Vertical Expansion of DeFi: The Rise of Decentralized Interest Rate Markets

This article was published in Crypto Valley Live, authored by Incuba Alpha Labs, compiled by IDEG and Leo Zhu.

Andre Cronje (YFI) recently made a statement regarding the merger of four well-known DeFi protocols (Pickle Finance, C.R.E.A.M, COVER Protocol, and Sushiswap), which has attracted widespread attention from the market. When industry leaders begin to consolidate their market positions through mergers and acquisitions, we can't help but wonder if this indicates that the competition in the DeFi sector has become too crowded, and the pace of development is slowing, leading to a market gradually divided among giants.

"Can DeFi continue to grow?"

We hold a very optimistic view on this question. The reason can be traced back to the real transformation brought about by DeFi.

"Assets" are currently the most scarce resource in the value exchange world built on blockchain, and the explosive growth of the DeFi industry is a response to this demand, as it has introduced "credit" as an asset into the blockchain world for the first time.

"Credit" refers to the relationship between creditors and debtors based on financing needs. Credit is the cornerstone of financial markets, and the rapid development of a financial market is closely related to the expansion of credit and the accumulation of leverage. Whether in traditional financial markets or in DeFi markets, top participants deeply understand this concept, either by referencing or issuing a new form of credit as a base asset to promote the expansion of underlying assets, or by creating a new financial product or market platform with higher efficiency to facilitate the accumulation of financial leverage.

In the DeFi world, "introducing credit as an asset" is still in a relatively early conceptual stage. Our investment directions mainly focus on two areas:

• Introducing new credit assets

• Introducing new methods for adding financial leverage

By referencing the development of traditional financial markets, we have identified some potential areas of overlap with the future development of the DeFi industry.

The Process of Credit Expansion and Leverage Accumulation

The ecological picture of traditional finance is very rich and complex, containing a vast array of different credits and dazzling leverage enhancement tools:

• Government/national fiscal financing needs are packaged into sovereign debt.

• Individual financial needs (such as housing, cars, medical care, education, and consumption) and corporate financial needs, such as working capital and capital expenditures, are packaged into different debt combinations.

These credits form the backbone of the financial market, where financial institutions create different financial assets (such as government bonds, mortgage loans, or credit card loans) on top of these debts, continuously increasing leverage through financial derivatives.

The result of credit expansion and leverage accumulation is the continuous growth of the balance sheets of all participants in the financial market.

Looking back at the most radical era of financial liberalization before 2008, we can observe how all participants in the financial market were interconnected through their balance sheets via the issuance of collateralized debt obligations (CDOs).

Given the complexity of the financial market structure, we abstract the core content of the above image for reference.

In the above scenario, credit is generated and circulated among parties through the following channels:

• An individual wanting to purchase a house (on the asset side) but needing a loan for funding will generate credit on the liability side.

• Commercial banks issue loans or purchase bonds on the asset side to support individual housing financing, while packaging various types of bond assets on the liability side and securitizing them into structured products.

• The non-bank financial sector purchasing credit-rated structured products allows banks to recover funds, thereby providing new mortgage loans, completing the process of financial leverage accumulation.

The entire process of credit expansion and leverage accumulation can continue to operate until credit deteriorates (creditworthy individuals receive excessive financing) and leverage collapses (subprime debt defaults, collateral prices plummet, leading to insolvency and inability to liquidate debts), resulting in a financial crisis.

During a financial crisis, it is the central bank that issues currency on the liability side and purchases various types of debt assets on the asset side to alleviate market distress, i.e., through quantitative easing, the central bank's balance sheet expands significantly at the cost of buying time for the entire system's collapse. The aforementioned CDO example illustrates the credit expansion, leverage accumulation, and balance sheet growth paths at each stage of the system.

DeFi Has Formed a Primary Financial System

The DeFi market can draw lessons from the worldview of traditional financial markets, but there are significant differences in market structure.

The DeFi system is very simple; we can think of it this way:

• MakerDAO is the central bank of the decentralized financial world (+Repo market)

• Aave and Compound are equivalent to commercial banks

• Other yield aggregation protocols are akin to non-bank financial institutions

By constructing such a simple analytical framework, we can analyze and explore how DeFi might develop next.

In the blockchain world, the most basic assets are BTC / ETH. Later, the emergence of stablecoins (especially USDT) began to create a credit system in the blockchain domain, making the financialization of digital assets and the robust development of the DeFi market possible. USDT was the first to introduce dollar credit by pegging to fiat currency, thus creating USDT for BTC collateral loans to meet the demand for credit expansion (margin trading). Similarly, MakerDAO issued the stablecoin DAI, collateralized by ETH, forming a financial market prototype similar to a central bank issuing currency.

