How (and Why) DeFi Uses Derivatives to Manage Risk and Returns

Table of Links

Abstract and 1. Introduction

2. Stablecoins and Lending Markets
3. Fixed-Rate Lending Protocols and Derivatives
4. Staking Derivatives
5. Staking Fees as Stable Interest
6. Stabilization Mechanisms
7. Some Caveats
8. Diversification, Interest Rates Swaps, and Tranching
9. Towards Universal Basic Income
10. Closing Remarks
11. Acknowledgements and References

3 Fixed-Rate Lending Protocols and Derivatives

One other issue in treating lending interest as stable income is that until recently, in decentralized finance, borrowing and lending interest rates tended to fluctuate flexibly according to market conditions. However, fixed-rate lending protocols are now available [36]. The key idea here is that we can trade the value of a loan on the market. That is, if a token is to give its holder the right to be paid $100, as a settlement of a loan, at a certain future date, then the token itself could be traded at a certain price. Assuming one generally prefers money right now over money in the future, one could probably only be willing to buy this token at a discount. How deep that discount is, in turn, should depend on when the loan matures. For loans that are to be settled further in the future, buyers may be willing to buy such a token only at a deeper discount. That is to say, the interest for longer-term loans should be higher. By setting up automated markets for these tokens [37], one can work out the general interest rates for loans for different durations - what is sometimes called a yield curve [38]. This curve is not entirely fixed in the long run. But it can allow relatively stable predictions to be made within a certain timeframe.

The token described above is essentially a bond. Specifically, it is what is called a zero-coupon bond, meaning that the bond itself generates no interests or other additional benefits; the attractiveness is just that it may be bought at a current price lower than the eventual loan settlement.

In traditional financial terms, bonds are a kind of derivatives, which are simply contracts that ‘derive’ their value based on some other asset. Some other types of derivatives include options for buying a certain asset at a certain price X at a certain future date. The holder may exercise the option only if the price turns out to be favorable. This could be useful, for example, for hedging purposes. That is, given that a party is obligated to fulfil a transaction in the future in a particular currency, such as to pay up for some consumed services. The party could end up suffering an unexpected loss if the price of the currency goes up. By holding the option token mentioned above, the party can be sure that the actual total cost would not exceed a certain point; if the price of the currency goes up above expectation, one can then exercise the option to buy the currency at the agreed price X, making a profit that would exactly compensate for the loss.

Notably, the derivatives market in the traditional financial world is large, in which the most traded type of derivatives are interest rate swaps. The trade volume for these alone are on the order of 10 times larger than the stock market [39]. These instruments allow two parties to trade on the future yield of an underlying asset. This can be useful for turning floating interest rate incomes into a fixedrate income, or vice versa. For example, if I have lent out money to someone who is to pay me back at whatever current fiat interest rate is, I may be able to find a third party to swap my interest income into a fixed rate. The third party may demand a lump sum, or may only offer a relatively low fixed rate. But if the deal is made, the third party will absorb the variability in future changes in fiat interest rates.

We will return to interest rate swaps in section 8. For now, what is important is that this sets the context for a type of derivative that is unique to decentralized finance, and is key to the problem of generating stable income.

4 Staking Derivatives

In a PoS network, staking derivatives are tokens that can be generated when one lends money to validators to allow them to qualify for the job of approving transactions [40, 41]. Without such tokens, there will be a number of risks involved in staking. The first is due to the fact that staking generally requires locking in the staked currency for a fixed period, typically up to a few weeks, during which the validators are considered qualified for the role (by demonstrating that they have enough stake). If the currency drops in value over this time, the lender may not be able to ‘unstake’ fast enough, i.e. to extract the money back from the validator, to stop the losses. The second is that if the validator fails to do the job correctly, such as not being present frequently enough to approve new transactions on time, there will be penalties, i.e. part of the staked currency will be ‘slashed’.

By having staking derivatives, it addresses the first problem by making the staked value essentially liquid. The staking derivative can be the contract allowing whomever holding the token to claim the staked currency, as the time matures. Therefore, by trading the staking derivative, one is essentially selling off the loan to the validator to someone else, in exchange for instant liquidity. As different people may have different speculations on the future value of the staked currency, general market mechanisms will determine its current price. Depending on the nature of the contract, the risk of slashing can also be taken into account.

Currently, not all PoS networks offer staking derivatives, at least not natively. However, the concept behind is straightforward and attractive, and we expect implementation and adoption to occur widely in the near future. As we will see in the next section, most relevant to the protocols for the generation of high stable interest is the fact that these staking derivatives can be used as collaterals for borrowing money.