Exploring the Emerging Crypto Debt Markets
The formation of open, transparent, and uncensorable credit
Today’s global debt markets are robust — transmitting trillions of dollars in value across a multitude of services that allow the economy to operate at never before seen scale. But while efficiency continues to increase, there are still a number of foundational issues that plague existing credit markets including a lack of transparency and a general over-reliance on trusted third parties.
Luckily, a parallel debt market is forming thanks to blockchain enabled assets like Bitcoin and Ether. Within the Ethereum community specifically, there’s already a core constituency that has coalesced around building decentralized financial (or #DeFi) services that are transparent, open-source, and uncensorable.
This post will highlight many of the components that make up this budding blockchain-based credit market and provide insight into the unique infrastructure and use cases enabled by each system.
Central Banking
Nearly every country in the world, and certainly every developed country, has a central bank. Central banks are in charge of setting the monetary policy for a given country. They’re able to influence the economy into either expansionary or contractionary phases by controlling the money supply.
Activity within debt markets is very contingent on global monetary policy. During times of expansion, governments and companies are more willing to issue debt to fund new initiatives and investors generally increase their exposure to riskier assets like equities and commodities. In times of tighter policy, issuing debt becomes more expensive and investors allocate towards less risky assets like bonds and fixed-income securities because they can earn an attractive rate of return without taking on substantial risk.
The two main flaws in central banking today are a lack of transparency and the politicization of a nation’s money supply. For one, there is little insight into most central bank balance sheets, calling into question the actual amount of money that’s moved in and out of circulation. Another core issue is the fact that a nation’s money supply is controlled by a single, central party. While central banks are supposed to operate in an apolitical manner, time and time again power over money has been abused by authoritarian governments.
MakerDAO is building a decentralized alternative to central banking. Crypto-asset holders can use the Maker credit system to access Dai, a trustless stablecoin pegged to the value of the U.S. dollar. To get Dai, crypto-asset holders must post collateral at least 1.5x the value of their debt.
Maker’s model is valuable for a number of reasons. First, the Maker system is fully transparent — anyone in the world is able to audit its entire history. Second, running a fractional reserve system is impossible because users are required to over-collateralize their debts. Lastly, Maker is still able to enact central banking policies like raising or lowering interest rates and setting the collateral requirements, but it does so through community controlled governance rather than a single central party.
In 2018, crypto-asset holders have largely been using Maker to trustlessly get investment leverage. Users can supply ETH as collateral and use their drawn Dai to amplify their exposure or protect their assets from downside sell pressure. This can all be done at an extremely attractive interest rate of 2.5% APR. With the imminent launch of Multi-Collateral Dai, users will also be able to access permissionless savings accounts through which they can earn interest on their Dai holdings. The interest rate offered to Dai holders will be a portion of the stability fee, so lenders will likely earn <2% APR.
The stability fee (i.e. interest rate) on Maker loans can also be changed by MKR token holders via the governance system. For instance, they are currently voting on whether or not to lower the stability fee to .5% to encourage more people to take out loans and create much-needed liquidity in secondary markets.
Crypto Asset Lending
Securities lending is a vital component of global finance, enabling borrowers and lenders to move assets to their most productive use. Borrowers are able to take on leverage, hedge risk, and access working capital without selling their existing assets. On the other side, lenders are able to earn interest on their long-term investments. In sum, the entire securities lending market totals $2 trillion USD in value globally.
Generally speaking, crypto asset lending can be broken up into two core buckets: custodial and non-custodial.
Custodial lending involves borrowing and lending from a trusted third party, while non-custodial lending refers to borrowing and lending through smart contracts.
The largest custodial lending avenue is Genesis Capital Trading, a subsidiary of Digital Currency Group that originated over $550 million USD in loans over the course of 6 months in 2018.
Crypto-asset holders can also borrow and lend from centralized exchanges like Bitfinex and BitMex, but recent insights into their practices have caused users to grow weary of the associated risks. Given how few platforms offer high-volume lending, borrowers and lenders are taking on interest rates in the high teens to access this margin.
Non-custodial avenues are emerging to serve the increasing demand for user-controlled lending. We recently announced Dharma Lever, a service that allows crypto-asset holders to trustlessly access margin in high volume from anywhere in the world, instantly and affordably. Users of any kind — be they institutions or large crypto-asset holders — will be able to use Lever to access the Dharma Credit Market, a global pool of borrowers and lenders. Creating a more globally accessible credit market that makes it easier for borrowers and lenders to find each other should lead to better price discovery and more competitive interest rates.