Once the foundation for credit expansion is established, the market will need more efficient ways to accumulate leverage. Lending protocols like Aave and Compound began to emerge in a manner similar to commercial banks. The rise of lending protocols also expanded the pathways for credit expansion. On the asset side of lending protocols, an increasing number of ERC-20 tokens began to be used for lending, and the explosive growth of liquidity mining further drove the surge in lending demand. On the liability side of lending protocols, yield aggregators like Yearn Finance, Pickle Finance, and Harvest Finance absorbed more funds and improved the efficiency of leveraged capital flow.

In terms of the core business logic of credit expansion in the current DeFi market, a relatively complete foundational financial system has formed in less than three years:

• Creating base assets using BTC / ETH as collateral (e.g., MakerDAO and Synthetic's synthetic assets)

• Oracles (ChainLink)

• Trading platforms (Uniswap, Balance, Curve)

• Lending protocols (Aave, Compound)

• Aggregators (Yearn Finance, Pickle Finance, APY…)

• Wallets (MetaMask, Mask Network)

All of these have formed a complete business chain, and relative market leaders have emerged at each stage.

We believe that the leading projects in each segment have already occupied a high position in the ecosystem, and the current market structure is quite unfriendly to new entrants, with the competition becoming somewhat overcrowded.

However, by comparing the aforementioned CDO product examples, it is clear that compared to traditional finance, DeFi is still in a relatively primitive stage. There remains a significant gap in credit richness and the complexity of leverage tools, which means that the DeFi market has great potential for transformative developments in the next phase.

Where Will the Next Ecological Opportunities Come From?

Opportunities lie in providing the highest quality credit and more effective leverage pathways for the market.

First and foremost, the next step in DeFi development urgently requires the expansion of the entire cryptocurrency world’s balance sheets, which means that emerging DeFi protocols need to further unleash the credit expansion potential of the current DeFi ecosystem and introduce more new base assets that can expand credit issuance.

To unleash credit expansion potential, we can start with credit ratings of different assets.

In traditional financial markets, we can see that the public sector, commercial banking sector, non-bank corporate sector, and private sector naturally exist in a hierarchy of credit ratings from strong to weak. Credit currency, as a liability of the central bank, requires support from government bonds and other safe assets, and if further expansion is needed, lower-tier qualified collateral, such as MBS, will be required.

As a decentralized protocol, DeFi does not have a credit rating based on entities but has gradually formed credit ratings based on business assets. Observing the balance sheet of MakerDAO, which acts as the "central bank," DAI, as Maker's debt, needs to rely on qualified collateral for issuance. The highest-rated credits on Maker's asset side are ETH and BTC, followed by stablecoins like TUSD (TrustToken) / PAX (Paxos) / USDC (Circle). If the DeFi market needs more DAI, Maker will need to expand its balance sheet. The first possibility that arises is also a limitation: the DeFi market lacks qualified collateral.

We believe that in the overall balance sheet of the DeFi market, BTC and ETH play a role similar to gold or government bonds, while stablecoins like USDC and DAI are positioned at the second layer as foreign exchange reserves or central bank debt; yTokens, aTokens (aUSD), cTokens (cUSD), sTokens (sUSD), and uTokens (uUSD) are at the third layer in a form similar to commercial bank liabilities; Altcoins and other LP Tokens are at the fourth layer in a form similar to corporate debt.

Currently, in the DeFi market, the greatest potential for unleashing credit expansion lies in the second layer (stablecoins) and the third layer (yield-bearing tokens).

For example, yield-bearing stablecoins like uUSD, yToken, aToken, cToken, and other assets with future income characteristics can be included as collateral or packaged into debt derivative instruments for financial innovation. The circulation of these yield-bearing tokens can release more liquidity, thereby increasing the leverage level of the entire system.

Additionally, there is the potential to expand assets in the fourth layer, i.e., corporate debt, such as introducing real-world financial assets (like supply chain or consumer finance) into the blockchain world (Centrifuge, NAOS Finance) and conducting loans based on off-chain asset collateral, or further exploring unsecured financing (Truefi), thereby expanding the balance sheet through the introduction of new credit.

Vertical Expansion: Utilizing Time Value to Enhance DeFi Leverage

If credit creation and balance sheet expansion are the "horizontal expansion" of DeFi, then enriching the DeFi market and utilizing tools like time value to add leverage is "vertical expansion," as the underlying assets become increasingly complex, leading to more fixed-term and fixed-rate financing needs on the asset side of DeFi protocols.

Therefore, the debt side of DeFi protocols will require liability costs, term management, and risk management, resulting in "vertical expansion" based on interest rate dimensions, bringing a whole new dimension to DeFi and creating more imaginative space.

Recently, the interest rate market has become the hottest topic in the DeFi world.

