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Ticket To Ride: Fixed-Term Debt Is About To Get Fungible

Understanding the many moving parts of DeFi’s newest lending/borrowing market

This is the second of two articles on “bond tickets."

Creating a market for DeFi lending/borrowing that evolves beyond pools with non-market-driven rates wasn’t easy. Numerous hurdles awaited us. For starters, doing this meant somehow solving for a basic not easily moved impediment – like kicking in a cement door – that is, the non-fungible nature of fixed-term debt.

Inherently, this was a rock solid given in the hypothesis, making it difficult to create a representation via tokenization.

To illustrate what we mean, consider two 30-day Zero Coupon Bonds (ZCBs) for the same amount but which originated one week apart. They do not have the same present value, do they? Why is that? Because of the time value of money (which assumes it gets put to use earning some interest, and not used in some ill-conceived paper mache project). 

You’ll recall that ZCBs are non-interest-paying securities that only deliver their payloads at maturity at which time the all-said-and-done interest can be calculated. Prior to that, interest gets estimated based on extrapolations of time horizons and other market comparisons. This is why we found ZCBs a touchstone for what we were trying to create – they lend themselves quite well to the challenge of creating a decentralized market for new debt

Two additional constraints shaped the creation of this new market, for bond tickets, which we introduced in our last article.

The market we create must be for secured debt, because otherwise the price needs to reflect credit risk that the protocol has no way of evaluating; additionally, while we need to match lenders and borrowers when it comes to prices, we don’t want particular lenders to be exposed to particular borrowers; but rather, the aim was to have all lenders exposed to the aggregate collateral structure of all borrowers, for the sake of establishing a single price.

Getting Into The Weeds

We’re excited and ready to discuss in detail the bond ticket market hosted on Jet Protocol.. 

Let's walk through the system from beginning to end. To start, let's use a hypothetical involving a borrower, Luke, who wants to borrow 100 USDC for 30 days. For the sake of our discussion, let's stipulate, for simplicity, that the face value of the 30-day bond underlying one ticket is 1 USDC. 

Borrowers can create ask orders, and, if the market is functioning as intended, the order will arrive and find a match. 

Here's where the tickets come into play.

To borrow 100 USDC, Luke is going to sell 105 tickets. Luke, we'll recall, is focused on training and strapped for cash, but he does have some Litecoin and a smattering of satoshis in cold storage. He can use these assets as collateral. Now, the Jet protocol does a few things:

  •  *A claim of 105 USDC is placed against their collateral.
  •  *The order goes to the market.
  •  *The order matches.
  • *The protocol issues call options on the borrower’s behalf, minting 105 tickets.
  • *To cover these calls, an obligation is created for the borrower to repay 105 USDC within 30 days.
  • *The tickets are delivered to the lender, who pays 100 USDC as the premium.
  • *The 100 USDC from the lender is delivered to the borrower.

Luke owes 105 USDC, having sold 105 tickets to acquire 100 USDC. Effectively, Luke's 30-day interest rate is 5%. 

So we kept the math simple and we'll concede here that this rate is not realistic and purely for illustrative purposes.

The Other Side of the Trade

Let's look at this borrow/lend activity from the lender's perspective. The lender is Larry, a typical yield farmer.Larry is holding 105 tickets. We explained at the end of our first article that the tickets were created in options’ likeness. (Go back and re-read it HERE).

Staking tickets to the protocol is the way the options are exercised – that’s how Larry harvests some yield.

Upon staking, the protocol issues a bond with a face value of 105 USD and also a time to maturity of 30 days to the lender. 

In 30 days time, Larry is able to collect 105 USD; the original loan he made, plus the interest. Lenders like the Larry in our example place bid orders into the 30-day USDC ticket order book with the purpose of trying to buy tickets at a discount to face value.

Here Come The Arbitrageurs

But what if the price of the bond is lower than that of the ticket?

Arbitrageurs will sell tickets and use the proceeds to buy the equivalent face value bonds, realizing an immediate profit with no net liability in 30 days – as the bond repayment can be used to cover the ticket repayment.

Conversely, suppose that the ticket is cheaper than the bond. Arbitrageurs will sell bonds and use the proceeds to buy the equivalent face value in tickets, locking in profits and netting off the repayments in 30 days.

In the absence of arbitrage, the price of bond tickets must match the price of similarly secured 30-day debt instruments.

Trivial though it may seem, the absence of arbitrage assumption is meant to underscore the fact that the tickets and the underlying bonds are the same instrument, essentially.

This is a common application of zero-strike call options in traditional finance.

Decentralized finance now takes the baton. Loans and their components are tokenized – through tickets – ushering in new debt markets, able to reflect future time value of money over fixed time periods, issuance to maturity, or tenors, all of which is not currently done within DeFi. Worlds are colliding. 

To summarize:

— Users can borrow or lend at any time for a fixed tenor at prices/rates they determine in a limit order book. 

— Prices reflect pure supply and demand of liquidity at the corresponding tenors.

— Protocol-imposed interest rate curves are no longer in play.

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