DeFi's vertical expansion: interest rate agreements will bring new changes to the decentralized financial world

If credit creation and balance sheet expansion are the "horizontal expansion" of DeFi, then enriching the tools and methods of increasing leverage in the DeFi market is a kind of "vertical expansion."

Written by Kira Sun and Ruby Wu, partners at blockchain investment firm Incuba Alpha

YFI announced the merger of well-known DeFi protocols such as Pickle, Cream, Cover, and Sushiswap in a short period of time, attracting the attention of the entire market. We can't help but worry that when industry first movers begin to use mergers/acquisitions to consolidate their market position, does it mean that the DeFi track is becoming crowded, or the growth rate is slowing down, and the market has entered a pattern of giants dividing up the market share?

Is there still a possibility for the DeFi market to continue to change? We are very optimistic about the answer to this question. The reason why we are optimistic is because of the real changes brought about by DeFi.

The world of value exchange that blockchain hopes to build is most in need of assets. The explosive development of DeFi responds to this desire, introducing "credit" as an asset into the blockchain world for the first time.

The so-called credit is the creditor-debtor relationship generated by the demand for funds. Credit is the cornerstone of the financial market, and the rapid development of the financial market has always been inseparable from the expansion of credit and the accumulation of leverage. Whether in the traditional financial market or the DeFi market, any financial institution or DeFi protocol that occupies a core position in the market has successfully answered this question without exception: they either introduced or created a new type of credit as an underlying asset to promote the process of credit expansion; or they created a certain financial product or trading market to provide a more efficient path to increase leverage for the expansion of credit.

The concept of "introducing credit as an asset" is still in its infancy in the DeFi world. Our worldview and investment logic for DeFi are based on the two directions of "introducing new credit" and "creating leverage methods". By referring to the development path and market ecology of the traditional financial market, we can find some possibilities that are revolutionary for the DeFi market.

The process of credit expansion and leverage accumulation

The ecosystem of the traditional financial market is rich and complex, containing a wide variety of credits and dazzling leverage tools:

The country's financing needs are packaged into sovereign debt; the private sector's financing needs, such as residents' home purchases, car purchases, medical and educational consumption, or the corporate sector's operating capital, capital expenditures, etc., are packaged into various types of debt - these credits are the cornerstone of the financial market. Financial institutions create financial assets such as bonds (such as government bonds) and loans (housing mortgages, credit card loans) based on these credits, and continuously increase leverage through various derivative instruments.

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

Taking the most radical era of financial liberalization before 2008 as an example, we can observe how all participants in the entire financial market are connected through balance sheets from the business path of subprime debt CDO (Collateralized Debt Obligation). Since the structure of the financial market is very complex, we only abstract the core part in the above figure for reference.

Individuals have the demand to buy a house. They buy real estate or land on the asset side and need funds to fill the gap, so credit is generated on the liability side. The commercial banking sector issues loans or purchases bonds on its asset side to support the individual's home purchase financing, and packages various bond assets on the liability side and securitizes them. Non-bank financial sectors purchase credit-rated structured products. After obtaining the funds, the bank can continue to provide housing mortgage loans, thus completing the leverage link.

The entire process of credit expansion and leverage accumulation can continue until credit sinks (people who actually have no ability to repay owe a lot of money) and leverage breaks (subprime debt defaults in large numbers, collateral prices plummet, and debts cannot be liquidated due to insolvency), resulting in a financial crisis. When the financial crisis comes, the central bank prints money out of thin air on the liability side and buys various debt assets on the asset side to save the market - that is, through quantitative easing, the central bank's balance sheet is expanded to pay for the collapse of the entire system. The example of CDO can well describe the path of credit expansion, leverage accumulation and balance sheet expansion in every link of the system.

The DeFi market has formed a primary financial system

The DeFi market can draw on the worldview of the traditional financial market, but there are also very significant differences in market structure.

The DeFi system is very simple. We can regard Maker as the central bank of the decentralized financial world (+Repo market), loan protocols such as Aave and Compound as commercial banking departments, and some yield aggregation protocols as non-bank financial institutions, and build a simple analytical framework to explore the possibility of the next development of the DeFi market through comparison.

