Fixed Rate Interest Markets: A Casual User’s Journey Through Fixed Rate Interest Using Element
If you’re currently active in crypto or just getting started, you’re probably used to hearing about variable interest but there hasn’t been much talk about fixed rate interest. Yet, fixed rate interest can open up a lot of opportunities. Variable rates are great when high and plentiful, but they can also be time taxing, difficult to navigate and require users to move and manage their assets frequently. Additionally, it can be difficult to understand the hundreds of different products and their associated risks, and users may end up paying significant amounts of money in transaction fees to recoup the costs of getting into a position. Users may also not want to open up an expensive loan to collateralize their favorite assets they don’t want to sell. Users may not even know enough about how to do that yet or just simply may not be sufficiently interested to go through all the trouble.
Fixed rate interest solves these problems. As discussed below, fixed rates are not time-taxing or hard to navigate because the interest stays the same for the life of the term or portion of the term. By means of comparison, if you look at the traditional finance space and the products offered, a Certificate of Deposit (CD) comes to mind. A CD is a product offered by banks that provides an interest rate premium in exchange for the agreement to leave a deposit untouched for a predetermined period of time. CDs offer fixed interest rates without the risk of being exposed to the volatility of the market.
All in all, fixed rate interest products offer the freedom to get exposure to high rates, don’t require users to move their capital around to find target interest, or cause users to spend all their hard-earned money on transaction fees.
The Benefits of Fixed Rate Interest
If a user has long-term goals or wants targeted returns and doesn’t want to deal with any type of volatility associated with variable rate alternatives, a predetermined or fixed rate can be desirable. By securing a fixed rate interest position it means they have one less variable to worry about.
Removes Reinvestment Risk
Reinvestment risk is the risk associated with users not being able to reinvest gained interest at a rate equal to or greater than their current return. When interest rates change frequently over time, securing a fixed rate position helps users avoid the risk of reinvestment that’s needed when taking variable positions. Taking positions in discounted assets to secure a fixed rate, purchasing longer-term fixed rates, and entering automated or actively managed yield ladders are just some of the ways to mitigate reinvestment risks. Fixed rates are the only type of fixed-income to have no underlying investment risk since they do not provide interest payments throughout their maturity periods or terms.
Longer Time Frames
When securing a fixed rate interest position, users can confidently forget about the position and come back for redemption when the term or maturity period has ended.
Accounting and Tax Benefits
The fluctuations of variable interest rates make it difficult for users, institutions, or investment firms to perform projected earnings for bookkeeping. Fixed rates products make it easier to determine if these products meet their minimum profit margins.
Fixed Rate Interest Products in TradFi vs. DeFi
Higher Annual Percentage Yields (APY)
Typical fixed rate interest offered in traditional markets vary between 0.1–1%, whereas, the DeFi markets offer access to APYs ranging from 5–25%. DeFi is lucky to have high APYs, which makes getting involved pretty appealing but as you will read below, there are many more reasons why DeFi and fixed rates can be attractive.
No Custodial Risk
No custody means that company’s do not manage cryptocurrency on the user’s behalf. In contrast, when depositing money in a bank account, the bank holds and controls the funds and often limits the ability to withdraw or send high amounts. DeFi protocols allow users to always maintain control over their cryptocurrency.
In the traditional finance industry, secondary markets for fixed rates are often non-existent, which results in illiquidity. This can be quite inconvenient for users, especially in the scenario where they need access to funds urgently, it is difficult to exit the position without taking a major haircut in value. Even in DeFi markets today, the current fixed rate interest products on the market don’t have enough liquidity to enter in and out of the position easily.
The underlying technology that DeFi is built on allows users to be able to track how their assets are utilized and transacted in real-time. The innate characteristics of blockchain technology make all transactions, code, and data accessible to anyone seeking that information. The availability of the information encourages a higher level of trust amongst users due to the absence of black boxes. This enables everyone to truly understand the various types of transactions that are occurring as well as the ability to examine and understand the code and its functionality.
Anyone with access to the internet can access any product or service built on the network. This allows previously underserved or “unbanked” members of society to get easier access to innovative products and investment opportunities.
Accessing Fixed Rate Income through Element
The fixed rates offered by Element are made possible by allowing users to have buy and sell access to variable interest, which essentially enables people to take fixed interest positions in exchange for variable ones. This enables users to have the rate upfront, they know the rate, they do not have to move around and pay extra fees, they get what they see. If a user is optimistic about the outlook of variable interest for a specific time frame, they can opt-in to enter a fixed-term period as well as perform leveraging mechanisms to further create a bigger discount in the fixed rate market by providing selling pressure to the market. This allows users to buy discounted fixed rate assets that don’t run the risk of variable interest depreciation, as the discounts are created on the base principal of the deposit.
