Improving Web3 Bonds

Improving Web3 Bonds

Written by
Shuting Hou
Date published
September 28, 2022

Fixed income has a total addressable market of $119T worldwide.

But that number in DeFi is under millions. Why is it so hard to create fixed-rate asset instruments in DeFi?How can a new token standard ERC-3475 change the game?

Let's dive in ūüßĶ

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1/ How are rates determined in DeFi lending?

To balance supply and demand, most lending protocols useutilization rate - interest rate feedback control mechanism:When supply > demand in the market, the mechanism decrease interest rate to encourage borrowing. Vice Versa.

2/ Thereby rates are hard to stay stable due to market fluctuations. (See the chart below)That's where the demand for fixed-rate assets comes from. The need for stability and predictability:

- To have more control over their investment

- To develop complex financial products

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3/ Before we dive into today's contents, here're some terms.

face value: the $$$ paid to the bond holder at maturity

zero-coupon bonds: bonds that do not pay interest during the life of the bonds. Investors buy zero coupon bonds at a deep discount from their face value

4/ Here's an analogy to the terms

:Imagine zero-coupon bonds are the wheat you grow in a field, the revenues you gain from the harvest of wheat is the face value.

And the seeds you purchased to grow the wheat are the discount prices you paid for a bond.

5/ Currently, there're two methods to secure fixed interest:

a. Trade "zero-coupon bonds":

The borrowers issue "bonds" in the form of ERC-20 tokens, gain the target assets from lenders and repay them at a fixed rate after maturity.

Source: Yield Protocol whitepaper

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6/ The price and interest rate of issued "bonds" are determined by the supply and demand in a single trading pool in the protocol.

@yield implemented an AMM (YieldSpace) that quote at consistent interest rates, minimizing losses from arbitrage.E.g., In Uniswap, arbitrage ->

7/ trades occur whenever there's a price change, while such behavior in Yield Protocol happen only when interest rate changes.

According to a graph comparing the market impact on Uniswap vs. Yield Protocol, @yield outperforms Uniswap on both interest rate and market quotes.

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8/ @NotionalFinance differentiates itself by using cTokens (Compound's wrapped tokens) as underlying assets.

This design enables the funds stored in the liquidity pool to generate interest over time, increasing capital efficiency for liquidity providers.

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9/¬†b. Split the principal and interest, then tokenize themÔľö

In @element_fi, users deposit their funds into a vault (Yearn Finance for example) to receive a floating interest rate, mint principal tokens (acting as zero-coupon bonds) and yield tokens (variable interest gained).

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10/ The protocol creates "secondary markets" for interest rates. But it also doubles the chances of suffering from AMM risks since separate pools are needed for principal and yield tokens.

Interest rate differential issues are more likely to happen as well.

11/ Interest income earned in vaults can also be redistributed based on risk tolerance.

E.g., Pool A contains lower-risk, fixed-rate assets; Pool B includes higher-risk, floating-rate assets.

The underlying logic is similar to the "principal-yield tokens" we just mentioned->

12/ But the difference here is that such structured products don't rely on AMM.

@Barn_Bridge issues NFTs in Pool A other than ERC-20 tokens, allowing price discovery in an internal system.

13/ So how are these protocols performing?

Notional Finance outperforms the others by having the highest TVL of 73.39M, and a USDC APR at 3.25%.

All four protocols experienced a massive slump in TVL, partially because we entered a bear time, but...

Source: DefiLlama

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14/ There're drawbacks within protocols themselves:

a. unappealing yield

If what Yield Protocol could offer is slightly the same or even lower than the one offered on Aave/Compound, why bother?

The competition outside DeFi is intense as well with 6-month U.S. T-bills at 3.76%.

15/ b. Limited choices

The maturity offered by current DeFi products is limited to months or up to a year.

While in real life, there're bonds last for years and pay interest back periodically (non-zero coupons) to investors before maturity. More options are provided in TradFi.

16/ The ideas of censor-resistant and decentralization is awesome, but if the products can't reach the standard in TradFi, massive adoption isn't likely to occur.

However, we now have a chance to issue more advanced bonds by upgrading ERC-20.

Why? And how?

17/ The current ERC-20 token standard represents a single entity, and don't have a complex data structure.E.g., If you wish to issue a bond based on DAI, you'll have to create a new ERC-20 token, say fDAI, that's pegged to DAI and represent the obligation of borrowing DAI.

18/ But with ERC-3475 invented by @DebondProtocol, you can now issue bonds directly on underlying asset (DAI). No need to create new tokens.

That's because ERC-3475 can record complex redemption logic (maturity, coupons, credit quality, etc.) that ERC-20 can't.

19/ ERC-3475 also unlocks new applications that none of the existing protocols can do.E.g., In reality, growing companies can issue convertible bonds where the bondholders can convert their debt into stock if agreed at a lower rate.

20/ This is a win-win situation for both parties because:

- companies pay lower interest when they're in early stages

- investors get profit from equity stocks if the project gets successful.

21/ In a Web3 setting, early-stage protocols can issue ERC-3475s to raise money, allowing investors to:

a. lend money to the project they like in a safer way

b. have the flexibility to transfer bonds into ERC-20s if they wish to engage more (DAO governance, profit-sharing)

22/ In a word, ERC-3475 not only simplifies the issuance of bonds but also grants us the ability to create various instruments.

And when decentralized bonds get more mature, we'll need Web3 credit rating agencies to better classify the assets.

Hint: Next thread topic

23/ For those who are interested in learning more about @DebondProtocol

24/ Main Takeaways:

- Bonds in DeFi is a huge undiscovered forest

- Maintaining fixed rates is hard due to market volatility

- We now have a new token infra to issue bonds with more complex structure

What are some other usage of ERC-3475 that you think of?

25/ I hope you enjoy reading the thread.