In the blockchain world, the most basic asset is BTC. The creation of stablecoins, especially USDT, has enabled credit to appear in the blockchain world, making the development of DeFi possible. USDT was the first to introduce US dollar credit by pegging to US dollar fiat currency, thereby creating a credit expansion of mortgaging BTC to borrow USDT to meet transaction needs. Similarly, Maker issued DAI by mortgaging ETH, forming a prototype of a financial market similar to the issuance of currency by the central bank.

Once the foundation for credit expansion is laid, the market will need more efficient ways and paths to increase leverage, and lending protocols such as Aave and Compound will begin to appear in a form similar to commercial banks.

The rise of lending protocols has also expanded the path of credit expansion. On the asset side of lending protocols, more ERC-20 tokens have begun to be used for lending, and the explosive development of liquidity mining has spawned strong demand for lending; on the liability side of lending protocols, yield aggregation protocols such as YFI, Pickle, and Harvest have begun to absorb more funds and improve the efficiency of leveraged capital circulation.

Based on the core business logic of credit expansion in the current DeFi market, in less than 3 years, the DeFi market has formed a relatively complete basic financial system: creation of basic assets based on BTC/ETH/collateral (such as Maker and synthetic assets) - Oracles (ChainLink) - DEX trading platforms (Uniswap, Balancer, Curve) - Lending protocols (Aave, Compound) - Aggregators (YFI, APY) - Wallets (MetaMask, Trust Wallet) have formed a complete business chain, and relatively leading head projects have been developed in each link.

We believe that the current leading projects in each link have occupied the high position of the ecology, the market structure is not friendly to subsequent competitors, and the existing track is obviously crowded. However, compared with the example of CDO products mentioned above, we can clearly find that the DeFi business model is still very rudimentary compared to traditional finance. There is still a huge gap in the richness of credit and the complexity of leverage paths. This contains the possibility of the next stage of change in the DeFi market.

Where will the next ecological high point opportunity come from?

The high-level opportunity of DeFi ecosystem lies in providing the market with the best credit and a more efficient path to leverage.

The next step in the development of DeFi first urgently needs to expand the balance sheet of the entire ecosystem, which means that emerging DeFi protocols need to further unleash the credit expansion potential of the current DeFi ecosystem and find more new underlying assets that can expand credit.

To release the potential of credit expansion, we can start with the credit rating of different assets. In the traditional financial market, we can see that the public sector, commercial banks, non-bank corporate sector and private sector naturally have a self-strong to weak credit rating. As a liability of the central bank, credit currency needs to be supported by the safest assets such as government bonds on the asset side. If it is necessary to further expand the money supply, it will require lower-level MBS and other qualified collateral.

As a decentralized protocol, DeFi itself does not have a credit rating based on the subject, but the credit rating of assets has gradually formed in the development of the business. Looking at the balance sheet of Maker, the "central bank", DAI, as a liability of Maker, needs to rely on qualified collateral to issue. The highest credit rating on the asset side of Maker is ETH and BTC, followed by stable currencies such as USDC. If the DeFi market needs to rely on the issuance of additional DAI to achieve expansion, Maker needs to expand its own balance sheet. The first possibility and limitation is: the lack of qualified collateral in the DeFi market.

We believe that in the overall balance sheet of the DeFi market, BTC and ETH play a role similar to gold or treasury bonds, and stable currencies such as USDC and DAI are in the second layer in the form of foreign exchange reserves or central bank liabilities; yToken, atoken (aUSD), ctoken (cUSD), stoken (sUSD) and utoken (uUSD) are in the third layer in the form of commercial bank liabilities; Altcoins, other LPTokens, etc. are in the fourth layer of credit in the form of corporate liabilities.

The DeFi market currently has the greatest potential for credit expansion in the second layer (stablecoins) and the third layer (income certificate tokens). Assets with future income characteristics such as interest-bearing stablecoins uUSD, yToken, aToken, cToken, etc. can be included as collateral or packaged into debt derivatives for financial innovation. The circulation of these income certificates can release more liquidity to increase the leverage level of the entire system.

