The Rise of On-Chain Tokenized Risk Protocols
“The fear of the unknown is possibly the most fundamental fear of human beings.”
Dr. Kevin Antshel
We are seeing the rise of on-chain tokenized risk protocols. Interest rates are both a barometer of the economy and an instrument for its control. In the traditional financial market, it is a vital input into the valuation of many financial products. In the DeFi world, money market protocols such as MakerDAO, Compound, and Aave were the first attempts at creating a decentralized money market. These decentralized money market protocols facilitate one of the basic financial needs – lending and borrowing in the DeFi world.
Traditionally, the money market is an extremely important element in the global financial system that provides short-term liquidity to facilitate the flow of the global financial market worth trillions of dollars today.
The DeFi Landscape
DeFi has experienced tremendous growth over the past year. With a total value locked of more than $100 Billion at its peak across all chains, growing from just over $ 1 Billion TVL roughly a year ago. With such massive growth in value, an influx of innovative DeFi protocols such as lending protocols, DEXs, Oracles, On-Chain perpetual swaps & options protocols, synthetic assets, and insurance protocols have formed an open, permissionless financial universe on the blockchain. As the industry continues innovating and building momentum, DeFi protocols are becoming increasingly sophisticated with their design and mechanisms. Hoping to bring structured products like risk hedging products, financial derivatives, credit/under-collateralized loans to the decentralized financial sector.
Without a doubt, there are significant risks in the DeFi world, as we are just beginning to form a structure of understanding for how the future decentralized finance could play out. In the traditional market, appropriate management of risk is an important part of the day-to-day function of a financial institution. However, much of this is missing in the DeFi world where the market participants can not hedge risks such as interest rate movements since there is no financial instrument to facilitate such activities.
When we look from the traditional debt market perspective, the majority of debt markets are driven by fixed-rate lending. This is where it offers certainty to relevant market participants, resulting in a simplified process in managing. However, existing DeFi lending protocols can only facilitate variable rate lending and borrowing activities. These rates can fluctuate significantly according to the market conditions and external factors. For example, the USDC borrowing rate on Aave experienced 2 significant hikes in the past year. In this case the rate was as high as 25% at one point during the first hike.
Figure 1: Historical interest rate for major DeFi lending protocols
DeFi vs CeFi
The DeFi world is different in comparison to the traditional financial market. Where we have “yield incentives” in the form of governance token rewards. These reward users who contribute to the protocol by providing liquidity. As a result, some of the DeFi users don’t mind having variable rate exposure as long as the yield incentives can cover the variable costs. However, we should also recognize that other types of individuals seek stable returns or institutions seeking to deploy in size. Thus, for DeFi to capture the full spectrum of the debt market and attract traditional capital into the game. DeFi lending protocols need to come up with fixed interest rate strategies to expand the “future of france” further to reach mass adoptions.
The fixed interest rate aspect in the DeFi lending protocol started with AAVE. AAVE parametrized the stable interest rate model to offer a fixed rate in the short term. However this can be re-balanced in the long- term in response to changes in market conditions. It offers a way for users to gain short-term fixed interest rate exposure, it is never a true fixed interest rate design. But it opens the door for the continuous experiment on interest rate protocols.
With the fast iteration of the DeFi industry, we are seeing various on-chain tokenized risk protocols such as fixed interest rate protocol. This surfaced on the market to offer market participants to off-load some of the risks to other participants. Although We are still a long way from seeing a proper DeFi yield curve and interest rate standard, current experiments on risk hedging protocols can form the cornerstone of the future DeFi risk market.
Tokenized Risk Protocols
In traditional financial markets, the Treasury bond yield curve is the benchmark for the pricing of all fixed-income products (Incuba Alpha, 2021).
A benchmark yield curve forms through zero-coupon treasury bonds with different maturities.
Yield curves form through various fixed-income products deriving from benchmark yield curves and risk spreads.
Deriving from the spot interest rate yield curve, we calculate the forward interest rate curve, and then the swap yield curve takes form, which provides a pricing benchmark for interest rate derivatives such as forward, futures, and swaps. Finally, the entire CDO product issuance process can be realized in the DeFi market, and the whole interest rate market system can be perfected.
The DeFi sector is still experimenting with how fixed-income products can be built and what the structure should be. Naturally, the DeFi sector will start imitating the structure of traditional fixed-income products. The below section will dive into some of the tokenized risk protocols in the market.
Figure 2: Tokenized risk protocols sector landscape
Future Cash Flow
Pendle enables the trading of tokenized future yield on an AMM system, it exists on top of first-degree protocols, supporting such as Aave and Compound. There are 3 components in the Pendle system that enables the trading of tokenized future yield:
Yield tokenization
Pendle’s Automated Market Maker (AMM)
Governance
The yield tokenization part splits the deposited yield-bearing tokens into two separate parts, the Ownership token (OT) and a yield token (YT).
