Links

Minimum Risk Rate of DeFi

Executive Summary

The fragmented and diverse nature of the Decentralized Finance (DeFi) ecosystem necessitated developing a framework similar to the risk-free rate in traditional finance. The article addresses this problem by establishing a methodology called the "Minimum risk rate of DeFi".

Context

Since the risk-free rate received so much negative feedback as a spurious and impractical concept, it makes sense to fix it in the to-be-built DeFi landscape. It’s recommended to use a term like “minimal risk rate” instead in DeFi.

TradFi

As mentioned, the traditional concept of the risk-free rate has a theoretical nature. This article is aiming to develop a more practical framework for the risk-free rate native to DeFi and its applications.
In order to understand the concept of the risk-free rate, it’s important to understand its context in traditional finance (TradFi).

Definition

The risk-free rate is defined as the yield one will receive without any associated risk, primarily of not getting paid on the maturity date. Normally, the risk-free rate is a rate of overnight deposit at the central bank because the Government can always repay its debt by simply printing more money. It’s overnight (for 1 business day) because if the tenor of the deposit is longer, there is arguably a higher liquidity risk that needs to be offset by a higher premium.
Not all Governments have enough credibility locally and internationally, which is usually reflected in the worth of the currency (exchange rate). If a country has substantial international debt to repay, it’s not as simple as just printing more money. There have to be underlying fundamentals supporting the repayment.
Market liquidity depth is also an important consideration - although Switzerland is a credible government, its size won’t be able to accommodate numerous international deposit institutions, so size matters.
Depending on the structure of the government and its monetary policy, there are different ways of defining risk-free rates. Let’s take the U.S. market as an example for the further assessment of the TradFi system.

U.S. Monetary System

The US Government sets the following two goals to the Federal Reserve (U.S. central bank) for the monetary policy: maximum employment and stable prices, which means low, stable inflation. Both imply the third important goal, moderate long-term interest rates [1]. In other words, they try to support long-term growth.
To fulfil these goals, the Fed has five monetary tools that are usually associated with the primary financial markets: reserve requirements, the discount rate (loans to deposit institutions), open market operations (debt market), the interest paid on reserves deposited (interbank deposit market), and overnight reverse repurchase agreements (repo market). The former three tools are traditional, and the open market operations is by far the most frequently used and the largest [2].
Open market operations (OMO) are simply buying and selling U.S. government securities to align the yield with the publicly stated Fed funds rate target. The Fed funds rate is an overnight money market target set by Federal Open Market Committee (FOMC) [3]. The usage of all other tools is also aligned with the FOMC decisions.
Here is an example of how the OMO tool is used. If the FOMC believes the economy is overheating (abnormal price growth, inflation), they would raise the target for the federal funds rate. The Fed trading unit will then start selling government securities, collecting payments from banks and reducing the balance of their reserves. Increased supply of government securities drives securities prices down and yield up to align with the new federal funds target. In the short term, the currency might depreciate, however it should appreciate through attention the higher yields from international investors.

TradFi Summary

In summary, TradFi has the following infrastructure bottom-up:
  1. 1.
    The primary target audience of risk-free rate interventions are large deposit institutions, which then pass those changes to their clients including mortgage holders.
  2. 2.
    Open market operations is performed by controlling the debt market, the biggest basis asset market.
  3. 3.
    Monetary policy is enforced by aligned usage of tools that involve interventions in core markets.
  4. 4.
    U.S. monetary policy goals are maximum employment and prices stability, including moderate 30 year funding rates.
  5. 5.
    The rate is actively controlled to achieve prosperity goals for the nation.
  6. 6.
    In order to claim risk-free status, the government must be credible and the economy large/diversified enough to support international demand (issuer).
  7. 7.
    The Risk-free rate is an overnight deposit rate in local currency to the central bank of a credible government.

DeFi

Let’s compare TradFi architecture to DeFi (with numbers corresponding to TradFi section summary).

1. Target Audience of Minimal Risk Rate

The crypto world is still in its infancy and dominated by a small number of players with significant resources (whales). This clientele usually has robust risk function, high sustainability and low risk mandate, which necessitates placing funds at a minimal risk rate. In this sense, DeFi is similar to TradFi.

2. The Biggest Basis Asset Market

In DeFi, the biggest non-derivative market, is the lending and borrowing market. MakerDAO is the largest DeFi protocol by total value locked, approximately USD 18B. [4].

3. Alignment Across Markets

The DeFi ecosystem, by definition is fragmented. Alignment is achieved through operation of arbitrageurs who profit by exploiting misalignments in yields.

