Over the past few months, decentralized finance (DeFi) has garnered widespread interest in the mainstream, with more and more ordinary people exploring various DeFi applications and looking to replace inefficient traditional financial products with this user-oriented, decentralized protocol. At this stage, the fixed-rate debt market plays a pivotal role in today’s financial world, with fixed-rate loans accounting for a significant share of the global lending market, where the interest rate remains constant throughout the life of the loan. Because the interest rate is known to be pre-determined, fixed rate loans are less risky and therefore attract many broader, longer and lower risk use cases.
Now, there is a growing desire to “adapt” this traditional financial product model to the crypto industry. To that end, Paul Veradittakit, a partner at Pantera Capital, has written a special article analyzing decentralized fixed-rate crypto lending protocols.
There is no denying that most decentralized financial lending agreements in the market today offer variable rate lending, meaning that the interest rate on the loan will change over the life of the loan. Some decentralized financial lending agreements have loan rates that fluctuate in a range of even between 2% and 65%. Due to this high volatility and low confidence in interest rates, variable rate loans are often considered risky.
With a problem comes a solution, and now a decentralized fixed-rate term loan agreement has emerged for cryptocurrencies on the blockchain. Users can use stablecoins to borrow and lend funds to and from the agreement, or to provide liquidity. And the annualized yields offered by such agreements are generally very competitive, reaching 6-7%. Therefore, decentralized fixed-rate crypto lending agreements such as these are very promising to become one of the most important decentralized financial applications.
How decentralized finance fixed rate lending protocols work
In the case of Notional Finance, for example, typically such decentralized fixed-rate lending agreements deploy several pools of liquidity between the native token and the backing asset, and use custom automated market makers (AMMs) to back fixed-rate loans. Borrowers can withdraw assets from such agreements and, in exchange, they receive a negative balance of tokens in the underlying cryptocurrency (again based on a fixed rate). At maturity, the token balance will require the borrower to return an equal amount of the associated cryptocurrency to the agreement.
When a borrower withdraws assets from a decentralized fixed-rate lending agreement, they generally need to set a maturity date, and unlike lenders, in exchange they receive a negative balance of tokens, the size of which is proportional to the total amount the borrower must pay at the fixed rate at the maturity date. After the maturity date, the token balance is essentially the basis for the borrower’s obligation to provide an equivalent amount of associated cryptocurrency. Similarly, lenders can deposit assets in such agreements and in exchange, they receive the native tokens associated with the cryptocurrency (also based on a fixed interest rate). At maturity, the lender can redeem these tokens for an equivalent amount of the associated cryptocurrency.
Lenders typically also set a maturity date after depositing assets into a decentralized fixed-rate lending agreement, and then receive the native tokens associated with the value of the deposited assets. The number of tokens lenders initially receive is proportional to the number of crypto assets they deposit, meaning that as soon as the maturity date is reached (or later), lenders can redeem the tokens they hold in their hands for the cryptocurrency they initially invested in at a 1:1 ratio, and then also receive a fixed interest return.
In addition, the native tokens are always generated “in pairs”, with one side being the asset (i.e. the credit token) and the other side being the liability (i.e. the debit balance), meaning that the assets and liabilities net out to zero across the ecosystem. To facilitate the efficient exchange of these fixed rates, as well as the tokens and associated cryptocurrencies, such protocols also use several liquidity pools. Each liquidity pool holds the native token and its associated cryptocurrency, meaning that each liquidity pool corresponds to a specific cryptocurrency and a specific maturity date. Both the share of tokens and the number of cryptocurrencies in the liquidity pool change as the maturity date approaches, by matching the rate corresponding to a fixed interest rate in this way. Normally, to manage these liquidity pools, the protocol would also use its own automated market maker (AMM) with custom enhancements (such as dynamic curve sensitivity) to help stabilize rates and reduce slippage (reducing the impact of deposits or withdrawals on the true rate).
Typically, such agreements will support several stable currencies for lending and providing liquidity, with the lending rate fixed for the life of the loan. However, the borrowing rate may vary depending on the loan size, the underlying stablecoin selected, the length of the loan term, and other lending conditions.
It is worth mentioning that some decentralized fixed-rate lending agreements have also introduced a new use case in the decentralized finance sector – fixed-rate lending service. The service has been welcomed by a number of users, especially those who are risk averse and do not want to take on long-term debt. In addition, a number of fixed-rate lending applications have been launched on a number of protocols, mainly including: providing early go sustainable liquidity for new DeFi projects; funding low-risk, low-return trading strategies; and using crypto assets for personal purposes such as paying off home mortgages.
Such fixed-rate based term decentralized loan agreements have been widely used upon release. Some of the agreements have even exceeded $10 million in lock volume value and have processed loan funds at the multi-million level.
