The next wave of DeFi innovation? Three development directions and implementation methods of fixed income protocols
Original source: Messari
Original title: "Fixed income agreement will be the next wave of DeFi innovation? "
Author: Rahul- Gamma Point Capital
Translator: Crypto Valley live
This article is a guest post from the Messari community. Rahul is currently the managing partner of Gamma Point Capital, a hedge fund focused on digital assets and decentralized finance. He previously worked on Morgan Stanley's foreign exchange hedge fund team and graduated from the Wharton School with a bachelor's degree in economics.
Credit is the cornerstone of every financial ecosystem. It allows those with surplus assets to lend those assets to borrowers who have productive or investment uses for those assets, thereby achieving non-zero-sum wealth creation.
The total size of the global credit market is about three times the size of the global equity market. According to ICMA, as of August 2020, the overall size of the global fixed income market was approximately $128.3 trillion. In addition, the interest rate derivatives market is the largest derivatives market in the world. According to the Bank for International Settlements (BIS), the total notional amount of contracts outstanding in the interest rate derivatives market was estimated at $524 trillion in the first half of 2019.
Source: Swap.Rate
While the majority of trading in the stock market is conducted electronically, almost all trading in the U.S. bond market is conducted in a distributed over-the-counter (OTC) market between brokers and large institutions. As a result, the fixed income market, while mature, is inefficient. DeFi is well-positioned to rapidly innovate in efficiency, liquidity, transparency, and accessibility for the world's largest financial markets.
"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 underlying 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 underlying issuers/assets (such as government bonds, corporate credit, municipal bonds, mortgage-backed securities); the other is to create new derivatives on existing credit forms (such as interest rate futures and swaps, collateralized debt obligations, credit default swaps).
DeFi has done a great job 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, to date, there has been primarily only one form of credit in DeFi - overcollateralized crypto-backed loans with variable rates. The playing field on the fixed-rate lending side and interest rate derivatives side is very open, and no clear winner has emerged yet.
In this article, we will focus on the three emerging parts of fixed-income protocols 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/tranches (CLOs): BarnBridge, Saffron
Fixed rate loans: zero coupon bonds and yield curve
Fixed rate loans are currently the most common type of loan in traditional finance. For example, according to Lending Tree, 88% of the $15.3 trillion in outstanding debt in the U.S. corporate bond and mortgage markets in 2018 were fixed rate terms. Fixed 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 lending protocols, fixed rate lending zero interest protocols allow users to borrow tokens against crypto collateral, which can be redeemed at par at maturity.
"With the existence of fixed yields in smart contracts, the types of derivatives in financial planning that you will be able to build and implement are reduced & complex, which will be a huge shock to traditional financial markets." - Barnbridge
With overcollateralized lending, users can borrow yield tokens against their deposited collateral and promise to repay them at par (e.g. $1). If these borrowers want to lock in a fixed rate, they will immediately sell their yield tokens at a discount (e.g. $0.85), knowing that at maturity they can buy them back at par at $1 and repay their loan. On the other hand, buyers of yield tokens are essentially lending out their $0.85 capital, knowing that they can always redeem it for $1 par at maturity, and effectively locking in a fixed yield.
Dan Robinson's seminal paper, The Yield Protocol: On-Chain Lending With Interest Rate Discovery, laid the theoretical foundation for on-chain zero-coupon bonds and yield curves. UMA launched the first yield dollar token (yUSD-SEP20), essentially a zero-coupon bond that matures and is redeemable for $1 and trades against USDC through an automated market maker (AMM) pool on Balancer.
Source: UMA
The Yield Protocol takes this concept a step further and creates a specialized AMM equation that accounts for the intrinsic upward price drift of zero coupon bonds, allowing LPs to deposit capital without exposing themselves to short-term losses (IL) and ongoing arbitrage.
As we have written here before, "Because the Yield Agreement offers 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 activity has been at the short end, with the long end remaining relatively stable.
Source: Roberto Talamas
Notional Finance has also just launched a fixed-rate lending protocol through a new financial primary product called fCash, a transferable token that represents a claim on positive and negative cash flows at a specific point in the future and can be traded against a base currency (such as DAI) in its native AMM-enabled liquidity pool. Lenders buy fCash and lock in an interest rate that represents the amount of the underlying currency they can claim for their fCash at maturity. Borrowers mint fCash and can sell fCash for base currency in exchange for an obligation to repay a fixed amount of base currency at a specific time in the future. fCash tokens are always minted in pairs - the assets and liabilities of the entire notional system always net to zero.
Source: Notional Finance Docs
It is worth noting that it is not easy to determine an accurate measure of "risk-free" yield in the DeFi ecosystem due to floating overcollateralization rates, large price fluctuations, and ultra-liquid collateral with superimposed risks. However, overcollateralized lending platforms like MakerDAO and Compound can be considered fair indications of risk-free floating rates, and collateral-backed yield USD tokens like UMA's uUSD and Yield Protocol's fyDai can give fair indications of risk-free zero-interest fixed rates. Yield-generating stablecoins like yEarn's yUSD will add more risks and should be appropriately compensated by the spread of the risk-free rate.
