Part 1: Quantitative Crypto Insight: Stablecoins and Risk-Free Course | by Coinbase | April 2022

By George Liu and Matthew Turk

In part one of this quantitative research piece, we introduce the collateralized decentralized finance (DeFi) lending platform known as Compound Finance and discuss its use case for stablecoins versus the notion of a “risk-free” interest rate from traditional finance (TradFi). Our goal is to tie these concepts together to show how different types of low-risk investing work in the TradFi and crypto markets.

This introduction examines the stablecoin lending yield and provides insights into yield development, volatility, and the factors driving lending yield. The second part of this article takes a closer look at the factors that affect loan yields.

Stablecoins are a niche part of the ever-expanding crypto ecosystem, primarily used by crypto investors as a convenient and inexpensive way to transact in cryptocurrency. The invention of stablecoins in the crypto ecosystem is brilliant due to the following properties:

• Similar to the fiat currencies used in model economies, stablecoins provide price stability for people transacting with digital currencies or between fiat and digital currencies.
• Stablecoins are native crypto tokens that can be settled on-chain in a decentralized manner without the involvement of a central body.

With the increasing acceptance of cryptocurrencies by investors from the TradFi world, stablecoins have become a natural medium of exchange between the traditional and crypto finance worlds.

Two of the core concepts shared in traditional and crypto finance are the concepts of risk and return. Expectedly, investors will likely demand a higher return for a higher risk. During the current Russia-Ukraine war, the Russian interest rate rose from an average of around 9% to 20% within 2 weeks, which is a clear indication of how the financial market reacts to risks.

Central to the risk-reward framework is the notion of a “risk-free” interest rate. In TradFi, this interest rate serves as the basis for evaluating all investment opportunities, as it indicates the return on an investment without risk over a given period of time. In other words, an investor generally views this base rate as the minimum return they expect on an investment, since sensible investors would not take additional risk for a return below the “risk-free” rate.

An example of a “risk-free” asset is US Treasury securities (treasury bills, bills and debentures), which is a financial instrument issued by the US government. When you buy one of these instruments, you are lending your money to the US government to fund its debt and pay its running costs. These investments are considered “risk-free” because their payments are guaranteed by the US government and the probability of default is extremely low.

A “risk-free” interest rate is always associated with a corresponding term/duration. In the example above, government bonds could have different maturities and the corresponding risk-free interest rate (also called government bond yield) is also different.

The duration can be up to one day, in which case we call it the overnight risk-free rate or the general collateral rate. This interest rate is linked to the overnight loan in the money market and its value is determined by supply and demand in that market. The loans are usually secured by highly rated assets such as government bonds and are therefore also considered risk-free.

Source: WallStreetMojo

With the growing acceptance of crypto assets and market around the world, crypto-based investing has become a popular topic for people previously only exposed to the traditional financial market. When entering a new financial market like this, these investors generally look first to the risk-free rate, as it is used as the anchor point for evaluating all other investment opportunities.

There is no concept of government bonds in the crypto world, and hence the “low-risk” (rather than risk-free) interest rate is achieved in DeFi-backed lending platforms like Compound Finance. We use the term “low-risk” here because compound finance, along with many other DeFi-collateralized lending platforms, are not risk-free but are subject to certain risks such as smart contract risk and liquidation risk. In the event of a liquidity risk, a user with negative account liquidity will be liquidated by other users of the protocol to bring his/her account liquidity back to positive (ie, above the margin requirement). When liquidation occurs, a liquidator may repay all or part of an outstanding loan on behalf of a borrower in exchange for a discounted amount of collateral held by the borrower; this discount is defined as a liquidation incentive. To sum up risk in DeFi, the closest we can get to being risk free is low risk.

