This article focuses on the Compound Finance review in the context of the existing fixed income market and emerging crypto fixed income market. Following topics are analyzed:
- How does traditional fixed income market work?
- Compound Finance review – interest rate
- Which risks are on the fixed income market?
- Compound Finance review – limitations
- What is required for the crypto fixed income market?
Compound Finance review in the context of fixed income market
Traditional fixed income market
Fixed income market has 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)
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.
Crypto fixed income market
In parallel the crypto fixed income market has emerged in 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 market, which is 20% of the crypto equity market at the moment, will become proportionally at least as big as traditional fixed income market – i.e. crypto fixed income market will become bigger than the crypto equity market, while crypto equity investments are simultaneously growing. The SmartCredit.io aim is to facilitate the emergence of the crypto fixed income market.
We will use Compound.finance as an example of crypto fixed income. 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.
This article focuses first on the Compound Finance review. After that, we look at the gaps between the Compound Finance and traditional fixed income market.
Compound Finance review – interest rate
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)
- Base Rate = 4.5%
- Multiplier = 15%
- Utilization Rate = ratio of lent out funds on platform to total funds
- 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 does the fixed income market work?
The fixed income market is driven by the interest rate. 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 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 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 the same credit quality, then we get the yield curve.
The yield curves are calculated via government bonds – for the Treasuries or 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).
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 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.
- The interest for different maturities is defined via yield curve
- There are multiple yield curves – per economy and credit risk score
- The interest for a specific entity is driven by loan maturity, economy and entity’s credit risk score
Which risks are on the fixed income market?
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.
Compound Finance review – Which limitations does it have?
We continue with the Compound Finance review and we look at the limitations of the Compound business model in the context of the traditional fixed income market.
Compound Finance has only variable rates, which are calculated at every new Ethereum block. But 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. Borrowers and lenders would mitigate their interest rate risk this way. This is not possible via Compound Finance.
Algorithmic interest rate
The Compound Finance interest rate is set algorithmically (via linear equation). However, in the traditional markets the “invisible hand of the market” sets interest rate via the equilibrium of supply and demand (for a given maturity and credit risk combinations).
Compound Finance 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. But 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.
Following risks have been identified in Compound Finance review
- 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)
What is required for Crypto Fixed Income Market?
Following components are required:
- 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.
- Crypto credit score – 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.
- Maturity matching – the lenders and borrowers’ obligations should have matching loan maturities. In the end, there are four possibilities.
- The lenders can call their loans at any time and borrowers can call their loans at any time
- The loans are issued for fixed maturities. This would require a yield curve as a basis for the specific interest rate calculation and not the algorithmic formula how currently implemented in Compound
- Someone has to become a “provider of the emergency liquidity”
- Or the maturity mismatch needs to be accepted
- Transferability of credit – this is achieved in the traditional via bonds. The issuers can transfer the bonds to buyers and there would be a secondary market for the bonds. This market would define the yield curve(s) based on the yields for different maturities and credit risks
- The credit money – the lending process in traditional banking creates fiat credit money, which is 90% of the total fiat money. For example, all fiat money on our bank accounts is credit-money created via lending. Only the notes and coins in our wallets are the base money. If looking back, then the credit-money has existed for 5’000 years. It existed most of this time as decentral-credit money. And only the last 100 years we did had centralized credit money.
We focused in this article on the Compound review. As first, the Compound has addressed key elements of crypto lending. However, several features required for the fixed income market are not yet there. Nevertheless, it’s a step in the right direction.
The Roadmap to the Crypto Fixed Income Market contains components, which already exist in the traditional fixed income market. We expect these components to become a part soon of the Crypto Fixed Income Market.
There is a lot to do!