Currently, there is a total traceable market for fixed income products of approximately $11.9 billion worldwide. But in DeFi, that number is less than a few million dollars.
So why is it so difficult to create fixed-rate asset tools in DeFi? How will the new token standard, ERC-3475, change the existing market landscape? Irons, let’s take a closer look at fixed income and ERC-3475.
How are interest rates determined in DeFi lending?
In the current DeFi market, in order to balance supply and demand, most lending protocols use utilization-interest rate feedback control mechanisms:
The mechanism lowers interest rates to encourage borrowers to borrow when supply in the market exceeds demand, and raises interest rates when supply is less than demand.
Therefore, due to market volatility, it is difficult to maintain stable interest rates on lending agreements (see chart below).
This is where the market demand for fixed-rate assets comes from.
The market demand for stability and predictability comes from:
- In order to have more control over your investment
- In order to develop complex financial products
Before we dive into today’s content, I’ll introduce some terminology to the ironmen.
Face Value: The U.S. dollar paid to bondholders at maturity
Zero-coupon bonds: bonds that do not pay interest during the life of the bond. Investors buy zero-coupon bonds at a lower price than the par value
Let me give the irons an analogy that contains the above terms: you can imagine that a zero-coupon bond is the wheat you grow in the field, and the income you get from the harvest of wheat is the face value. And the seeds you buy to grow wheat are the discounted price you pay for the bonds.
There are currently two fixed-rate models in the DeFi space
Currently, there are two ways to guarantee fixed interest.
Trade “Zero Coupon Bonds”
The borrower issues “bonds” in the form of ERC-20 tokens, which receive the target assets from the lender and repay them at a fixed interest rate after maturity.
The price and interest rate of the issued “bonds” are determined by the supply and demand of the single trading pool in the agreement.
Yield Protocol implements an AMM (Yield Space automatic market maker) that minimizes arbitrage losses with consistent interest rate quotes.
For example, in Uniswap, arbitrage-> transactions occur whenever there is a price change, while this behavior in the Yield protocol only occurs when interest rates change.
Based on a chart comparing the market impact of Uniswap and Yield Protocol. Yield Protocol outperforms Uniswap in terms of both interest rates and market quotes.
Notional Finance differentiates itself by using cTokens (Compound’s packaging tokens) as the underlying asset.
This design enables funds stored in liquidity pools to generate interest over time, improving the capital efficiency of liquidity providers.
Split principal and interest, and then tokenize it
In Element Finance, users deposit their funds into a vault (using Yearn Finance as an example) to get a floating interest rate, mint principal tokens (as zero-coupon bonds) and earnings tokens (variable interest earned).
The agreement creates a “secondary market” for interest rates.
But it also doubles the chances of being exposed to automated market maker risk, as principal and earnings tokens require separate pools. At the same time, interest rate differential issues are more likely to occur.
Interest income earned in the vault can also be redistributed according to risk tolerance.
For example, pool A contains low-risk fixed-rate assets. Pool B includes high-risk, floating-rate assets. Its basic logic is similar to the “principal earnings token” we just mentioned. But the difference here is that this structured product does not rely on an automated market maker.
Barn Bridge issues NFTs in pool A other than ERC-20 tokens, allowing prices to be discovered in internal systems.
Performance and issues with current DeFi fixed-rate agreements
So how are these protocols performing?
Notional Finance outperformed other protocols, with a total lock-up of 73.39 million and an annualized yield of 3.25% on USDC.
All four agreements have experienced a massive decline in total locking, in part because we entered a bear market.
Defects in the protocol itself
Of course, in addition to this reason, these protocols themselves have certain flaws.
The benefits are not ideal
If yield agreements offer slightly the same or even lower than what Aave/Compound offers, then why use them? In addition, competition outside the DeFi space is also fierce, such as the US June DAU annual Treasury rate reached 3.76%.
The choice is limited
Currently, DeFi products are offered for a limited period of several months or up to one year.
In real life, some bonds last for many years and pay investors interest (non-zero) periodically before maturity.
As a result, traditional finance offers more options.
The idea of censorship and decentralization of the DeFi protocol is great, but mass adoption is unlikely to happen if the product doesn’t meet the standards of traditional finance.
However, we now have the opportunity to issue more advanced bonds by upgrading ERC-20.
Why are we issuing new standards? What about the new standard?
The current ERC-20 token standard represents a single entity and has no complex data structures.
For example, if you want to issue DAI-based bonds, you must create a new ERC-20 token, such as fDAI, which is pegged to the DAI and represents the obligation to borrow DAI.
But with ERC-3475, invented by the Debond Protocol, you can now issue bonds directly on the underlying asset (DAI) without having to create a new token.
This is because ERC-3475 can record complex redemption logic (expiration date, coupons, credit quality, etc.), while ERC-20 cannot.
At the same time, ERC-3475 unlocks new applications that cannot be achieved by existing protocols. In reality, for example, a growing company can issue convertible bonds, and bondholders can convert their debt into shares if they agree at a lower interest rate.
This is a win-win for both parties because:
- Companies pay lower interest rates at an early stage
- If the project is successful, the investor gets a profit from the stock
In the context of Web3, early-stage protocols can issue ERC-3475 to raise capital, enabling investors to:
- Lend money to their favorite projects in a safer way
- If they wish to participate more, they have the flexibility to convert bonds to ERC-20 (DAO governance, profit sharing)
All in all, ERC-3475 not only simplifies the issuance of bonds, but also gives us the ability to create a variety of tools.
And as decentralized bonds become more mature, we need Web3 credit rating agencies to better classify assets.
- Bonds in DeFi are a huge undiscovered blue ocean market.
- Due to market volatility, it is difficult to maintain a fixed interest rate.
- We now have a new token system that allows for the issuance of bonds with more complex structures
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/articlelearn-about-the-defi-fixed-income-agreement-and-the-new-bond-standard-erc-3475/
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