Vertical Expansion of DeFi: decentralized interest market rises Part 2

Incuba Alpha Labs
9 min readDec 16, 2020

So as the second half of our last article, here is

If credit creation and balance-sheet expansion are DeFi’s “horizontal expansion”, the tools and ways to enrich the DeFi market to leverage is a “vertical expansion” — as underlying assets become more complex, the asset-end of the DeFi protocols will face more demand for fixed-term and fixed-rate financing. Accordingly, the debt end of the DeFi protocols will require interest costs, duration management, and risk management, resulting in a “vertical expansion” based on the interest-rate dimension, bringing about a whole new dimension of DeFi market capacity and more possibilities of great imagination.

The interest-rate market is becoming the hottest topic in the DeFi world recently.

As we have explored above, our view of the DeFi world is to answer the question “how to achieve credit expansion and leverage accumulation more effectively in financial markets.” More diversified credit will be introduced into the blockchain as assets, driving a whole new kind of credit expansion, which is the “horizontal expansion” of DeFi’s balance-sheet expansion. At the heart of the interest-rate market is the need to locate more efficient paths to increase financial leverage in the DeFi market, which is the “vertical expansion” of the DeFi market. We believe that such a new dimension of expansion will bring more interesting possibilities to the DeFi market.

Although different from that of traditional financial institutions, the core of the DeFi protocols is to manage its own balance sheet. The difference after deducting the cost of capital from the asset returns is retained as earnings. Purely from a business perspective, this is not substantially different from the profit model of financial institutions. This provides the most basic business logic for constructing the DeFi interest rate market.

At the same time, as DeFi’s balance sheet expands, more and more assets will require fixed term and fixed interest rate, and require more financial instruments and marketplace to increase financial leverage. This will make DeFi protocols generally face the pain points of managing financial cost, capital duration and interest rate risk. Similar to the traditional financial market, these pain points will give rise to a large number of DeFi protocols that undertake the positioning of “non-banking financial institutions” (such as investment banks, insurance companies, asset management companies, etc.).

We have noticed that some very innovative DeFi interest rate, insurance, risk management and derivative protocols are emerging in the market at the moment. The interest rate market is a new track in the layout of new ecosystem. There is no doubt that these innovators will potentially grow to be new market leaders at the level of Uniswap, Maker and Aave.

The interest rate market shall make financial leveraging more efficient

While the concept of interest rates may seem simple, it would be as difficult to build feasible financial solutions as the decentralized derivative racetrack. In the traditional financial concept, interest rates are the key factors in pricing different risky assets, and the term structure of interest rates can also reflect people’s expectations of future interest rate changes.

The interest rate itself is a very complex system. Central banks can set policy rates, including benchmark rates, interest rate on excess reserve, and interest rates for various monetary policy instruments; the money market has Libor, repurchase rates, etc.; the credit market has interest rates for deposits and loans; and the bond market has different interest rates for treasury bonds, municipal bonds and corporate bonds.

Similarly, Maker’s interest rate policies include stable rate and DSR (Dai Savings Rate), the rates of Aave and Compound include interest rates on deposits and loans, and liquidity mining like Curve or other DeFi protocols that provide expected APY rates. These interest rates obviously have different credit ratings, all of them are floating rates, open-ended maturities and strongly impacted by centralized party on interest rate pricing.

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

  1. What interest rate market will be built in different credit ratings
  2. What fixed income products are created to serve financial leveraged demand; and
  3. How to set and price the fixed interest rates with different maturities, i.e. the term structure of interest rate (yield curve)

Three ways of constructing decentralized interest rate market

In traditional financial markets, the Treasury bond yield curve is the benchmark for the pricing of all fixed income products.

  1. A benchmark yield curve is formed through zero-coupon treasury bonds with different maturities.
  2. Yield curves are formed through various fixed-income products based on benchmark yield curves and risk spreads.
  3. Based on the spot interest rate yield curve, the forward interest rate curve is calculated, and then the swap yield curve is formed, which provides a pricing benchmark for interest rate derivatives such as forward, futures and swaps. Finally, the entire CDO product issuance process can be realized in the DeFi market, and the whole interest rate market system can be perfected.

All of the emerging protocols that build the DeFi interest rate market cannot be divorced from this fixed income product pricing logic, and all DeFi interest rate protocols basically follow this logic, but each makes a single-point breakthrough at a certain point in the business line, leading to three typical directions:

One is the construction of zero-coupon bonds, such as Yield’s ytoken, UMA’s uUSD, and Notional. These protocols take the form of the issuance of fixed-maturity zero-coupon bonds with ETH as collateral (such as yETH-DAI-3month). The most intuitive form of the product is interest-bearing stable coins with fixed maturities, in which the implied interest rate is set by trading or through AMM tokens for such bond tokens.

This is simply the definition of a benchmark yield curve in traditional financial markets, which rely on the credit of zero-coupon bonds. In the DeFi market, zero-coupon token bonds with ETH as collateral, similar to the credit of Treasury bonds, can be used as an approximate alternative to zero-coupon bonds, to construct a basic benchmark spot yield curve for the DeFi market.

The other is Token securitization of yield tokens with future cash flow returns, such as Barnbridge, Benchmark and Centrifuge. These projects draw on the aforementioned CDO product issuance model, essentially creating new fixed-income products that package cash flow from Aave or Compound for structured securitization financing. Senior tranche Token with fixed interest rates and Junior tranche Token with floating interest rates are issued.

