The bond market in crypto
Comparison between traditional and crypto bond markets
Special thanks to Suah Kim, Praveen.S, Gongpil.C, and Kevin.J for the productive feedback on the posting.
A lot of concepts frequently used in crypto are actually from traditional finance. A ‘bond’ is not an exception. However, several differences, not just similarities, between bonds in mainstream banking and bonds in crypto exist. In this sense, combined with examples of relevant crypto projects, it would be helpful to understand the bond market in crypto by comparing itself to its legacy counterpart.
What is a ‘bond’ in traditional finance?
To put it simply, if you invest money in a bond, the principal, with accrued interests, will be returned after a fixed amount of time or maturity. Of course, if the issuer goes bankrupt, some, if not all, of your money is likely to evaporate.
As you can easily guess, bonds help both investors and issuers achieve specific goals. For example, investors can earn extra cash in interest payments with their idle money. Moreover, a bond is regarded as the safer asset class in that it bears the obligation for promised payouts and is senior to stocks in terms of payments.
In the case of issuers, a bond is an efficient vehicle to raise a massive amount of capital without diluting the governance power. Additionally, issuers can enjoy the ‘leverage effect.’
Bonds in crypto: how they are different from their traditional counterparts
Since there are numerous bonds in crypto with unique features, narrowing the range of discussion is necessary. First, we inherit the basic definition of traditional bonds. Second, we do not include lending or staking services because they are not generally tradable.
1. bonds from investor’s perspective
Like traditional bonds, if you put some funds into bonds in crypto, after a certain amount of time, or the vesting period, you will be entitled to obtain both principal and accrued interests.
However, underlying currencies differentiate bonds in crypto from their counterparts. For example, traditional bonds are denominated in fiat currencies such as USD or KRW. Moreover, the payment currency is the same as the underlying currency. Since fiat currencies are issued and authorized by sovereign nations, they are generally less volatile. At the same time, they do not guarantee any additional rights, including voting rights, other than the normal functions we expect from money. Therefore, traditional bonds are for those who are more concerned about losing their money than reaping enormous returns or actively participating in the decision-making process of the issuer.
However, bonds in crypto are more flexible in satisfying diverse risk profiles and needs. For instance, the base of SMART Yield Bonds in BarnBridge is lending pools consisting of stablecoins like DAI or USDC. Therefore, you can avoid the inherent volatilities of cryptocurrencies. It is similar to traditional bonds, whose underlying currencies are fiat currencies and the same as the payment currency. It is also notable that these bonds comprise several tranches. We can further reinforce the downside protection by choosing the senior tranche with the fixed interest rate.
By the way, it is not the end of the story. You may be more interested in higher returns. Additionally, increasing exposure to the promising project may seem attractive. In this case, the Olympus DAO bond is the perfect option. In the ‘bonding’ process, we get OHMs, native tokens of Olympus DAO, in exchange for other cryptocurrencies like DAI or LP tokens. Since OHM is the governance token of Olympus DAO and backed by a combination of crypto assets, bonds in Olympus DAO share some features of stocks in a conventional sense. Consequently, it is possible to aim for more profits at the expense of augmented risks.
2. bonds from issuer’s perspective
Bonds in crypto are accessible to a broader range of issuers. For example, while big entities like governments or corporates issue traditional bonds, even ordinary users can create their bonds in the crypto arena. Platforms such as Position Exchange and DeBond are open to everyone who want to issue bonds with collaterals. It is fair to say that the primary market where bonds are born has become more democratic.
The goals of issuers are also different. Governments or enterprises issue bonds to raise capital for maintaining and growing the organization. Because launching new businesses or projects probably costs a lot, borrowing money from others in the form of bonds will be efficient. Of course, relatively minor items such as everyday expenses may be covered, too.
However, this is not necessarily the case in crypto. For example, crypto-assets obtained by bonding in Olympus DAO sit still in the treasury to ensure the minimum intrinsic value of OHM. We have to note that treasury reserves are acquired, not borrowed, and not consumed. Considering new OHMs are generated with bonds issued and sold, bonding in Olympus DAO acts as a minting mechanism for OHMs as a collateralized store of value.
