Rising-rate environment tests DeFi’s stickiness

With benchmark DeFi yielding less than lower-risk assets like US Treasuries, blockchain-based finance has entered uncharted territory.

After the Federal Reserve’s fourth consecutive 0.75% hike on November 2, the benchmark US interest rate stands at 4%, its highest level since January 2008.

Crypto, like most risk assets, thrives when interest rates are low and capital is plentiful. The last cycle of monetary tightening saw rates peak at 2.5% in early 2019. Meanwhile, 2018 saw a crypto bloodbath, with the overall market capitalization falling from $850 billion in January to just $108 billion. dollars at the end of the year.

Federal funds rate. Source: St. Louis Fed

Crypto markets have been relatively calm since the last rally – Bitcoin and Ether are down less than 1%, and Binance’s BNB is up 5%.

President Powell’s statement asserts that continued interest rate increases are appropriate, indicating that the world’s largest central bank is unlikely to become dovish in the near term.

Rising rates pushed yields on short-term Treasuries to 3.5%, according to YCharts. This is higher than the rates available on the three major stablecoins deposited on DeFi’s three major lending protocols, Aave, JustLend, which is on the Tron blockchain, and Compound.

Capital Flight

And all things being equal, yield-seeking capital should follow the best low-risk rates, so it’s curious why investors are still lending to DeFi.

“There is definitely a capital base in DeFi that is very sticky,” Teddy Woodward, co-founder of Notional, a fixed-rate yield protocol with $91.7 million in TVL, told The Defiant. He said rising rates in traditional finance have somewhat drawn capital into DeFi, but that strength has had limited effect so far.

“This rate divergence pulls [capital] and the wider the rate divergence, the stronger the pull,” he said. Woodward pointed out that USDC’s outstanding supply has fallen 24% since June and suggested that higher interest rates may be to blame, as USDC’s yield is 2% or less on three main loan protocols.

Allan Niemerg, co-founder of Yield Protocol, another fixed-rate protocol, agrees with Woodward. He thinks frictions in the transfer of capital between traditional finance and DeFi explain why investors are still deploying their capital in crypto.

Friction between DeFi and TradFi

“DeFi is still relatively immature and not very well connected to traditional finance,” he said. “And so rates that move in traditional markets don’t necessarily have a huge impact on DeFi right now.”

Even as traditional finance rates continue to rise and draw more stablecoins out of DeFi, the two entrepreneurs don’t seem worried that this will threaten blockchain-based finance at its core.

ETH Price + BTC Price + BNB PriceSource: The Defiant Terminal

“It’s not that DeFi would die,” Woodward said. “It’s just that people should be borrowing at rates that reflect the macro environment and maybe that just means there would be less borrowing overall.”

Niemerg believes the true value of DeFi exists regardless of the pricing environment. Although he added that higher rates could lead to less venture capital investment and less high-risk financial strategies.

Two tariffs

For Niemerg, it’s usually just noise, though. “The signal, the hard work that I see happening every day in the ecosystem, which keeps growing,” he said.

Theoretically, as stablecoins leave DeFi, borrowing rates on loan protocols would increase to reflect the lower availability of dollar-pegged assets. In a world with less friction between the two financial systems, traders would arbitrate the two rates until they were broadly identical.

So far they haven’t converged, but that doesn’t mean they won’t if rates keep rising. “People don’t change their allocation on a dime,” Woodward said.

Fixed rates

Going forward, there are a few trends to watch in DeFi. On the one hand, the focus may be on yield on Ether, rather than stablecoins.

Notional is set to launch an ETH-based leveraged product, where Woodward sees returns staying high thanks to the ETH staking rate after moving to Proof-of-Stake consensus. “I think the yield on ETH and the sources of demand for ETH are just a lot less cyclical,” Woodward said.

Additionally, fixed rates can play a role in bringing more capital into DeFi. Businesses looking to invest in their future seek fixed rate loans to reliably forecast their cash flow. DeFi has so far only seen floating-rate protocols adopted due to their simplicity, but if the fixed-return market matures, it could bring new entrants into open finance.

“I can definitely see fixed rates as a very important part of the next cryptocurrency boom,” Niemberg said, adding that fixed rates could allow crypto to connect more fully to the traditional financial system.

For now, DeFi is in flux. With eye-popping yields harder to come by, and those that exist attract more skepticism, it will be difficult to attract institutional capital that can fetch near-risk-free rates in highly liquid bond markets.

But if Niemberg is correct, the high returns that characterized the last crypto cycle are not where the true value of DeFi lies.

“DeFi is going to be successful through innovation,” he said. “Because it builds something that people ultimately want. And we are still very, very early in this process.

About Mitchel McMillan

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