The missing pieces of the DeFi puzzle

A particular use case of Ethereum saw considerable growth in 2018 — the nascent financial ecosystem collectively known as ‘Decentralised Finance’ (or ‘DeFi’ for short). MakerDAO in particular has been exceptionally successful, with over 1.5% of ETH now locked up as collateral in loan instruments known as Collateralised Debt Positions (‘CDPs’) with the loans themselves denominated in DAI — a stablecoin pegged to USD.

Against this backdrop work continues on ETH 2.0 — the delivery of improvements to the Ethereum base-layer protocol, aimed mainly at providing additional transaction throughput. The goal is to reduce energy consumption and increase efficiency. As a feature of the spec, there are rewards to be had for staking ETH appropriately.

The need for income-generating assets

For me, the grand vision of the open financial ecosystem is to shift control back to the individual from the largely unaccountable institutions which dominate currently. To achieve this, functional alternative methods of financial cooperation need to be established and, in order to challenge existing institutions, these methods need to be able to compete financially.

A key component of a successful financial system is a means to efficiently allocate capital to those who are best placed to utilise it. In return, the providers of this capital obtain a reward for doing so. This is investment and in its current simplest forms can be a loan (either to a bank, a government or a corporation), or buying a small share of a company.

Individuals and entities have a need for viable investment options for their holdings, otherwise they find their value eroded through inflation. Blockchain-based systems have the ability to improve access to these investment instruments while cutting underlying costs of provision.

However, currently most on-chain value is held in wallets or on centralised exchanges where no return is generated — the equivalent of storing cash in the mattress. DeFi and ETH 2.0 are creating a variety of assets in which anyone can invest freely and earn a passive return without requiring permission or being subject to censorship. Meanwhile other ecosystem participants benefit from either additional network security or the ability to borrow funds for use.

What’s coming and what’s available?

There are now a number of options available or in the works to earn a passive return within the Ethereum Ecosystem.

Ethereum PoS Staking

The most obvious (but also likely the furthest away) is becoming a staker in the proposed Proof-of-Stake protocol. The risks and expected rewards of being an Ethereum validator in the latest specifications of ETH 2.0 have been followed and excellently summarised by Eric Conner and the rest of the ethhub team, with some input from Vitalik Buterin. It would also be possible to abstract some of the risks away by using a staking service.

The interest obtained is variable, depending on the total number of ETH locked up in in the staking protocol. There is still some uncertainty over minimum lock-up and withdrawal periods, but it seems like the direction is moving towards stakers coming in and out as they please without too many time constraints.

The uncertainty regarding the final outcome and associated future changes is an emerging key property of many on-chain passive return assets. I’ve started calling it ‘governance risk’ in my head and investors/stakers will likely require compensation for this similarly to how they require compensation for liquidity and credit risk now — a discussion worthy of a separate post.

Dai Savings Rate

Another soon-to-be-released option will be locking up DAI in a Dai Savings Rate contract. Again, it will be possible to enter and withdraw without any fixed time periods.

The return will be set by a Rates Policy Oracle via Maker token governance, and is expected to be below the Stability Fee charged on CDPs. The introductory article uses a figure 1% below this fee. Given the 2.5% Stability Fee at the time the expectation was of a roughly 1.5% rate of return.

However, the MakerDAO community has recently narrowly voted to reduce the Dai Stability Fee back to 0.5%. While encouraging for the issuance and adoption of Dai, this implies a much lower potential Dai Savings Rate. Again — governance risk is a significant consideration.

Interestingly, in contrast current central banks, Maker is unlikely to be able to set this to be a negative rate. Unlike real-world entities, the retail and institutional users of DAI would have no real incentive to lock it up in Maker’s system if it generated a negative return — just holding DAI is a viable alternative.

Another peculiarity is that the return here is denominated in a stablecoin by holding and locking up this same stablecoin. Whether Ethereum users ultimately prefer this to holding and obtaining a return on ETH is a separate question that also deserves its own post.