Procuring liquidity cannot be ignored, too. Traditional bonds also help secure liquidity, but the implications are starkly different. For instance, the liquidity for issuers of traditional bonds is like cash or cash-equivalent assets. In this case, liquidity is for covering operational costs or preparing for contingencies. However, bonds in crypto view liquidity as ease of transactions involving native tokens. The thick and sustainable liquidity can absorb selling pressures well, stabilizing the value of native tokens and thus the underlying ecosystem.
Interestingly, many crypto projects deploy unique methods to capture liquidity. In the case of Olympus DAO, the concept of ‘Protocol Owned Liquidity(POL)’ has been materialized by accepting LP tokens for bonding. Since the protocol possesses liquidity, it is more resilient to ‘mercenary liquidity’ issues.
BarnBridge takes a bit different path. Rather than owning the liquidity, it tries to appeal to a broader base of users. How? As already mentioned, BarnBridge divides bonds into several tranches based on risk/return profiles. While the senior tranche offers less upside with more downside protection, the junior tranche boasts higher leveraged returns at the expense of shrunk downside protection. In other words, it can lure liquidity from not only risk-averse users but also risk-loving users.
Position Exchange utilizes the concept of ‘stakeable bonds’ to attract liquidity. If you stake Position Bond units in the Bond Pool, earning the stable and fixed APR combined with interests is possible. It is likely to act as a positive driving force for sustaining the liquidity in the system by locking funds in POSI-denominated bonds. (POSI: the native token of Position Exchange)
For individual issuers, bonds in crypto may open the door to more simplified funding. In mainstream finance, you must deal with the agonizing paperwork to prove your credibility. In contrast, qualified collaterals are sufficient to issue bonds and thus secure the capital in crypto bonding protocols. The smart contracts will enforce the relevant procedure.
3. The valuation of bonds
The valuation of bonds comes down to the interest rate and thus needs the ‘standard rate’ or the risk-free rate. In traditional bonds, the US treasuries rate acts as the reference rate because USD has been a global reserve currency. Consequently, the interest rate of all other government or corporate bonds relies on the US treasuries rate or, more strictly speaking, US federal funds rate.
Stablecoins play a similar role to bonds in crypto because they are supposed to maintain the peg to fiat currencies like USD. However, they try to go a step further: decentralization. The whole legacy system can be in jeopardy if the US gets unstable. Of course, it is also the case for USDC or USDT, stablecoins backed by USD, or liquid USD-denominated assets. In contrast, DAI is relatively less vulnerable to the ‘single point of failure issue. Instead of tieing its value to a single currency, it is collateralized by multiple cryptocurrencies. The downfall of the specific crypto project is unlikely to sway the DAI-centric valuation system.
The bond market in crypto
1. limited version
- the limited bond market
It is straightforward that a bond needs the bond market. Of course, how it works depends on relevant assumptions we hold. For example, you may buy or sell whatever amount of bonds you want. On the other hand, imposing some restrictions on transactions is also possible. For this reason, it would be helpful for our discussion to divide the bond market into two categories: the limited market and the unlimited market.
The bond market is ‘limited’ because a limited amount of bonds are for sale in a fixed period. A new bond market continuously opens and closes whenever necessary. For instance, in Olympus DAO, if needed, the bond market for the specific quote token is held. It is similar to the company that seeks to issue bonds and find appropriate investors.
Moreover, in both cases, the interest rate, or the discount rate, is inversely proportional to the demand for bonds. The more those who want to buy bonds are, the lower the interest rate or the discount rate is.
However, there is one crucial difference. While the issuer and a few investment banks are responsible for issuing and selling corporate bonds, codes written in smart contracts govern the bond market in crypto.
The decentralized nature of automation allows for more flexibility, and the dynamic interest rate illustrates this well. Olympus DAO is one of the crypto projects which has implemented the function by introducing the ‘bond control variable.’
- How the limited bond market works
To understand how the bond control variable works, you should know that the capacity, the target amount of bonds to sell, is supposed to decrease linearly. For example, if the bond market lasts for 24 hours, 25%(6/24) of the capacity ought to be exhausted during the first six hours of the market.
Unfortunately, considering significant fluctuations in the appetite for bonds, it is hard to guarantee a steady, linear decrease in the capacity without the proper intervention. In this situation, the bond control variable aims at guiding bond buyers in a way that gradually decreases the target size of bonds as intended. For instance, if plenty of people want to invest in bonds, the bond control variable will rise, which leads to a lower discount rate and a higher bond price.
