Have you watched Howl’s Moving Castle from Hayao Miyazaki?
If you haven’t, please go check it out, it’s an amazing movie. As the name suggests, a magical castle roams across the landscape on a pair of spindly legs.
I find quite a parallel between this wonderful contraption and DeFi. The castle, devoid of symmetry and striking with its eye-catching distorted shape, is a hodge-podge of unrelated parts just like the protocols in the DeFi ecosystem. And the castle moves thanks to the fire demon Calcifer residing in its hearth. That’s not too different from the way the spirit of innovation and creativity motors the DeFi space.
Sound crazy? Well, consider how DeFi transitioned from a set of experiments conducted by tech geeks to the warzone of degen speculations. At this time, the implementation of fixed returns will be a reliable fuel in DeFi’s engines. It will stoke further adoption and let it roam the earth even more freely.
And now that I’m done with metaphors, let’s dive into why we need fixed interest rates and how some of the current DeFi protocols bring it to space.
The shortcomings of DeFi and fixed APY
Certainty is what gives confidence to the markets. The more the uncertainty, the more the businesses are unable to create a consistent model of the future. They must endure a problematic decision-making process on how to allocate their resources for the upcoming years. Companies need to minimize uncertainty and maximize the accuracy of their predictions to pursue long-term objectives without noise.
The desire for certainty is not constrained to business either. We all have varying risk tolerances when it comes to the game of investing and choose different paths when seeking capital efficiency. Some of us want to have a stable and trustable option rather than a riskier one with possible additional gains. Through using saving accounts, these risk-averse capital owners eliminate the uncertainty of the markets in exchange for lower maximum returns and peace of mind, but they may still benefit from a capital gain.
However, since the early adopters of a new technology are seldom constituted of risk-averse people, the first generation of DeFi protocols did not prioritize offering stable income but tried to appeal to its risk-tolerant users with high return potentials.
This resulted in highly lucrative but volatile APYs, which dominated the industry narrative for quite some time. And they still do to a large extent. As you can see below, composite lend rates (DAI-USDC-USDT-ETH) in some of the major protocols had experienced significant fluctuations in the last couple of months.
The volatility in variable interest rates deters investors from participating in the DeFi protocols. Imagine a business depositing USDT to C.R.E.A.M. Finance with an active interest rate of 7.5% on June 7. In just a month, the APY on the deposit would go down to 6.3% and risk further contraction depending on the state of the market.
This volatility means that the business should constantly readjust its expectations on future yield. This requires modeling for future utilization rates of the protocols, future total supply, and total borrow. Going through this test will most likely make the business get cold feet about using DeFi.
Succeeding in the game of yield farming also isn’t easy. It requires frequent trading, active monitoring, and meticulous risk management (HBR, 2021), which can be well beyond the capability of an average investor. Besides, going in and out of positions necessitates deep liquidity, and since most protocols don’t have an adequate TVL for large investments, it becomes difficult for institutions to explore the possibilities of DeFi.
A New Dawn: How do protocols tackle the fixed interest rate problem?
Then there are also certain security issues inherent to the technology (e.g. exploits, bugs, rugpulls, etc.) which render the DeFi services even more unattractive for these people. There are certain insurance protocols (e.g. Nexus Protocol, Cover Protocol, InsurAce) addressing the smart contract security risks, but these protocols are also in their infancy and they also have their own problems that slow down their adoption (Poor UX due to the separateness of DeFi protocols and the lack of fintech applications that can provide a seamless connection; the ambiguity around how to conduct decentralized assessments of insurance claims; the functionalities are not extensively battle-tested to ensure the coverage of large amounts).
All these challenges sow uncertainty and inconsistency and spur the necessity of high yield rates for an appealing risk-reward ratio for investors. While that might be a plausible solution for some, this kind of a trade-off is not good for the risk-averse.
We can summarize the shortcomings that slowed down the general adoption of DeFi in four points:
Volatility in interest rates; poor UX compared to TradFi counterparts; hard to navigate in the space without slippage, and certain risks inherent to DeFi.
