This article sorts out the 4 existing fixed income models in DeFi

We all know that fixed-rate returns are uncommon due to the volatility of the crypto market. This is a huge problem for creditors and debtors looking to match fixed-rate liabilities with fixed-rate assets. TradFi (traditional finance) entities in particular need access to a convenient fixed rate solution for proper asset and liability management.

The ability to mitigate the risks associated with a given investment is critical for every type of financial institution (banks, pension funds, insurance companies and hedge funds) and is often achieved through derivatives, which provide high funding for risk management Efficient solutions and often receive more favorable accounting and disclosure treatment than balance sheet restructuring activities.

From the perspective of lenders in the financial market, without effective hedging against changes in ETH pledge yields, lenders cannot provide fixed-rate products that do not face significant interest rate risk. While over-the-counter OTC desks have developed derivative contracts for ETH staking yields, these contracts are inaccessible to many market participants and are off-chain, limiting use cases and integrating the protocol with the composable ecosystem that DeFi provides isolated.

For example, a commercial bank looking to hedge against rising interest rates might choose to sell Treasury futures instead of selling Treasuries in exchange for cash. In this way, the bank retains the interest of the sale on the one hand, and on the other hand, the use of futures contracts avoids the immediate transfer of cash or other assets between counterparties, thereby avoiding a taxable event for the seller.

And ordinary individuals (i.e. users who do not operate according to the “Degen Standard”) also place a lot of importance on mitigating the volatility of their portfolios. In a bear market, when BTC reaches $69,000 and ETH exceeds $45,000, you are likely to trade some potential returns in exchange for protection from the market downside.

Unfortunately, we all seem to want the stars, but end up shooting ourselves in the foot. We all pray for the bull market to resume, but in the meantime, you have a chance to absorb more knowledge than Tai Lopez sitting in a garage full of books and Lamborghinis (BlockBeats note, Tai Lopez is an American influencer who reads books via internet Start a business, go from bankruptcy to a billionaire).

When the next bull market hits, you’ll learn about a variety of fixed income derivatives and products, allowing yourself to better manage your portfolio risk in the next cycle.

Fixed Rate Solutions in DeFi

Developers are already working hard to find solutions to dampen volatility in the crypto market. Some people turn to all kinds of exotic derivatives when looking for the next advanced DeFi product. Currently, there are four common solutions for obtaining fixed income:

1. Income split

2. Interest rate swaps

3. Structured Finance and Transactions

4. Fixed Rate Loans

Analysis of the fixed and variable returns provided by these unique approaches and their respective protocols will allow us to compare future returns between different strategies by adjusting for the return on investment (ROI) of the income stream proportional to the unique risk profile of the underlying asset.

Let’s take a closer look at each.

1. Income split

A yield split protocol, as the name suggests, splits a yield-generating token (such as rETH or stETH) into principal and yield components with known expiration dates.

What is the income and principal?

Imagine borrowing $100 at 6% per annum, repaying it at the end of each month, and repaying the loan within a year. Every month, this generates $0.50 in bank interest. If calculated on a monthly basis, these interest payments yield about 6.17% to the lender. At the end of the year, the borrower must also repay the principal (or loan amount) of $100.

The loan given in the above case represents an interest-only repayment structure, the type employed in debt instrument yield split agreements. Importantly, there must be a definite expiry date for the principal and yield tokens to be priced.

Before that, all the income generated by the underlying assets will only be owned by the income Token holders. When the contract expires, the holder of the principal token will be able to exchange the principal token for the underlying collateral at a ratio of 1:1. Since the income does not belong to the holder of the principal Token, it will be traded at a price lower than the face value of the underlying.

The difference between the underlying asset and the principal token is actually the value of the income token, and the income token will be greater than zero before the contract expires. The formula for determining the value of principal and income Token can be expressed as:

Income Token price + principal Token price = underlying asset price

If the total value of the income and principal tokens is greater than the value of the underlying assets, there is an arbitrage opportunity, and the principal and income tokens can be minted and sold in the market. When the price of the underlying asset is greater than the total value of the yield and the principal Token, there will also be arbitrage opportunities, so that two types of Tokens can be purchased and redeemed to obtain the underlying asset of greater value. Therefore, the total price of principal and income tokens will closely reflect the value of the underlying asset.

