5 Highlights From Our Webinar: “The Unwinding Carry Trade and its Impact on DeFi Lending”
On April 2nd, CryptoMonday hosted a webinar on the impact on DeFi of the unwinding of the Japanese carry trade. You can view a replay on our YouTube channel:
We were joined by three great panelists to discuss this intricate topic:
Sam Kazemian, Co-founder of Frax Finance
Kory Hoang, Co-founder of Stably & dTRINITY
Liam McDonald, Business Development at Morpho
While the concept might seem niche, its implications for the decentralized finance (DeFi) landscape are significant. Here are five key points that emerged from their insightful conversation:
1. Understanding the DeFi Carry Trade and its Current State
The webinar kicked off by defining the carry trade in the context of DeFi. Essentially, it involves borrowing an asset cheaply and reinvesting it in another asset that offers a higher yield. This strategy has been prominent in traditional finance for decades, exemplified by the Japanese Yen carry trade where low interest rates in Japan allowed investors to borrow yen and invest in higher-yielding currencies. However, recent unwinding of such trades due to changing macroeconomic conditions has implications for DeFi. In DeFi, the carry trade often involves leveraging yield-bearing stablecoins like those potentially backed by delta-neutral strategies involving shorting cryptocurrencies. The current “unwinding” refers to a period where the profitability of these short positions decreases or even becomes negative, impacting the yields associated with these stablecoins.
2. The Stablecoin Evolution Continuess
Sam provided a historical backdrop of stablecoins, highlighting the evolution from dollar-backed tokens to over-collateralized models and eventually to algorithmic approaches. A crucial distinction was made by Kory between endogenously-backed algorithmic stablecoins (backed by their own ecosystem tokens) and exogenously-backed ones (backed by external assets). The former, like Terra/Luna, have proven to be riskier and are likely to face stricter regulations.
Sam expressed his view that on-chain algorithmic stablecoins, even successful ones like the original Frax (V1), represent “M2 or M3” money — hypothecated forms of digital dollars — as opposed to “M1,” which he believes will be directly represented by institutionally custodied and legally compliant digital dollars like Frax USD. Sam sees algorithmic stablecoins as valuable innovations for yield generation but not the ultimate solution for scalable, safe digital base money.
3. The Inherent Higher Risk of DeFi, The Unwinding Notwithstanding, Still Necessitates A Risk Premium On Yields.
The panelists discussed how the unwinding of traditional carry trades and the demand for yield are shaping DeFi. Liam pointed out that the recent sell-off in longer-tail equities and crypto in August was influenced by the Yen carry trade unwinding. DeFi protocols are actively trying to deliver more efficient yields by innovating in areas like yield-bearing stablecoins and lending protocols. This includes models that aim to replicate traditional opportunities but with potentially better rates. However, the inherent higher risk of DeFi compared to traditional finance necessitates a risk premium in any potential yields.
4. Mitigating Risk Remains A Priority For DeFi Protocols
A significant point of discussion was the need to mitigate risk in DeFi lending to attract institutional capital. Liam emphasized Morpho’s approach with risk-isolated lending markets, allowing users to choose their collateral exposure, contrasting it with earlier peer-to-pool models. Liam also highlighted the importance of protocol security, citing Morpho’s immutable contracts and hack-free history. Kory echoed this, noting that reducing risk is essential for improving risk-adjusted returns in DeFi. Both agreed that security is just as crucial as yield in making DeFi more appealing to ttradfi.
5. The Untapped Potential of the Demand Side in DeFi Lending
Kory highlighted a crucial imbalance in DeFi: a strong focus on the supply side (lenders and yield-bearing asset holders) with less emphasis on the demand side (borrowers). Yield-bearing stablecoins, while providing yield for holders, can be capital inefficient as borrowing them increases debt due to the accumulating yield. dTRINITY is tackling this by introducing dUSD, a stablecoin where the yield generated by its exogenous reserves is redirected to borrowers as interest rebates, effectively reducing their borrowing costs. This innovative approach aims to create more demand for borrowing, increase utilization of lending protocols, and should ultimately lead to higher yields for lenders. The panelists agreed that focusing on the demand side through such mechanisms is vital for the continued growth and sustainability of DeFi lending.
In conclusion, the webinar provided a comprehensive overview of the DeFi carry trade, its current challenges, and the innovative solutions being developed to enhance yield efficiency, security, and overall market dynamics. The discussion underscored the evolving nature of DeFi and its ongoing efforts to bridge the gap with traditional finance while forging its own unique path.
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This content is for educational purposes only. It does not constitute trading advice. The author of this article may hold assets mentioned in the piece.
