Vertical expansion of DeFi: the decentralized interest rate market has just risen

Andre Cronje (YFI) recently announced the merger of the four well-known DeFi agreements (Pickle Finance, CREAM, COVER Protocol, and Sushiswap) that attracted widespread market attention. When the industry's top leaders began to consolidate their market position through mergers/mergers and other methods, we couldn't help but start thinking about whether this meant that the competition on the track in the DeFi industry became too crowded, the development speed began to slow down, and the market gradually Turn to the pattern of giant carve-up.

"Can DeFi continue to grow?"

We are very optimistic about this issue. Investigating the reasons, we can start with the real changes brought by DeFi.

"Assets" are currently the most scarce resource in the world of value exchange built by blockchains. The explosive growth of the DeFi industry is in response to this demand because it introduced "credit" as an asset into the blockchain world for the first time .

The so-called "credit" refers to the relationship between creditors and debtors based on financing needs. Credit is the cornerstone of the financial market. The rapid development of a financial market is inseparable from the expansion of credit and the accumulation of leverage. Whether in the traditional financial market or in the DeFi market, the top participants have a deep understanding of this sentence, and promote the expansion of the underlying assets by quoting or issuing a new type of credit as a basic asset; or create a new asset More efficient financial products or market platforms facilitate the accumulation of financial leverage.

In the DeFi world, "introducing credit as an asset" is still in a relatively early conceptual stage. There are two main investment directions:

Introduce new credit assets and introduce new methods of adding financial leverage

After referring to the development of the traditional financial market, we have discovered some potential interoperability with the future development of the DeFi industry.

The process of credit expansion and leverage accumulation

The market ecology portrait of traditional finance is very rich and complex, including a large number of different credits and dazzling leverage addition tools:

The government/country's fiscal financing needs will be packaged into sovereign debt. Individual financial needs (such as real estate, cars, medical care, education, and consumption) and corporate financial needs, such as working capital and capital expenditure, are all packaged into different debt combinations.

These credits form the backbone of the financial market. Financial institutions create different financial assets (such as treasury bonds, mortgage loans, or credit card loans) on these debts, and continuously increase leverage through financial derivatives.

As a result of credit expansion and leverage accumulation, the balance sheets of all participants in the entire financial market continue to expand and grow.

Recall the most radical era of financial liberalization before 2008. From the issuance of Collateralized Debt Obligation, we can observe how all participants in the financial market are connected through their balance sheets.

In view of the complexity of the financial market structure, we abstract the core content in the above figure for reference.

Under the above circumstances, credit is generated and circulated among all parties through the following channels:

When an individual wants to buy a house (on the asset side) but needs a loan to provide financial support, credit will be generated on the liability side. Commercial banks issue loans or purchase bonds on the asset side to support individual housing financing, and on the liability side, they package and securitize various types of bond assets to form structured products. The purchase of structured products with credit ratings by the non-bank financial sector can enable banks to recover funds and then provide new mortgage loans, thus completing the process of increasing financial leverage.

The entire process of credit expansion and leverage accumulation can continue to run until credit declines (people with bad credit get a lot of financing) and leverage breaks (subordinated debt defaults, collateral prices plummet, reaching insolvency and making it impossible to liquidate debts) Situation), resulting in a financial crisis.

When the financial crisis broke out, it was the central bank that issued currency on the debt side and purchased various types of debt assets on the asset side to bail out the market. That is, through quantitative easing, the central bank’s balance sheet expanded substantially at the expense of The collapse of the entire system pays for it. The above CDO example illustrates the credit expansion, leverage accumulation, and balance sheet growth path of each stage of the system.

DeFi has formed a rudimentary financial system

The DeFi market can learn 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 like this:

MakerDAO is the central bank of the decentralized financial world (+Repo market). Aave and Compound are equivalent to some other aggregate income agreements of commercial banks, which are equivalent to non-bank financial institutions.

It is possible to analyze and explore the possibility of how DeFi will develop next by constructing such a simple analysis framework.

In the blockchain world, the most basic asset is BTC/ETH. Later, the emergence of stable coins (especially USDT) began to create a credit system in the blockchain field, making it possible for the financialization of digital assets and the strong development of the DeFi market. USDT took the lead in introducing US dollar credit by pegging US dollar legal currency, thus creating USDT for BTC mortgage loans to meet the demand for credit expansion (margin trading). Similarly, MakerDAO issued a stable currency DAI with ETH as collateral, forming a financial market prototype similar to the currency issued by the central bank.

