Ticket To Ride: Building Continuous, Fixed-Term, Decentralized Debt Markets
New fungible bond token model takes DeFi to next level
This is the first of two articles on a new, unprecedented form of decentralized lending/borrowing – introducing fixed-term “bond tickets."
Debt markets are huge, complex and constantly changing.
Wall Street has invented numerous structured vehicles allowing financial wizards to make, facilitate, slice, dice, package, sell, re-sell and bet on loans.
Traditional, centralized, intermediary-run capitalism has spawned its share of debacles over the decades. From the junk bond boom and bust in the 1980s to the credit default swap-spawned chaos of 2008, smart financial engineers left us all to wonder – what were they thinking?
And yet, as of today, the global bond market stands in excess of $125 trillion, according to the International Capital Markets Association. Calamities always seem to give way to growth no one sees coming.
During the 1980s, junk bonds grew into a $200 billion sector which by 1990 had vanished, not to return for several more years. Now known as high-yield bonds, sub-investment grade paper is today an $11 trillion market.
The mother of all credit debacles in 2007-2008 ranks as one of the worst financial catastrophes the world has ever known, resulting in the loss of more than $2 trillion from the global economy.
Only one of the longest bull markets in history followed.
The decentralized finance ("DeFi") sector, only a few years into its existence, has had its share of growing pains – and given us some questionable structures. Decades from now, DeFi conventions of today likely will come under bewildered scrutiny.
But we're not talking about coding bugs vulnerable to exploitation or unstable algorithmic stablecoins.
Rather, we contend the overall state of DeFi lending/borrowing activities, as currently configured, could most aptly be described as dysfunctional.
*Rates aren't determined by the supply/demand of available funding; instead, the rate gets decided by a given protocol's fiat determination. Or, in other words, "because we said so."
* Lenders have no guarantees that they will be able to withdraw their funds, while incentives for liquidity providers are risk-averse to the point of being pointless, resulting in a poorly thought-through practice of creating lending pool buffer funds, about as an efficient use of capital as doing paper mache art using $100 bills.
* Even the government of a tiny island nation will have a fairly robust debt market, one comprising multiple interest rate and time horizon structures. Lending pools? A single, instantaneous, highly volatile rate disconnected from any semblance of a notion that market participants may have their own varying liquidity needs.
The DeFi landscape lacks many examples of offerings that would purport to seek to fill the term-structure variety void; and indeed there are some products based around periodic auctions for debt with fixed maturities. But it’s not a particularly flexible approach and hasn’t proved very alluring relative to your basic lending pools.
Users want access to financing 30-day or 90-day loans, not loans that have a duration between whatever date it is now and, say, the end of September.
Restructuring DeFi Debt Markets
All of this leads us to an interesting corner of the fixed-income market, representing an elegant solution to lending/borrowing protocol limitations.
Of all the myriad instruments brought about under the rubric of traditional finance, there is a singularly fundamental, essential debt security –the Zero Coupon Bond (ZCB), also sometimes called an accrual bond.
ZCBs don’t pay interest. Investors in ZCBs don’t realize any profits until maturity, which is why they trade at a discount.
It is only at the time of maturity that the issuer pays to the holder the full face value, or "par," of the ZCB instrument.
Here’s another term to note “tenor.” That’s the amount of time between issuance and maturity.
Knowing tenor and face value, and following the lead of comparable debt market trading, investors can deduce whether there is or isn’t any premium harvesting, or arbitrage, to be had, and can trade these instruments with risk-tolerance in mind; how the trades turn out, whether profitable or not, is determined by whatever the difference winds up being between the purchase price and the end-game/time’s up par value return.
Note, importantly, there’s never an established interest rate. Interest instead is imputed, or estimated, based on the known parameters in place.
Here is an essential quality of the ZCB space that inspired us to take this concept into DeFi. Let’s make sure we explain it clearly.
Bond Investing 101, A Refresher
For example, a bond with a face amount of $20,000, that matures in 20 years, with a 5.5% yield, may be purchased for roughly $6,855.
At the end of the 20 years, the investor will receive $20,000. The difference between $20,000 and $6,855 (or $13,145) represents the interest that compounds automatically until the bond matures.
The annualized rate associated with the ratio of price to face value is called the yield to maturity.
Bond prices and yields have an inverse relationship. When a yield goes down, the price of a bond goes up. Why is that? The fixed interest rate paid out by most bonds grows more attractive if interest rates fall below it, and a more attractive bond becomes more in demand and hence the price rises.
If interest rates go up, conversely, investors will eschew the lower rate paid by a bond, demand will diminish, and the price will fall.
Because ZCBs don't pay regular interest, their value-added is derived from the difference between purchase price and full face value paid at maturity.
Bond Tickets Are Born
For some investors, locked-in yield is in itself an attractive feature of ZCBs.
For DeFi markets, ZCBs and their moving parts – par value, price as discounted versus par value, estimated interest, time remaining until maturity – provide us a pathway forward for creating a new framework for decentralized debt offerings that go well beyond lending pools and their glaringly arbitrary inefficiencies.
To solve for inefficiencies, Jet is setting out to create a DeFi marketplace for new debt, using a ZCB-inspired model and relying on tokens, or “bond tickets.”
To be clear, the plan is to create many, many bond ticket markets, term-structure-wise, ranging at launch from 24 hours out to six months. All depending on usage and demand from users.
There’s a complicated (but not that complicated) flow of participants, actions and protocols associated with this marketplace Jet is launching. More to come on that later in this two-part series.
For now, though, let’s boil down bond tickets into some simple concepts.
Think of them as a fungible token tied to bets on snap bond auctions conducted as needed, all the time.
What these tickets really are, we’ll concede, is an instrument familiar to options traders: zero-strike perpetual American call options (on bonds, from 1 to 180 days, issued on exercise).
Let’s review some of the terms associated with Jet Bond Tickets:
- Zero-strike. No payment required to exercise. Perpetual. What you think it means. The option never expires.
- American. Trading jargon. It just means the option can be exercised at any time.
- Call option: the right, but not the obligation, to receive a bond upon exercise.
Options are bought and sold at a price called the “premium.” This is the price of a bond “ticket.”
If you are outside the gates of a concert, the supply of available tickets will shape the floor/ceiling pricing dynamics.
But what if it’s not clear who is taking the stage or whether they even will, just that there is a concert lined up?
In the context of tickets, how much would someone pay for a bond that gets issued upon an option being exercised? It’s exactly equal to the price of the would-be bond. Otherwise it would be possible for arbitrageurs to lock in risk-free profit via offsetting positions in bonds and tickets.
Jet took the mechanics of options markets and key attributes of ZCBs and combined them with elements of tokenization, taking something non fungible – fixed-term debt – and opening the door for a decentralized market that truly takes DeFi to the next level and beyond.
In the next article, we'll further unpack our new instrument, and examine what a market for tickets is going to look like.