Fixed Rate Lending and why it is important?
Recap
At Port Finance, our goal is to bring a suite of interest rate products to Solana. We aim to provide a one-stop solution for all of our users’ borrowing and lending needs including the following key products
- Variable Rate Lending Product
- Fixed Rate Lending Product
- Interest Rate Swaps
With the unveiling of our Variable Rate Lending Product, Port Finance now supports over 10 major assets and has achieved ~300M USD in Total Value Locked (TVL) in less than 2 months of the token launch. Port Finance is also becoming an integral part of the Solana Ecosystem, with a large network of partnerships across Solana-based DeFi Protocols such as Raydium, Mercurial, Orca and Marinade.
Overview
Our next phase of development will be focusing on building our Fixed-Rate Lending Products. We believe that these products are still nascent, there is huge potential for its demand to surpass our Variable Rate Lending Products.
In traditional financial markets, the demand for fixed rate lending is 25 times as large as variable rate lending. However, this relationship is reversed in defi. Aave and Compound combined have over $20B TVL locked while fixed rate lending protocols such as Element, Yield and Notional on Ethereum only have ~$100M of TVL combined.
Generally, fixed rate lending products are often more desirable since users don’t need to actively rebalance their position from changes to interest rates.
Why is this so?
From a users’ standpoint, variable rate lending without the concept of maturity is easier to understand and use, similar to the relationship between perpetual swap and futures in crypto trading. Additionally, liquidity mining incentives from Compound and Aave attract even more liquidity, drawing more users towards their Variable Rate Lending Products. Furthermore, DeFi is still relatively early in the adoption curve, users are less sensitive to fluctuating interest rates given the triple-digit APYs that are deemed as commonplace. We believe that with the maturity of this space and a growing number of institutions joining DeFi, demand for the “set and forget” Fixed-rate Lending Solutions will continue to grow.
Fixed Rate Lending on Ethereum and How Can We Do Better?
Some of the most notable fixed rate lending protocols in Ethereum include:
These protocols utilize varying types of bonding curves to determine the fixed lending rates. Concretely, Notional uses a logit curve, Yield and Element use constant power sum.
Using AMM to determine the fixed lending rates has the advantage of fast time to market and also an easy to use UX where users don’t need to set a minimum in terms of lending / maximum in terms of borrowing interest rate that they are willing to accept.
We believe, however, using an AMM style for implementing fixed rate lending is undesirable as we see more institutional investors joining the space and as the Defi user base gets sophisticated. We have observed several limitations using the AMM style curve.
Firstly, the usage of a bonding curve reduces capital efficiency since the bulk of the capital is idle. During each swap, only a small portion of the capital is utilised while having an order book can better concentrate the liquidity.
Secondly, AMMs have more slippage compared to orderbook. Suppose that a trade will be profitable if the traders can obtain a 4% interest rate until maturity. Using an AMM can easily cause slippage which ruins the trade given that the margin of error is rather small compared to buying and selling exotic coins that can easily go up 10X.
Finally, many of the curves that are commonly used have the issue of when it comes to close to maturity, since it will mimic a stable curve. This reduces the price discoverability when the maturity is very close.
Consequently, Port Finance intends to adopt an order book to match between fixed-rate borrowers and lenders. Having an orderbook will not only address the above issues. It will also allow Port to execute more granular operations mimicking limit orders such as:
- borrow only if the annual interest is lower than 5%
- lend only if the annual interest is over 4%
We do want to acknowledge that using an order book makes passively providing liquidity hard. However, as DeFi adoption grows, there will be more sophisticated players joining the fray to provide liquidity and we will be able to overcome this hurdle.
Implementation Overview
At a high level, we will introduce a new program which tokenizes assets that are deposited into the variable rate lending into their corresponding principal tokens and yield tokens. The principal tokens can be redeemed one to one to the underlying tokens after maturity. And the yield token represents the actual yield gain during the timer period.
Due to the time value of money, principal tokens will be traded less than the underlying assets. By buying principal tokens using underlying assets, users effectively lend at a fixed interest rate. Conversely, when users sell their principal tokens to underlying tokens they effectively take out a fixed rate loan.
Concretely, for USDC we will have a USDC / principal token USDC market. The users who buy the principal tokens (redeemable at the end of maturity 1 to 1 to USDC) using USDC are effectively lending out their USDC to the seller of the principal tokens. Since the principal token is only redeemable after maturity, the buyer of the principal tokens can get it at a discounted price. Users pay 100 USDC and be able to get back, say 104 principal tokens, which is effectively a 4% APY for lending out their USDC.
The yield tokens represent the yield that the asset generated when depositing into our variable rate products, so how much this token can be redeemed is subject to interest rate change. And by having this token, market participants can speculate on the average interest rate over a period of time. This effectively creates an interest rate swap market where the buyer of the yield token swaps their fixed yield to a variable rate while the seller obtains a fixed rate using a variable rate.
The team at Port will be heads down building and further details will be released prior to the official launch of our new product. As always, we look forward to bringing the best suite of interest rate products on Solana, for our users.
The Future
Fixed rate lending can help us to bridge from a more niche Defi use case to a more mainstream use case since it’s more user-friendly to know the APY upfront.
For everyday users who buy crypto via Fintech applications such as Cash App or Revolut and choose to hold their crypto portfolio, we envision they are able to take a loan using the Port Fixed Rate lending backend to buy cars, properties or stocks.
For institutional users, such as proprietary trading firms, DAO or protocols treasury, we hope that they are able to grow their capital using fixed rate lending which makes the management process and accounting easier.
Concluding Thoughts
We believe that fixed rate lending has the potential to be even larger than variable rate lending which is at 20B TVL. And we argue that using an order book to implement fixed rate lending is more capital efficient, provides better price discoverability, lower slippage and supports more complex order types. Our vision is that the benefit of Defi can be bridged to millions of users through some of the Fintech applications.
