Vertical expansion of DeFi: the rising decentralized interest rate market

Vertical expansion of DeFi: the rising decentralized interest rate market

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Author: Incuba Alpha Labs

Words: 3776

Translator: DRD

Translation agency: DAOSquare


DeFi The Decentralized Finance

APY Annual Percentage Yield

DEX Decentralized Cryptocurrency Exchanges Decentralized Exchange

Andre Klanger (AC) recently announced the merger of Pickle Finance, Cream, COVER Protocol and Sushiswap, four well-known DeFi protocol projects, which have attracted widespread market attention. When industry leaders began to consolidate their market position through mergers and acquisitions, we realized that DeFi is actually too crowded and its growth is slowing down, and the market is being divided by big companies.

“Will DeFi continue to grow?”

We are very optimistic about the answer to this question. The reason for optimism must start with the real changes brought about by DeFi.

For the value exchange world that the blockchain field strives to create, “assets” are the most scarce. The explosive growth of DeFi, through the introduction of “credit” as “asset” into the blockchain world for the first time, has met this desire.

The so-called “credit” refers to the debt-to-debt relationship based on financing needs. Credit is the cornerstone of the financial market, and the rapid development of the financial market has always been inseparable from the expansion of credit and the accumulation of leverage. Whether in the traditional financial market or in the DeFi market, top participants either introduce or create a new type of credit system as basic assets, or create a financial product or platform to facilitate asset leverage.

In the DeFi field, the concept of “introducing credit as an asset” is still in its infancy. There are two main directions:

  • Introduce new credit assets
  • Introduce a new method of financial leverage

We referred to the development of traditional financial markets and found that many of them can be used by DeFi.

Process of credit growth and leverage accumulation

At present, the landscape of the traditional financial market can be described as full, including a variety of credit businesses and dazzling leverage tools:

The government’s financing needs are packaged as sovereign debt.

Financing for individual needs (such as housing, automobiles, health, education, and consumer goods industries) or corporate needs (such as working capital and capital expenditures) is packaged into a variety of debt products.

These credits form the backbone of the financial market. Financial institutions have created financial assets such as bonds (such as treasury bonds), loans (mortgage loans, credit card loans), etc., and continue to increase leverage through various derivatives.

As a result of credit expansion and leverage accumulation, the balance sheets of all participants in the entire financial market continue to grow.

Consider the most radical era of financial liberalization before 2008. From the issuance of mortgage-backed bonds, we can see how all participants in the financial market are connected through their balance sheets.


In view of the complexity of the financial market structure, we have refined the core content for reference.

Under the above circumstances, credit is generated and circulated through the following channels:

  • Credit is created when the debt ends, for example when a person wants to buy a house but needs a loan.
  • Commercial banks issue loans or purchase bonds on the asset side to support housing financing on the debt side; package various bond assets and securitize basic assets to form structured products.
  • Non-bank financial departments purchase structured products with credit ratings, and banks provide mortgage loans after recovering the funds, thereby completing the process of financial leverage.

The entire process of credit expansion and leverage accumulation can continue until credit declines (people with poor credit get huge financing) and leverage breaks (subordinated debt defaults, collateral prices plummet, and insolvency leads to the failure of debt liquidation). Lead to a financial crisis.

The outbreak of the financial crisis was when the central bank issued more currencies to purchase various types of debt assets to bail out the market. Through quantitative easing, the central bank’s balance sheet continued to expand and eventually collapsed. The above CDO example illustrates the path of credit expansion, leverage accumulation, and organic growth of the balance sheet at each stage of the entire system.

DeFi has formed a rudimentary financial system.

The DeFi market can learn from the world view of the traditional financial market, but there are significant differences in market structure.


The DeFi system is actually very simple.

We can think of it like this:

  • If you borrow money in a decentralized financial world, you can compare MakerDAO to a central bank (+ repurchase)
  • Lending agreement Aave and Compound are equivalent to commercial banks
  • Some other aggregate revenue agreements are equivalent to non-bank financial institutions.

In the blockchain world, the most basic asset is BTC/ETH (Bitcoin and Ethereum). Later, stablecoins, especially the creation of USDT, began to create a credit system in the blockchain world, making the financialization of cryptocurrency possible. USDT is the first to introduce the U.S. dollar credit system by pegging to the U.S. dollar, thereby creating USDT for BTC collateral loans to meet the needs of credit expansion (margin trading). Similarly, MakerDAO issued DAI with ETH as collateral, creating a financial market prototype similar to the central bank’s printing of money.