In addition, the inclusion of assets in the form of the fourth layer (corporate liabilities) can be further expanded. For example, financial assets such as real-world supply chains or consumer finance can be introduced into the DeFi ecosystem, such as Centrifuge and Naos.Finance, to achieve lending based on off-chain asset collateral; synthetic assets such as gold or stocks can be introduced, such as Synthetix and Mirror Protocol; or credit lending without collateral can be explored, such as TrueFi, to achieve the purpose of DeFi expansion by introducing new credit.

Vertical expansion: Helping the DeFi market increase leverage

If credit creation and balance sheet expansion are DeFi's "horizontal expansion", then enriching the tools and methods of increasing leverage in the DeFi market is a kind of "vertical expansion": as the underlying assets become increasingly complex, the asset side of the DeFi protocol will face more and more fixed-term and fixed-rate credit demands. Correspondingly, the liability side of the DeFi protocol will also face the need for liability costs, duration management, and risk management, thus forming a "vertical expansion" based on the interest rate dimension. This will bring a new dimension of DeFi market capacity and more possibilities with huge imagination. In this dimension, the development of the DeFi interest rate market is most worthy of attention.

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

As discussed above, our perspective on the DeFi world is to answer the question of "how to achieve credit expansion and leverage accumulation more effectively in the financial market". More diversified credit will be introduced into the blockchain as assets, driving new credit expansion, which belongs to the "horizontal expansion" of DeFi's balance sheet expansion; the core issue of the interest rate market is the need to help the DeFi market improve the efficiency of increasing leverage, which belongs to the "vertical expansion" of the DeFi market. We believe that a new dimension of market expansion will bring more interesting possibilities to the DeFi market.

Although the form is different from that of traditional financial institutions, the core of the DeFi protocol, as a vehicle for conducting financial business, is the management of its own balance sheet. The difference between the cost of funds on the liability side and the income generated on the asset side is deducted and retained as profit. From a purely business perspective, this is not substantially different from the profit model of financial institutions, which provides the most basic business logic for building the DeFi interest rate market.

At the same time, as the balance sheet of the DeFi ecosystem continues to expand, more and more assets will put forward fixed-term and fixed-rate credit requirements, and will also put forward more financial instruments and trading markets that increase leverage, which will make DeFi protocols generally face the pain points of asset-side and liability-side funding costs, duration management, and interest rate risk management. Similar to the traditional financial market, these pain points will give rise to a large number of DeFi protocols that assume similar "non-bank financial institutions" positioning (such as investment banks, insurance companies, asset management companies, etc.). We see that some very innovative interest rate, insurance, risk management and derivatives agreements are emerging in the market at this moment. The interest rate market is a new track for the layout of a new ecology. Among these innovators, there will undoubtedly be new market leaders that can rival Uniswap, Maker, Aave and other levels.

Understanding the DeFi interest rate market: making leverage more efficient

However, the concept of "interest rate" seems simple, but if we really focus on the implementation of the DeFi interest rate market, its difficulty is no less than that of the decentralized derivatives track.

In the concept of traditional finance, interest rates are the benchmark for key factors in pricing major asset classes, and the term structure of interest rates can also reflect people's expectations for future interest rates.

The interest rate itself is a very complex system. The central bank can set policy interest rates, including the benchmark interest rate, excess reserve rate, and various monetary policy tool interest rates; the money market has Libor, repurchase rate, etc.; the credit market has deposit and loan interest rates; the bond market has government bonds, interest-bearing bonds, credit bonds and other interest rates. Different bonds have different ratings, credit ratings, maturities, and interest rates.

Similarly, Maker's interest rate policy includes a stable rate and DSR (DAI Savings Rate), Aave and Compound's interest rates include deposit rates and loan rates, and Curve and other liquidity mining or other DeFi protocols provide expected APY rates. These interest rates obviously have different credit ratings, are all floating rates, have no fixed term, and have a strong centralized influence on interest rate pricing.

