Fixed DeFi: Crossing the Growth Hurdle

In the past year, myriad fixed-income DeFi protocols have emerged. The creation of YieldSpace by Yield Protocol in late 2020 spurred the birth of numerous protocols, all descending from the original YieldSpace AMM.

Initially designed as an AMM for the trading of fixed-rate, fixed-term bonds, YieldSpace was was adopted by some protocols for their own fixed-rate lending markets, and by others for the purpose of creating interest rate markets on external yield-bearing tokens.

If fixed income is the future of finance, why does the TVL of these protocols look like this?

Total TVL of fixed-income protocols has been on a downtrend since November 2021

In Anna Karenina, Tolstoy writes “All happy families are alike, but every unhappy family is unhappy in its own way.”

In the same way, all fixed-income protocols today are alike in that they have failed to achieve distribution.

Their offerings are often siloed and complex — and can be categorized by one of two fatal flaws:

Fixed Rates in a Silo. These protocols must compete with incumbent lending protocols.Composability without Liquidity. These protocols must attract liquidity from niche market participants. They

Protocols under category 1 offer fixed-rates to users, but on their own fixed-rate lending protocols, which are miniscule in comparison to incumbent protocols. They require a market-wide migration of capital from incumbent lending protocols into nascent fixed-income lending protocols in order to be viable.

Protocols under category 2 may provide a way to earn fixed-rates on 1 or 2 existing DeFi protocols, but their usability relies on the liquidity of their interest rate derivatives markets, which they fail to bootstrap. They must attract and retain a separate niche of market participants for the liquidity of the derivatives markets upon which they depend.

For fixed-rates to be widely available to DeFi users through existing protocols, one of two paradigm shifts must occur: either (a) fixed-rate lending replaces variable-rate perpetual CDP models like Compound, Aave, and Maker or (b) an unprecedented amount of interest rate speculators suddenly enters the space.

Given the product-market fit of CDP lending in DeFi, it seems unlikely fixed-rates will seize their throne anytime soon — most leveraged traders are fairly insensitive to interest rate variability and prefer rolling debt in order to keep positions open for as long as they like.

While interest rate speculation has potential as one of DeFi’s nascent markets, existing interest rate markets suffer from fragmentation — they exist in siloes, which precludes market participants from being able to obtain useful IR exposures, and makes liquidity scarce and expensive.

Interest rate markets serve three types of market participants: hedgers, speculators, and arbitrageurs. In fixed-rate protocols such as Element and Swivel, users locking in fixed rates are sellers of interest rate risk. Who is taking the other side of this trade? (If you said liquidity providers, try again)

Arbitrage opportunities, especially on long-dated crypto interest rate instruments (eg. the 12-month yield of Lido stETH being priced at 4.5% when the current yield is 5.5%), are difficult to measure due to the unpredictable behavior of these yields. Historical data is scarce, and no models exist for describing them. The return on this risk is also negligible compared to other opportunities available to sophisticated market participants.

Speculation opportunities are heavily limited due to the isolated nature of markets. On Element, for example, one can buy long exposure to Lido stETH’s yield through the steCRV — ePyvCurve-stETH principal pool. If I am long the interest rate of Lido stETH, it means I’m expecting it to go up — but against what? Directional bets on overall ETH staking yield can be done through the futures market, which has billions of dollars in liquidity. The backwardation of Ether futures confirms that this has been most traders’ choice.

The result is a market used only by hedgers and of little use to others. Liquidity in these interest rate markets is therefore scarce, which makes fixed-rate staking unusable.

Enabling access to fixed income products at scale is predicated on solving the shortcomings of interest rate markets, and distributing this solution along the path of least resistance.

The main issue with interest rate markets today is that there is no incentive to be naked long interest rate risk. Longing the yield of Lido stETH is not useful in isolation, but being able to bet on the yield of Lido stETH vs. Rocketpool rETH is useful. In fact, being able to bet on performance of protocols in this manner provides much more precise exposure than trading governance tokens.

If interest rate markets were unified across protocols sharing a common numéraire asset (eg. rETH/stETH/cETH), a better mechanism for competition for liquidity may also emerge. Protocols could compete on their 12-month yield on ETH for example, rather than throwing liquidity mining at users only to have them churn after subsidies evaporate.

However, these unified markets still have the high hurdle of attracting adequate liquidity. Suppose 10% of users of a DeFi protocol with $5bn TVL want to earn fixed rates. In order for these users to all lock in their interest rates, the interest rate markets on this protocol’s yield need to be able to absorb $500mm of notional volume.

In effect, this means category 2 fixed-income protocols must attract more liquidity than the incumbent protocols on which they build.

Which begs the question: How can interest rate markets achieve the size they need to become viable?

The answer lies in Metcalfe’s law.

Metcalfe’s law simply states that the value of a network is proportional to the square of the number of nodes in the network. Similarly, we posit that the value of unified interest rate markets grows in proportion to the number of protocols participating in them.

How can fixed rates become accessible throughout DeFi?

One protocol that has taken this network effects-focused approach to this question is Blume.fi.

Blume.fi enables users to earn guaranteed rates on their favorite DeFi protocols. Blume provides an API that enables protocols to effortlessly set up fixed-rate deposits. Their solution is twofold — interest rate markets are unified, and will propagate along the most connected nodes in the network: incumbent protocols.