BarnBridge v2 — The Detailed Guide on How to Earn Fixed Income in DeFi
BarnBridge launched Smart Yield on March 15th, 2021, a risk tokenization application to take on unique investment positions based on your preferred risk appetite. It allowed users to perform a simple interest rate swap, with one side taking on more variable risk and the alternative side taking on a fixed rate of return.
BarnBridge v2 has introduced a novel mechanism for users to more seamlessly earn fixed yields on their deposits. To create this next generation of fixed-income protocol, we had to make changes at the protocol level and not just at the application layer (Smart Yield). We upgraded our governance contracts, moved our DAO to Optimism, introduced a BarnBridge DAO LP side, integrated BarnBridge with Aave markets, and likewise. Hence, one can assume it’s appropriate to call it BarnBridge v2 rather than a mere Smart Yield v2.
The key focus of the team has been to tackle and eliminate challenges preventing the rise of fixed income in DeFi. Let’s find out why fixed income in DeFi hasn’t taken off to date and see how our latest offering fixes some of the previous issues up to this point.
A Brief History of Fixed-Income DeFi
Fixed income broadly refers to debt instruments that offer a fixed interest rate on your deposits. There aren’t any major DeFi protocols that allow you to borrow and lend at the originator, albeit attempts at doing so. Instead, most of everything in DeFi is based on a variable rate of return. BarnBridge, instead of attempting to build a fixed lending and borrowing market, uses a novel structure to “swap” the variable rate of return into two separate streams of return, with one being fixed.
This fixed rate gives participants certainty about the returns on their deposits, facilitating efficient forecasting and planning. And fixed rates are how the “real world” has traditionally done financial modeling and planning.
Fixed income is not new to DeFi. Several attempts have been made to launch lucrative fixed-income products for DeFi users, driven by the comparison to the estimated ~$128.3 trillion global market value of TradFi fixed-income products. But, this thesis has yet to play out in DeFi. Fixed-income in DeFi is, instead, plagued with liquidity crises arising out of small-scale adoption.
Today, on the 5th of October, the total fixed-income DeFi market size is a mere ~$0.5 billion, roughly 0.45% of the DeFi money markets, as tracked on DeFi Llama. Let’s unravel some of the reasons responsible for this minuscule participation in fixed-income DeFi.
- First, no one feels comfortable locking their fast-moving assets for very long periods of time, as a lot can happen in a very short time frame in the crypto space. Most of the existing fixed-income protocols offer tenors in the range of 90–180 days, with some extending up to a year. On top of this, lenders feared that they might lose their money if the borrowers defaulted on their loans and the protocol reached insolvency. So, this inherent counterparty risk also contributed to shooing away the potential users.
- Second, a lack of liquid secondary markets and DeFi money lego integrations for the trading of fixed-income positions kept away opportunists and arbitrageurs from using these products. This is primarily due to the considerable variations in their modus operandi. For instance, the majority of the fixed income protocols operating in the DeFi space used ERC-721 standards to represent the unique positions of users, whereas the DeFi money legos work on ERC-20. Until recently, it was impossible to access secondary liquidity against your fixed-income positions.
- Last, the nature of their valuation techniques and the number of moving components in a protocol made the fixed income products quite complex and hard to comprehend for an average user. For instance, most of the protocols involving fixed income products operate on the Zero Coupon Bonding mechanism, which is not the simplest to grasp.
Enter BarnBridge v2
Stewarded by the BarnBridge DAO, BarnBridge v2 is a decentralized and open-source protocol that allows users to earn fixed yields on their deposits.
You can open a fixed income position before the start of an epoch (30 days at launch) and claim your fixed yields when it ends. It is also possible to borrow against your BarnBridge v2 liquidity proof tokens, which represent your share in the fixed side pool, without having to exit your positions.
Jumping into BarnBridge v2 pools
BarnBridge v2 implements an epoch-based approach for its pools. An epoch is a fixed tenor for which a user locks their assets in a pool to earn a fixed interest rate. At launch, BarnBridge v2 has 30-day epochs.
Every pool in BarnBridge v2 navigates through three different phases, Deposit, Withdrawal, and Epoch running.
A pool first enters the Deposit period after being deployed. In this phase, a pool accepts deposits from users, which later earns them a fixed yield.
A pool stays in the Deposit period until the Withdrawal period starts.
Each new deposit that’s added to the pool lowers the fixed APR rate, so if at some point users are no more comfortable with the rate they are getting, they can also withdraw their deposits during the Deposit period.
The withdrawal period is sandwiched between the Deposit period and the Epoch Running period. During this period, new deposits are halted, and users are allowed to withdraw their funds from the pool in case they are not comfortable with the final APR, causing the advertised fixed yield to go up for others who remain in the pool.
A pool is labeled as epoch running once it has started to earn yields on its deposits. During this period, no deposits or withdrawals are possible to/from this pool. However, users can pre-deposit into a pool undergoing a Deposit period by signaling a rollover of their active pool positions if they choose to do so.
During the current period, the pool also accepts deposits into the following epoch. So, for instance, if the current epoch running is #3, the users are able to deposit into epoch #4.
After the epoch running ends, users can withdraw their deposits and gains.
Let’s understand these different periods with an example.
