Part 1: Quantitative Crypto Insight: Stablecoins and Risk-Free Rate

By George Liu and Matthew Turk

In half one among this quant analysis piece, we introduce the decentralized finance (DeFi) collateralized lending platform referred to as Compound Finance and talk about its use case for stablecoins, compared to the notion of a “risk-free” rate of interest from conventional finance (TradFi). Our purpose is to tie these ideas collectively to coach on how several types of low-risk funding work throughout the TradFi and crypto markets.

This introduction examines stablecoin lending yield and shares insights on yield efficiency, volatility, and the elements driving lending yield. Part two of this piece will look at the elements that drive lending yield in additional element.

What are Stablecoins?

Stablecoins are a distinct segment a part of the ever-growing crypto ecosystem, primarily utilized by crypto traders as a sensible and cost-efficient technique to transact in cryptocurrency. The invention of stablecoins within the crypto ecosystem is good due to the next properties:

• Similar to the fiat currencies utilized in mannequin economies, stablecoins present stability in value for folks transacting throughout digital currencies or between fiat and digital currencies.
• Stablecoins are native crypto tokens that may be transacted on-chain in a decentralized method with out involvement of any central company.

With the rising adoption of cryptocurrencies by traders from the TradFi world, stablecoins have turn into a pure change medium between the normal and crypto monetary worlds.

Risk-Free Interest Rate

Two of the shared core ideas within the conventional and crypto monetary worlds are the ideas of danger and return. Expectedly, traders are prone to demand greater return for greater danger. During the present Russia-Ukraine struggle, the Russian rate of interest elevated from a median of roughly 9% to twenty% in 2 weeks, which is a transparent indication of how the monetary market reacts to danger.

Central to the framework of danger and return is the notion of a “risk-free” price. In TradFi, this price serves as a baseline in judging all funding alternatives, because it provides the speed of return of a zero-risk funding over a time frame. In different phrases, an investor typically considers this baseline price at the least price of return she or he expects for any funding, as a result of rational traders wouldn’t tackle extra danger for a return decrease than the “risk-free” price.

One instance of a “risk-free” asset is the U.S. Treasury debt asset (treasury bonds, bills, and notes), which is a monetary instrument issued by the U.S. authorities. When you purchase one among these devices, you might be lending the U.S. authorities your cash to fund its debt and pay the continuing bills. These investments are thought of “risk-free” as a result of their funds are assured by the U.S. authorities, and the possibility of default is extraordinarily low.

A “risk-free” price is at all times related to a corresponding interval/maturity. In the instance above, treasury debt property may have totally different maturities, and the corresponding risk-free price (additionally known as treasury yield) are totally different as nicely.

The length might be as brief as someday, wherein case we name it in a single day risk-free price or basic collateral price. This price is related to the in a single day mortgage within the cash market and its worth is set by the availability and demand on this market. The loans are sometimes collateralized by extremely rated property like treasury debt, and are thus deemed risk-free as nicely.

Source: WallStreetMojo

Compound V2 and Stablecoin Lending Yield

With the expansion in acceptance of crypto property and the corresponding market globally, crypto primarily based investing has turn into a well-liked matter for individuals who have been beforehand uncovered solely to the normal monetary market. When getting into into a brand new monetary market like this, the very first thing these traders typically observe is the risk-free price, as it is going to be used because the anchor level for evaluating all different funding alternatives.

There is not any idea of treasury debt within the crypto world, and as such, the “low-risk” (slightly than risk-free) rate of interest is achieved in DeFi collateralized lending platforms comparable to Compound Finance. We use the time period “low-risk” right here, as a result of Compound Finance, together with many different DeFi collateralized lending platforms, are usually not risk-free, however slightly topic to sure dangers comparable to good contract danger and liquidation danger. In the case of liquidity danger, a consumer who has adverse account liquidity is topic to liquidation by different customers of the protocol to return his/her account liquidity again to optimistic (i.e. above the collateral requirement). When a liquidation happens, a liquidator might repay some or all of an excellent mortgage on behalf of a borrower and in return obtain a reduced quantity of collateral held by the borrower; this low cost is outlined because the liquidation incentive. To summarize danger in DeFi, the closest we are able to get to risk-free is low-risk.