Figure 3: Illustration of Pendle yield tokenization process
Users can trade the yield token via the Pendle AMM to long or short the future interest rates without owning a capital heavy asset directly.
Pendle’s design reminds me a lot of interest rate derivatives in the traditional market. Where the valuation of these financial instruments needs to incorporate the time value of money. Thus, Pendle creates a unique type of AMM that caters to all assets with time-decaying properties, since the value of a yield token is time-dependent where yield token holders entitlement to less yield as time passes and the token becomes worthless upon expiration. The Pendle AMM curve will shift at the equilibrium point and adjust itself to account for the time decay.
Figure 4: The changing weights of X and Y cause changes in the shape of the curve
Pendle’s yield token AMM could also become the oracle in the interest rate space for other tokenized risk protocols such as 88mph to be used as the fixed interest rate oracle, such that 88mph can offer the market rate “without needing to maintain a market”. Just like how Uniswap’s AMM uses by various DeFi protocols for different purposes. Pendle’s yield token AMM could pioneer the evolution of the tokenized risk protocols sector.
Element Finance
Element Finance is targeting to create a fixed rate, capital-efficient yield protocol for users. It emphasizes its principal token rather than the yield token to enable fixed yield products to be offered in the DeFi market. It expands the fixed-variable component in the lending interest rate world to include e.g. farming yield, ETH 2.0 yield, etc.
There are 3 components in the Element Finance system that enables the protocol to offer fixed yield products to users:
Yield tokenization including Principal token and Yield token
Element Finance Automated Market Maker (AMM)
Governance
Figure 5: Illustration of Element Finance yield tokenization process
Similar to many other future cash flow tokenized risk protocols, the yield tokenization part of the protocol also splits the yield generating base asset into two separate parts called the Principal token (PT) and a yield token(YT) which forms the backbone of Element Finance. Additionally, Element Finance focuses on usability, enabling the creation of fixed-rate vault strategies on top of its infrastructure. It can potentially integrate with existing DeFi protocols such as MakerDAO, Compound, AAVE, Yearn to structure fixed rate products. Furthermore, there are potentials for tranche lending protocols to leverage Element Finance’s fixed-rate products as the backstop for senior tranche. It also introduces the De- Collateralize concept to improve capital efficiency in the DeFi market which is in essence a fixed-term loan that pays the borrow fees upfront while being backed by a yield position.
APWine
APWine is focusing on building its protocol for future yield tokenization. It does not offer fixed interest rates but enables the market to trade future yields. The protocol is to target farmers, traders, and liquidity providers who wish to lock in their future yields.
Figure 6: Illustration of APWine’s future yield tokenization process
The protocol splits the deposited yield-bearing tokens into two separate parts,
Principal Tokens (PTs)
Future Yield Tokens (FYTs)
APWine currently features an order-book-based exchange for trading FYTs, however, the protocol is working on a custom AMM design that is tailored for trading future yield.
Swivel Finance
Swivel Finance also leverages two token designs, termed Notional Tokens (nTokens) which is the interest coupon and zero-coupon token (zcToken). However, the protocol implements an orderbook rather than using the AMM model like Pendle and Element Finance which aims to provide capital efficiency enhancement and customizability.
There are 3 major components in its implementation:
High throughput off-chain orderbook & libp2p network
Siloed & censorship resistant on-chain orderbook
A ledger to track active lending agreements
Figure 7: Key differences of Pendle, Element Finance, APWine, and Swivel Finance.
Tranche Lending
BarnBridge on the high level achieves risk hedging by pooling users’ funds and depositing into respective underlying markets and disproportionately distributing the outcome via “seniors” or “juniors” tranches. It borrows the idea of collateralized debt obligation (CDO) from the traditional market. The SMART Yield bonds allow DeFi users to gain access to fixed yield via the “senior” tranche where the “junior” tranche takes up the variable-rate risks in return for a higher yield.
The protocol itself can further expand to include such as tranches for volatility derivatives. We can use such a product to mitigate market price risk by segregating the risk/reward to fit various risk appetites.
Figure 8: Illustration of BarnBridge future yield tokenization process
Saffron Finance
Saffron Finance focuses on customizable risk and returns profiles for liquidity providers. It separates the future earning stream and the NPV of utilized principal in each tranche based on the concept of payback waterfall.
The payback waterfall is split between two primary tranches.
A yield enhanced “A” tranche
A risk mitigated super-senior “AA” tranche
88mph
88mph allows you to lend your crypto assets at a fixed interest rate. There are 4 main products in the 88mph system:
Fixed-interest rate bond (FIRB)
The protocol uses a linear model for determining the fixed interest rate offered to the FIRB holders. The protocol keeps track of 30 Day EMA variable rates on the yield protocols and offers 50% of the EMA as the fixed rate.