Once the foundation for credit expansion is laid, the market will soon need more effective leverage. Soon lending agreements like Aave, Compound and others began to appear in the form of commercial banks. The rise of loan agreements has also expanded the path of credit expansion. On the asset side of the lending agreement, more ERC-20 tokens are being used for loans, and explosive liquidity mining has stimulated a surge in loan demand. On the debt side, Earns Finance, Pickle Finance, and Harvest Finance and other income machine guns Pool products absorbed more capital and improved the efficiency of leveraged capital flows.

In terms of the core business logic of credit expansion in the DeFi market, a relatively complete basic financial system has been formed in less than three years:

  • Create basic assets based on BTC/ETH as collateral (such as synthetic assets of MakerDAO and Synthetic)
  • Oracle (ChainLink)
  • Trading platform (UniSwap, Balance, Curve)
  • Loan Agreement (Aave, Compound)
  • Aggregate income projects (Yearns Finance, Pickle Finance, APY…)
  • Wallet (MetaMask, Mask Network)

The above has formed a complete business line, and market leaders have emerged at all stages.

We believe that the leading project has taken a dominant position, which is not friendly to new entrants and competitors, and some tracks on the existing stadium are already too crowded.

However, comparing the above examples of CDO products, it can be clearly seen that DeFi is still very rudimentary compared with traditional finance. There is still a big gap between the richness of credit and the complexity of leverage tools, which means that the DeFi market may still undergo major changes in the next stage.

Where is the next opportunity area to occupy the head position?

The opportunity lies in providing the market with the highest quality credit and more effective leverage.

The next step in the development of DeFi requires an urgent need to expand the balance sheet of the entire crypto world, which means that the new agreement needs to release the potential of the current ecology and introduce new standard assets to expand the scope of credit.

To unleash the potential of credit expansion, we can start with credit ratings for different assets.

In the traditional financial market, we can see that public institutions, banks, non-bank institutions, and private institutions naturally exist in a situation where the credit rating of the main body goes from strong to weak. As the debt of the central bank, fiat currency needs the support of national debt and other safe assets. If further expansion is required, only the interest rate level of collaterals such as mortgage-backed securities (MBS) can be reduced.

As a decentralized protocol, DeFi has no project-based credit rating, but gradually formed a credit rating for business assets. Judging from the balance sheet of the “central bank” MakerDAO, DAI’s debt actually has qualified and guaranteed collateral. In terms of Maker assets, ETH and BTC have the highest ratings, followed by stable currencies such as TUSD (TrustToken)/PAX (Paxos)/USDC (Circle). If DeFi needs more DAI, Maker will need to expand its balance sheet. The biggest opportunity in the Defi market is also the biggest limitation, which may be the lack of qualified collateral.

In our view, in the overall balance sheet of the DeFi market, BTC and ETH play the role of gold or national debt, while stable currencies like USDC and DAI are in the second echelon in the form of foreign exchange reserves or central bank liabilities. Commercial bank liabilities are at the third level, such as: yToken, atomic (aUSD), ctoken (cUSD), stoken (sUSD), utoken (uUSD); and Altcoins, and other LPTokens appear in the form of corporate debt on the fourth level.

At present, the greatest potential for credit expansion in the DeFi market lies in the second level (stablecoin) and the third level (proof of income).

For example, uUSD, yToken, aToken, cToken and other stable currencies with future income characteristics can be incorporated into collateral or packaged into debt derivatives for financial innovation. The circulation of these future income certificates can release more liquidity and increase the leverage level of the entire system.

In addition, this is also a major opportunity to expand the fourth-tier (corporate liabilities) assets. For example, products that introduce real financial assets such as supply chain or consumer finance into the blockchain world (Centrifuge, NaOS.Finance), lending based on off-chain asset mortgages. And further attempts to explore unsecured financing (Truefi), by introducing new credit to expand the balance sheet.

Vertical expansion: use time value to increase leverage in DeFi

If creating a credit system and expanding a balance sheet are the “horizontal expansion” of DeFi, then the tools and methods to enrich the DeFi market and use time value to achieve leverage are “vertical expansion”. As the underlying assets become more complex, the asset side of the DeFi agreement will face more demand for regular and fixed-rate financing.

Therefore, the debt side of the DeFi agreement will need to consider interest costs, term management, and risk management. These “vertical expansion” based on the interest rate dimension will bring a whole new dimension and more possibilities to the development of DeFi.

In recent years, the interest rate market has become the hottest topic in the DeFi world.

As discussed earlier, our views on the DeFi world focus on the issue of “how to more effectively achieve credit expansion and leverage accumulation in the financial market”. More diversified credit will be introduced into the blockchain as an asset to promote a new kind of credit expansion, that is, the “horizontal expansion” of DeFi’s balance sheet. The core of the interest rate market is the need to find more effective ways to increase the financial leverage of the DeFi market. This is the “vertical expansion” of the DeFi market. We believe that this new dimension of expansion will bring more interesting possibilities to the DeFi market.

