In the field of traditional finance, fixed-rate lending dominates the market. A lot of loans are made at fixed interest rates for fixed periods. According to statistics, the size of fixed-rate lending and borrowing in traditional finance is 25 times that of variable-rate lending and borrowing. But in the DeFi world, a lot of borrowing is done at variable rates. This means that lenders and borrowers face a lot of uncertainty when doing lending and borrowing, and are unable to determine the income or the cost. The mainstream lending platforms AAVE and Compound, both of which offer mainly variable rate lending, account for $15 billion of TVL, while Element and Notional, which specialize in fixed lending and borrowing, have less than $700 million of TVL. Why variable-rate lending is much larger than fixed-rate lending in DeFi? We think there are three main reasons:
Loans without fixed terms are easier to understand and operate. Users can adjust loans in real-time according to their needs, which is more convenient and more suitable for short-term speculative day traders.
Users' returns are often much higher than the cost of borrowing, making customers insensitive to changes to variable interest rates. In the DeFi world, where you often find hundreds of percent annualized returns, a change in borrowing rates for a few points is trivial;
Liquidity mining incentives offered by mainstream lending platforms AAVE and Compound have lowered borrowing costs and encouraged users to continue borrowing at variable rates. At the same time, the advantages of fixed-rate lending and borrowing are:
Except for DeFi, most debt markets are based on fixed-rate loans. Fixed-rate loans are generally less risky, giving both lenders and borrowers more confidence in their lending contracts, enabling long-term investment strategies and leveraged trading positions. However, variable-rate lending and borrowing cannot offer such certainty.
Variable rate lending mainly serves short-term speculative day-trading cryptocurrency traders with narrow product range, short duration, and high risk. In the event of large fluctuations in the cryptocurrency market, the interest rates of these lending products can fluctuate greatly, further magnifying the loan risk. In Aave's case, in August 2021 alone, USDC's lending rate fluctuated between 1.8% and 69%, making it difficult for lenders and borrowers to plan for investment decisions and appropriate risk hedging.
Fixed-rate lending and borrowing can be used to fund risk-averse investors' low-risk, low-return, and long-term trading strategies, or even can be used for personal use, such as paying off a home mortgage.
3. We believe that as more institutional investors enter the DeFi arena, they are more sophisticated in making clear investment plans and schedules, so the demand for fixed-rate lending will start to increase.
Here are a few fixed-rate lending platforms that are rapidly emerging.
Element
Element Finance is a blockchain protocol based on Ethereum. It allows customers to earn fixed-rate returns over a certain period and currently supports 11 fixed-rate assets and 6 wallets. Since its establishment on June 30, 2021, its TVL has reached $178 million. It raised $32 million in Series A funding in October 2021.
So far, Element has been used by 9,000 users. In the future, continuing to attract individual investors, it is also actively attracting fund managers to participate in the project. The company has launched a program called Treasury Management Initiative to attract other DeFi protocol makers, funds, and institutions to invest in Element.
Structurally, Element divides deposit assets into two parts:
•PT: Principle Token (PT), principal Token
•YT: Yield Token (YT), income Token
For the YT token, if the investor is optimistic about the current rate of return, he can choose to sell YT, that is, sell the right of interest earnings during this period, get prepaid interest, and lock in profits in advance. It can help investors to avoid the impact of future rate fluctuations.
At the same time, if some investors are optimistic about USDC's future return rate, they can buy YT with a small amount of capital, to gain exposure to volatile return rates in a more capital-efficient way. It eliminates the security concerns of the underlying assets, for example, the principal is lost due to security loopholes in the agreement. Moreover, by entering this position, traders can also use it to hedge against interest rates.
After the completion of minting PT and YT, user A can sell PT in the market and retain YT at the same time. In this way, the interest income is locked and the liquidity of the underlying assets is obtained. At this time, PT is similar to a zero-coupon bond, so it will be discounted when it is sold. In this case, when investor B buys PT, it is equivalent to buying the underlying asset at a discount. After maturity, investor B can convert PT into the underlying asset at a 1:1 exchange rate to earn the difference as income. If user A is very optimistic about YT's growth, as long as the discount of PT sold is not higher than YT's yield, user A can continue to cycle the minting process and leverage the income. However, this requires a high level of actuarial and accurate prediction of future underlying asset returns.