Once the foundation for credit expansion is laid, the market will need more and more efficient ways to stack leverage. Lending agreements such as Aave and Compound began to appear in the form of similar commercial banks. The rise of loan agreements has also expanded the path of credit expansion. On the asset side of the lending agreement, more and more ERC-20 tokens have begun to be used for lending, and the explosive growth of liquidity mining has driven the surge in lending demand. On the liability side of the loan agreement, income aggregators such as Years Finance, Pickle Finance, and Harvest Finance have absorbed more funds and improved the efficiency of leveraged capital flows.

As far as the core business logic of credit expansion in the DeFi market is concerned, in less than three years, a relatively complete basic financial system has been formed:

Use BTC/ETH as collateral to create basic assets (such as MakerDAO and Synthetic’s synthetic assets) oracles (ChainLink) trading platforms (Uniswap, Balance, Curve) lending protocols (Aave, Compound) aggregators (Yearns Finance, Pickle Finance, APY) …) Wallets (MetaMask, Mask Network)

The above has formed a complete business chain, and relative market leaders have emerged at all stages.

We believe that the current leading projects in various links have occupied a high ecological position, the existing market structure is very unfriendly to subsequent new competitors, and the current track is already a bit too crowded.

However, by comparing the above CDO product examples, it can be clearly seen that DeFi is still at a relatively primitive stage compared with traditional finance. There is still a big gap between the richness of credit and the complexity of leverage tools, which means that the DeFi market has great potential for change in the next stage.

Where does the next high ecological opportunity come from?

The opportunity is to provide the market with the highest quality credit and more effective leverage.

First, and most importantly, the next step in the development of DeFi is the urgent need to expand the balance sheet of the entire cryptocurrency world, which means that the emerging DeFi protocol needs to further release the credit expansion potential of the current DeFi ecosystem and introduce more that can be expanded New basic assets for credit investment.

In order to release the potential for credit expansion, we can start with the credit ratings of different assets.

In the traditional financial market, we can see that the public sector, commercial banking sector, non-bank corporate sector, and private sector naturally exist in the credit ratings of entities that are strong to weak. Credit currency, as a central bank's liability, requires the support of national debt and other safe assets, and if it is necessary to further expand the amount of input, it will require low-level qualified collateral, such as MBS.

As a decentralized protocol, DeFi does not have a credit rating based on the subject, but has gradually formed a credit rating based on business assets. Observe the balance sheet of MakerDAO as the "central bank". As Maker's debt, DAI needs to rely on qualified collateral to issue. The highest credit ratings on the Maker asset side are ETH and BTC, followed by stable coins such as TUSD (TrustToken) / PAX (Paxos) / USDC (Circle). If the DeFi market needs more DAI, Maker will need to expand its balance sheet. The first possibility appears, but it 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 have played a role similar to gold or national debt, and stable currencies such as USDC and DAI are in the second layer in the form of foreign exchange reserves or central bank debt; while yToken, atomic ( aUSD), ctoken (cUSD), stoven (sUSD) and utoken (uUSD) are in the third tier in the form of similar commercial bank liabilities; Altcoins and other LPTokens are in the fourth tier in the form of similar corporate debt.

At present, in the DeFi market, the greatest potential for credit expansion to be released lies in the second layer (stable currency) and the third layer (revenue certificates).

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

In addition, the fourth level is to expand the assets in the form of corporate debt. For example, financial assets in the real world (such as supply chain or consumer finance) will be introduced into the blockchain world (Centrifuge, NAOS Finance) and be based on off-chain asset mortgages. Loans, or a further attempt to explore unsecured financing (Truefi), thereby expanding the balance sheet by introducing new credit.

Vertical expansion: using time value to increase the leverage of DeFi

If credit creation and balance sheet expansion are the “horizontal expansion” of DeFi, then enriching the DeFi market and using tools such as time value to increase leverage is “vertical expansion” because the underlying assets become more and more complex, and the asset side of the DeFi agreement Will face more fixed-term and fixed-rate financing needs.

Therefore, the debt side of the DeFi agreement will require debt cost, maturity management and risk management, which will lead to "vertical expansion" based on the interest rate dimension, which brings a whole new dimension to DeFi and brings more room for imagination.

Recently, the interest rate market is becoming 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 the financial market". More diversified credits will be introduced into the blockchain as assets, thereby promoting a new kind of credit expansion, which is the "horizontal expansion" of DeFi's balance sheet expansion. The core of the interest rate market is the need to find more effective ways to increase the financial leverage in the DeFi market, which is the "vertical expansion" of the DeFi market. We believe that this new expansion method will bring more interesting possibilities to the DeFi market.

