Will Fixed-Rate Projects Incentivize Traditional Funds to Gravitate to DeFi?
When farming was at its peak during the summer of 2020, it wasn’t uncommon to see annualized yields (APY) of 1000% or even 10,000%, pretty much everything was on the table. Even though much of the speculative energy has cooled, the most talked about question is when/how is DeFi going to replace traditional finance. We think fixed rates are going to play a part in the transformation.
In fact, in traditional financial markets, fixed rate loans are amongst the most important forms of loans. Allan Niemerg, founder of Yield Protocol, stated that around 90% of mortgage loans in the United States are fixed-rate loans. Some of the largest financial products are fixed rate products, such as the US bond market (that is worth more than $100 trillion USD)or derivative products that contain fixed rate components(such as the interest rate swap market that is estimated to be over $500 trillion USD).
Almost all DeFi products provide an APY with a floating rate of return in some way or form. The actual annualized return will change depending on the number of funds in the pool or potentially with changes in mining rules. In other words — investors cannot accurately predict capital returns strictly on APY alone. Therefore, in recent months, calls for the introduction of fixed interest rates in the DeFi market has increased.
Projects with this concept have also appeared one after another and usually fall into two categories:
Project provides lending functions — eg. Yield Protocol, Notional
Project does not provide lending function and needs to rely on other agreements to achieve revenue — 88mph, NAOS Finance
Projects with Lending Functionalities
Yield Protocol has a derivative token called fyToken that functions similarly to a zero-coupon bond and can be exchanged with Dai on a 1:1 basis. However, the price of fyDai will be lower than Dai until it reaches maturity.
Because of this, borrowers can choose to use ETH as collateral to generate fyDai. Since the price of fyDai is generally lower than the price of Dai, lenders will buy more fyDai with a single Dai. Borrowers can loan Dai by collateralizing ETH. The lender can then exchange fyDai back to Dai to earn more than the principal after maturity is reached. For lenders, this difference between fyDai and Dai is their source of income.
Similar in concept to Yield Protocol, Notional allows both lenders and borrowers to choose from three different borrowing cycles. The longer the borrowing cycles, the higher the corresponding interest rate. Instead of fyDai, Notional introduced their own derivative token called fCash, which operates similarly as FyToken — both can redeem a corresponding amount of original tokens after expiration.
Projects without Lending Functions: Income from Agreements
88mph positions itself as “a protocol that allows users to lend their crypto assets such as AaveUSDC, yUSD, and other yield-bearing assets at a fixed interest rate with infinite liquidity.” Currently, 88mph supports a library of tokens including USDC, UNI, yCRV, crvSBTC and many more. The protocol puts tokens provided by users into DeFi products such as Compound, Aave, and Yearn to earn floating income, through aggregation of fund pools, and income bonds. This in-depth design ensures users can generate a stable income even when floating interest rates fall sharply.
Users can deposit funds into corresponding pools with redemption cycles ranging from 7 to 365 days. The fixed interest rate of each pool is prominently shown to the user through the 88mph UI. After depositing the funds, users will receive an ERC-721 based NFT token that corresponds to their rights and interest. This NFT token can be transferred to other accounts or sold directly on markets such as OpenSea. When the loan expires, users can get back their principal along with the interested based on the fixed interest rate.
NAOS Finance, unlike pure crypto-native protocols, tokenizes high quality real-world assets with steady income streams. NAOS Finance utilizes a senior/junior tranche design to differentiate risk-return profiles. Lenders in the senior tranche receive fixed and guaranteed interest, whereas the junior tranche provides a much higher upside on the variable interest catering for appetite of the traditional DeFi community.
Let’s illustrate this in a scenario. Assume the entire asset pool is $1M and it is generating 12% APY.
The pool is then divided into a senior tranche (80% or $800K) with 5% fixed interest and a junior tranche (20% or $200K) with variable interest.
When the asset pool reaches maturity:
Total Pool Returns: $1M x 12% = $120K interest generated
Senior tranche: $800K x 5% = $40K fixed interest allocated to the lenders
Junior tranche: $120K — $40K = $80K interest allocated to the lenders
In this case, the return on junior tranche represents a whopping 40% return! ($80K / $200K = 0.4)
In our model, the more conservative investors can lock in the fixed yield with the senior tranche, whereas the more adventurous investors can choose to take part in the junior tranche for greater rewards!
In this article, we’ve brought up a few projects that best illustrate the methodologies of projects with lending functions and ones without. Yield Protocol and Notional are two projects that best demonstrate the concept of zero-coupon bonds in the DeFi space. Whereas 88mph does not directly provide loans but depends on other DeFi agreements to generate income.
While we can’t definitively say that any of these projects will incentivize traditional funds to take the plunge into DeFi. We also have to be cognizant that the appetite for risk in DeFi is much higher than of traditional finance — crypto investors are more accustomed to crazy, wild swings. To those types of investors, the returns on fixed rate products may not be sexy enough. However, the participation of larger funds is going to be a key driver in the growth of DeFi as a space. Therefore, going forward, fixed rate DeFi projects should be designed to be closer to traditional financial products, which may help ease the conceptual transition and attract more interested investment from outside the crypto family.
About NAOS Finance
NAOS Finance is a DeFi lending protocol allowing lenders and SME borrowers to facilitate permissionless and borderless loaning/borrowing transactions on the blockchain. Built on Ethereum, our platform lets users tokenize real-world assets and subsequent lending.
We operate compliantly and legally in top markets around the globe, maintaining safety as a top priority and fostering enhanced trust in the lending/borrowing process.
To remain informed on everything about our project, be sure to visit our website and join the family by following our social media platforms:
Revision 1.4.21 — 88mph offer maturity terms between 7 and 365 days. Eg. user can select a maturation of 88 days.