When we discuss interest rates in the context of DeFi, the real question we need to discuss is

1. What interest rate markets are constructed at different credit levels?

2. What kind of interest rate products should be created to serve the demand for leverage?

3. How to set and price a fixed interest rate term, i.e., form the term structure of interest rates (yield curve)?

Detailed explanation of the three major directions of DeFi interest rate agreement

In the traditional financial market, the Treasury yield curve is the benchmark for pricing all fixed-income products. The interest rate pricing process requires:

1. The benchmark yield curve is formed through zero-coupon government bonds. With the benchmark yield curve, the DeFi interest rate market can have an anchor for interest rate pricing;

2. Forming a yield curve based on the benchmark yield curve and risk premium through various fixed income products;

3. The forward interest rate curve is calculated based on the spot interest rate curve, and then the swap yield curve is formed, thereby providing a pricing curve for various interest rate derivatives such as forwards, futures, swaps, etc., and ultimately the complete issuance path of CDO products can be realized in the DeFi market, realizing the improvement of the entire interest rate market system.

At present, all emerging protocols dedicated to building the DeFi interest rate market cannot deviate from the scope of this fixed-income product and pricing logic, and all DeFi interest rate protocols follow this logical line, focusing on a single point in the upstream and downstream to make a single breakthrough, mainly forming three typical directions:

1. Create zero-interest bonds, such as Yield's ytoken, UMA's uUSD and Notional Finance. These protocols all use ETH as collateral to issue zero-interest bonds in stablecoins with fixed maturities (such as yETH-DAI-3month). The most intuitive product form is an interest-bearing stablecoin with a fixed maturities. The implied interest rate is priced for such bond tokens through transactions or AMMs.

This form is actually a simple copy of the form of constructing a benchmark yield curve in the traditional financial market. The traditional market needs to rely on the credit of zero-coupon bonds of different maturities, while the DeFi market can use ETH credit similar to treasury bonds to issue bonds as an approximate substitute for zero-coupon treasury bonds, building the most basic and benchmark spot yield curve for the DeFi market.

2. Adopting the token securitization method with cash flow income, such as Barnbridge, Benchmark and Centrifuge. These projects draw on the CDO product issuance method mentioned above. In essence, they create new fixed-income products that can package cash flow income based on Aave or Compound, carry out structured grading and asset securitization, and issue priority Senior Tokens and subordinated Junior Tokens. The subordinated investors bear the floating interest rate, and the priority investors can obtain fixed-term and fixed-interest income.

As the Token asset securitization model matures, such protocols can merge the cash flows of more underlying asset pools, issue more tranches (such as introducing mezzanine or more priority layers), and allow users to discover interest rates of different maturities through transactions, AMMs or quotations, thereby constructing a yield curve for fixed-income products. The yield curve in this dimension needs to be supported by the credit of the underlying assets cToken or aToken, similar to commercial bank financial bonds, and is subordinate to ETH-DAI bonds similar to government bonds in terms of credit rating.

3. Introduce interest rate swap financial derivatives, such as Horizon, Swap.rate, DeFiHedge, etc. Interest rate swap refers to the exchange of fixed interest rate and floating interest rate between two funds with the same currency, principal and term. It is a mature and large-scale financial derivative type in the traditional financial market. DeFi users can sign such interest rate swap contracts to swap floating interest rates for fixed interest rates with counterparties for a fixed term. The yield curve in this dimension is mainly introduced by observing the structure of spot interest rate and forward interest rate curves to hedge, arbitrage or trade interest rate risks with financial derivatives.

However, even though they all use financial derivatives such as interest rate swaps, different DeFi protocols have very different ways of constructing fixed interest rates. DeFiHedge and Swap.rate trade interest rate swap contracts of different maturities through order books, but the trading mechanism design is slightly different. Horizon, on the other hand, adopts a combination of token asset securitization and interest rate swaps, allowing priority users to freely quote the fixed income rate they want to obtain, while subordinated users bear floating interest rates. After maturity, the cash flow of the underlying asset income is distributed in order from low to high according to the quoted interest rate, and a yield curve is formed through the game between users.