Floating-Rate Bond (FRB)
The FRB allows users to step in and fund these debts created by the FIRB. FRB users essentially act as the guarantor for FIRB users to get a fixed rate determined by 50% of the EMA. The FRB users then eat up the variable-rate risks and receive compensation by a higher rate if the underlying variable interest rate increases.
Zero-Coupon Bond (ZCB)
The ZCB is a product built on top of the FIRB which opens the door for tradable FIRB on the secondary market.
Structured products
With the introduction of a new per-deposit variable rate bond system in 88mph v3, structured products such as perpetual yield futures can be built on top of the existing infrastructure.
The protocol also offers 2 main derisking mechanisms in order to stay solvent in different market conditions:
Pooling the deposits together to form a pool to protect the protocol against catastrophic risks.
Funding the system’s debt via the floating-rate bonds.
Zero Coupon Bond
Inspired by Dan Robinson and Allan Niemerg in their paper “The Yield Protocol: On-Chain Lending With Interest Rate Discovery”.There are a few implementations of the Yield Protocol with certain tweaks by the UMA project (Yield Dollar), Hifi Finance, and Notional Finance.
On a high level, the Yield Protocol introduces the concept of fyTokens, a fungible token similar to a zero-coupon bond that allows fixed-rate borrowing and lending. The fyTokens work quite similar to the traditional zero-coupon bond market where the price of the bond floats freely before maturity, but trades at discounts and offers full face value (par) profits at maturity. The fixed interest rate can be calculated by the difference between the purchase price and the par value.
Notional
Notional is a protocol that facilitates fixed-rate, fixed-term crypto-asset lending and borrowing through a financial instrument called fCash.
fCash tokens are the building blocks of the protocol, they always generate in pairs: assets and liabilities, and always net to zero across the protocol. It leverages the accounting equation concept where assets=liabilities+equities
Figure 9: The building blocks of the Notional system- fCash tokens
What’s more interesting for Notional Finance is the Notional AMM, which introduces Dynamic Curve Sensitivity. Notional Finance believes that the optimal liquidity curve sensitivity will vary vastly as a function of time to maturity. In addition, the static curve sensitivity will only be appropriate for a narrow window of time.
Figure 10: Problems with static sensitivity
Interest Rate Swap
Horizon Finance allows participants to swap between variable and fixed interest rates through a game-theoretic approach to form decentralized interest rate markets. The protocol currently supports yyCRV and xSushi markets.
On a high level, Horizon Finance deposits a pool of money P which consists of money from multiple participants to the target yield protocols over a period of time (Payout time), say 1 day.
Since the current DeFi protocols only offer a variable rate. Users do not know how the lifetime interest rate could be. However, the protocol allows them to submit fixed interest rate “bids” which they think is a fair rate. If they choose not to submit a bid, the protocol will offer a variable rate to the participants.
For each payout round, the protocol will distribute the income of P preferentially. This is done in order from the lowest to highest bids in the fixed interest rate space. Any leftover income will distribute to the variable rate participants.
This game-theoretic approach assumes the market will collectively act rationally. In an attempt to maximize their individual utility according to their risk preferences.
If over time weighted interest rate of fixed IR bids is higher than average realized rate of underlying income stream. Fixed IR bids soak up greater income than they otherwise would receive. They do this at the cost of participants still willing to accept the variable rate.
If over time the weighted interest rate of the fixed IR bids is lower than the average realized rate of the underlying income stream. Participants still sitting in the ‘variable’ pool effectively receive an income boost.
Final Thoughts
Any financial market fundamentally exposes participants to risks. Financial instruments such as interest (yield) rate instruments made available to relevant participants to off-load these risks to counterparties. These counterparties have the abilities to take on these risks in exchange for earning a higher compensation. In the traditional market, a significant portion of the financial products is fixed rather than variable. On the other hand, DeFi lending protocols are currently 100% under the variable rate regime. Which lacks the environment for DeFi to cross over with the traditional market. And bring the money into this open, permissionless financial world on the blockchain.
Not everyone has the ability to take every risk; We are in the early stage of the “future of france” where the market does not have the necessary tools for DeFi users to hedge certain risks such as yield risk. However, these tokenized risk protocols are the beginning of a new chapter in the DeFi world.
Although these protocols have a degree of sophistication as financial instruments which not every user will understand. However, we believe the unprecedented creativities will happen via protocol-to-protocol layer where we leverage the nature of DeFi lego compatibilities. In order to create both standardized and exotic decentralized financial instruments to drive further growth.
We believe the rise of on-chain tokenized risk protocols will play an increasingly pivotal role in the ecosystem. Helping DeFi to evolve and creating the next-level financial instruments for a diverse group of players to enter the space.
Don’t trust, verify. The sky’s the limit.
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