- Pros and cons of the limited bond market
The limited bond market like Olympus DAO has both pros and cons. If we look at the bright sides first, this type of market has been tested and proven. Of course, it is a bit premature to call Olympus DAO ‘a fantastic success’, given the recent plunge of OHM’s value following the hawkish pivot by central banks around the globe. Still, it has survived. This kind of ‘track record’ is crucial to solidifying trust among users in the relatively nascent blockchain industry.
A limited market is also more resilient to price manipulation. Even though malicious activities occur, potential fallouts can be limited to the exact bond market where these incidents happen.
However, we cannot ignore several downsides. For example, the capacity focuses on supply, so the limited bond market entails a greater risk of ‘demand shock.’ It is a huge issue because many protocols link reward incentives to the bonding program. Consequently, if we continuously fail to predict the demand in a large margin, it will undermine the confidence in the whole ecosystem.
In addition, a lack of flexibility in terms of market schedules can lead to more inconveniences. First, it restricts the discretion in policies by protocols because their actions should reflect the conditions of each specific market. Opportunity costs for users or investors may rise due to potential conflicts between bond market schedules and financial states.
2. unlimited version
- The importance of the secondary market
The bond market does not necessarily have to be limited. In other words, the concept of bond markets with infinite capacity is not beyond imagination.
We see the traditional bond market as a combination of two main categories: the primary market and the secondary market. The primary market is where bonds are first issued. The bond market of Olympus DAO covered in the previous section is the primary market. Although we only discussed the limited version of the primary market, lifting the limits is also possible. For instance, if there exist no restrictions on the capacity or market hours, users can bond any amount of assets for OHMs whenever they want.
However, the primary market only is not sufficient. Why? One word can tell you everything: Liquidity. Let’s say we have the primary market without any shackles. In this case, the number of bonds issued does not matter. The term structure is also comprehensive, ranging from days to years. By the way, there is a problem. After buying bonds, the only way to get your money back is to wait until maturity. In other words, your money is locked in bonds. Therefore, even without limitations, investors may be reluctant to purchase bonds worth tens of thousands of dollars, especially if they have longer maturities.
The secondary market can solve this. It is where issued bonds change their owners freely. Even though payments are not due, you can sell bonds and exit the position. Of course, it relieves concerns about the liquidity of bonds.
Surprisingly, the secondary market also makes the more compact term structure possible. If a bond with a maturity of one month is issued and sold after 13 days, it is the same as buying a bond with 17 days left. In other words, as long as demand exists, the de facto maturity of this bond can be any number between 0 and 30 days.
Reduced interest costs are notable, too. If bonds are relatively illiquid, the issuer compensates for the opportunity costs from illiquidity by raising the interest rate. We can decrease the ‘liquidity costs’ by encouraging transactions in the secondary market.
- Examples for the secondary market
Not surprisingly, some crypto projects support the secondary market, not just the primary market.
TraDAO is one of the OHM forks which supports the secondary market. Users can list bonds in the market regardless of vesting periods. Plus, TraDAO’s marketplace has another unique trait: liquidation. Unlike Olympus DAO, you can purchase TraDAO bonds partially, similar to installments we already know. If some users do not manage to repay their installment debts, corresponding bonds go through a liquidation process in the secondary market. Anyone can buy these bonds for a discounted price.
DeBond is the platform to offer customized services related to bonds based on ERC-3475. Any institution or individual can attach diverse conditions to bonds so that these products serve their financial needs. On top of that, bonds can be traded on Bond DEX, cut and packaged, and circulated in the secondary market.
Superbonds, built on the Solana chain, is a bit different. First of all, all of its bonds give buyers fixed-rate interests. Additionally, only the protocol can issue bonds after liquidity is provided in USDC by liquidity providers or bond underwriters. Therefore, users are only able to buy bonds or provide liquidity. Nevertheless, the point is essentially the same: Because a bond assumes the form of NFT and owners can redeem it before maturity, we can expect almost identical effects seen in the concept of secondary markets.
