I recently have read an insightful article wirrten by an crypto expert, Terry. He predicts that fixed income will become DeFi's next frontier due to its intrinsic advantage of preserve wealth and diversify risk.
I excerpt the essence of the article for you to read. If you are interested in the original, you can click on the link to view the column of Terry.https://medium.com/@terrycktse/fixed-income-defis-next-frontier-3673aab241a8The cornerstone of fixed income markets is the benchmark interest rate. While the mechanics can confound outsiders, the core concept is intuitive. Market players assume bonds issued by governments of G7 sovereigns to be free of credit risk — that is, the full faith and credit of those governments will always redeem their debt. These governments borrow at a rate set by their central banks — the benchmark. Everyone else — including other governments — borrow with a spread on top of that benchmark, where that spread theoretically reflects the credit risk of those borrowers. For instance, if the benchmark is 2%, and one bond yields 5%. The 3% spread, theoretically, reflects its credit risk.
Such was taught in finance textbooks, and such was the way of the financial world for many decades before the crisis of 2008.
The story is now familiar. In order to resuscitate financial markets and to nurse the badly wounded economy back to health, benchmark interest rates effectively became zero for more than a decade since. Governments could borrow at virtually zero cost, so could highly-rated institutions.
And borrow they did. Ministries of Finance around the world effectively conspired with their central banks to print money, and highly rated institutions levered up to buy financial assets. Stock prices soared. Startup valuations soared. Bitcoin soared. Paradoxically, as governments printed more money, government debt piled up, and governments must print more money. The addiction slides further into the deep, and that assumption of no credit risk seems less and less secure. When some US politicians openly called for not paying back China for holding Treasuries, a US default has become a real plausibility.
And yet, the benchmark interest rate stays at zero. Not only is zero interest rate depressing yields of all other fixed income assets, it also fails to price sovereign credit risk. Suddenly, the strange land of DeFi, one where benchmark interest rate does not really exist, does not look so absurd anymore.
As mentioned in the previous article On the Sustainability of Decentralized Finance, DeFi must fulfill the need for fixed income in order to attract the vast swath of traditional capital, and pricing it without a benchmark interest rate will be its chief obstacle. There are two broad paths to overcome this:
- Creation of synthetic fixed income assets through derivatives, for example, a total return swap on a portfolio of crypto assets
- Introduction of real economy assets that generate cash flows
These paths can cross and combine. They both trace back to the first principles of finance: time value of money, regular payment schedule through economic production, risk and expectations. However, ultimately, no derivative can replace real assets.