As the Token securitization model matures, such DeFi protocols can consolidate cash flow returns from more underlying asset pools, issue more tranche (such as the introduction of mezzanine or more tiers of senior tranches), and allow users to pricing appropriate interest rates of different maturities through trading, AMM, or quotes, thereby creating a yield curve for the fixed-income products. The yield curve for these fixed-income products need to be backed by the credit of the underlying asset, cToken or aToken, the credit rating of which is similar to financial bonds of commercial banks and subordinated to ETH-DAI bonds.

The third is to introduce interest rate swaps, such as Horizon, Swap.rate, DeFiHedge, and so on. An interest rate swap is a forward contract in which one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps usually involve the exchange of a fixed interest rate for a floating rate, or vice versa. By having access to such an interest rate swap contract, DeFi users can swap floating interest rate into a fixed interest rate with a fixed term. Interest rate swaps can be fixed or floating rate in order to hedge, arbitrage or manage exposure to fluctuations in interest rates. The yield curve in this dimension is mainly to hedge, arbitrage, or trade interest rate by observing the structure of spot and forward interest rate curves.

But even with the introduction of interest rate swaps, different DeFi protocols tend to construct fixed interest rates in very different ways. DeFiHedge and Swap.rate are order-book based interest rate swaps trading platforms, but the design of the trading mechanism is slightly different. Horizon adopts a combination of Token securitization and interest rate swap, which allows users to bid the fixed interest rates they want. The cash flow of underlying asset returns is distributed according to the users from the lowest bid to the highest bid, and a yield curve is formed through game theory.

The above three ways to construct the DeFi interest rate market are not simply good or bad, because different interest rate protocols have different positions on the business lines targeting on segmented interest rate market and credit rating. Most importantly, the pricing mechanism is different even if the same financial instrument is used, such as interest rate swap, so the DeFi interest rate protocols are not directly competitive, and facing different constraints at present.

Zero-coupon bonds, for example, take up a lot of over-collateral, involve complex borrowing and clearing activities, and rely on Uniswap trading or AMM for interest rate pricing. In the early and illiquid stages of the market, it is difficult to effectively price interest rates through trading. The benchmark yield curve is likely not to reflect the actual interest rate structure. This bond product is expected to be more suitable for BTC, ETH, and assets with relatively high credit ratings such as aToken and cToken, which can not meet the financial needs of long-tail erc-20 tokens.

In the case of token securitization, the first step is to find a yield asset pool that can generate cash flow. Obviously, the options are relatively limited. This type of protocols will grow with the expansion of DeFi eligible collateral. Moreover, if the implied interest rate of senior tranche tokens need to be valued through trading or AMM, there are similar drawbacks to zero-coupon bonds. If the protocol sets a given fixed interest rate, the pricing is not fully market-oriented and difficult to consider it decentralization.

In the case of interest rate swap derivatives, the pricing of such derivatives relies on credible spot curves and forward curves. Currently, trading of such swaps may be inactive under the constraints of the absence of the yield curves in the DeFi market and the lack of liquidity. Such derivatives may be priced more skewed than the fair price, but swaps are relatively the most direct paths for users to lock in the risk of interest rate volatility.

If we compare the issuance of CDOs in traditional financial markets, we can see that DeFi only meet the needs of packing credit into financial assets like loans or bonds.

The following steps are still blank:

  1. asset securitization and derivatives,
  2. structured financing and interest rate pricing,
  3. interest rate hedging or speculation.

Only after these three steps are completed can the DeFi interest rate market be constructed in a closed loop and DeFi could answer the proposition of “how to increase financial leverage more efficiently”.

But the potential market size of interest rate market may be more than 10 times larger than the underlying credit market. DeFi interest rate protocols such as Token securitization, zero-coupon bonds, and interest rate swap derivatives can each occupy certain segments of this market, and there is a very good chance to grow into a new group of DeFi leading players. As the interest rate market grows, there will be more demand for risk management protocols such as insurance, asset management&liquidation and so on.

Even if DeFi interest rate market is still facing a lot of challenges. DeFi has its own characteristics in keeping with the objective laws of financial business. We are looking forward to more novel ideas beyond what traditional financial market has built.

Will interest-bearing stable coins become the first use case of the zero-coupon token, or will they capture the market share of the stable coins, or will they form a totally original DeFi bond market?

When the DeFi interest rate market has a decentralized anchorage for interest rate pricing, will Aave, Compound and other lending protocols be willing to introduce long-term liquidity lending designed to improve their basic interest rate incentive models; will DEXs like Uniswap release the redundant assets in the liquidity pool to provide more liquidity to the market, thereby further expanding the multiplier for DeFi credit expansion?

When DeFi protocols encounter a short-term liquidity shortage such as huge redemption and sharp increase in loan demand, will they be willing to issue zero-coupon bonds for short term borrowing in order to avoid a run on the market or improve the efficiency of capital, so as to form a brand-new market similar to the inter-bank lending market?

Will the emergence of new fixed-income products continue to stimulate the development of various types of investment banking and asset management business, so as to create a super platform protocol with diversified financial service capabilities similar to JPMorgan in the era of mixed financial business?

DeFi’s cutting-edge experiment has only just opened the door to the interest-rate market, and behind it, possibilities are limitless.

Hell is empty, and all the devils are here.



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