The valuation of principal and income tokens is affected by the income generated and the time to maturity. Yields fluctuate over time. Therefore, when the yield increases, the willingness to buy yield tokens will increase, and vice versa. As the expiration of the contract approaches, investors will also be less willing to pay for the income token, because the total amount of income to be generated is low.

Holders and buyers of principal tokens essentially fix their returns, as they can hold their securities until their maturity, and redeem them at that time for a known amount of the underlying asset. There is no interest rate fluctuation, because changes in earnings, whether negative or positive, are borne by the earning token holders.

Protocols using the principal/revenue Token structure include:

1.Element Finance

2.Sense Finance

3.Swivel Exchange

4.Pendle Finance

Although there are subtle differences, these protocols all divide the assets that generate income into principal and income tokens. This structure allows users to engage in leveraged variable rate speculation, where users mint principal and yield tokens from the underlying assets, sell the principal tokens, and purchase more underlying assets, repeating the process until the desired variable rate exposure is achieved or by purchasing principal tokens to lock in a fixed interest rate.

2. Interest rate swaps

Interest rate swaps, while prominent in the TradFi world, have not yet been implemented on a large scale in the DeFi market.

It was first used in DeFi by Voltz Protocol . The premise of Voltz is simple, and the agreement is designed to provide a product similar to a traditional interest rate swap: The buyer agrees to pay a fixed rate and receive a variable rate from the seller. In Voltz’s terminology, buyers of interest rate swaps are called “Variable Takers,” and sellers of swaps are called “Fixed Takers.”

Margin built into the protocol greatly increases capital efficiency, enabling users to hedge or expand their exposure to interest rate volatility with less capital.

Just as the notional derivatives market in TradFi dwarfs the spot market, the notional value of Voltz’s interest rate swaps market has the potential to far exceed the market value of its underlying assets. If this dynamic is the same as the TradFi market, this will be a huge opportunity.

So how does Voltz work?

Fixed rate bearers (swaps sellers) in Voltz can fully collateralize their positions without exposing users to liquidation risk or increasing the risk of potential interest rate changes.

Voltz further improves capital efficiency by modeling the upper and lower bounds on which interest rates are expected to fluctuate before a given pool of funds expires to calculate initial and liquidation margin requirements. Oracles provide the pool with interest rate information and determine cash flow allocations for fixed and variable rate bearers, while virtual automated market makers are used for price discovery.

The nature of the swap means that fixed rate bearers have a known and capped payout. However, variable rate bearers have unlimited upside risk to the variable rate increase offered by the underlying asset. The return matrix produced by this phenomenon incentivizes more speculation within the variable rate bearer group.

Additionally, liquidity providers are critical to the protocol’s ability to provide a seamless trading experience for both fixed and variable rate bearers.

Voltz’s AMM is modeled on Uniswap and adopts the concept of centralized liquidity. Since only one asset is required for trading, LPs on Voltz are not subject to impermanent losses. However, they face losses from what the protocol calls “Funding Rate Risk,” which occurs when there is an imbalance between fixed and variable rate bearer activity and rates fall outside the LP’s liquidity scale.

As a result, the LP now holds an out-of-the-money position. Funding interest rate risk effectively replaces the impermanent losses of spot market AMMs. This is a trade-off that must be considered and balanced against the ability to earn protocol transaction fees.

3. Structured financial instruments and transactions

Tranching protocols also draw inspiration from traditional financial instruments, including the infamous Collateralized Debt Obligations (CDOs), the culprit behind the 2008 financial crisis. There are different noteholders in a CDO, and each class has a different repayment priority.

The current DeFi layered protocols are:

1.Tranche Finance


What these protocols essentially do is segregate liquidity and risk into different pools. Both protocols establish senior (lower risk) and junior pools (higher risk), with senior pools having priority access to any cash flow income from loans or yield farming activities, secured by credit enhancements on the junior tranche. For example, participants in the junior pool will suffer losses when the earnings generated by the underlying are insufficient to repay the senior pool.

