In this article, we would like to compare two different instruments: the fixed income asset class and the DeFi investment protocol. The former is a traditional type of asset class while the latter is a new form of investment, less institutional and unregulated, but with great potential in the near future.
Hence, we would like to highlight the strengths of the two investments as well as their weaknesses.
As of 2021, the size of the bond market is estimated to be 123,5 trillion dollars (total debt outstanding). As it is visible in the graph, the equity share represents only a small percentage of the total value issued compared to the one pertaining to the debt market.
After the 2008 Global Financial Crisis, bonds markets saw years of low and relatively stable interest rates. In general, we have seen a “flattening “ of the yield curve (both in Europe and the USA ) as the spread of long and short-term bond yields has narrowed.
Given the yields, today investors can expect very low returns that are close to zero, so why are they still opting for investments in bonds then?
Investors buy bonds for different reasons based on their primary needs and strategies. For example, a pension fund’s strategy could be to buy bonds to match their pension liabilities scheme. Overall, in a portfolio, bonds can add value through diversification, decreasing the overall risk and volatility of the portfolio.
Indeed, bonds are considered a safe investment even though investors must watch out against the risk of inflation and price volatility.
Corporate bonds issuance has increased accordingly and resulted, in 2019, in a record amount of corporate debt. Together with this trend, we can also highlight that with a volume increase, credit quality has also changed. As a matter of fact, the share of investment-grade BBB bonds has soared while the high-quality bond share has plunged. Since 2017, BBB-rated issuances have accounted for more than half of all investment-grade issuance and stood at 51% in 2019.
The quality change of credit has affected the strategies of investors that have to follow some regulations.
To sum up, the volume of bonds in the market is increasing, their yields are decreasing and their overall quality is worsening too.
Lastly, during the last two decades, corporate bond ownership by households has declined, mostly in the UK and the Eurozone.
What does the bond market need? Innovation.
We have seen many different substantial innovations in the fixed income market during the past decade. As a matter of fact, today investors can choose among asset-back securities, low grade corporate bonds, traditional sovereigns, ecc. Today, we can do even more.
DeFi is an alternative Financial Technology based on public blockchains. These peer-to-peer services enable the creation of banking-like services such as earning interest, borrowing, lending, trading assets, or derivatives, everything using smart contracts as a founding technology.
In substance, DeFi eliminates the role of traditional financial intermediaries since it transfers value directly. Users will provide funds to the smart contract that will deposit money into a liquidity pool. The latter ensures that enough liquidity is present at a specific moment so that the buyer (borrower) doesn’t have to wait for the seller (creditor) to sell.
How to invest in a decentralized finance lending protocol? You first have to choose both the token and the protocol you want to use. The borrower will bear an interest to the amount borrowed while the creditor will generate a passive APY on its investments.
This is what an Aave interface looks like, one of the currently most adopted DeFi protocols. As we can see for each token we have a liquidity pool and for each liquidity pool we can deposit or borrow. Based on the transaction we want to perform, we bear different interest rates.
Smart contracts enforce rules around withdrawing and depositing on the pool.
On a very basic level, the platform allows anyone globally, to add or remove cash from a liquidity pool in exchange for interest, at any time.
DeFi was born in 2018 and, since then, it has experienced fast-paced growth. The total value at stake in pools is constantly increasing, counting now 75 billion dollars – You can check these numbers on DeFiPulse
Right now, most of the DeFi apps use cryptocurrencies as collateral inside liquidity pools. In the upcoming future, new types of assets could be used, including real-world assets such as bonds or real estate.
The most relevant advantages of DeFi come from the usage of blockchain technology and smart contracts. Indeed, these two elements provide faster transactions, more transparency, accuracy, enhanced security and efficiency compared to traditional exchanging goods services.
DeFi is permissionless meaning that anyone can access it. The main objective is the emancipation of financial services by financial institutions hence DeFi does not depend on institutions for data storage, oversight, server spaces and other factors since everything is done by the smart contract.
Enhanced security is given by the immutability and transparency of all data end transactions that are accessible and visible on public blockchains, while smart contracts act as a neutral referee in the relationships inside the pools. Hence, it would be impossible to manipulate data and transactions.
Moreover, this discussion would not be complete without mentioning the advantages of tokenization. Thanks to Ethereum capabilities, issuing a token is fairly easy.
A token is essentially a digital asset running on a blockchain and can have different uses. It could serve as a Security token, digital share, or even a fiat currency. Any asset class, including those coming from real-world economies, can be translated into transparent, tradable tokens which can be exchanged easily without geographical limitations.
Lastly, DeFi is a tool to valorize saving applications enabling users to earn passive interests that, compared to the ones that the TradFi is giving, are highly rewarding.
Given the newness of this technology, DeFi is vulnerable to some kinds of risks; namely: technological risk, asset risk, and compliance/legal risk.
Technology risk rooted in the blockchain technology is that the Ethereum public blockchain is far from infallible. Scalability issues and increased customer adoption often correlates with more attacks, bugs and network congestion. This can lead to higher transaction fees or liquidation issues.
In fact, cryptocurrencies as collateral are often pledged in DeFi transactions. Given its volatility, it is possible that the value of the collateral will decline sharply, potentially causing liquidation. For instance, this volatility can fuel a situation of uncertainty that could lead to the plummeting of a token value.
Given the recent increase in the volume of transactions on the DeFi protocol, and the infancy of the technology many regulators are thinking about the future prospects of compliance with the DeFi technology. This exposes users and investors to the risk of non-compliance in an uncertain regulatory environment.
Investor identity verification: a pure DeFi is KYC-free. On the blockchain, people are identified by their addresses rather than their investor profiles and history. This could be an attention point if we want to boost Defi methodology for the TradFi.
Even if, as of today, many risks are embedded in the DeFi space, it is only a matter of time until these risks become manageable. Indeed, decentralized finance has the potential to disrupt the conventional financial services industry or at least complement it.
What if there is a way of combining the low-risk feature of bonds with the enhanced efficiency of the DeFi protocol?
What if there exists a method of making DeFi more remunerative but also safer?