Compound and Roadmap to Crypto Fixed Income Markets

Traditional fixed income markets have emerged in the last 350 years with:

  • 19 trillion USD base money (central banking created money – M0)
  • 36 trillion USD narrow money (M1)
  • 73 trillion USD global equity markets
  • 90 trillion USD broad money (M3)
  • 215 trillion USD global debt (governments, corporations plus households)

(Source: https://cryptovoices.com/basemoney and http://money.visualcapitalist.com/worlds-money-markets-one-visualization-2017/ )

The M0 money – the base-money – is created by the central banks. The other types of money include M0 plus credit-money, which is created via the commercial banks via lending (every time one takes a loan from the bank new credit-money is created; every time one pays back the loan the credit-money is destroyed). The global debt includes M3 money and bonds (transferable standardized debt obligations).

We see that in traditional finance the debt markets are bigger than the equity markets. They are older as well – let’s think that the laws allowing the creation of corporations are just some hundreds of years old and the laws for debt obligations are thousands of years old.

In parallel the crypto monetary system is developing – it has emerged since the last 10 years:

  • 2 trillion USD base money (Bitcoin, Ether, Litecoin)
  • ca 0.0001 trillion USD narrow money (M1 – via MakerDAO DAI)
  • ca 0.001 – 0.005 trillion debt obligations (via crypto lending platforms)

Our vision is, that crypto fixed income markets, which are 20% of the crypto equity markets at the moment, will become proportionally at least as big as traditional fixed income markets – i.e. crypto fixed income markets will become bigger than crypto equity markets, while crypto equity investments are simultaneously growing.

Let’s look now on Compound.finance. It has become a popular Decentral Finance (DeFi) product and is managing ca 150 million USD of crypto assets as a decentralized money market fund.

Considering the popularity of the Compound and our aim to facilitate fixed income markets emergence in the crypto sector we decided to research the gaps between the Compound and traditional fixed income markets.

This article looks at:

  1. How does Compound work?
  2. How do fixed income markets work?
  3. Which risks do we have on the fixed income markets?
  4. Which limitations does Compound have at the moment?
  5. Which elements do we need on the roadmap to crypto-fixed-income markets?

How does Compound work?

Compound emulates money market funds via smart contracts

  • Borrowers can borrow free funds from Compound, they will pay daily interest and they can end their loan at any time
  • Lenders can put their assets into the money market fund, they receive daily interest and they can withdraw any moment, assumed there is enough liquidity in the fund. If this is not the case, then they have to wait till borrowers are paying back their loans

The interest rate is set continuously via the following formula

Borrower Annual Interest = Base Rate + (Multiplier * Utilization Rate)

Where:

  • Base Rate = 4.5%
  • Multiplier = 15%
  • Utilization Rate = ratio of lent out funds on platform to total funds

For example:

  • if utilization ratio is 60% (60% of all funds have been lent out), then we get the annual interest = 4.5% + 15% * 60% = 13.5%
  • if utilization ratio is 99% (99% of all funds have been lent out), then we get the annual interest = 4.5% + 15% * 99% = 19.35%

A linear equation is setting the variable interest rate, the “markets invisible hand” is not involved.

How do the fixed income markets work?

 Fixed income markets are driven by interest. We have written earlier an extensive analysis of “What drives the interest in the fiat economy and how much should it be?” and “What drives the interest in the crypto economy and how much should it be”.

Let’s recap – the key drivers for the “base interest” are:

  • Consumption preferences
  • Time preferences
  • Rate of base-money production/destruction in the economy
  • Rate of credit-money production/destruction in the economy
  • The proximity of individuals to the “money creation” in society
  • Store of the value function

Some of these drivers increase interest, others decrease interest. Referenced articles calculated what should be the base interest rate for the fiat economy and for the crypto economy. NB – the interest which we calculated, does not match with the base interest rate in our current central banks driven economy.

The base interest rate in the economy – the “risk-free rate”- is set by the central banks. For example, in the U.S. we have 2%, in the Eurozone -0.4% and in Switzerland -0.75% (yes, these are negative “risk-free rates”).

Loans have different maturities – 1 month, 3 months, 9 months, 1 year and so on. Usually, the loans with longer maturities have higher interest and vice versa. If we plot the interest rates for different maturities and for the same credit quality, then we get the yield curve.

Yield curve
Yield curve

https://www.investopedia.com/terms/y/yieldcurve.asp

The yield curves are calculated via government bonds – for the Treasuries or for the German Bunds. Government bonds are considered “risk-free” and they do have high liquidity.

Some countries face higher default-risk (some of South-European Countries) and in the case of free markets, their yield curves should be higher if U.S. or Germany’s yield curves.

Different entities have different credit risk ratings (from AAA till BBB – these are investable, and then there are risk ratings below BBB – a.k.a. junk b0nds).