Almost all the DeFi protocols strive for optimizing at least three points mentioned above. To get a better perspective on the relationship between fixed APY services and adoption, let’s explore several protocols that aim to mitigate interest rate volatility.
Let’s start with 88mph. This is a community-controlled, fixed-rate, yield-generation protocol built on top of Ethereum. It offers three unique products to its users: Fixed- interest rate bonds (FIRB), zero-coupon bonds (ZCB), and floating-rate bonds (FCB- which are called Yield Tokens in v3). All approach the issue of fixed APY differently and carry differing implications.
Let’s start with FIRBs.
Fixed-interest rate bonds
FIRB is basically a savings account with several DeFi-native sophistications. Investors deposit stablecoins or tokens into the protocol and get a fixed amount of return over a preset lending duration.
88mph v2 FIRB interface
88mph utilizes these funds by putting them into the yield-generating vaults of prevalent DeFi protocols such as Compound, Aave, and Yearn. The fixed interest rate offered to the investors is determined by the 30-day Exponential Moving Average (EMA) of the floating rates on these protocols. However, since 88mph needs to hedge the rate against volatility, it doesn’t offer the full APY, but instead provides 50% of the EMA of the floating rate as the fixed rate.
In return for their deposits, investors get an ERC-721 NFT representing the principal funds which they can hold on to, transfer to other wallets, or trade in the secondary markets. Investors also enjoy a continuous payment of fresh-minted $MPH as a reward for their contribution to the protocol. They can stake these tokens to earn a share from protocol fees and yield farming rewards.
So by purchasing FIRB, investors are able to earn both a consistent passive income and a variable amount of MPH tokens which give them the ownership of the protocol on top of the possibility to earn additional income.
Floating-rate bonds (Yield Tokens in v3)
The second product is floating-rate bonds. FRB don’t provide fixed rates but still play a significant role in maintaining a sustainable protocol.
88mph FRB interface v2
FRBs allow users to fund the debt (fixed interest rate promised to FIRB holders) created by fixed-interest rate bonds by letting them bet on the 30-day EMA of floating-rate APYs used to calculate FIRB (APY in Compound, Yearn, Aave, etc.). If this rate ends up being greater than the fixed interest rate during the lending duration, the protocol distributes the yield promised to FIRB holders. A certain amount of excess undistributed yield gets utilized by 88mph.
FRB purchasers expect that they can get a share of this additional revenue generated when floating-rate APY is greater than FIRB APY. Hence, an appreciation of the floating- rate APYs or a depreciation not greater than 50% are the two scenarios that make FRB profitable.
However, if the floating-rate APY is lesser than FIRB APY, then 88mph uses the funds collected from FRBs to cover the debt. The speculative nature of FRBs make them an undesirable choice for the risk-averse but an attractive one for those with different risk appetite.
FRB with <50% floating-rate APY
The last major product offered by 88mph is ZCB. These are mirrored tokens that do not pay interest like FIRBs but instead trade at a discount and offer full face value of the underlying currency at the time of maturation.
For instance, Alice purchases a ZCB for $80 with an implied interest rate of 25%. This means that Alice will be able to redeem her token for $100 at the maturation date.
While FIRB purchasers get an ERC-721 NFT as a representation of their deposit, ZCB purchasers get ERC-20 tokens wrapped with fixed interest rates. This gives lenders the possibility of owning a more liquid and easily tradable asset class which includes going in and out of positions with minimal friction and additional saving from gas.
Fixed interest rate bonds and zero-coupon bonds let regular investors benefit from owning a savings account in a non-custodial manner. And with the v3 mainnet is just around the corner, 88mph has the potential to play a key role in the gap between DeFi and unsophisticated investors.
Also… They have the coolest radio page I’ve ever seen.
While 88mph protocol provides a fixed interest rate by offering a percentage of the floating rates and creating a hedge with FRBs, Element Finance embraces an innovative approach to the problem. It splits the deposits into two separate fungible tokens, Principal Token (PT) and Yield Token (YT), and capitalizes both through staking and using yield generating vaults on major protocols like Yearn. Having two separate tokens allows Element Finance users to construct various strategies by combining fixed and variable interest rates.