- For instance, let’s say epoch #1 has just been announced with $10,000 in available realized yields. Upon learning about the available yield to be claimed in this epoch, Bob decides to open a fixed yield position by depositing $100,000 of DAI in this pool. Assuming Bob is the only person who bids for the available yield, then that would result in a fixed return of 10% APY (assuming an epoch lasts a year for the sake of simplicity) on his deposit.
But, in this example, that is not the case as Alice and Chad also sign up for the same epoch and deposit $50,000 and $250,000, respectively. This led to a redistribution of the available yields amongst the three participants, and the new fixed yield on offer reduces to 2.5% APY (Dividing available yields by total bidding capital). As per the new calculations, Bob will get $2,500, Alice will get $1,250, and Chad will receive $6,250 in fixed yields at the end of the epoch.
Now, there may be a case where Bob is not satisfied with the final 2.5% APY on offer and thinks he can make a better return somewhere else. So, Bob will exit his position from this epoch once the withdrawal window arrives.
- Bob’s exit from this epoch will lead to one final readjustment in the advertised interest rate as the total bidding capital changes. This will benefit Alice and Chad, who will now earn an increased fixed rate of 3.333% (+0.833%) on their deposits and make $1,666.67 and $8,333.33, respectively.
Where does the Fixed Yield come from?
BarnBridge v2 swaps variable yields from money markets with fixed yields for its users. This is accomplished by bringing in the novel mechanism of Earned Yields (or Realized Yields), yields earned from Aave on the last epoch deposits. In other words, this mechanism pushes forward the earned cumulative yield on the last epoch’s deposits into the epoch going forward.
Just like the Junior/Senior investment structures common in traditional finance, there are two sides to a BarnBridge v2 pool, a fixed rate position or the Senior side and an LP position or the Junior side. The users take the Senior position by depositing into the fixed-rate pool, while the BarnBridge DAO acts as the Junior side. The BarnBridge DAO doesn’t earn any yield from its deposits outside of a “funding rate” set by the DAO to power the LP side.
The assets from both sides are collectively supplied to money markets, where they earn a variable yield. This accumulated yield is then pushed forward as the realized yield and is available for bidding in the next epoch. A user can sign up for a new epoch and earn a fixed yield on their deposits. This mechanism allows BarnBridge v2 to offer a sustainable fixed APY to its users.
How to deposit/withdraw from BarnBridge v2?
Users can deposit into an epoch that is in its Deposit period. When a user deposits assets (DAI at launch) in an epoch, they receive proof of liquidity tokens. These are ERC-20 tokens representing their share in the pool and are minted at the time of deposit.
An epoch that has finished its run and is no longer active is marked as Ended. This is when users are able to withdraw their deposits and the earned yield by exchanging their proof of liquidity tokens.
Is it possible to lever up your yields?
BarnBridge v2 allows you to leverage your open positions. To do so, you can borrow from Aave during the Deposit period (prior to the 1d withdrawal), redeposit the borrowed amount, and repeat the loop to gain a max 4x leverage.
But what if you need liquidity in the mid of an epoch?
Worry not! With BarnBridge v2, it is now possible to unlock liquidity against your fixed-income positions, thus saving you from any associated opportunity cost with your deposits while they continue to earn you attractive yields.
As a depositor, you are allowed to borrow secondary liquidity from Aave with the same loan-to-value (LTV) and borrow rate as you would originally have had if you supplied your assets to Aave instead. To borrow against your BarnBridge v2 fixed income position, you will need to deposit your proof of liquidity tokens that you received after making your deposit and claim them back after you have repaid the loan and any accrued interest.
It is also possible to sell your proof of liquidity tokens on secondary markets if you ever need to exit your position prior to the maturity period.
What are the associated risks?
DeFi and risks go hand in hand, and BarnBridge v2 is no exception. The biggest risk associated with BarnBridge v2 is its originator, i.e., Aave defaulting. This could be either due to the Aave protocol going insolvent or getting hacked. Complete insolvency is out of the question here, given the fact that all borrowings on Aave are backed by collateral, and their LTV is closely monitored and adjusted throughout the borrowing tenure.
Another possibility of how the users might lose their deposits is in case either of the protocols, i.e., Aave or BarnBridge, gets hacked. However, the chances of that happening are relatively less, given both Aave and BarnBridge have undergone multiple internal and external security audits, and their competent teams have followed the best security practices in all of their past releases.
Comparative view of Mainnet vs OP fees
Although BarnBridge v2 has been launched on the Ethereum mainnet first, it is all set to be launched on the two leading Ethereum scaling networks: Arbitrum & Optimism. These Layer 2s have optimistic rollups in their core and offer lower gas fees, lower latency, greater throughput, and a world-class developer & user experience.
When writing this article, it only costs $0.10 and $0.21 for a swap transaction on Arbitrum and Optimism, respectively, while the same transaction is costing $4.18 on Ethereum. L2s are cheaper to transact by 21–42X than the mainnet. This should translate into increased user participation, as more users can afford to transact on the BarnBridge v2 on these Optimistic rollups.
Disclaimer: All DeFi apps/protocols have inevitable DeFi technology risks associated with them, and users’ due diligence is required before investing.