As mentioned above, our view on DeFi is to answer the question of "how to more effectively achieve credit expansion and leverage accumulation in financial markets." More diversified credits will be introduced as assets into the blockchain, thus driving a new form of credit expansion, which is the "horizontal expansion" of DeFi balance sheets. The core of the interest rate market is to find more effective ways to enhance financial leverage in the DeFi market, which is the "vertical expansion" of the DeFi market. We believe that this new mode of expansion will bring more interesting possibilities to the DeFi market.

Although different from traditional financial institutions, the core of DeFi protocols is to manage their own balance sheets. The difference between the income generated from the asset side and the funding costs from the liability side is retained as profit. Purely from a business perspective, this is not much 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 the DeFi balance sheet expands, more assets will require fixed terms and fixed rates, necessitating more financial tools and markets to increase financial leverage. This will also expose DeFi protocols to the pain points of funding costs on the asset/liability sides, long-term management financial costs, and interest rate risks.

Similar to traditional financial markets, these pain points will give rise to numerous DeFi protocols to take on the role of "non-bank 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. The interest rate market is a new track for deploying new ecosystems. Undoubtedly, these innovators have the potential to become new market leaders at the level of Uniswap, MakerDAO, and Aave.

The Interest Rate Market Will Make Financial Leverage More Effective

Although the concept of interest rates seems simple, establishing viable financial solutions is as challenging as building a decentralized derivatives track. In traditional financial markets, interest rates are a key factor in pricing different risk assets, and the term structure of interest rates can reflect expectations about future interest rate changes.

Interest rates themselves are a very complex system. Central banks can set policy rates, including benchmark rates, excess reserve rates, and rates for various monetary policy tools; the money market has Libor (London Interbank Offered Rate), repo rates, etc.; the credit market has deposit and loan rates; the bond market has rates for government bonds, municipal bonds, and corporate bonds. Different bonds have different ratings, credit levels, and terms, leading to varying interest rates.

Similarly, MakerDAO's interest rate policy includes stable rates and DSR (Dai Savings Rate), while Aave and Compound's rates include deposit and loan rates, as well as liquidity mining in DeFi protocols that offer expected APY rates. These rates clearly have different credit ratings, and they are all floating rates with no fixed maturity dates, and they are subject to strong centralized influences in pricing.

When we discuss interest rates in the context of DeFi, the real issues we need to address are:

• What kind of interest rate market should be established for different credit levels?

• What fixed-income products need to be created to meet the demand for financial leverage?

• How to set and price fixed rates for different terms, i.e., the interest rate term structure (yield curve)?

Three Approaches to Building a Decentralized Interest Rate Market

In traditional financial markets, the government bond yield curve serves as the benchmark for pricing all fixed-income products.

• The benchmark yield curve is constructed using zero-coupon government bonds of different maturities, which can serve as the foundation for pricing the entire DeFi interest rate market.

• Based on the benchmark yield curve and risk spreads, various fixed-income products form the yield curve.

Using the spot interest rate yield curve, we can calculate the forward interest rate curve and then construct the swap yield curve, providing a pricing benchmark for various forward, futures, and swap interest rate derivatives. Ultimately, this can realize the entire CDO product issuance process in the DeFi market and improve the entire interest rate market system.

The establishment of all emerging protocols in the DeFi interest rate market cannot be divorced from this pricing logic for fixed-income products, and all DeFi interest rate protocols should adhere to this logic. On this basis, protocols with different business routes can make breakthroughs at specific points in the upstream and downstream, with three typical development directions:

One is the construction of zero-coupon bonds, such as Yield's ytoken, UMA's uUSD, and Notional Finance. These protocols issue fixed-term zero-coupon bonds collateralized by ETH (e.g., yETH-DAI-3month). The most intuitive form of the product is a fixed-term interest-bearing stablecoin, where the implied interest rate of these bonds is priced through trading or AMM tokens.

This merely replicates the definition of the benchmark yield curve in the traditional financial market, which relies on the credit of zero-coupon bonds. In the DeFi market, zero-coupon token bonds collateralized by ETH have credit similar to government bonds, which can serve as a close substitute for zero-coupon bonds, establishing a basic benchmark spot yield curve for the DeFi market.

Another is the securitization of yield-bearing tokens with future cash flow returns, such as Barnbridge and Benchmark Protocol. These projects draw on the previously mentioned CDO product issuance model, essentially creating new fixed-income products that package cash flows from Aave or Compound for structured securitization financing. They issue priority bonds with fixed rates and subordinated bonds with floating rates.

As the token securitization model matures, such DeFi protocols can merge cash flow returns from more underlying asset pools, issue more tiers of tokens (e.g., introducing intermediate or more levels of priority tiers), and allow users to set appropriate rates for different terms through trading, AMM, or quoting, thereby constructing the yield curve for fixed-income products. The yield curve of these fixed-income products needs the credit backing of underlying assets like cTokens or aTokens, whose credit ratings are similar to financial bonds of commercial banks, belonging to the subordinated tier of ETH-DAI bonds.