- Pros and cons of the unlimited bond market
Of course, there exist both merits and drawbacks to unlimited bond markets, too. First of all, they are more flexible concerning responses to diverse situations. For example, if the protocol suddenly needs to issue bonds on a large scale, the limitless market probably requires nothing more than lowering the discount rate. In contrast, in the limited system, making the additional limited market may be necessary.
The continuity of ‘monetary policies’ can be guaranteed, too. By definition, the limited bond market lasts for a pre-specified interval of time, so there exists an ‘end’ of the market. As the market approaches the close, actions may not be that effective because there is not much time left. Of course, each bond market starts with new underlying conditions, so it can often be closed without achieving the target. Unlimited bond markets are more immune to the issue.
Unfortunately, the feature of being unlimited, if abused, can backfire. If loopholes or bugs exist in the mechanism, they might disrupt the whole system in the form of a crash due to the possibility of being exploited infinitely many times. Even without such glitches, the prolonged period of lackluster demand can cause a ‘fire sale’ of native tokens, hurting their intrinsic value.
The compatibility of different standards is also a hurdle to overcome. For instance, existing AMMs or lending platforms do not recognize ERC-3475 bonds by DeBond. It may seriously restrict the liquidity of ERC-3475 bonds.
3. The third way?
- The circuit breaker and buyback
The hybrid market combining features of both systems is also possible. Let’s say we first implement the bond market with few limits. However, if certain events occur, the circuit breaker is activated. For instance, once the bond price touches the lower bound, the market is suspended. In this scheme, we can enjoy the flexibility of the limitless bond market and minimize the potential hits from price manipulation.
Proper monetary policies can maximize the efficiency of this market. For example, if the circuit breaker is triggered and the price of the native token continues to slide, the protocol can execute buyback. Olympus DAO has already implemented a similar policy by issuing inverse bonds. Inverse bonds enable users to sell OHMs for treasury assets. The protocol not only shrinks the supply of native tokens but enhances the backing rate of tokens with buyback at low prices.
- Merged tokens
The limitless bond market with perpetuities can be a perfect environment for ‘merged token.’ In this case, bonds are the minting mechanism of native tokens. After depositing underlying assets in the treasury, users get newly minted tokens. The core idea of a merged token is that the protocol provides users with the tokenized perpetuity with zero coupons backed by a combination of underlying assets and native tokens. For instance, if 1 OHM bond price equals 0.1 ETH, but the user still wants to maintain ETH exposure to some extent, the protocol can issue the perpetuity(merged token) collateralized by 0.3 OHM and 0.07 ETH. Of course, the remaining 0.03 ETH back 0.3 OHM.
Merged tokens can satisfy the diverse risk profile of investors. Of course, multi-collateral bonding will probably reinforce the effect with more options.
Conclusion
In this writing, we delved into bonds in crypto in comparison to traditional bonds.
Bonds return (principal+interests) to investors after a specified amount of time. In addition, lots of capital comes in through the bonding process. However, unlike their conventional counterpart, bonds in crypto can satisfy investors with various risk profiles. Additionally, a broader range of issuers can join the primary market. Bonds in crypto are crucial to stabilizing the value of native tokens and securing liquidity, too.
Bond markets in crypto are divided based on whether limits on relevant parameters exist. The bond market in Olympus DAO complies with imposed limits by adjusting the bond control variable. While the limited market is more resilient to attacks and has weathered several tests, we should not overlook its lack of flexibility.
Unlimited bond markets can flourish if we establish primary and secondary markets with few limits. Projects such as TraDAO, DeBond, and Superbonds suggest the vision for the secondary market. The limitless market ensures more flexibility for policies. Unfortunately, it also means enough space for potential attacks. The compatibility of diverse standards is also a problem.
The hybrid market, such as the limitless bond market with circuit breakers and appropriate monetary policies, may solve the issues aforementioned in both markets. Merged tokens, which combine the limitless market with perpetuities, can also be an alternative.
Disclaimer: By the way, although I tried my best to do a quality analysis on the bonds in crypto, you have to be aware of several limitations in the posting. First, since there are probably more relevant crypto projects, I might have generalized some features too much. Moreover, the inherent volatilities of cryptocurrencies may affect the valuation of bonds in crypto a lot, but I did not explicitly point it out that often. I thought it was the problem of cryptocurrencies, not the structure of bonds.
