DEFI BLOG SERIES
Building Yield Curve for Decentralized Finance
A missing piece to complete institutional-grade finance
Introduction
In cryptocurrency, most lending service on decentralized finance (DeFi) projects provide pool-based yield farming. In traditional finance classification, this market could be categorized as a money market, however; we haven’t seen a capital market so far. We discuss how to build the capital market for crypto currency to achieve full-scale Decentralized Finance that seamlessly migrate into traditional finance. This is the third article of the DeFi blog series presented by Secured Finance.
Money Market: For short-term (less than 1y) finance.
Capital Market: For long-term (more than 1y) finance.
Counterparty Risk
In DeFi, users don’t have credit history; therefore, hedging the counterparty risk depends on over-collateralization. If the price fluctuation goes beyond the buffer, then users have to provide more collateral; otherwise, the collateral will be liquidated with a penalty.
To avoid liquidation, users should maintain a high collateral ratio. DeFi has no middleman who does margin calls. Therefore, the static collateral amount tends to be high. According to this article, the average collateral ratio is 348%. This inefficient use of capital is the bottleneck for institutions to join Decentralized Finance.
The high volatility of crypto-assets limits lending service maturities, generally up to 90 days. To manage those risks and extend maturities, we need to develop a collateral management system like traditional banks have. Also, credit scoring is another approach and you may explore from here.
Collateral Management
The core of the collateral management system is calculating the present value of financial products where its price changes all the time. Traditionally, a bank’s middle office calculates a present value, and if collateral is not enough, they do a margin call on a daily basis. Financial technologies let us build a financial model to calculate the present value of long-term, complex cash flows.
For example, in the 5y loan below, how is the present value of the future cash flow calculated? We need discount factors (DF) corresponding to each payment. Note that even if DF1 is 1/(1+r), DF2 is not always 1/(1+r)² because it assumes special case where interest rates are the same regardless of the maturity.
Collateral management is harder for longer maturities. When comparing 1y and 5y loans, a 5y loan has greater risk on the present value. For example, the price impact of a 1% interest-rate change for a 1y loan is about 1%; however, for a 5y loan, the price impact is about 5% (ignoring DF for simplicity).
Understanding the interest rate model is not straightforward because interest rates are interlinked among various maturities. The theory is called ‘Bond Math’ which explores the term structure of interest rates.
Yield Curve
To calculate discount factors to obtain an accurate present value, we need interest rates for various maturities from bonds and loans. By plotting interest rates along the time axis, we can build a yield curve.
The shape of the yield curve tells economic conditions, expected forward rates, foreign capital inflows and outflows, credit ratings, etc. There are popular theories to explain the shape of the yield curve.
- Pure Expectation Theory
- Liquidity Premium Theory
- Market Segmentation Theory
In practice, pure expectation theory, combined with no-arbitrage pricing, is the crucial component of derivatives pricing (i.e., collateral management). For example, we can calculate a forward rate. Suppose the 1y rate is 1%, and the 2y rate is 2%; what is the 1y into 1y forward rate? How do you roughly expect 1y interest rate one year from now? We welcome your thoughts and answers at our Discord channel!
Pool-based or Order-book-based?
If we build a loan market, we need to take care of those theories for determining the interest rate. Traditionally, we found the best solution: Let market dynamics to decide. There is no genius who can beat the market, so supply-demand price discovery is the golden theory.
In traditional finance, we use order-book-based price (yield) discovery. The price represents the current market as all the market participants follow the same international standard protocol. It is a globally applicable price because arbitragers close the gap between different prices.
In DeFi, most lending protocol use pool-based price (yield) discovery. The price is algorithmically determined by a utilization rate. This is a great invention and works well for spot-exchange and low-liquid market. But it introduced a new capital risk called impermanent loss.
Challenges to Scale Further
Overall, the pool system successfully built a money market, but we see problems in creating the capital market, and inviting institutional participants.
First, we have to understand that pool-based price is a local price derived from an extremely simplified modern finance theory. As shown below, inter-pool arbitrage doesn’t seem to work, as each protocol has a unique algorithm and different token economics are involved (source). We need a simple, interoperable, and standard protocol for scaling further.
Another difficulty for pool-based lending is to extend maturity. Since the pool provides a local price, we cannot simply interpolate interest rates and thus cannot calculate the forward rate. Therefore, we need many pools. For example, a loan from the 5y lending pool will become a 4y 364days loan the next day and if we want to return the loan, we need 4y 364 days pool. In the same way, in one month we need the 4y 11months pool. We need to develop a better algorithm that includes the term structure of the interest rates.
Conclusion
The pool-based lending protocol successfully built a money market for crypto-assets. However, it is not easy to extend maturity to build a capital market. We discussed the importance of collateral management using the yield curve. Then we compared pool-based and order-book-based market making, and provided some improvements for the pool system. Now that we are getting enough liquidity in the crypto-assets space, it’s the best time to review the golden system of collateral management and the order-book system to build an institutional DeFi.
Next Articles
How ‘Swap’ works and why it’s the largest market
A practical guide for various swaps in business practice
How structured products are made and why they are profitable
A handbook of Secured Finance derivative solutions
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