If we speak of specific loans, then the interest for a given maturity is calculated as follows:

  • Economy’s yield curve is taken as a basis
  • Credit risk of a specific entity is added on the top
  • Loan originators add their own margins and fees

If the loans are structured as bonds, then we are creating transferable and tradeable debt instruments. The aggregate of all these bonds creates a global bond market with a size of 100 trillion USD.

Key points:

  • The interest for different maturities is defined via yield curve
  • There are multiple yield curves – per economy and per credit risk rating
  • The interest for a specific entity is driven by maturity, economy and entity’s credit risk rating

 Which risks do we have on the fixed income markets?

 Credit risk is the risk that the borrower will be late with the payments or will not pay at all. If loans are secured, then the collateral ownership will move over to the lender. If loans are not secured, then the lender will take the borrower into court or will sell the non-performing loan to the loan liquidators.

Interest rate risk exists in case of variable rate loans – in case that the variable rate will go up against the borrower. It exists as well in the case if we want to roll-over the loans and the interest rate has increased in the meantime.

Market risk is a risk that the market moves against the market participants. For example, in collateralized lending is the risk, that market has flash crashes, which will trigger the liquidations.

Which limitations does Compound have at the moment?

We note following in Compound business model:

No yield curve, but only the variable interest rate

The Compound has only variable rates (calculated at every new Ethereum block), there is no yield curve. If someone needs to take a loan for 3 months, then he needs to finance this for 90 days with variable rates.

In traditional fixed income, one would take a 90 days loan and fix the interest rate based on the yield curve. His interest rate risk would be mitigated, the interest rates could not go against the borrower.

Algorithmic interest rate

The Compound interest rate is set algorithmically (via linear equation). In traditional markets, we do have the “invisible hand of the market”, which would set the interest rate via the equilibrium of supply and demand for a given maturity and given credit risk.

Maturity mismatch

Compound users are lending/borrowing money at short maturity and are practically rolling over day by day into the new variable interest rate.

Both sides – lenders and borrowers can stop the loans at any time. However, there is no way to call in existing loans from the borrowers. If borrowers like their interest rate, they can stay on their loans for a long time and keep paying the interest. If for example lenders would like to receive their funds, but the fund’s utilization is too high (i.e. that the unallocated funds are not available), then the lenders have to wait till borrowers will pay back funds or new funds are submitted into the fund.

That’s a typical maturity mismatch situation. The loan maturity for the borrowers is unlimited. The loan maturity for the lenders is daily (they can call in their loans at any time). The result is a maturity mismatch, which is 99% of cases not an issue, but it can be an issue if everyone and their grandma are running to the same exit-door at the same time. If this situation happens, the lender will be unable to withdraw his funds.

Which risks exist on Compound:

  • The lenders on the platform are exposed to the credit risk (due to the maturity mismatch).
  • The borrowers on the platform are exposed to the interest rate risk (due to only variable interest rate)
  • The borrowers are exposed to the market risk – in case market moves against them and their positions get liquidated (however, this is common for all collateralized lending platforms)

Which components do we need?

Following components are required:

Roadmap
Roadmap
  1. Yield curve – The “invisible hand of the market” would set the interest rates for different maturities and credit risks. The interest rates would be an equilibrium of credit supply and credit demand, they would be driven by the market only.

The yield curve would show the interest rate for different maturities. I.e. instead of using only variable interest rate, there should be as well 1 week, 1 month, 3 months, 6 months, 12 months, and longer maturity interest rates.

  1. Credit risk calculation – different borrowers have different credit qualities. Every loan originator prefers good credit risks as opposed to bad credit risks. Good credit risks should have fewer collateral requirements and vice versa. Good credit risks have to pay less interest and vice versa.
  1. Maturity matching – the lenders and borrowers’ obligations should have matching loan maturities. On the end there are four possibilities:
  • If the platform offers the possibility to the lenders to call in their loans any time, then it should be possible to call in the loans from the borrowers as well.
  • If this is not the case, then loans have to be given for fixed maturities (which will require a yield curve as a basis for the specific interest rate calculation).
  • If neither of these possibilities exists, then someone has to become a “provider of the emergency liquidity”.
  • If that’s not the case then we are getting the maturity mismatch situation
  1. Transferability of credit – in traditional fixed income this is achieved via bonds. The issuers can transfer the bonds to buyers and there would be a secondary market for the bonds (where the yields for different maturities and credit risks will define the yield curve(s))
  2. And last but not least – the credit money – a lending process in traditional banking is creating fiat credit money, which is 90% of our total fiat money. All fiat money on our bank accounts is the credit-money. Only the notes and coins in our wallets are the base money.

The credit-money itself has existed for 5’000 years. Most of this time as decentral-credit money. Only the last 100 years we did had centralized credit money.

Summary

The Compound has addressed key elements of crypto lending, however, it lacks several features required for the fixed income markets. Nevertheless, it’s a step in the right direction.

The Roadmap the Crypto Fixed Income Markets requires several additional components. These components are part of traditional fixed income markets and they will be part of Crypto Fixed Income Markets too.

There is a lot to do!

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