In exchange for providing security to senior pool participants, junior pools have the ability to generate additional upside if the total revenue earned by senior pool funds exceeds what is paid to senior pool participants. Participants in the premium pool receive a fixed interest rate and enter positions at or below the current yield generated by the base yield token.

BarnBridge uses the following formula to calculate the yield offered to the premium segment:

Senior Yield = Moving Average Yield * Junior Loanable Liquidity / Total Pool Liquidity (where “Moving Average Yield” is defined as the three-day moving average yield generated by the underlying asset)

In contrast, Tranche Finance votes through governance tokens to determine the fixed rate offered to all fixed rate interest rate bearers, which means that the rate is not fixed and may change at any time. Changes in fixed interest rates may benefit or disadvantage senior segment participants.

The previous iteration of BarnBridge V1, while designed to protect the returns of premium pool participants, did not explicitly guarantee a fixed rate, as the premium pool participants faced a potential drop in returns after the variable rate offered by the underlying securities dropped significantly, so neither did it. Be sure to offer a true fixed rate.

4. Fixed rate loan agreement

Just like their mainstream sister protocols, Aave and Compound, which offer variable-rate loans, fixed-rate loan protocols use an over-collateralized loan model. Unlike a floating-rate loan agreement, however, the lender and borrower agree to a fixed rate, and the resulting transaction looks similar to a zero-coupon bond issued by the borrower.

Fixed rate loans can have a similar clearing process to floating rate loan agreements. At the maturity of the loan, the borrower pays the lender a fixed interest rate. Additionally, the pre-specified term means that lenders cannot access their funds until the loan matures, and borrowers face the impact of prepaying the loan, which is in contrast to the lender’s on-demand withdrawals (if liquidity is available) and borrowers in variable rate agreements. The ability to fully close a position at any time varies.

In a fixed-rate loan agreement, the borrower may incur a default penalty or be forced to close the loan until the contract expires.

A fixed rate loan agreement includes:

1.Notional Finance

2.Yield Protocol


Outperform benchmark rates

At this point, you might be wondering:

“How can I include fixed-rate derivatives and lending strategies in my portfolio to surpass the passive income-generating benchmark rate that comes with ETH staking rewards?”

I used this extremely detailed analysis of block validator returns to establish a benchmark rate for ETH stakers. The analysis was conducted prior to the merger, so I scaled the upper and lower quartile boundaries (optimistic and pessimistic return scenarios) based on current ETH staking yields.

Going back to the whole concept of “mortgage Ethereum can be considered a composite bond, the interest rate may one day be quoted as the spread of the ETH rate of return”, consider this rate of return as a risk-free rate or the lowest rate of return that senior DeFi investors are willing to accept .

While all of the above protocols allow users to hold fixed rate positions, only a few (Voltz Protocol, Element Finance, Sense Finance, Notional Finance, and Yield Protocol) offer yield products that I believe are comparable to ETH staking reward rates.

In the graph below, we compare the estimated ROI by staking ETH over the maturity of the fixed-rate strategy with the return offered by the fixed-rate instrument:

Bankless: This article sorts out the 4 existing fixed income models of DeFi

Current variable APY and APR yields on the underlying asset listed for each asset, image via Bankless

Fixed rates in red represent strategies with lower returns than pessimistic estimates. In contrast, fixed rates shown in orange indicate that the strategy met or exceeded pessimistic forecasts, but failed to exceed expected staking returns. Light green shaded sections meet or exceed expected variable ROI for staking, while dark green sections meet or exceed the most optimistic staking expectations.

Since the variable returns of liquid collateral derivatives and ETH-stETH stable pools are not the same as those of ETH staking, we can assume that they have different risk profiles.

For rETH and stETH, slashing is less risky than independently staking Ethereum, and both protocols provide slashing insurance to protect user deposits. Also, staking with Lido or Rocket Pool is much easier than running your own validator, and users who don’t meet the 32 ETH minimum staking threshold also have the opportunity to participate. Investors trade marginal returns for these guarantees and conveniences, accepting yields below the risk-free rate.