Decentralized fixed-rate lending vs. centralized financial fixed-rate lending
As we know, in the traditional financial model, people need to hold and exchange loan assets using fiat currency, while crypto lenders based on the “centralized finance” model use cryptocurrencies. Currently, there are a number of crypto projects in the market that offer fixed-rate crypto loans to users through the “centralized finance” approach, where lenders effectively play a role very similar to that of a central bank.
However, crypto lending agreements based on the “centralized finance” model still have some key issues, such as: low accessibility (similar to most current traditional banking services); poor transparency; and significant counterparty risk (any lending service agent can default on a financial transaction). Therefore, those crypto lending agents based on the “centralized finance” model may be at risk of defaulting on their financial transactions.
Decentralized finance differs significantly from centralized finance, especially decentralized fixed-rate lending agreements, which are often transparent, automated, and liquid. Through decentralized lending services, counterparty risk can be significantly reduced. In addition, lenders and borrowers have full predictability in how funds are used, and loan rates and parameters are often controlled by the user community rather than a centralized institution.
Fixed Rate Lending vs. Variable Rate Lending
The total size of the U.S. debt market is currently estimated at $46 trillion and the total size of the global debt market is estimated at $128 trillion, compared to total outstanding debt of only about $19 billion in decentralized financial lending agreements.
The opening paragraph also mentions that outside of the decentralized finance space, most debt markets are driven by fixed-rate loans. Fixed-rate loans are loans offered at fixed, constant rates, which reduce risk and allow for long-term strategies and leveraged trading positions because such loan contracts give lenders and borrowers more confidence in their borrowing and repayment, and this is why fixed-rate loans dominate countless classic financial use cases.
In decentralized finance, on the other hand, most lending agreements offer variable rate lending, where the interest rate on the underlying lending product can change at any time during the term of the loan. If you want to use these lending agreements, you can only hold or exchange crypto assets, so if there is a high volatility in the cryptocurrency market, it usually triggers a huge shock in the interest rate of these lending products, which further amplifies the risk of variable rate lending. for the average investor who is looking for a low risk and reliable investment is not what they expect to see.
Therefore, the only way to attract more traditional non-crypto users and expand the range of use cases is for lending agreements to offer fixed-rate lending services. Only then can cryptocurrencies be better applied to the financial debt market.
Lending use cases in decentralized finance
Fixed-rate crypto lending agreements in the decentralized financial space are popular with many users, especially those who are risk averse and do not want to take on long-term debt. For example, one of the beneficiaries is traditional lenders, which pay their customers in return at a fixed rate and therefore usually prefer to borrow at a fixed rate. Floating-rate loans can hurt the profitability of these companies and introduce significant risk into their business models.
In addition, trading companies also prefer to borrow at fixed rates rather than floating rates because this model can fund more reliable and lower-return trading strategies; while expected returns may be lower at fixed rates, highly volatile rates can put companies at risk and do not ensure profitability.
We also see that decentralized financial projects in desperate need of liquidity may also seek fixed-rate loan products rather than engage in liquidity mining. With liquidity mining, decentralized financial projects must return a handsome return to the liquidity provider in a relatively short period of time, but the exact outcome depends on the success of the project, which could become unsustainable or even bloodless if something goes wrong, whereas fixed-rate loans can guarantee project liability and obligations over the long term.
Of course, cryptocurrency holders who need liquid assets may prefer to borrow cryptocurrency assets at a fixed rate rather than sell their cryptocurrency assets outright and lose their positions. Fixed rate lending products enable such holders to explore greater investment opportunities, which they can fund flexibly using their own cryptocurrency holdings and with much lower risk. There are reportedly users who have received fixed rate loans directly from fixed rate crypto lending agreements to pay off their entire mortgage mortgages.
Globally, decentralized finance is capturing more of the financial ecosystem’s market share. Platform-based fixed-rate crypto lending products are critical in this process. For the fixed-rate debt market, such protocols actually offer an extremely promising model that allows users to borrow and lend cryptocurrencies at lower risk than ever before, while also greatly expanding the scope of DeFi’s use cases.
There is no doubt that decentralized finance will become a larger share of the global financial ecosystem in the future, and fixed rate loan agreements will continue to improve, such as longer maturity dates that can be set, more types of collateral to choose from, better returns available to liquidity providers, etc.
It is believed that as the cryptocurrency market continues to grow, decentralized fixed-rate loan agreements will unlock more new crypto-finance use cases and bring better returns to investors.
Portions of this article were taken from Paul Veradittakit’s blog
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/pantera-capital-partners-decentralized-fixed-rate-crypto-lending-protocols-in-one-article/
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