To have a clearer picture of how the protocol functions, let’s have a look at the major components of the protocol.
Principal tokens are the representative token versions of the deposited assets that become one-to-one redeemable at the maturation date (e.g. At the end of the 90 day lock- up period, 1 ep:ETH can be traded for its face value, 1 ETH) .
Element Finance enables principal tokens to be traded at a discount and thus lets its users benefit from a marketplace for fixed-rate income positions. Selling principal tokens and only holding to yield tokens allow investors with higher risk appetites to optimize for the opportunity cost of illiquid assets and benefit from a variable APY.
The other part of the split, Yield tokens are the representative tokens of the variable gain coming from yield generating vaults. The average yield these tokens earn throughout the term is wrapped around the token, meaning that the generated income throughout the term becomes the YTs’ redemption value (e.g. redemption value with 1
eY:yETH with 10% average APY can be redeemed for 0.10 ETH at the end of the term). In other words, other than being a part of the protocol’s splitting mechanism, YTs are practically similar to the widespread variable APY we see in DeFi.
Here is a quick example of how PTs and YTs come together.
Bob deposits 1 ETH to the protocol and mints YTs and PTs into the Yearn yETH vault with 10% APY, and in return, he gets 1 eY:yETH and 1 eP:yETH. One option for Bob is to remain cool with his position throughout the term, redeem 1 eP:yETH for 1 ETH and 1 eY:yETH for 0.1 ETH (if the interest rate on Yearn’s vault stays stable) at the maturation date, having 1.1 ETH in the end.
Minting into a vault with 87 days remaining to its maturation. Principal token value appreciates as we get closer to the maturation date.
However, if Bob decides that the opportunity cost of locking his funds in the protocol is greater than the potential income he’ll receive, he can opt-out of his position. Since Element Finance allows Bob to trade his principal tokens, he can sell eP:yETH to Alice at a discounted rate (e.g. for 0.95 ETH). This lets Alice redeem the principal token for 1 ETH at the maturation date, enjoying a 5.3% fixed APY on her purchase.
Selling PT for a discount
Bob then can either choose to allocate his unlocked funds elsewhere and benefit from a variable interest coming from his eY:yETH, or he can reinvest it in the protocol to increase his capital efficiency in a way that Element Finance calls Yield Token
Compounding. Basically, YTC can be described as the process of selling principal tokens and re-depositing the acquired amount to sell principal tokens again. By following this loop-like action, Bob increases his exposure to yield tokens and takes a leveraged position.
All in all, through splitting the funds into two distinct components, Element Finance not only promises an efficient marketplace for fixed income but also gives investors the opportunity to optimize their capital allocation strategies with PT markets.
One different approach to borrowing and lending with fixed interest rates comes from Notional. The protocol uses fCash, a token representing users’ interactions with the lending/borrowing services and works as a tool for clearing accounting balances within the protocol. The value of each fCash is determined by the amount of cash flow it represents and the maturity date when it becomes redeemable.
On the lending side, fCash works conceptually similar to principal tokens or zero-coupon bonds in the sense that it represents a positive future cash flow to the holders and gives them the right to redeem the token for a predetermined amount of stablecoin. To follow the same accounting principles, fCash is noted with a negative integer on the borrower’s side, indicating debt and thus a future cash outflow.
Leonard as a lender has a positive fCash balance while Barbara has a negative one, showing her total obligation.
Borrowers deposit collateral to mint an fCash and then sell it on the market for instant access to USDC or DAI. The selling process happens automatically, meaning that borrowers do not actively mint and sell fCash, but the protocol does it on their behalf, sends the borrowed amount on their wallet, and creates a future obligation for the borrower. On the other side of the equilibrium lenders buy fCash and hold these tokens until maturity with the expectation to redeem them for fixed profit.
One important thing about Notional’s fixed interest rate mechanism is as follows: The exchange rate is determined at the time of the trade, but doesn’t provide the same rate for each user. This means while Alice lands a 5% income on her deposit, the lender after her, Bob, might get a different rate such as 4.8% or 5.1% due to the change in the amount of fCash and stablecoins in the liquidity pool. This translates into fixed but differing interest rates for the participants.