To make clear, for the sake of this publish (and half two), we’re wanting into Compound V2. On Compound, customers work together with good contracts to borrow and lend property on the platform. As proven within the instance diagram above:

• Lenders first provide stablecoins (or different supported property) comparable to DAI to liquidity swimming pools on Compound. Contributions of the identical coin kind a big pool of liquidity (a “market”) that’s accessible for different customers to borrow.
• The borrower can borrow stablecoins (take a mortgage) from the pool by offering different helpful cash like ETH as collateral within the above diagram. The loans are over-collateralized to guard the lenders such that for every $1 of the ETH used because the collateral, solely a portion of it (say 75 cents) may be borrowed in stablecoins.
• Lenders are issued cTokens to symbolize their corresponding contributions within the liquidity pool.
• Borrowers are additionally issued cTokens for his or her collateral deposits, as a result of these deposits will kind their very own liquidity swimming pools for different customers to borrow as nicely.

How a lot curiosity a borrower must pay on their loans, and the way a lot curiosity a lender can obtain in return, is set by the protocol formulation (primarily based on provide/demand). It will not be the intention of this weblog to provide a complete introduction to the Compound protocol and the numerous formulation concerned ( events please discuss with the whitepaper for an in-depth schooling). Rather, we wish to concentrate on the yield that an investor can generate by offering liquidity to the pool, which can facilitate our yield comparability between the 2 monetary worlds.

A Compound consumer receives cTokens in change for offering liquidity to the lending pool. While the quantity of cTokens he holds stays the identical by way of the method, the change price that every unit of cToken may be redeemed with to get the fund again retains going up. The extra loans are taken out of the pool, the extra rate of interest will likely be paid by the debtors, and the faster the change price will go up. So on this sense, the change price is a sign of the worth of the asset {that a} lender has invested over time, and the return from time T1 to T2 may be merely obtained as

R(T1,T2)=changeRate(T2)/changeRate(T1)-1.

Additionally, annualized yield for this funding (assuming steady compounding) may be calculated as

Y(T1,T2)=log(changeRate(T2)) — log(changeRate(T1))/(T2-T1)

USDT/USDC Lending Yield Analysis

While the Compound swimming pools help many stablecoin property such USDT, USDC, DAI, FEI and so forth, we’re solely going to research the yields on collateralized lending for the highest 2 stablecoins by market cap, i.e. USDT and USDC, with market capitalizations of $80B and $53B respectively. Together, they make up over 70% of the whole marketplace for stablecoins.

Here under are the plots of the annualized each day, weekly, month-to-month, and biannual yields generated in keeping with the formulation within the earlier part. As one can see, the each day yield is fairly risky, whereas the weekly, month-to-month, and biannual yields are respectively the smoothed model of the prior granular plot. USDT and USDC have fairly comparable patterns within the plot, as lending of each of those property skilled excessive yield and excessive volatility for the beginning of 2021. This signifies there are some systematic elements there which are affecting the DeFi lending market as a entire.

Source: The Graph

One speculation of the systemic elements that would have an effect on the lending yield includes crypto market information comparable to BTC/ETH costs and their corresponding volatilities. To illustrate an instance (greater danger on this case), when BTC and ETH are in an ascending development, it’s believed that many bull-chasing traders will borrow from the stablecoin swimming pools to purchase BTC/ETH after which use the bought BTC/ETH as collateral to borrow extra stablecoins, after which repeat this cycle till the leverage is at a satisfying excessive degree. This leverage impact helps the traders to enlarge their returns as BTC/ETH retains going up. We will discover this evaluation extra partly two of this weblog publish.

Future Directions

This weblog has given a broadly relevant introduction to DeFi collateralized lending by way of the lens of Compound Finance and the way it compares to “risk-free” charges from TradFi. As talked about above, partly two of this weblog publish, we’ll additional look at collateralized lending yields and share our insights on yield efficiency, volatility, and driving elements.

We, as a part of the Data Science Quantitative Research staff, intention to get a superb holistic understanding of this house from a quantitative perspective that can be utilized to drive new Coinbase merchandise. We are in search of folks which are passionate on this effort, so if you’re eager about Data Science and specifically Quantitative Research in crypto, come join us.

The evaluation makes use of the Compound v2 subgraph made accessible by way of the Graph Protocol. Special due to Institutional Research Specialist, David Duong, for his contribution and suggestions.

Part 1: Quantitative Crypto Insight: Stablecoins and Risk-Free Rate was initially revealed in The Coinbase Blog on Medium, the place persons are persevering with the dialog by highlighting and responding to this story.