There is no inherent advantage or disadvantage among these three paths to building the DeFi interest rate market, because different interest rate protocols are positioned at different positions on the interest rate pricing business line, with different target interest rate markets and credit ratings, and different financial instruments created. Even if the same financial instruments such as interest rate swaps are used, the pricing mechanisms are different. Therefore, these DeFi interest rate protocols are not in direct competition with each other, and they also face different objective constraints at this stage.

For example, the form of zero-coupon bonds requires a large amount of collateral, involves complex lending and liquidation behaviors, and relies on Uniswap transactions or AMMs to achieve price discovery. In the early stages of the market and when liquidity is insufficient, it is difficult to effectively price interest rates through transactions. The resulting benchmark yield curve may not reflect the actual interest rate structure. Moreover, this type of bond product is expected to be more suitable for lending relationships of BTC, ETH, and even high-credit-rating assets such as aToken and cToken, and cannot meet the financial needs of long-tail ERC-20 currencies.

For token securitization, the first thing to do is to find an asset pool that can generate income cash flow. Obviously, the current choices are relatively limited. This type of protocol will achieve substantial development as the capacity of eligible DeFi collateral expands. In addition, if priority tokens need to be priced through transactions or AMMs, they also have similar shortcomings to zero-coupon bonds. If the protocol gives an agreed priority fixed interest rate, the pricing is not completely market-based and it is difficult to call it decentralized.

For interest rate swap derivatives, the pricing of such derivatives needs to rely on credible spot yield curves and forward curves, and is itself downstream of interest rate pricing. Currently, due to the lack of yield curves in the DeFi market and insufficient liquidity in interest rate swap transactions, market trading may not be active. The pricing of such derivatives may deviate more from the fair price, but it is relatively the most direct path for users to lock in interest rate volatility risks.

Interest rate agreements will give birth to a new batch of DeFi giants

If we compare the CDO issuance path in the traditional financial market mentioned above, the current DeFi market has only formed a link of converting financing demand into mortgage assets.

1. Forming derivatives through asset securitization packaging;

2. Conduct structured issuance and interest rate pricing;

3. There is still a blank in the process of establishing interest rate risk hedging or speculative positions.

Only when these three links are completed can the construction of the DeFi interest rate market be considered closed, and DeFi can answer the question of "how to leverage more efficiently".

However, the total market space of these three links may be more than 10 times higher than the underlying credit market. DeFi interest rate protocols such as token securitization, zero-coupon bonds, and interest rate swap derivatives can occupy specific links respectively, and there is a very high chance that a new batch of DeFi market giants will grow.

As the interest rate market becomes more complete, the demand for risk management will become more vigorous, and DeFi protocols such as insurance, risk management, and asset liquidation will also usher in explosive development opportunities.

Even though there are still many huge challenges in building a DeFi interest rate market, DeFi has its own characteristics under the premise of complying with the objective laws of financial business. We very much look forward to more novel ideas in the interest rate field that go beyond traditional financial thinking.

Will interest-bearing stablecoins become the first use case to achieve a breakthrough in the zero-interest bond model, will they seize the share of stablecoins, or form a native bond market?

When the DeFi interest rate market has a decentralized interest rate pricing anchor, are lending protocols such as Aave and Compound willing to introduce long-term liquidity lending designs to improve their own basic interest rate incentive models; will DEXs such as Uniswap release idle assets in the funding pool to provide more liquidity to the market, thereby further expanding the DeFi credit expansion multiplier?

When DeFi protocols encounter short-term liquidity gaps such as huge redemptions and surging loan demand, are they willing to issue zero-interest bonds to borrow from each other to avoid bank runs or improve capital leverage efficiency, thereby forming a new market similar to the interbank lending market?

Will the emergence of new financial products continue to stimulate the development of various investment banks and asset management businesses, thereby giving birth to super platform protocols with diversified financial service capabilities, similar to JPMorgan in the era of mixed financial operations? DeFi's cutting-edge experiments have just opened the door to the interest rate market, and there are infinite possibilities behind the door.

Hell is empty, and all the devils are here.

Hell is empty, and the demons are all on earth.