Interest Rate Markets
The ability to trade future yields as assets/tokens 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 and hedge on interest rate risk.
Given the prevalence of floating rate yields in the DeFi ecosystem, there is a huge opportunity for interest rate swap (IRS) protocols to step in, allowing lenders and LPs to swap floating yields and lock in fixed yields.
Source: Delta Exchange
Benchmark is a protocol that enables the tokenization and trading of future yields. It allows participants to strip the yield of an underlying asset and trade that yield separately as its own token. In this way, Benchmark enables holders of these assets to sell their rights to a (variable) yield for cash upfront, thereby locking in a fixed rate for a fixed period of time. Buyers of these rights purchase yield tokens to gain exposure to variable yields in a capital-efficient manner without the need to stake collateral and worry about liquidation.
Source: Benchmark
In addition, Benchmark has developed a new AMM variant that takes into account the time decay (theta) of yield tokens. Since yield tokens are designed to be worthless when they expire on a specific date, price decay would otherwise cause LPs to lock in permanent losses on traditional AMM platforms.
Horizon builds on similar concepts and solves the problems of limited fungibility and liquidity of fixed-term yield tokens, as well as the margin and AMM requirements associated with such tokens. It adopts a game theory approach to form a decentralized interest rate market, by introducing an interleaved auction market of different maturities (Horizon tokens), participants can compete for priority payment in exchange for yield caps in a fair and transparent competitive environment.
Swivel Finance (formerly DeFi Hedge) is a protocol that builds the infrastructure for creating algorithmically enforced fixed-rate lending protocols and truly trustless interest rate swaps. Users are able to create a fixed-side or floating-side interest rate swap quote for any Ethereum token offered by Compound or Aave. Buyers are then able to fill in the bidder's terms, locking up the maker and buyer's funds until the agreed-upon term is complete, at which point one party returns its capital and fixed rate of return, while the other returns the remaining floating interest.
By using the CLOB system, Swivel avoids the need for AMM pools and completely avoids slippage. Additionally, by running on top of larger lending protocols like Compound and Aave, it does not have to bootstrap both sides of the market.
Source: Swivel.Finance
Securitization and Conversion
The legacy of Wall Street would be incomplete without the infamous mortgage-backed securities that collapsed the global economy in 2008. Irresponsible use of leverage led to an overvalued bubble followed by a catastrophic correction. Yet the fundamental innovation behind MBS and other convertible securities is very powerful - the segmentation of cash flows into different risk profiles to meet the needs of a variety of investors with different risk profiles and utility functions.
Source: Wikipedia
BarnBridge is a volatility derivative protocol that aggregates the yields of different protocols and pools them into high-yield and low-yield convertibles with different risk profiles. SMART Yield Bonds pool and deposit collateral into a lending protocol or yield generation contract, which then bundles its yields into different convertible bonds and marks them. As a result, the most senior convertible bonds have lower yields and a safer risk profile, while the more junior convertible bonds have higher yields but additional risk exposure. SMART bonds essentially enable free market pricing of yield risk buying and selling.
This allows users to not only obtain a fixed rate yield, but also pool the yields of numerous protocols across the ecosystem, creating greater efficiency by diversifying risk and smoothing the industry yield curve.
Saffron is another protocol that tokenizes on-chain asset ownership, giving liquidity providers greater flexibility and dynamic exposure by using Saffron pools to select customized risk and return profiles.
Saffron tokenizes the future income stream and the net present value of the principal used for each tranche of assets separately. Based on the income from the tokenized holdings, it is allocated accordingly across all tranches through a return waterfall. The initial application of the return waterfall utilizes two main convertible bonds: one is a yield-enhanced "A" convertible bond, and the other is a risk-reduced super senior "AA" convertible bond.
The added liquidity, after being removed, is used to repay the initial principal of AA holders, and then pay the principal and interest of the yield-enhanced A tranche. In exchange for this enhanced return, participants in the A tranche must stake Saffron's native token (SFI) to mitigate the failure of the underlying platform (such as Compound, Aave, or Curve). In this case, the Saffron protocol acts as a custodial service for risk transfer between A tranche participants and AA tranche participants.
Overall, the potential for the DeFi market to unlock credit expansion is huge. The migration of yields and yield-based derivatives from the less efficient centralized financial system to the more efficient decentralized financial system may be one of the largest wealth flows in human history, and it will be very interesting to see how protocols across fixed-rate lending, interest rate markets, and convertible bond yields step in to provide the market with the highest quality credit and opportunities to efficiently obtain leverage across the entire risk curve.
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