4. Goals

In DeFi there is no central point of control, hence no explicitly stated goal. However, certain organizations are willing to contribute to the long-term growth of DeFi industry. Given that banking existed for hundreds of years, it makes sense to assume that the best goals for DeFi are the same:
  • Maximum employment of the DeFi community.
  • Stable prices, including low inflation. Note that in DeFi inflation is different. It is associated not with having more quantity of currency from one issuer but rather limited quantity from increasing number of issuers.
  • Long-term projects (usually related to infrastructure) supporting environment.

5. Control

In general, interest rates are passively controlled by platform pre-built logic driven by supply and demand of funds. Logic varies across different platforms.

6. Credible Issuer with High Market Depth

Stable means of payment in crypto could be classified into the following categories [5]:
  • Centralized Finance (CeFI) stablecoin, e.g., USDC, USDT, BUSD.
  • DeFi stablecoins (fully backed by third party assets), e.g., DAI.
  • Algorithmic stablecoins (different to others as they proactively control supply and demand like Fed), e.g., UST, FRAX, FEI.
  • Algorithmic stableassets, e.g., RAI.
Another option could be the biggest native blockchain tokens like ETH, SOL or AVAX. These tokens have an additional utility of being able to be used as gas payment on the associated chains. On the other hand, their disadvantage is that the market price (in fiat) is volatile. Since the real economy is based on "stable" fiat money, market price volatility represents a significant source of risk.

7. Tenor and Counterparty

The DeFi landscape of applications is highly concentrated and dominated by big players. Although there is higher liquidity risk, cryptocurrencies might accrue interest and can be withdrawn from borrowing platforms intraday.

Minimum Risk Rate of DeFi 1.0

Assuming the perspective of the user and community as a whole, the minimum risk rate is defined as:
The approach provides the best alignment given the provided background.
Here is an example as of 15 February 2022:
Aave
Compound
TVL, in USD bln [4].
10.85
7.22
Token
Deposit rate, Aave
Deposit rate, Compound
TVL-weighted rate
On-chain Volume, in USD bln. [6]
USDT
2%
2.31%
2.12%
116.24
USDC
1.86%
1.67%
1.78%
65.5
DAI
2.27%
2.42%
2.33%
12.42
Based on these inputs, the minimum risk rate equals to 2.02%. It is significantly higher than the Fed Funds Rate of 0.25%.

Implementation

This model has been implemented in Credmark Modelling Framework (Cmf) with slug "finance.min-risk-rate".
The model result is shown below on block number 14207338, which was generated on 2022/2/14 23:59:27 UTC.
Token
Deposit rate and TVL in Aave
Deposit rate and TVL in Compound
TVL-weighted rate
Total Supply*
USDT
0.0195 / 1.049e9
0.0193 / 0.815e9
0.0194
39.8e9
USDC
0.0183 / 3.565e9
0.0168 / 2.769e9
0.0176
42.6e9
DAI
0.0222 / 1.499e9
0.0244 / 2.942e9
0.0236
7.4e9
*Note: we use total supply in the place for on-chain volume because it's immediate availability.
Based on the inputs, the minimal risk rate is 0.0189 or 1.89%.

Other options for Minimum Risk Rate

  • Staking yields of the largest L1 token, ETH as a currency Although it’s arguably more important in the long-term, it introduces significant price volatility that is not in line with the assumed community goals. This risk could be managed through having consumer products from the real economy denominated in ETH, such as rental costs.
  • Yield received from Liquidity Providing in stablecoins to the largest DEXs From the user perspective, it might represent minimal risk. However, it wouldn't have sufficient market depth and is not aligned with the goals of the DeFi community.
  • Implied Futures Yields The Biggest market are the Perpetual futures. Although, carry trading (hence deriving implied yield) is possible, it’s unstable as the payments are based on the market sentiment. If there are more buyers than sellers, the futures are sold at a premium and vice versa. Instability of yield is also not addressing DeFi community goals.

References

  1. 1.
    What is the Fed: Monetary Policy, Accessed on 14 February 2022 https://www.frbsf.org/education/teacher-resources/what-is-the-fed/monetary-policy/
  2. 2.
    Federal Reserve Bank of San Francisco, Accessed on 14 February 2022 https://www.frbsf.org/education/teacher-resources/what-is-the-fed/monetary-policy/
  3. 3.
    Fred Economic Data, Accessed on 14 February 2022 https://fred.stlouisfed.org/series/FEDFUNDS
  4. 4.
    DeFi Pulse, Accessed on 14 February 2022 https://www.defipulse.com/
  5. 5.
    How to DeFi: Advanced https://www.coingecko.com

Contributors

Discord Handle
ETH Address
Reward
Contribution
atulemis#0983
0x5fb7584838fB467e90bb8a1df3a278482e34E856
0 CMK (internal)
Original version
kunlun@8324
0x109B3C39d675A2FF16354E116d080B94d238a7c9
0 CMK (internal)
Implementation