Over the last few weeks different DeFi projects have emerged, offering customers the opportunity to get exposure to the most common traditional securities on the market: US Treasury Bills.
The bridging of traditional securities on-chain is the clearest ongoing DeFi trend and this post aims to analyze the main projects and their impact on the evolution of the DeFi space.
Convergence of on-chain – off-chain rates
Approximately twelve months ago, before the FED and other central banks started to raise interest rates, 3 month TBills – i.e. bonds issued by the US Treasury department with a 3 month maturity – were distributing a yield slightly above 0, around 0.4%.
Twelve months later, the same instrument guarantees its investors 10x more: 4.59%.
The TBill bears some risk but it is considered the closest thing in circulation to a risk-free rate. DeFi has no comparable asset in terms of risk profile, adoption, and trust in the issuer. Still, some investment opportunities could proxy the TBill and be considered the DeFi risk-free rate (Octavio elaborated more on the topic in one of his latest newsletters).
One of the potential risk-free rates in DeFi is the Aave USDC Lending rate. This can be considered a proxy because it represents the service for an over-collateralized loan in which the borrower posts some valuable collateral to borrow USDC.
Around twelve months ago, the Aave USDC rate paid to lenders slightly less than 2%, and that figure has remained pretty equivalent today.
Essentially, over the last 12 months investing in risk-free assets on-chain was much more profitable than doing it off-chain. Today it is the other way around.
This new paradigm has produced multiple consequences.
First, some capital left the DeFi ecosystem to migrate towards the TradFi ecosystem, even though DeFi has shown some form of retention of capital – especially among very committed crypto pioneers, but also due to some hurdles in liquidating crypto positions into FIAT.
Second, this situation is highly incentivizing start-ups to build bridge technologies and offer on-chain capital the same returns that would be accessible off-chain.
The utopian goal of these bridges is to connect the two parallel ecosystems, allowing a frictionless capital transfer between the two worlds which would spin up some convergence dynamics between the two risk-free interest rates.
US Treasury bonds onchain
Convergence between rates implies the existence of an easy transmission mechanism between the two ecosystems.
These mechanisms, informally defined as DeFi-TradFi bridges, are simply instruments that give exposure to traditional assets on DeFi rails.
The first and most obvious security to connect traditional finance to DeFi is US Treasury bonds, and a plethora of services are working relentlessly in that direction.
Ondo Finance
Ondo Finance started as a decentralised investment bank, a permissionless protocol built to accelerate DeFi adoption through a more granular exchange of risk.
In the last ⅔ months, the project pivoted towards real-world assets and, a few weeks ago, the project unveiled a new, pretty exciting product: bonds on the Ethereum chain.
Through Ondo it is possible to buy three types of bonds: OUSG, US treasury bonds; OSTB, a short-term investment grade corporate bond; and OHYG, a high-yield corporate bond fund.
Concretely, customers that buy one of Ondo’s products, for example OUSG, are buying a claim on a fund (regulated in the British Virgin Islands) that invests in a specific ETF, for instance OUSG funds invest in a BlackRock US Treasuries ETF.
To build this product Ondo orchestrates a plethora of service providers:
- Clear Street, broker and custodian of the ETFs;
- Coinbase, stablecoin custodian which stores the USDC sent to Ondo to buy OUSG;
- Coinbase Prime, the exchange handling conversions of FIAT into Crypto and vice versa;
- NAV consulting, the Ondo fund administrator;
Ondo’s tokens are not fully permissionless: they can be accessed only by KYCed and AMLed investors, whitelisted by Ondo. Similarly, there is no full transferability of the tokens issued by Ondo: free circulation of the tokens is restricted and prohibited to anyone not appropriately qualified as an investor in the fund.
Restricting transferability implies a partial restriction to composability: if a user can’t freely transfer tokens, it will be harder to build products on top of it. Being composable is one the key value propositions of DeFi, a complete lack of composability could be the death of any DeFi product. So, to mitigate this issue, Ondo has built a money market protocol called Flux.
Flux is a fork of Compound, but it adds support for permissioned tokens (like OUSG, OSTB, OHYG). Essentially, through Flux – which is a whitelisted entity by Ondo and can receive OUSG – Ondo customers can pledge their OUSG in exchange for USDC.
As in every DeFi money market, if the loan gets undercollateralized, a liquidation is triggered but, differently from Compound, Flux’s liquidators have to be whitelisted – so KYCed and AMLed – something pretty new for traditionally anonymous or pseudonymous decentralized finance applications.
Flux is a key element of the Ondo ecosystem. Through Flux, Ondo not only allowed users to pledge OUSG and get USDC but also positions itself in a very smart way to attract stablecoin liquidity from every corner of DeFi. Currently, lending USDC on Ondo provides a return of 3.57%, almost twice what the same USDC loan would accrue through Compound.
Cytus Finance
Cytus Finance’s product is similar to Ondo’s: it allows customers to buy US treasury bonds on DeFi rails.
Customers of Cytus Finance are buying a claim on a fund that directly invests in US treasury bonds. In this case, Cytus buys the securities directly and not an ETF exposed to the securities.
As per Ondo, the fund is regulated in the British Virgin Islands, and there is no free accessibility to it: users must be KYCed and AMLed, and, more importantly, the product is closed to US investors.
From a transferability point of view, Cytus tokens are even more restricted and tokens can be transferred only with the prior written consent of the manager.
New-Comers
As mentioned before, TBills on-chain are one of the hottest things in DeFi today, and various projects are jumping on that wagon.
Kuma announced a few weeks ago that FMA (Financial Market Authority in Liechtenstein) approved their prospectus to issue tokens backed by NFTs, which are in turn backed by sovereign bonds.
Based on the very limited documentation available online, Kuma will be offering tokens that represent a claim on a pool of NFTs. These NFTs are issued by Mimo Capital and collateralised by sovereign bonds offered by Mimo.
Last but not least, Backed (the project I’m proud to have joined a few months ago) will be soon releasing its fixed-income product.
Backed is a Swiss-regulated company that has been building a compliant product for distributing fully backed ERC-20 tokens. Backed bTokens are (as the name says) fully backed: for every unit of token issued there is an equivalent security held by a regulated custodian.
As per Ondo, users will have to go through a KYC process to issue and redeem bTokens, but bTokens will have more degrees of freedom in terms of transferability.
Currently Backed offers only a stock product that is already available in a Uniswap pool, but it will soon provide fresh updates with new products.
Conclusions
As my readers already know, I’m extremely bullish on DeFi and I’m firmly convinced that DeFi rails are the infrastructure where the future of finance is being built.
Bonds are the first tool to migrate these rails, but they are a crucial one.Only with a frictionless and reliable transition between ecosystems in place will investors safely adopt this new technology.
I’m convinced that there is enough room for multiple players in the bridging world but the necessary feature to become relevant in the space will be COMPOSABILITY.
To win in DeFi one needs to be a useful element to the rest of the ecosystem. If projects don’t fully embrace composability, I suspect they will not be able to achieve the scale and adoption needed to compete seriously.
Resources
- Ondo Finance
- Ondo introducing bonds on-chain – Link
- Ondo terms of service
- Restricted securities – Link
- Regulation D – Link
- Flux