If Carlos uses 10 ETH to purchase discounted ETH at a 10% APY for a one-year lockup, he will get 11 Principal Tokens. Once the fixed term ends, he can take his 11 Principal Tokens and redeem them for 11 ETH. Without effort, he has secured an additional 1 ETH.
Element’s Fixed Rate Interest Use Cases
Initial Use Cases
Interest, Fixed Interest, and Stability
For casual users or institutions managing large amounts of capital, they may not have the bandwidth or the understanding of DeFi and its associated risks to constantly manage and monitor their positions. Additionally, users may not want to deal with the complexities surrounding taxes or the risks associated with new products being released. For these users, securing a fixed rate of income can be both helpful and more appealing, allowing them to not have to actively manage their positions.
Fixed Rate Income Liquidity
Element brings liquidity to fixed interest income. If a user has a term period for their fixed rate interest position, they are free to exit their term or position halfway through and still collect the profits along the way.
Bearish on Variable Interest
Users might have a bearish outlook on variable yields offered in the market and believe they will decrease over the next 3–6 months. In such a scenario, they can opt to enter a high fixed rate yield position by purchasing principal tokens. In the event that the variable yields do begin to decrease, the user is protected against the downturn and is earning a fixed rate return on their assets.
Boost Interest by Staking on an Automated Market Maker
If a user is already looking to purchase BTC or ETH for a specific period of time, it makes sense to gain that exposure at a discount. During the period of holding the discounted asset, they may stake their principal tokens on an Automated Market Maker (AMM), such as Balancer or Uniswap. By doing so, they can gain a significant boost on the fixed rate interest from the trading fees that staking on the AMM provides.
Trading Fixed Rate Interest Tokens (aka Principal Tokens)
For frequent traders who regularly enter positions ranging from 1–2 weeks up to a calendar month, trading principal tokens can make for a better form of trading instrument, generating them a higher rate of return without incurring any further trading risks.
For more detailed explanations of these use cases, check out the “Initial Use Cases of Principal Tokens” section of the Element Construction Paper.
Future Use Cases: Building on Top of Element
The Decentralized Finance (DeFi) industry is powering a new generation of interest rate markets and Element is at the forefront of this new revitalization movement.
The Element Protocol can be used to build many other mechanisms that introduce further avenues of capital efficiency to all types of users and is dedicated to providing continued innovation. There are many possible structured products that can be built on top of Element, such as:
A certificate of deposit (CD) is traditionally a product offered by banks that provides an interest rate premium in exchange for the agreement to leave a deposit untouched for a predetermined period of time. CD terms vary depending on what the institution wants to offer as well as what penalties are applied for early withdrawal. CDs offer fixed interest rates without the risk of being exposed to the volatility of the market. They can often be higher than the rates paid by many savings bank accounts, however, that’s not saying much as the average rate for a 1-year CD is 0.18 percent.
Automated CDs can be built on top of Element, offering users access to fixed rate interest ranging from 5–25%, while also providing the ability to exit at any time without a penalty.
One-to-One Collateralized Loans or Fixed Term Lending
Current lending or borrowing products in DeFi require over-collateralization, which means using an asset as collateral on a loan where the value of the asset exceeds the value of the loan. This process is in place to avoid liquidation or the loss of the user’s collateral. Even with this design, a market flash crash or another extreme case can still initiate a liquidation.
In the case of Element, using the principal portion of a user’s fixed rate position, they can secure a close to 1:1 collateralization ratio since the assets converge in price. For example, 1 ETH principal will always be 1 ETH after its lockup or term ends. They can also buy the ETH principal token on the market, use it as collateral for an ETH-backed loan while earning the fixed rate interest it provides. Their fixed rate interest may end up exceeding the borrowing interest, ultimately gaining them a profit.
Automated Debt Repayments
Debt repayments are typically a manual process that requires users to constantly monitor the health of their loan and make adjustments or payments to keep it healthy.
Element can enable users to use their principal as collateral or by providing liquidity to gain further interest on their assets while keeping the underlying exposure to the fixed rate interest. This type of product can provide users with the ability to get an advance on their future interest immediately to pay off any debt they may have. Additionally, as their assets are generating fixed interest, the user may decide to use their fixed rate generating principal as collateral to acquire capital for miscellaneous usage and expenses. The entire process of debt repayment can be done automatically as fixed rate interest gained can be used for debt repayments. As fixed rates provide a clear rate of return, the user can account for the total duration needed for the debt repayment to occur. Any additional interest earned from compounding fixed rates or AMM fees could further speed up the repayment process for the user.
To learn more about the potential future products that can be built on top of Element, check out the “Building on top of the Element Protocol” section of the Element Protocol Construction Paper.
Keep a lookout for the next blog post coming soon, which will highlight a Sophisticated User’s Journey Through Fixed Rate Interest Using Element.