Compound

Compound acts as an algorithmic money market and is live on main net right now, making it possible to earn interest on a handful of ERC20 assets, including DAI and wrapped ETH. It launched in September, and the rates obtained for lending were very low until early December, at which point a single high-value borrower caused the DAI supplier annual interest rate to spike into the high teens. As of 12/12/2018 the return obtainable was hovering at around 8%. As of 08/01/2019, the Dai Supply APR is back down to ~3.3%. This shows a single participant can currently have a huge impact on the asset outcomes obtained by others. Early days.

Sources: https://medium.com/makerdao; compound.finance; US Department of Treasury, 12/12/2018. docs.ethhub.io, 08/01/2019.

What’s missing?

A notable characteristic of the three potential ways of generating a return described above is that it is possible to deposit and withdraw funds at a moment’s notice, essentially creating money market-type instruments. While this may seem like a desirable characteristic, due to the variability of return rates, it is hard to guarantee how much money you will earn within a month, a year or longer.

Source: US Department of Treasury, 12/12/2018

One of the key aspects of a successful financial system is the ability to invest your holdings into a predictable, long-term return. This is crucial for pension funds and insurance companies — between them these groups form a significant chunk of the global investment portfolio.

Furthermore, instruments such as these are vital for long-term individual savings, especially for those who do not desire volatility, e.g. people about to purchase property or those closer to retirement.

In addition to being helpful for insurance-type and savings use cases, something like this would encourage long-term thinking and potentially lead to improvements in the matching of project assets to liabilities in the Ethereum space.

And it’s lacking in DeFi.

What could we do?

It’s likely possible to implement higher ETH PoS rewards for fixed longer-term lock-up periods; to some extent this was already present in previous specs involving the ~4 month withdrawal period. In theory, it is possible that incentivising stakers to lock up their ETH for longer periods of time by providing additional interest would actually contribute to the security of the network in the form of both more stakers and guarantees that there will be at least a certain amount of ETH staked at specific points in the future. However, due to the variable nature of the returns depending on staking volumes, it is likely that this would need to have a floating return of type instant validator rate + x%, again making returns unpredictable.

Dharma Protocol is working towards longer-term fixed assets with its ability to create flexible loan instruments and I’m excited to see what happens with Dharma Lever. However, it’s not quite there yet — for now it still relies on p2p matching and currently interest rates are very variable. Of the 525 loans originated on Dharma (as of 12/12/2018), 16 (3%) were (a) above $10 in value, (b) over-collateralised (sidestepping the ‘lending money to a stranger on the internet’ problem) and so implying they were unlikely to just be experiments and (c) of a greater duration than 1 month.

It may also be possible to create derivations of Compound that allow for pooled algorithmic markets on longer-term assets by forcing users to lend/borrow for a fixed period of time. This would be a reasonably complex endeavour — a system of duration-based tranches would be required, with individual users’ positions jumping between them over time as their positions run down. The ‘strangers on the internet’ problem would currently necessitate an appropriate collateral system matched to the tranches. Even then, if the rates obtainable are based on supply and demand of lenders/borrowers, it’s difficult to see how the return could be fixed over time.

The key issue for long-term assets remains a lack of borrowing counterparties — not many users/projects want to borrow crypto long-term at the moment. Long-term borrowers fundamentally need to believe that they can borrow funds for a specific amount of time, utilise them to create and capture value, then repay the loan and retain the added value. The current unpredictability of crypto values, issues around user onboarding and slow adoption of a tangible link to physical property all combine to make the current demand for borrowing speculative and, hence, short-term.

We at Nexus Mutual will continue to monitor this niche with great interest and would love to chat more.

Note: This article was originally drafted w/c 10th December (before a self-imposed crypto news embargo), so a few of the figures may be out of date. In the meantime, Max from Dharma Protocol released a wonderful overview of the Emerging Crypto Debt Markets, which touches on many similar topics, albeit with a few slightly different interpretations (e.g. PoS staking) — definitely worth a read!