Although different from traditional financial institutions, the core of the DeFi agreement is to manage its own balance sheet. The return on assets minus the cost of capital is the income. From a purely commercial point of view, this is not essentially different from the profit model of financial institutions, but it provides the most basic business logic for constructing the DeFi interest rate market.

At the same time, with the expansion of the DeFi balance sheet, more and more assets require fixed maturity and fixed interest rates, and more financial instruments and markets are needed to increase financial leverage. This will make DeFi agreements generally face the pain points of managing financial costs, capital maturity and interest rate risks.

As with traditional financial markets, these pain points will give rise to a large number of DeFi “non-bank financial institutions” to undertake these businesses (such as investment banks, insurance companies, asset management companies, etc.).

We have noticed that some very innovative DeFi interest rate, insurance, risk management and derivatives agreements have appeared on the market. The interest rate market is a new track in the layout of the new ecosystem. There is no doubt that these innovators will have the potential to grow into new market leaders such as UniSwap, MakerDAO and Aave.

The interest rate market will increase the efficiency of financial leverage

Although the concept of interest rates may seem simple, it is indeed difficult to establish viable financial solutions. In traditional financial markets, interest rates are a key factor in the pricing of different risky assets, and the interest rate structure can also reflect people’s expectations of future interest rate changes.

The interest rate itself is a very complex system. The central bank can set policy interest rates, including benchmark interest rates, excess reserve interest rates and interest rates for various monetary policy instruments; the money market has Libor and repurchase interest rates; the credit market has deposit interest rates and loan interest rates; Treasury bonds, government bonds and corporate bonds also have different interest rates.

Similarly, MakerDAO’s interest rate policy includes fixed interest rates and DSR (Dai Savings Rate), Aave and Compound interest rates include deposit and loan interest rates, and liquidity mining, such as Curve or other DeFi agreements that provide expected APY interest rates. These interest rates are obviously different in credit rating, and they are all floating interest rates, no time limit, and interest rate pricing is also affected by centralized entities.


When discussing interest rates in the context of DeFi, the real issues that need to be discussed are:

  • What kind of interest rate market will be built on the basis of different credit ratings?
  • Which fixed-income products are created to meet the needs of financial leverage
  • How to set and price fixed interest rates for different deposit maturities, such as the term structure of interest rates (yield curve)

Three ways to build a decentralized interest rate market

In traditional financial markets, the Treasury bond yield curve is the benchmark for pricing all fixed income products.

  • A benchmark yield curve is formed on the basis of zero-interest Treasury bonds with different maturities.
  • Based on the benchmark yield curve and risk spreads, a new yield curve is formed through various fixed-income products.
  • On the basis of the spot interest rate yield curve, the forward interest rate curve is calculated to form a swap yield curve, which provides a pricing benchmark for interest rate derivatives such as forwards, futures, and swaps. Finally, implement the entire CDO product issuance process in the DeFi market and improve the entire interest rate market system.


All new agreements created to build the DeFi interest rate market cannot be separated from the pricing logic of this fixed income product, and all DeFi interest rate agreements should follow this logic. But different commercialization routes may produce three typical development directions:

One of them is the construction of zero-coupon bonds, such as Yield’s ytoken, UMA’s uUSD and Notification (Teddy Woodward). These agreements take the form of issuing fixed-term zero-coupon bonds, with ETH as collateral (for example, a 3-month period). The most intuitive form of the product is a fixed-term interest-bearing stablecoin, and its implicit interest rate is realized by trading or acquiring AMM tokens.

This is a redefinition of the benchmark yield curve by the traditional financial market using zero-coupon bond credit. In the DeFi market, the zero-coupon token bond with ETH as the collateral is similar to the national debt credit, which can be used as a substitute for the zero-coupon bond to construct a basic benchmark spot yield curve.

The other is to securitize tokens that have future cash flow returns, such as Barnbridge (Tyler Scott Ward), Benchmark Protocal. These projects draw lessons from the issuance model of the aforementioned CDO products, and essentially create new fixed-income products that package Aave or Compound’s business for structured securitization financing. In this way, fixed-rate priority bonds and floating-rate subordinated bonds can be issued.

The maturity of the DeFi protocol token securitization model has further consolidated the development of asset pools based on cash flow returns, issuing more small-value securities (such as the introduction of mezzanine or advanced parts of multiple layers), and allowing users to exchange different Term interest rate pricing. For example, AMM or quotes to create a yield curve for fixed income products. The yield curve of these fixed-income products needs to be supported by the credit of the underlying asset (cToken or aToken). The credit rating of the underlying asset is similar to that of commercial bank financial bonds and belongs to ETH-DAI bonds.