The third is the introduction of interest rate swaps, such as Horizon Finance, Swap.rate, and DeFiHedge. An interest rate swap is a forward contract that exchanges one future interest payment stream for another based on a specified principal amount. Interest rate swaps typically involve converting fixed rates to floating rates or vice versa. By obtaining such interest rate swap contracts, DeFi users can convert floating rates into fixed rates with specified terms. Interest rate swaps can be either fixed or floating rates to hedge, arbitrage, or manage interest rate volatility risks. The yield curve in this dimension is primarily hedged, arbitraged, or traded by observing the structure of spot and forward interest rate curves.

However, even with the introduction of interest rate swaps, different DeFi protocols tend to construct fixed rates in very different ways. DeFiHedge and Swap.rate are order book-based interest rate swap trading platforms, but the design of their trading mechanisms is slightly different. Horizon Protocol adopts a combination of token securitization and interest rate swaps, allowing users to bid for the fixed rates they desire. The cash flows of underlying asset returns are allocated based on users' bids from lowest to highest, forming the yield curve through gaming.

The above three methods of constructing the DeFi interest rate market do not have a simple good or bad distinction, as different interest rate protocols have different positions in the business line based on segmented interest rate markets and credit ratings. Most importantly, even when using the same financial tools (such as interest rate swaps), the pricing mechanisms differ, so these DeFi interest rate protocols do not directly compete and currently face different constraints.

For example, zero-coupon bonds occupy a large amount of excess collateral, involve complex lending and liquidation processes, and rely on Uniswap trading or AMM for interest rate pricing. In the early stages of the market with insufficient liquidity, it is challenging to price interest rates effectively through trading. The resulting benchmark yield curve may not reflect the actual interest rate structure. Therefore, it is expected that this bond product will be more suitable for assets with relatively high credit ratings, such as BTC, ETH, and aTokens and cTokens, and will not meet the financial needs of long-tail ERC-20 tokens.

For token securitization, the first requirement is to find a pool of assets that can generate yield cash flows. Clearly, the current options are relatively limited. This type of protocol will grow as the collateral that meets DeFi requirements expands. Furthermore, if it is necessary to determine the implied interest rate of priority bonds through trading or AMM, it also shares similar drawbacks with zero-coupon bonds. If the protocol sets a given fixed rate, the pricing will not be entirely market-oriented, making it difficult to consider it decentralized.

For interest rate swap derivatives, the pricing of such derivatives relies on reliable spot yield curves and forward curves. Currently, in the DeFi market, under the constraints of missing yield curves and lack of liquidity, such swap trading may be inactive. The pricing of such derivatives may deviate from reasonable prices, but interest rate swap trading remains the most direct way for users to lock in interest rate volatility risks.

If we compare the issuance of CDOs in traditional financial markets, we can see that the current DeFi market only meets the demand for packaging credit into financing needs such as loans or bonds.

The following links are still missing:

• Asset securitization and packaging into derivatives

• Structured financing and interest rate pricing

• Establishing interest rate hedging or speculative positions

Only by completing these three links can the DeFi interest rate market form a closed loop, allowing DeFi to effectively answer the question of "how to enhance leverage more effectively."

However, the potential market size of the interest rate market may actually be more than ten times that of the underlying credit market. DeFi interest rate protocols like token securitization, zero-coupon bonds, and interest rate swaps can occupy specific portions of this market and have a high likelihood of growing into new DeFi market giants. As the interest rate market develops, the demand for risk management protocols related to insurance, asset management, and clearing will also increase.

Although the DeFi interest rate market still faces many challenges, DeFi itself has characteristics that align with the objective laws of financial business. We look forward to more novel ideas emerging on the foundation already established in traditional financial markets.

Will yield-bearing stablecoins become the first use case for zero-coupon tokens? Or will they capture market share from stablecoins? Or will they form a completely original DeFi bond market?

When the DeFi interest rate market has a decentralized interest rate pricing anchor, will lending protocols like Aave and Compound be willing to introduce long-term liquidity lending that improves their basic interest rate incentive models? Will decentralized exchanges like Uniswap release redundant assets in liquidity pools to provide more liquidity for the market, further expanding the multiplier effect of DeFi credit expansion?

When DeFi protocols encounter situations of massive redemptions and sharply rising loan demands, will they be willing to issue zero-coupon bonds for short-term borrowing to avoid market runs or improve capital efficiency, thus forming a new market similar to interbank lending?

Will the emergence of new fixed-income products continue to stimulate the development of various investment banking and asset management businesses, thereby creating super-platform protocols with diversified financial service capabilities similar to JPMorgan in an era of mixed financial operations?

The frontier experiments of DeFi have just opened the door to the interest rate market, and behind it lies infinite possibilities.

Hell is empty, and all the devils are here.