Although different from traditional financial institutions, the core of the DeFi agreement is to manage its own balance sheet. The difference after deducting the capital cost on the liability side from the proceeds generated on the asset side is retained as revenue. From a purely commercial point of view, 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 and more assets will require fixed maturity and fixed interest rates, and more financial instruments and markets will be needed to increase financial leverage. This will also make the DeFi agreement face the capital cost of the asset/liability end, the financial cost of long-term management and the pain points of interest rate risk.

Similar to traditional financial markets, these pain points will generate a large number of DeFi agreements to assume the positioning 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 agreements are emerging on the market. The interest rate market is a new track for the deployment of a new ecosystem. There is no doubt that these innovators will likely become new market leaders at Uniswap, MakerDAO, and Aave levels.

Interest rate markets will make financial leverage more effective

Although the concept of interest rates may seem simple, building a viable financial solution is as difficult as building a track for decentralized derivatives. In traditional financial markets, interest rates are a key factor in the pricing of different risky assets, and the term structure of interest rates can also reflect people's expectations for future interest rate changes.

The interest rate itself is a very complex system. The central bank can set policy interest rates, including benchmark interest rates, excess reserve interest rates and interest rates for various monetary policy instruments; there are Libor (London Interbank Offered Rates) and repurchase rates in the money market; deposit and loan interest rates are available in the credit market ; The bond market has interest rates such as treasury bonds, municipal bonds and corporate bonds. Different bonds have different ratings, credit ratings and maturities resulting in different interest rates.

Similarly, MakerDAO's interest rate policy includes stable interest rates and DSR (Dai deposit interest rate), Aave and Compound interest rates include deposit and loan interest rates, and liquid mining such as Curve or other DeFi protocols that provide expected APY interest rates. These interest rates obviously have different credit ratings. They are all floating interest rates, have no fixed maturity date, and have a strong centralization effect on pricing.

When we discuss interest rates in the context of DeFi, the real issues that need to be discussed are actually:

What kind of interest rate market should be established at different credit levels, which fixed-income products should be created to meet the needs of financial leverage. How to set and price fixed interest rates with different maturities, that is, interest rate term structure (yield curve)

Three ways to build a decentralized interest rate market

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

The benchmark yield curve is constructed through zero-coupon government bonds of different maturities, which can be used as the basis for pricing the entire DeFi interest rate market. According to the benchmark yield curve and risk spread, a yield curve is formed through various fixed-income products. Based on the spot interest rate yield curve, calculate the forward interest rate curve, and then construct the swap yield curve, so as to provide a pricing benchmark for various forwards, futures and swaps and other interest rate derivatives. Finally, the entire CDO product issuance process can be realized in the DeFi market, and the entire interest rate market system can be improved.

The establishment of all emerging agreements in the DeFi interest rate market cannot be separated from the pricing logic of this fixed income product, and all DeFi interest rate agreements should follow this logic. On top of this, agreements on different commercial routes can make a single-point breakthrough to a certain point upstream and downstream, and there are three typical development directions:

One is the construction of zero coupon bonds, such as Yield's ytoken, UMA's uUSD and Notional Finance. These agreements take the form of issuance of fixed-term zero coupon bonds with ETH as collateral (for example, yETH-DAI-3month). The most intuitive form of the product is an interest-bearing stable currency with a fixed term, in which the implicit interest rate of these bonds is priced through trading or through AMM tokens.

This is just a copy of 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 national bonds, which can be used as an approximate replacement for zero-coupon bonds to build a basic benchmark spot yield curve for the DeFi market.

The other is the securitization of revenue tokens with future cash flow returns, such as Barnbridge and Benchmark Protocol. These projects draw on the aforementioned CDO product issuance model and essentially create new fixed-income products that package cash flows from Aave or Compound for structured securitization financing. Issue priority bonds with fixed interest rates and subordinated bonds with floating interest rates.

As the token securitization model matures, such DeFi protocols can combine cash flow returns from more basic asset pools, issue more tokens (for example, introduce intermediate or more priority files), and allow users Through trading, AMM or quotation, the appropriate interest rates for different periods are set to construct the yield curve of fixed income products. The yield curve of these fixed-income products requires the credit of the underlying asset cToken or aToken as a backing. Its credit rating is similar to the financial bonds of commercial banks, which are subordinate to ETH-DAI bonds.