The third is to introduce interest rate swaps, such as Horizon Finance, Swap.rate and Defihedge. Interest rate swap is a kind of forward contract. In this type of contract, a certain amount of principal is paid with a future interest in exchange for another interest. Interest rate swaps usually involve the exchange of fixed and floating interest rates. Using this interest rate swap contract, DeFi users can swap floating interest rates into fixed interest rates with a fixed term. Interest rate swaps can be fixed interest rates or floating interest rates, which can hedge, arbitrage and manage interest rate fluctuation risks. The yield curve of this dimension mainly uses the structure of spot and forward interest rate curves to hedge, arbitrage or interest rate transactions.

But even with the introduction of interest rate swaps, the ways in which different DeFi agreements construct fixed interest rates are often very different. DeFiHedge and Swap.rate interest rate swaps are based on the order book, but the design of their trading mechanism is slightly different. The Horizon protocol uses a combination of token securitization and interest rate swaps, allowing users to bid at the fixed interest rate they want. The cash flow of the underlying asset income is distributed according to the user from the lowest bid to the highest bid to form a yield curve.

The above three methods of constructing the DeFi interest rate market are not good or bad, because different interest rate agreements target different segments of the interest rate market and credit rating business lines. The most important thing is that even if the same financial instruments are used, such as interest rate swaps, their pricing mechanisms are different. Therefore, the current DeFi interest rate agreement is not in a state of direct competition, but each has its own constraints.

For example, zero-coupon bonds require large amounts of over-guarantees, involve complex lending and liquidation activities, and rely on Uniswap transactions or AMM for interest rate pricing. In the early stage of lack of liquidity in the market, it is difficult to effectively price interest rates through trading. The benchmark yield curve may not reflect the actual interest rate structure. Such bond products are more suitable for BTC, ETH, aToken, cToken and other high-credit assets, and cannot meet the financial needs of other erc-20 tokens.

In the case of token securitization, the first step is to find a pool of income assets that can generate cash flow. Obviously, the options are relatively limited. Such agreements can only grow with the expansion of DeFi collateral. In addition, if the implied interest rate of premium tokens needs to be valued through trading or AMM, there are similar flaws as zero coupon bonds. If the agreement sets a given fixed interest rate, the pricing is not completely market-oriented, and it is even more difficult to achieve decentralization.

As far as interest rate swaps are concerned, the pricing of such derivatives relies on credible spot interest rate curves and forward interest rate curves. Currently, due to the lack of yield curve and lack of liquidity in the DeFi market, such swap transactions may not be active. The pricing of such derivatives may be more distorted than fair prices. But relatively speaking, swap transactions are still the most direct way for users to lock in the risk of interest rate fluctuations.


If we compare the debt-collateralized bonds in the traditional financial market, we can see that DeFi only meets the need to package credit into financial assets such as loans or bonds.

The following steps are still blank:

  • Asset securitization and derivatives,
  • Structured financing and interest rate pricing,
  • Interest rate hedging or speculation.

Only by completing these three steps can the DeFi interest rate market be built into a closed loop, and DeFi can truly answer the proposition of “how to increase financial leverage more effectively”.

But the potential market size of the interest rate market may be more than 10 times larger than the underlying credit market. DeFi interest rate agreements, such as token securitization, zero coupon bonds, and interest rate swap derivatives, can each occupy certain segments of this market. This is an excellent growth opportunity for major DeFi participants. With the development of the interest rate market, the demand for risk management agreements such as insurance, asset management and liquidation will increase.

Even the DeFi interest rate market still faces many challenges. DeFi has begun to have its own characteristics and also meet the characteristics of financial business regulations. We hopefully look forward to the emergence of more innovative ideas beyond traditional financial markets.

Will interest-bearing stablecoins become the first example of zero-coupon tokens? Or will they occupy a certain market share of stablecoins? Or will they form a completely native DeFi bond market?

When the DeFi interest rate market has a decentralized interest rate pricing anchor, will Aave, Compound and other lending agreements be willing to introduce long-term liquidity loans to improve their basic interest rate incentive model; will DEXs such as UniSwap release the redundancy in the liquidity pool? Excess assets to provide more liquidity to the market, thereby further expanding DeFi credit expansion?

When the DeFi agreement encounters short-term liquidity shortages, such as huge redemptions and a sharp rise in loan demand, they will be willing to issue zero-coupon bonds as short-term loans to avoid a run on the market or increase the efficiency of capital use, thus forming a new similar Is it in the interbank lending market?

Will the emergence of new fixed income products continue to stimulate the development of various investment banks and asset management businesses? Create a super platform agreement similar to JP Morgan Chase’s diversified financial service capabilities in the era of mixed operation?

It can be said that DeFi has just opened the door to the interest rate market. Behind it, there are unlimited possibilities.

Hell is empty, the devil is on earth

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