Provide ETH-stETH liquidity for Curve, represented by steCRV principal Token, which also has a different risk profile than simple pledge Lido. In addition to the native smart contract risk and impermanent loss risk within Lido, the enhanced return represents the smart contract risk from Curve. While Curve is battle-tested, the high returns suggest that investors are less willing to accept returns below the current variable APR. If this were not the case, we would expect yields to be close to the current variable ETH staking reward rate. To account for these differences in the risk profile of various major assets compared to Ethereum staking, the estimated variable ROI generated by the staking return analysis is proportionally adjusted for risk.

Unfortunately, I have to announce that the media attention to Voltz has brought a lot of “smart money” to the protocol. Although the protocol looks degen, the fixed ROI generated by the interest rate swap of rETH and stETH is surprisingly close to the expected ROI of Lido or Rocket Pool. Sorry, no obvious arbitrage opportunity here.

But the Voltz protocol allows speculative market participants to place bets based on what they believe the market is moving, and provides sophisticated market participants the only opportunity of any protocol to hedge upside and downside risks at effective rates. If you think the staking reward rate will decrease, you can use the fixed rate provided by Voltz, and similarly, users who are bullish on the staking reward rate can take advantage of the variable rate provided by the protocol.

Element’s fixed-income ETH product has slightly underperformed the expected ROI on staking, but the similarity in returns compared to the variable staking ROI offered by the principal token provides risk-averse investors with the ability to hedge against interest rate fluctuations . Using Element Fixed Income provides a similar end result to using the Voltz protocol, but using a different investment vehicle.

Notional is a little unusual when it comes to fixed loans. Both earlier and longer-term maturity fixed-rate loans offered fixed returns that were lower than pessimistic estimates. In addition, the APR offered by the fixed-rate loan maturing in September was 111% higher than the APR offered by the December note. If this isn’t an inverted yield curve, I don’t know what is. Is a terrible market crash imminent? It’s possible, but we’ll leave that question to the economists.

Yield Protocol also failed to provide the ideal fixed rate for ETH lending. The inefficiency of the fixed-rate loan market may be a direct result of current market uncertainty and volatility, as lenders must lock their ETH to maturity: flexibility and liquidity are critical to portfolio health in a bear market.

Alpha can also be found in fixed income

While several potential arbitrage opportunities have come to the fore, the most enticing may be the fixed yield on ETH offered by Sense Finance until May 31, 2027. Fixing ETH’s annual rate of return at 7.21% is too good to pass up.

This fixed rate exceeds the most optimistic future rate of return, proportionally adjusted for stETH’s risk profile. While the gas fee may increase, temporarily increasing the staking reward rate, it is also plausible that increasing the number of validators will reduce the increase in rewards and thus lower the return on ETH.

Additionally, beacon chain withdrawals are not currently enabled, which means that if the gas fee is further reduced, the number of validators will remain the same, artificially depressing staking yields, as the number of validators can only respond to increases in the gas fee.

Voltz provides the best solution to reduce interest rate risk for participants who wish to obtain “market pricing” for their yield derivatives. Actual market pricing enables entities to hedge portfolio risk and does not force them to take speculative positions on the direction of interest rates. Instead, it allows variable-rate cash flows to be converted from staking to fixed yields at rates that are competitive with expected ETH staking returns.

The ability to fix interest rates in DeFi is critical for the industry to be adopted by traditional financial institutions. The recently launched Voltz is an important innovation in the decentralized fixed-rate derivatives market, not only because the protocol improves capital efficiency, but also because it provides accurate pricing for interest-rate swaps, especially with current alternative fixed-rate product in comparison.

In addition to interest rate risk management protocols, the market inefficiencies of fixed rate protocols compared to staking ETH offer sophisticated DeFi users the opportunity to gain an accessible, low-risk source of returns. In addition, these products provide DeFi users with another source of speculation and enable a new “Degen standard of behavior” that is trading interest rates rather than trading tokens.

As cryptocurrencies become more mainstream, the importance of fixed-rate markets is likely to increase. While the range of practical use cases for yield derivatives today is relatively limited, the rigidity of the crypto market will align the demand for fixed rate products in DeFi with that observed in the TradFi market.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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