The third is to introduce interest rate swaps, such as Horizon Finance, Swap.rate, DeFiHedge, etc. An interest rate swap is a forward contract that exchanges one type of future interest payment flow for another according to a specified principal amount. Interest rate swaps usually involve the conversion of fixed interest rates to floating rates, or vice versa. By obtaining such interest rate swap contracts, DeFi users can convert floating interest rates into fixed interest rates with a fixed term. Interest rate swaps can be fixed or floating interest rates in order to hedge, arbitrage or manage the risk of interest rate fluctuations. The yield curve in this dimension is mainly used to hedge, arbitrage or transaction interest rates by observing the structure of the spot and forward interest rate curves.

However, even with the introduction of interest rate swaps, different DeFi agreements tend to construct fixed interest rates in very different ways. DeFiHedge and Swap.rate are interest rate swap trading platforms based on order book, but the design of the trading mechanism is slightly different. HorizonProtocol uses a combination of token securitization and interest rate swaps, allowing users to bid on the fixed interest rates they need. According to the user's lowest bid to the highest bid, the cash flow of the basic asset income is distributed, and the yield curve is formed through the game.

The above three ways of constructing the DeFi interest rate market are not simply good or bad, because different interest rate agreements have different positions on the business line for the segmented interest rate market and credit rating. The most important thing is that even if the same financial instruments (such as interest rate swaps) are used, the pricing mechanism is different. Therefore, these DeFi interest rate agreements are not in direct competition, and currently face different constraints.

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

For token securitization, the first thing is to find an asset pool that can generate income cash flow. Obviously, the current options are relatively limited. This type of agreement will grow with the expansion of collateral that meets DeFi requirements. In addition, if it is necessary to determine the implied interest rate of a senior bond through transaction or AMM, it also has similar disadvantages as zero coupon bonds. And if the agreement sets a given fixed interest rate, the pricing will not be completely market-oriented, so it is difficult to think of it as decentralized.

For interest rate swap derivatives, the pricing of such derivatives relies on reliable spot yield curves and forward curves. Currently, under the constraints of the lack of yield curve and lack of liquidity in the DeFi market, such swap transactions may not be active. The pricing of such derivatives may deviate from reasonable prices, but interest rate swap transactions are still the most direct way for users to lock in the risk of interest rate fluctuations.

If we compare the issuance of CDOs in the traditional financial market, we can see that the current DeFi market only satisfies the need to package credit into financing such as loans or bonds.

The following links are still missing:

Asset securitization and packaging into derivatives

Structured financing and interest rate pricing

Establish interest rate hedging or speculative positions

Only by completing these three links can the DeFi interest rate market form a closed loop and DeFi can answer the proposition of "how to increase leverage more effectively."

However , the potential market size of the interest rate market may actually be more than 10 times that of the basic credit market. DeFi interest rate agreements such as token securitization, zero-coupon bonds and interest rate swap derivatives can occupy a specific part of this market and have a high chance of growing into a new DeFi market giant. With the development of the interest rate market, the market's demand for insurance, asset management, liquidation and other risk management agreements will also increase.

Although the DeFi interest rate market still faces many challenges, DeFi itself has characteristics that conform to the objective laws of financial business. We look forward to more innovative ideas that will burst out on the basis of the established traditional financial markets.

Will interest-bearing stablecoins become the first use case of zero-interest tokens? Or occupy the market share of stablecoins? Or form a completely primitive DeFi bond market?

When the DeFi interest rate market has a decentralized interest rate pricing anchor, are lending agreements such as Aave and Compound willing to introduce long-term liquidity loans that can improve their basic interest rate incentive model? Will decentralized exchanges such as Uniswap release redundant assets in the liquidity pool to provide more liquidity to the market, thereby further expanding the multiplier for DeFi credit expansion?

When the DeFi agreement encounters short-term liquidity shortages such as huge redemptions and sharp rise in loan demand, are you willing to issue zero-coupon bonds with short-term borrowings to avoid a run on the market or increase the efficiency of capital use, thus forming a brand new similar to banks The market for inter-bank lending?

Will the emergence of new fixed income products continue to stimulate the development of various investment banks and asset management businesses, so as to create a super platform agreement with diversified financial service capabilities similar to JP Morgan Chase in the era of financial mixed operation?

DeFi's cutting-edge experiments have just opened the door to the interest rate market, and there are endless possibilities behind it.

Hell is empty, and all the devils are here.

The hell is empty and the demons are in the world.

Source of this article: Coin World