Non-custodial lending that leverages smart contracts also stands to benefit from three primary efficiency gains. First, by creating an open market of borrowers and lenders, interest rates on Dharma Lever will be competitive and transparently determined. Second, loan agreements are settled instantly rather than the usual hour-long, and sometimes even day-long, OTC settlement times. And finally, users never give up custody of their funds, protecting users from hacks and theft.
Money Markets
For crypto-asset holders today, there exist few ways to earn interest to offset both protocol inflation and expensive security costs. While there are a few centralized exchanges that offer lending opportunities, most users opt to safeguard their funds in self-custodied wallets, incurring a negative real yield on their long-term investments.
Compound is fixing this by creating a protocol for algorithmic money markets that allows crypto-asset holders to borrow and lend with instant liquidity. Any human or machine that wants to access a protocol or speculate on an asset can seamlessly do so without having to wait for a counterparty. Similarly, lenders can start earning interest the moment they deposit their funds.
While money markets are a huge step forward for the Ethereum ecosystem, they suffer from the same lack of demand that plagues the entire asset class. With little present utility or any cash flows, there really isn’t any demand to borrow crypto-assets. Conversely, every holder wants to earn interest on their crypto-assets, creating a large market imbalance and unattractive interest rates.
Lending rates have remained consistently low since Compound launched, ranging between .01% — .4% APR. Borrow rates have fluctuated between 5% — 12% APR.
Except for some notable ERC20 exchange listings, lenders haven’t been able to secure high yields. However, the Dai money market has been a big exception to this phenomenon. Soon after the market launched, one large crypto asset holder, in particular, began to borrow large amounts of Dai, collateralized by REP and WETH, to pay off an existing CDP. Both borrow and lend rates hovered in the high teens for about a week.
Proof of Stake Bond Yields
With Proof of Stake, we’re starting to see a bond-like market emerge within the crypto asset class. Proof of Stake enables crypto-asset holders to participate in the block production process by either staking their assets behind themselves or a validator. If your staked assets are bonded to a validator who rightfully adds a block to the blockchain, you get a portion of the block reward. If we frame PoS participation as yield that’s accessible to everyone who holds that particular asset, it starts to look a lot like a ‘risk free’ government bond that crypto-asset holders can use to offset protocol inflation.
In a volatile asset class like crypto, we can expect a large number of investors to flock to Proof of Stake assets as a way of reducing risk and securing predictable cash flows. Similarly, investors can combine decentralized lending and staking primitives to create asset-neutral portfolios. A number of firms have already sprouted up to help both individual and institutional investors participate in this new block validation process including Vest, Staked, and Bison Trails.
Today, there are four high-fidelity networks in which users can earn interest for staking. Interest rates fluctuate relative to protocol inflation rates, ranging from 7% — 104% APR. A number of PoS powered public blockchains are slated to launch in the next 12–18 months, which will bring the total value of stake-able assets to $50 billion USD.
Conclusion
Crypto debt markets are rapidly evolving. Whether it’s borrowing from a trustless central bank, programmatically lending your assets through a smart contract, or earning interest for helping secure your favorite blockchain, these systems promise to give investors new opportunities to generate yield while at the same time remaining open, transparent, and censorship-resistant.
But decentralized credit markets still have a long way to go before they reach the maturity and sophistication of the existing financial system. They’re still far too fractured along both price discovery and liquidity. Interest rates vary widely across each market and orders are often relegated to siloed order books.
As the ecosystem develops and price discovery takes shape, crypto debt markets will play an increasing role in helping the ecosystem grow, allocate risk, and offset protocol inflation.
We’ve slowly started to roll out Dharma Lever to a closed group of alpha partners. If you’re interested in becoming an alpha partner and gaining early access to Dharma Lever, the easiest way to do so is by reserving your spot on the waitlist.
Thanks for your support,
Team Dharma
Max Bronstein is theMarketing Manager at Dharma Labs — a YCombinator and Polychain Capital backed R&D shop focused on building infrastructure for an efficient, borderless, and transparent credit market.
Max was formerly a Venture Associate at BTC Inc, and graduated from the UCLA with a B.A. in Political Science and a Minor in Entrepreneurship.
