises
Derivatives, the Second Half of DeFi
The Yield Curve Cometh: Why Fixed-Rate Loans in Crypto Matter
