What is an operating yield curve in DeFi?
The yield curve in U.S. Treasuries has inverted. It happened in late March and again in early April. And yes you should care.
Looking back at the past six yield curve inversions going back to 1978, five were followed by an economic recession.
But wait, some greenhorns might be asking, what’s a yield curve?
On a simple "here’s your loan, and here's what you owe me" chart (otherwise known as the interest rate term structure), you'll typically find rate levels on the Y (vertical) axis and time horizon (maturity) levels on the X (horizontal) axis.
Thus, one might (should) expect to see a short-term (e.g. 2-year) loan with a relatively low (say 2%) interest rate attached to it; that’s relative to a loan that gets paid back over a longer period of time – one that presumably would be associated with a higher rate (reflecting the time value of money).
Visualize the short-term zero-coupon note, if you will, on a graph chart, as a plotted point in the lower left hand corner.
As you’d expect, we’d place the plot point for a 12-year loan carrying a 6% rate further up, and to the right.
Connecting the dots – it’s an upward sloping line; go ahead and call it a curve.
As a forecasting tool, the yield curve is intuitive enough. The inversion – when short-term rates flip higher than long-term rates – is viewed as inherently troubling. Why? Because the implication is that the near-term outlook is looking dicey even relative to unseen, completely unknown conditions that’ll play out much further down the line.
The curve is used – in traditional debt markets – to structure trades with interest rate terms that are engineered to earn profit and/or serve as a hedge.
A good example of this is the "carry trade." It's one in which a financier or investor borrows at low interest rates and lends at higher interest rates.
But what about decentralized financial markets, are there not interest rate term structures to be utilized here? Not quite, as it turns out.
For all of its innovations, the "DeFi" realm still lacks a robust set of tools for the practical matter of plotting a digital asset-lending/borrowing protocol-driven curve.
Quickly digesting the prices/yields and spreads among U.S. Treasuries, considered the world's most liquid financial instruments – clearly defined, with universally understood maturities – is relatively easy. Just switch on a Bloomberg terminal or Google “treasuries” and “yields.”
DeFi yield curves are harder to pin down. That’s because of the way these markets are run, in a non-traditional, automated, decentralized way. It’s just done differently, relative to the straightforward "bond math" to which we've grown accustomed.
Let’s say Popeye's portly pal Wimpy wants to score himself a hamburger today (but happily pay for it on, say, Tuesday); in this cartoon caper, the provider of the burger can figure out a fair level of interest to charge Wimpy by gaining an understanding of the item's accurate present value and contrasting it, versus the public data on interest rates, particularly those connected with various other meat-and-bun-based loans, plotting interest rates along the time axis, constructing a curve.
The pricing ultimately will represent the current cartoon burger marketplace with Wimpy and other eaters, vendors and related counter-parties all reading off the same menu i.e. following the same internationally recognized standard set of agreed discovery protocols. Gaps between disparate prices are closed by arbitragers some of whom may be in possession of information that might suggest Wimpy is overextended on his food budget (possibly even seeking out a credit default swap instrument to hedge that risk).
Moving away from the Wimpy example and into the more complicated (but not necessarily that complicated) realm of DeFi projects ... we're mainly talking about borrowing/lending protocols that run on yield farming structures based on pools of liquidity.
Pool-based price/yield discovery happens algorithmically. It’s pegged to a utilization rate, suitable enough for spot markets that aren't always liquid.
However, DeFi bond math gets fuzzy, owing to a form of capital imbalance risk known as "impermanent loss." And this transient, hard to make uniform, state is what so complicates matters.
Not exactly impermanent
An impermanent loss can occur when a liquidity provider deposits assets to a liquidity pool – and then the price of the deposited assets changes. A reduced dollar value at the time of withdrawal compared to the time of deposit is marked as an impermanent loss but can still be made up when trading fees are factored in, which is why even an impermanent loss can turn profitable if enough trading fees are piled up.
Just as interest rate swaps can be tailored to suit parties’ counter-theories about the direction of rates over periods of time, there could be an entirely new field for the pricing of DeFi-related instruments, based around the hedging and extrapolation of impermanent loss and trading fee factors.
DeFi protocols and their pool-based pricing mechanisms don’t necessarily play well together. There’s no universal standardized maturity “menu,” as with Treasuries. Every pool and related borrowing/lending action is localized and not easily extrapolated.
Yield curves are formed by the observation of prices of financial instruments that have well-defined maturities; the yield curve is then used to price other instruments. In crypto, there are not yet suitable instruments to use as inputs to this procedure. Not yet anyway.
Jet Protocol plans launching secured zero-coupon bond instruments via continuous markets for debt of specific tenors.
Keep reading our blog for more information and more deep dives into DeFi’s big blind spot – the lack of inputs for plotting a kind of traditional “centralized” bond market curve for DeFi.