With benchmark DeFi yielding less than low-risk assets like U.S. Treasuries, blockchain-based finance has entered unfamiliar territory.
After the Federal Reserve’s fourth consecutive 0.75% hike on Nov. 2, the benchmark U.S. interest rate stands at 4%, the highest it’s been since January 2008.
Crypto, like most risk assets, thrives when interest rates are low and capital is plentiful. The last monetary tightening cycle saw rates peak at 2.5% in early 2019. Meanwhile, 2018 saw a crypto bloodbath, with overall market capitalization crashing from $850B in January to just $108B by the end of the year.
Crypto markets have been relatively calm since the latest hike — Bitcoin and Ether are down less than 1%, and Binance’s BNB is up 5%.
Chairman Powell’s statement asserts that continued increases in interest rates are appropriate, indicating that the world’s largest central bank is unlikely to turn dovish in the near term.
Rising rates have pushed short-term Treasury bill yields to 3.5%, according to YCharts. That’s higher than the rates available on the top three stablecoins deposited on DeFi’s top three lending protocols, Aave, JustLend, which is on the Tron blockchain, and Compound.
And all else being equal, yield-seeking capital should follow the best low-risk rates, so it’s curious why investors are still lending in DeFi at all.
“There’s for sure a base of capital that’s in DeFi that is very sticky,” Teddy Woodward, co-founder of Notional, a fixed-rate yield protocol with $91.7M in TVL, told The Defiant. He said rising rates in traditional finance have somewhat attracted capital in DeFi, but that force has had a limited effect so far.
“This rate divergence is pulling [capital] out and the wider that rate divergence goes, the stronger that pull is,” he said. Woodward pointed out that the circulating supply of USDC has dropped 24% since June, and suggested that higher interest rates may be responsible as the yield on USDC is 2% or lower on the top three lending protocols.
Allan Niemerg, co-founder at Yield Protocol, another fixed rate protocol, agrees with Woodward. He believes that the friction in moving capital between traditional finance and DeFi accounts for why investors are still deploying their capital in crypto.
Friction Between DeFi and TradFi
“DeFi is still relatively immature and not that well connected to traditional finance,” he said. “And so, rates moving in the traditional markets don’t necessarily impact DeFi just yet in huge ways.”
Even if rates in traditional finance continue to rise and attract more stablecoins out of DeFi, both entrepreneurs don’t seem concerned that it would threaten blockchain-based finance at its core.
“It’s not that DeFi would die,” Woodward said. “It’s just that people would have to borrow at rates that reflect the macro environment and maybe that just means there would be less borrowing overall.”
Niemerg thinks that DeFi’s true value exists regardless of the rate environment. Though he added that higher rates could lead to less venture capital investment and fewer high-risk financial strategies.
To Niemerg, that’s generally just noise, however. “The signal, the hard work that I see happening every day in the ecosystem, that keeps growing,” he said.
Theoretically, as stablecoins leave DeFi, borrowing rates on lending protocols would go up to reflect the lower availability of dollar-pegged assets. In a world with less friction between the two financial systems, traders would arbitrage the two rates until they were by and large the same.
So far, they haven’t converged, but that doesn’t mean they won’t if rates keep going up. “People don’t shift their allocation on a dime,” Woodward said.
Moving forward, there are a few trends to watch for in DeFi. For one, the focus may move toward yield on Ether, rather than stablecoins.
Notional is set to launch a leveraged product based on ETH, which is where Woodward sees yields staying high thanks to ETH’s staking rate after its move to Proof-of-Stake consensus. “I think that ETH yield and sources for ETH demand are just much less cyclical,” Woodward said.
Also, fixed rates may play a role in bringing more capital into DeFi. Businesses aiming to invest in their future look for fixed-rate loans in order to reliably forecast cash flows. DeFi has only seen variable rate protocols adopted so far due to their simplicity, but if the fixed yield market matures, it could bring new participants into open finance.
“I can totally see fixed rates being a really important part of the next cryptocurrency boom,” Niemerg said, adding that fixed rates could allow crypto to connect more wholly with the traditional financial system.
For now, DeFi is in flux. With eye-popping yields harder to find, and those that do exist met with more skepticism, it’s going to be hard to attract institutional capital that can get near risk-free rates in the highly liquid bond markets
But if Niemerg is right, the high yields which characterized crypto’s last cycle aren’t where DeFi’s true value lies.
“DeFi is going to succeed because of innovation,” he said. “Because it builds something that people ultimately want. And we’re still very, very early in that process.”