For trading fCash, Notional uses an AMM with a liquidity curve specifically tailored for low-slippage trading. By calculating the curve with two parameters decided by governance and one parameter decided by liquidity providers, Notional doesn’t fully rely upon the invisible hand of the market, but also upon the practice of actively providing a novel structure to keep the liquidity curve efficient.
fCash is practically minted through lending. And while trading these tokens, users benefit from a fairly low-slippage thanks to Notional’s slippage-minimizing liquidity curve.
Settling matured fCash balances is similar to what we see commonly in major lending platforms. If John is not able to clear its negative fCash at maturity, settlers liquidate a part of John’s collateral. And if John’s free collateral (i.e. the amount of excess collateral beyond the value of debt) goes to or below zero, settlers liquidate John before maturity to secure protocol’s solvency.
Notional introduces a specialized mechanism to pass beyond the fluctuating interest rates and provide fixed and solid income. And all things considered, from the users’ perspective, its lending and borrowing services offer a mixture of the UX that major lending protocols offer (liquidation dynamics) and that redeemable tokens like zero-coupon bonds and PTs offer.
Element Finance and Pendle Finance offer similar practical approaches. They both split the deposited amount into two distinct minted tokens where one represents the underlying asset while the other represents the yield. Nonetheless, On the 151st episode of Blockcrunch, @TN_Pendle from Pendle says that there are certain distinctions between protocols from a design perspective. While Element Finance focuses on the utilization of the principal component (PT in Element Finance, called OT in Pendle) as a yield-bearing asset, Pendle places its focus on the yield component (YT). That’s why most of the development stated on Pendle’s roadmap revolves around yield tokens and AMM rather than OT.
Pendle extends these practical distinctions by introducing a novel type of DeFi derivative: tokens that decay with time. To provide a more efficient and accurate trading of future yield tokens on its AMM, the protocol adds “time” to the constant product invariant formula of the pools. Usually the prices of the tokens in a pool are determined by the supply of the assets (x.y=k). This new formula takes the yield to maturity into account and calculates the value of YTs in the Pendle AMM as a function of future possible yields.
The value of YT differs highly (~4x) as a function of expiry dates (The pool on the left has 525 days until expiry meanwhile right has 161).
Creating a marketplace for the YTs allows a set of strategies to use capital more efficiently.
Similar to how Yield Token Compounding in Element Finance opens up the possibility to get exposure to leverage by trading principal tokens, Pendle AMM offers the same in YTs by enabling investors to speculate on future interest rates. While speculation lets users benefit from floating interest rates, it is not suitable for those who seek fixed income. Therefore, in order to get a fixed interest rate, Pendle users can lock in their funds, mint OTs and YTs, and sell their YTs to cash for a definite income.
For instance, imagine Bob depositing 100 aUSDC to mint 100 YT-aUSDC and 100 OT- aUSDC. After minting, Bob sells his 100 YT-USDC for 5 USDC, immediately getting cash for the future yields. When the lock-up term comes to an end, Bob redeems his OTs for 100 aUSDC, leaving him with 100 aUSDC and 5 USDC. Through selling his variable yields to other investors, Bob fixes his returns and benefits from a pre-acquired fixed interest.
It’s fair to say that Pendle’s AMM for YTs introduces a novel way for trading future incomes. Through optimizing its AMM to minimize IL caused by trading time-decaying tokens, Pendle offers a more efficient marketplace for interest rates and therefore weaves a promising future for its fixed-interest rates services which are powered by variable APY markets.
According to the information shared on the “Next Steps in Institutional DeFi” webinar, Aave is to roll out its fixed-interest rate platform Aave Arc to meet institutional demand. However, there isn’t much information on how this new institutional lending platform will operate. The only knowledge at hand is that Aave Arc will be decentralized, offer a separate pool from other Aave pools, require KYC and whitelisting, and be specifically for institutions and corporations.
Hasan Furkan Gök is a contributing hub analyst at Messari. This is his first guest column for The Defiant.