Messari: Fixed Income Protocols May Be the Next Wave of Innovation in DeFi

This article was published in Crypto Valley Live, authored by Rahul Rai, translated by Davida, and edited by Miko.

This article is a guest post from the Messari community. Rahul is currently a managing partner at Gamma Point Capital, a hedge fund focused on digital assets and decentralized finance. He previously worked in 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 these assets to borrowers who have productive or investment uses for them, thus enabling non-zero-sum wealth creation.

The total size of the global credit market is approximately three times that of the global equity market. According to ICMA data, as of August 2020, the overall size of the global fixed income market was about $128.3 trillion. Additionally, 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 outstanding contracts in the interest rate derivatives market was estimated to be $524 trillion in the first half of 2019.

Source: Swap.Rate

While most trading in the stock market is conducted electronically, nearly all trading in the U.S. bond market occurs in a decentralized over-the-counter (OTC) market between brokers and large institutions. Therefore, although the fixed income market is mature, it is inefficient. DeFi is fully capable of rapidly innovating efficiency, liquidity, transparency, and accessibility for the largest financial markets in the world.

"The interest rate market is becoming one of the hottest topics in the recent DeFi space. The potential market size of the interest rate market could be over 10 times that of the underlying credit market." - Incuba Alpha Labs

Traditional financial institutions create new credit instruments primarily through two avenues: one is to create new forms of credit through new underlying issuers/assets (such as government bonds, corporate credit, municipal bonds, mortgage-backed securities), and the other is to create new derivatives on existing forms of credit (such as interest rate futures and swaps, mortgage debt obligations, credit default swaps).

DeFi has excelled in innovation around lending (MakerDAO, Compound, Aave), trading (Uniswap, Sushiswap, Curve), aggregation (yEarn, Rari, 1inch, Matcha), synthetic (Synthetix, UMA), and insurance (Nexus Mutual, Cover) protocols. However, so far, there is primarily only one form of credit in DeFi—over-collateralized crypto-backed loans with variable interest rates. The competitive landscape for fixed-rate loans and interest rate derivatives is very open, with no clear winners emerging yet.

In this article, we will focus on three emerging segments 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 Markets (IRS): Horizon Finance, Benchmark, Swivel

Securitization / Tranches (CLOs): BarnBridge, Saffron

Fixed Rate Loans: Zero-Coupon Bonds and Yield Curves

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 corporate bonds and mortgage debt in the U.S. market in 2018 had fixed-rate terms. Fixed rates allow participants to lock in a predetermined interest rate without bearing the risk of interest rate fluctuations.

As an increasingly popular alternative to variable rate loan protocols, zero-coupon fixed rate loan agreements allow users to borrow tokens against crypto collateral, which can be redeemed at maturity for the corresponding face value.

"With the existence of fixed yields in smart contracts, you will be able to build and implement derivatives in financial planning with reduced complexity, which will be a huge shock to traditional financial markets." - Barnbridge

Through over-collateralized lending, users can borrow yield tokens against their deposited collateral and commit to repaying at face value (e.g., $1). If these borrowers want to lock in a fixed interest rate, they would immediately sell their yield tokens at a discount (e.g., $0.85) because they know they can buy them back at face value of $1 at maturity and repay the loan. On the other hand, the buyers of the yield tokens are essentially lending out their $0.85 capital, knowing they can always redeem it for $1 at maturity, effectively locking in a fixed yield.

Dan Robinson's groundbreaking paper "The Yield Protocol: On-Chain Lending With Interest Rate Discovery" laid the theoretical foundation for the creation of zero-coupon bonds and yield curves on-chain. UMA launched the first yield dollar token (yUSD-SEP20), which is essentially a zero-coupon bond redeemable for $1 at maturity and can be traded against USDC in its native AMM liquidity pool on Balancer.

Source: UMA

The "Yield Protocol" takes this concept further and creates a dedicated AMM equation to explain the inherent price upward drift of zero-coupon bonds, allowing limited partners to deposit capital without exposure to short-term losses (IL) and ongoing arbitrage.

As we previously wrote here, "Since yield protocols offer many different maturities, we can construct a yield curve similar to the U.S. Treasury curve used by global fixed income analysts."

As shown in the figure below, most activity is concentrated at the short end, while the long end remains relatively stable.

Source: Roberto Talamas

Notional Finance has also just launched a fixed-rate lending protocol through a new financial primitive called fCash, which is a transferable token that represents a claim on positive and negative cash flows at specific future points in time and can be traded against underlying currencies (e.g., DAI) in its native AMM liquidity pool. Lenders purchase fCash and lock in an interest rate, which represents the amount of the relevant currency they can claim for their fCash at maturity. Borrowers mint fCash and can sell it for underlying currency in exchange for the obligation to repay a fixed amount of underlying currency at a specific future time. fCash tokens are always generated in pairs—the assets and liabilities of the entire nominal system always net to zero.

