Fixed-rate credit protocols: a foundation for new DeFi user types and credit expansion?
In a recent guest article on Messari, Rahul Rai, Managing Partner at Gamma Point Capital, a cryptoasset hedge fund, laid out his thesis for why fixed-income DeFi protocols are positioned to disintermediate elements of the traditional fixed-income industry, while also providing summaries of some of the more noteworthy emergent DeFi projects related to fixed-rate lending, interest rate markets, and securitization.
Central to his hypothesis is the conviction that DeFi is inherently superior to centralized fixed-income services regarding efficiency, liquidity, transparency, and accessibility. Although one could argue the extent to which each of these claims is true, especially that of liquidity, along with the definitions of each of the four parameters, by and large, we would concur with these assumptions. Despite this, the author at times conflates the bond market with fixed-income more generally and, while the former is certainly the largest subset of the latter, there are important reasons why the existing bond market operates in a seemingly inefficient, fragmented, and opaque manner and, by extension, why it is less likely to be disintermediated by DeFi protocols anytime soon.
Much of the bond market operates as it does due to the construction of the assets and the typical investment demands of their buyers. Both corporations and governments, local or national, typically issue a wide range of bonds, differing in their implied interest rates and time to expiration, making it costly for popular exchanges to list the majority of bonds or their corresponding derivatives and debt instruments. Furthermore, the typical buyers of bonds are generally long-term holders rather than short or medium-term traders and speculators, making many, if not most bond markets illiquid and therefore requiring broker-dealers and OTC desks to facilitate any trades – introducing the additional costs and inefficiencies cited by the author.
While some of these issues could be resolved through automated DEX listings, the persistent absence of reliable or effective credit rating mechanisms within the cryptoasset industry, combined with the legal and regulatory burdens of tokenizing bonds and other securities, casts serious doubt as to the feasibility at least in the medium-term of bond issuance, trading, and settlement occurring on-chain.
Conversely, there is arguably a place for fixed-rate lending services more generally, aimed at consumers seeking lending services beyond variable rate alternatives already offered by platforms such as Compound and others. To this end, the author offers an excellent summary of some notable projects tackling fixed-rate lending as well as interest rate markets, and securitization—for which we encourage readers to read the original article.
The origins of fixed-rate lending products, such as UMA’s Yield Dollar and Yield Protocol, can reasonably be traced back to a paper by Dan Robinson of Paradigm and Allan Niemerg of Yield Protocol published in April 2020, which specified how synthetic tokens (yTokens) could be minted and collateralized by cryptoassets, with the token ‘maturing’ at a predetermined date. These tokens could then be bought and sold on secondary markets before reaching maturity, allowing a fixed interest rate to be determined based on the following two factors:
- The price differential between the secondary market sale price and the expiration price.
- The time until expiration.
Since the paper’s publication, there has been a gradual increase in the range of protocols offering fixed-rate lending as well as interest from consumers therein, although no single project has yet been able to breakthrough in the way that its variable-rate competitors have.
That being said, the interest rate predictability that is provided by fixed-rate products arguably pushes the DeFi sector one step closer to attracting new user groups from outside the industry by catering to the needs of more conservative debtors. Equally the surety of fixed-rates could plausibly lead to significant growth in outstanding credit and loans within the ecosystem by increasing the confidence that borrowers have, allowing them to take on more debt. At this stage, the fixed-rate lending subsector is far too nascent to make any firm prognostications about, however, given its potential to grow DeFi’s userbase and the amount of circulating credit, it is certainly an area worth understanding and observing.