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Fantastic article walking readers through the importance of yield curves and Fixed Income Borrowing & Lending (5 min read)
by Jack Purdy
The Yield Curve Cometh
Historically, if you wanted to earn interest on your stablecoins, you went to your favorite decentralized money market (Compound, Aave, etc) and made a deposit to earn the market rate. It didn’t matter if you were lending them for a month or two years - you got the same rate as everyone else during that time. There’s been no way to differentiate time preference and reward those wanting to lock-up capital for longer periods of time.
If that seems weird, that’s because it is.
It ignores a fundamental principle regarding the time value of money. A dollar today is worth more than a dollar tomorrow. Therefore, if I give you a dollar for two years as opposed to one month, you should pay me more (on an annualized basis). However, in crypto the instruments needed to express this have not existed… but that’s changing.
A Primer on the Yield Curve
Typically, in fixed-income markets, lenders can match their preferred time horizon with the maturity of a bond. As that maturity extends into the future, the yield increases to adequately compensate for the opportunity cost of capital. This is known as fixed-rate lending, and when you plot a bond’s yield over time, it curves.
Fixed rate lending is a useful tool for investors as it enables them to earn a predetermined interest rate over a set amount of time. It is also helpful for borrowers, as it gives them certainty around the interest rate they pay on loans.
In addition to being a necessary instrument for a functioning financial system, fixed-rate loans can provide valuable insight into investor sentiment. A steeper yield curve means the market believes there to be good times ahead. Why? It means lenders require a higher yield to convince them to lend over longer time horizons because they deem there to be more profitable opportunities elsewhere.
Conversely if the curve flattens, then investors are content with lower yields in both the short and long term, indicating that they don’t expect much future growth.
When the yield curve actually inverts, meaning long-term rates drop below short-term rates, this indicates investors are expecting a severe downturn that will lead central banks to lower rates further. This leads them to lock in whatever rate they can get. Inverted yield curves are a powerful economic indicator that has predicted the last several US recessions.
Fixed-Rate Primitives in Crypto
To date, there haven’t been fixed-rate lending in DeFi leaving stablecoin holders at the mercy of volatile interest rates. Anyone looking to borrow or lend is faced with uncertainty as to their return on (or cost) of capital. For example, rates to borrow Dai on Maker started the year at 0.5% and a few months later, were around 20%.
The absence of fixed-rate lending has left prospective borrowers with crippling uncertainty while depriving the ecosystem of the ever-so-useful yield curve.
Thankfully, that’s all changing. The first instance of decentralized fixed-rate loans came this summer with UMA’s yield dollar. Next came Yield Protocol, which allows fixed-term borrowing and lending of Dai, which will reveal a Dai yield curve. And more is on the way with projects such as Mainframe continuing to iterate on this idea.
**This is not financial advice. Investing in bitcoin and cryptocurrency is extremely risky. Please do your own research. The ideas and news presented in this newsletter are my personal opinions and meant for informational and entertainment purposes only.