Source: Notional Finance Docs

It is worth noting that determining an accurate measure of "risk-free" yield in the DeFi ecosystem is not easy due to fluctuating over-collateralization rates, high price volatility, and the risk layering of over-liquid collateral. However, over-collateralized lending platforms like MakerDAO and Compound can be considered fair indicators of risk-free floating rates, while collateral-backed yield dollar tokens like UMA's uUSD and Yield Protocol's fyDai can provide fair indications of risk-free zero-coupon fixed rates. Yield-generating stablecoins like yEarn's yUSD carry additional risks and should be appropriately compensated through the spread of risk-free rates.

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, enhances market efficiency, and allows market participants to speculate on and hedge against interest rate risks.

Given the prevalence of floating rate yields in the DeFi ecosystem, interest rate swap (IRS) protocols have a huge opportunity to intervene, allowing lenders and LPs to swap floating yields for 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 the underlying asset and trade that yield as their own token separately. In this way, Benchmark enables holders of these assets to sell their rights to (variable) yields in a prepaid cash manner, thereby locking in a fixed rate for a specified period. The buyers of these rights purchase yield tokens to gain exposure to variable yield risk in a capital-efficient manner without having to stake collateral and worry about liquidation.

Source: Benchmark

Additionally, Benchmark has developed a new AMM variant that accounts for the time decay (theta) of yield tokens. Since yield tokens are designed to have no value at expiration on a specific date, otherwise, price decay would lead to LPs locking in permanent losses on traditional AMM platforms.

Horizon builds on a similar concept and addresses the limited interchangeability and liquidity of fixed-term yield tokens, as well as the margin and AMM requirements associated with such tokens. It employs a game-theoretic approach to form decentralized interest rate markets, allowing participants to compete for priority payments in exchange for yield caps through the introduction of interspersed auction markets with different maturities (Horizon tokens).

Swivel Finance (formerly DeFi Hedge) is a protocol that establishes the infrastructure for creating algorithmically enforced fixed-rate lending protocols and true trustless interest rate swaps. Users can create fixed or floating rate swap quotes for any Ethereum token offered by Compound or Aave. Buyers can then fill in the terms of the bidders, locking in the funds of both the maker and the buyer until the agreed-upon term is completed, at which point one party will return its capital and fixed yield, while the other will return the remaining floating interest.

By using a CLOB system, Swivel avoids the need for AMM pools, completely eliminating slippage. Additionally, by operating on top of larger lending protocols like Compound and Aave, it does not have to guide market participants on both sides.

Source: Swivel.Finance

Securitization and Tranching

Without the notorious mortgage-backed securities that caused the global economic collapse in 2008, Wall Street's legacy would be incomplete. Irresponsible use of leverage leads to inflated bubbles followed by catastrophic corrections. However, the foundational innovation behind MBS and other tranched securities is very powerful—splitting cash flows into different risk profiles to meet the needs of investors with various risk profiles and utility functions.

Source: Wikipedia

BarnBridge is a volatility derivatives protocol that aggregates yields from different protocols and bundles them into high-yield and low-yield tranches of debt. The SMART Yield Bond (Structured Market Adjusted Risk Tranche) pools collateral and deposits it into lending protocols or yield-generating contracts, then bundles the yields into different tranches and marks them. Thus, the most senior tranches have lower yields and safer risk profiles, while the more junior tranches have higher yields but additional risk exposure. SMART bonds essentially achieve free market pricing of yield risk.

This allows users to not only obtain fixed-rate yields but also aggregate yields from 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, allowing liquidity providers greater flexibility and dynamic exposure by using Saffron pools to select customized risk and return scenarios.

Saffron tokenizes the future cash flows of each tranche of assets and the net present value of the utilized principal separately. Based on the tokenized yields, returns are allocated accordingly through a waterfall across all tranches. The initial application of the return waterfall utilizes two main tranches: one is the yield-enhanced "A" tranche, and the other is the risk-reduced super senior "AA" tranche.

The increased liquidity, once removed, is used to repay the initial principal of the AA holders, followed by the payment of principal and interest to 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 risk of failure of the underlying platform (such as Compound, Aave, or Curve). In this case, the Saffron protocol acts as a custodial service for the risk transfer between A tranche participants and AA tranche participants.

Overall, the DeFi market has immense potential to unleash credit expansion. The migration of yield and yield-based derivatives from inefficient centralized financial systems to more efficient decentralized financial systems could be one of the largest wealth transfers in human history. It will be fascinating to see how protocols across fixed-rate loans, interest rate markets, and tranche yields intervene to provide the highest quality credit and effectively access leverage across the entire risk curve.