Notional
Notional is an Ethereum-based protocol that allows users to borrow crypto assets at fixed rates through an on-chain liquidity pool. Its goal is to provide the DeFi ecosystem with lending markets that can predict interest rates over the long term, thus providing DeFi markets with lending services similar to traditional financial markets.
The project was launched in January 2020 by Teddy Woodward and Jeff Wu at a Hackathon in San Francisco. After one year of research and development, the project was officially launched and quickly gained attention and funding. In April 2021, Notional announced the closing of a $10 million Series A funding round led by Pantera Capital. At that time, Notional had received $17 million TVL and processed $10 million in borrowings. In June 2021, Notional announced plans to upgrade to Notional V2 in November. The changes primarily include extended terms for lenders and borrowers, flexible dates for lenders and borrowers, and announced partnerships with Compound to improve the liquidity provider experience. Within a week, Notional’s TVL reached close to $1 billion.
The company uses on-chain automated market makers (AMM) to offer fixed-rate bonds. The agreement currently offers fixed-rate borrowings for US dollar (USDC) and token (DAI) for up to one year, while wrapped bitcoin (wBTC) and Ether (ETH) for up to six months. According to a news release, the company has received three independent audits from ABDK Consulting, Certora, and Code Arena.
With the help of the "zero-coupon bond" concept, Notional tokenized an online transferable zero-coupon bond into fCash, so each fCash has a Token exchange pool associated with it on the platform. Since the assets allowed to be traded are CTokens (Compound certificates of deposit, which are interest-bearing assets), the liquidity of the exchange pool is made up of fCash and CTokens.
Notional fixed-rate deposit and loan mechanism is as follows:
Fixed-rate deposits: when lenders deposit DAI, Notional deposits it in Compound, converts them into cDAI, then goes to the zero-coupon liquidity pool and buys the discounted fDAI. At maturity Notional redeems the cDAI and converts it back into DAI, earning a fixed interest yield.
Fixed-rate Borrowing: After pledging an asset (such as ETH), the lender mints fDAI, sells it at a discount to cDAI in the exchange pool "fDAI/cDAI", converts it into DAI in the Compound. On the due date, the borrower returns the fDAI face value. The difference between the fDAI and the DAI lent is the borrowing cost.
Currently, the Notional platform supports depositors to deposit ETH, WBTC, DAI, or USDC for fixed interest income, and borrowers to pledge these assets to generate fCash to lend DAI. In addition, users can also be rewarded with Notional Platform token NOTE by providing cETH, cWBTC, cDAI, or cUSDC to provide liquidity to the "fCash/CToken" exchange pool.
With the recent update to V2, the redemption structure has changed significantly, distinguishing between denominations and settlement currencies. fCash is denominated in any base token, but is settled in a separate base token. When the loan matures, fCash is redeemed at the same token value of the CToken, not the underlying token.
Although the introduction of CToken may seem like an unnecessary step in the lending process, it is crucial to Notional's success. Splitting the currency allowed Notional to optimize capital efficiency while maintaining its ability to borrow at fixed rates. Liquidity providers deposit CTokens in pools to enhance their yields as they receive both CToken lending rates and LP fees. CToken balances also incur interest on the underlying crypto assets, thus avoiding the need to roll loans forward. This unique feature makes Notional is the only protocol that allows fixed lending across multiple cryptocurrencies.
Conclusion
We discussed two different approaches to fixed lending and borrowing solutions. Notional used a zero-coupon bond approach, while Element used tokenized income approach. Both of them have robust growth and stable TVL. And we are seeing a lot of new protocols coming, for example, Yield, Hifi, Pendle and so on. These protocols enrich investors’ choices and bring new energy to the DeFi world.
Globally, DeFi is capturing more market share in the financial ecosystem. In this process, the development of platforms of fixed-rate lending and borrowing products is crucial. Such protocols like Element and Notional offer very promising models for the fixed-rate debt market, allowing users to borrow and lend cryptocurrencies at lower risk than ever before, while greatly expanding the usage of DeFi.
There is no doubt that decentralized finance will become a larger share of the global financial ecosystem in the future, as fixed-rate lending and borrowing continue to improve in the following areas, such as longer maturities that can be set, more types of collateral to choose from, and better returns available to liquidity providers.