Understanding Fixed-rate Lending in DeFi

The world of decentralized finance (DeFi) continues to evolve, offering innovative financial products that mirror traditional finance (TradFi). One such product is fixed-rate lending through bonds. This article will educate you on the principles and mechanisms of bonds, their history in traditional finance, their application in DeFi, and their use cases.

Overview

Imagine you need some money, but instead of asking a friend, you write a note that says, “I promise to pay back this amount with some extra as a thank you by a specific date.” This note is like a bond. In finance, a bond is a way for people or companies to borrow money from others with a promise to pay it back later with interest.

In DeFi, the process is similar but uses cryptocurrency. Users can leverage their crypto assets as collateral to issue bonds, which can then be sold to obtain other tokens. Eventually, the bond issuer must pay back the bond’s value plus interest to retrieve their collateral.

Traditional Finance History

Bonds have been a cornerstone of traditional finance for centuries. The earliest recorded bonds were issued by Italian city-states like Venice in the 12th century to fund wars and public projects. These early bonds paid a fixed annual interest, making them a reliable investment.

Over time, bonds became a primary method for governments and corporations to raise capital. For example, during the 19th century, American cities used municipal bonds to finance infrastructure projects, while corporations issued bonds to fund industrial expansions and railroad construction.

During significant events like World War I and II, bonds played a crucial role in financing war efforts. The U.S. government issued Liberty Bonds and War Bonds, raising billions to support military expenditures. These bonds not only provided necessary funds but also engaged the public in the war effort.

DeFi Adoption

In DeFi, the concept of bonds is adapted to the blockchain environment, offering similar benefits of predictability and stability. Here’s how fixed-rate lending works in this context:

Bond Issuance

In traditional finance, bonds are a way for entities to raise funds by borrowing from investors. Similarly, in this proposal, bonds are issued using an over-collateralization method:

• Users deposit collateral tokens (e.g., USDT, USDC, ETH) into a bond contract.
• The contract calculates the number of bond tokens (e.g., Bond-WING) that can be issued based on the collateral’s value.
• These bond tokens have an expiration date.

This method ensures that the value of the collateral exceeds the value of the issued bonds, reducing the risk of default.

Bond Sales

After issuance, these bonds can be sold:

• Users can set a price to sell their Bond-WING tokens and obtain WING tokens.

In TradFi, bonds are sold in the open market, and their prices fluctuate based on interest rates and the issuer’s creditworthiness. In DeFi, this process is streamlined, but the principles remain similar.

Bond Redemption

On the maturity date, bond issuers must deposit the bond’s local currency into the smart contract to retrieve their collateral. Bond holders can redeem the bonds for the principal amount and interest. If the collateral’s value drops and the issuer does not redeem the bond, the collateral is allocated to the bond holder, protecting their investment.

Use Case

Let’s consider a practical example to illustrate the use case of fixed-rate lending in DeFi:

Scenario: Alice Needs Funds for a New Project

Alice, a crypto enthusiast, needs funds for a new project but doesn’t want to sell her ETH. She decides to use her ETH as collateral to issue bonds.

1. Issuing Bonds: Alice deposits her ETH into a bond contract. Based on the value of her ETH, she is issued Bond-ETH tokens with a specific expiration date.
2. Selling Bonds: Alice sells these Bond-ETH tokens at a discount to obtain USDT or another token she needs for her project. She sets the borrowing interest rate she is comfortable with.
3. Redeeming Bonds: Upon the maturity date, Alice must deposit the equivalent value of USDT back into the contract to retrieve her ETH. Bond holders redeem their Bond-ETH tokens for the principal and the agreed-upon interest.

Benefits to Alice:

• Liquidity without Selling Assets: Alice gets the funds she needs without selling her ETH.
• Predictable Costs: The fixed interest rate ensures she knows exactly what she needs to repay.

Benefits to Bond Holders:

• Stable Returns: They receive a predictable return on their investment.
• Reduced Risk: The over-collateralization reduces the risk of default.

Conclusion

Fixed-rate lending in DeFi offers a stable and predictable financial product, mirroring the benefits seen in traditional finance. By leveraging blockchain technology, DeFi platforms can provide innovative solutions that enhance financial planning and risk management for users.

Bonds have proven their worth in traditional finance over centuries, funding everything from infrastructure projects to wartime efforts. Now, in the world of DeFi, they continue to offer reliable and stable investment opportunities, fostering the growth and stability of the crypto financial ecosystem.

We hope this article has helped you understand the principles and mechanisms of bonds in both TradFi and DeFi. As the DeFi space continues to evolve, fixed-rate lending through bonds represents a significant step towards more predictable and stable financial products.