For clarity, for this post (and part two) let’s look at Compound V2. On Compound, users interact with smart contracts to borrow and lend assets on the platform. As shown in the example diagram above:

• Lenders initially deliver stablecoins (or other supported assets) like DAI to liquidity pools on Compound. Contributions of the same coin form a large pool of liquidity (a “market”) available for other users to borrow.
• The borrower can borrow (borrow) stablecoins from the pool by providing other valuable coins such as ETH as collateral in the diagram above. The loans are over-collateralized to protect lenders, so for every $1 of ETH used as collateral, only a portion of it (e.g. 75 cents) can be borrowed into stablecoins.
• Lenders are issued cTokens to represent their respective contributions to the liquidity pool.
• Borrowers also receive cTokens for their collateral deposits, as these deposits form their own liquidity pools for other users to borrow as well.

How much interest a borrower has to pay on their loans and how much interest a lender can receive in return is determined by the protocol formulas (based on supply/demand). It is not the intention of this blog to provide a comprehensive introduction to the Compound protocol and the many formulas involved (interested parties please read the white paper for in-depth training). Rather, we wish to focus on the return an investor can generate by providing liquidity to the pool, which facilitates our return comparison between the two financial worlds.

A Compound user receives cTokens in exchange for providing liquidity to the loan pool. While the amount of cTokens he holds stays the same throughout the process, the exchange rate at which each unit of cToken can be redeemed to get the credit back keeps increasing. The more loans that are taken out of the pool, the more interest borrowers pay and the faster the exchange rate rises. So in that sense, the exchange rate is an indication of the value of the asset that a lender has invested over time, and the return from T1 to T2 can be obtained just like that

R(T1,T2)=ExchangeRate(T2)/ExchangeRate(T1)-1.

Additionally, the annualized rate of return for this investment (assuming continuous compounding) can be calculated as follows

Y(T1,T2)=log(ExchangeRate(T2)) — log(ExchangeRate(T1))/(T2-T1)

While the compound pools support many stablecoin assets such as USDT, USDC, DAI, FEI, etc., we will only analyze the secured loan returns for the top 2 stablecoins by market cap, i.e. USDT and USDC, with market caps of $80 billion $53 billion and $53 billion respectively Together they make up over 70% of the total stablecoin market.

Here below are the charts of the annualized daily, weekly, monthly and semi-annual returns generated according to the formulas in the previous section. As can be seen, the daily return is quite volatile, while the weekly, monthly, and semi-annual returns are each the smoothed version of the previous granular chart. USDT and USDC show quite similar patterns in plot as the lending of these two assets showed high yield and high volatility in early 2021. This suggests that there are some systematic factors affecting the DeFi lending market as a whole.

Source: The graphic

One hypothesis of the systemic factors that could affect loan returns are crypto market data such as BTC/ETH prices and their corresponding volatilities. To illustrate an example (higher risk in this case), when BTC and ETH are in an uptrend, it is believed that many bulls will be chasing investors borrowing from the stablecoin pools to buy BTC/ETH and then the bought one BTC/ETH will be used as collateral to borrow more stablecoins and then repeat this cycle until leverage is at a satisfactorily high level. This leverage helps investors increase their returns as BTC/ETH continues to rise. We will explore this analysis in more detail in part two of this blog post.

future directions

This blog has provided a broadly applicable introduction to DeFi secured lending through the lens of Compound Finance and how it compares to TradFi “risk-free” rates. As mentioned above, in part two of this blog post, we will further examine secured loan returns and share our insights on yield trends, volatility and drivers.

As part of the Data Science Quantitative Research team, we aim to get a good holistic understanding of this area from a quantitative perspective that can be used to promote new Coinbase products. We are looking for people who are passionate about this effort. So if you are interested in data science and in particular quantitative research in crypto, Come join us.

The analysis uses the Subgraph Compound v2 exposed through the Graph protocol. Special thanks to Institutional Research Specialist, David Duong, for his input and feedback.

Learn Crypto Trading, Yield Farms, Income strategies and more at CrytoAnswers
https://nov.link/cryptoanswers