Structured Bonds

Structured Bonds Explained 

Projects like BarnBridge, Hifi, Saffron and others are pooling liquidity to create structured bonds. With the exception of some short duration experimental products, fixed rate lending generally doesn’t exist in DeFi. 

Tranching is the key concept and driving force behind these new protocols’ efforts to create fixed rate lending markets. Assuming a stablecoin liquidity pool, it’s possible to carve the pool into 2 (or more) tranches. Let’s assume the tranches are split at 70/30 with 70 being the fixed rate senior piece and 30 the variable rate junior. The overall pool of stablecoin is invested in other variable rate lending protocols (Aave, Compound), earning yield. Due to the yield of the overall pool (plus potentially protocol tokens), the ability to create term and fixed rates presents itself. For example, the 70% (senior) tranche can be given a maturity and a fixed rate. The 30% (junior) tranche can have a variable, but potentially higher rate of return. In exchange for this higher return, the 30% tranche takes the risk of losing principal, as it is used to ensure that the 70% tranche pays off, in full, by a certain maturity date.

What to Know

Tranching is a risk pooling and allocation method that is borrowed from Tradfi. By tranching out an interest-bearing pool of capital, DeFi structured bond protocols can create different types of risk to fit investor funding needs and risk appetite. 

Because senior bonds offer stability and a fixed rate for the term of the loan, investors in the senior tranche are subject to a lower rate of return than the junior tranche. The junior tranche holders take the risk of locking up their capital for a specific term and potentially losing some of their principal. In effect, the junior tranche serves as ‘over-collateralization’ for the senior tranche. If the yield on the overall pool is not sufficient to support the senior bond fixed rate payments, then the junior tranche will be used to make up for the missing yield.

Why it Matters

Innovation in DeFi lending is happening at a blistering pace. But one of the hallmarks of healthy capital markets is a yield curve. As of now, nearly all DeFi loans are variable rate. So an investor can borrow DAI today at 5.55%, but in a week, they may be paying 1%, or 10% to borrow DAI, as variable rate lending markets are subject to minute-by-minute changes of supply and demand for coins. Variable rates constrains liquidity, as borrowers and lenders can count on neither funding costs nor returns, over a fixed term. 

Fixed rate lending and a DeFi yield curve would have an immense impact on the growth and viability of the DeFi ecosystem. With known and stable funding rates across different maturities, borrowers can guarantee themselves a funding cost for a specific term and employ risk-appropriate strategies. Conversely, lenders, managing their own liabilities, can be guaranteed a return over a set amount of time, locking in spread or NIM (net interest margin).