New Forms of Collateral Arrive To Diversify DeFi

So far, the only trustworthy collateral in the crypto space is BTC and ETH. Stablecoins became a trend because they can also be used as collateral for loans and expand the balance sheets of services such as Maker or Compound.

To expand credit in the crypto market, new forms of collateral are needed.

The next step in DeFi is to create new forms of collateral and new types of assets for the transfer of risk to investors that are willing to take it.

A well functioning fixed income market will create a more efficient DeFi market since it will become easier for investors to model and price risk.

For example, in traditional debt capital markets, the yield curve or credit spread, i.e the difference in yield between short term and long term bonds, is used as a very powerful indicator of investors’ expectations on future economic growth and returns. 

In crypto, there is no such thing as a yield curve since there are no fixed income products yet. If you go to Compound or Aave and lock your ETH to earn the interest rate, you will get the same yield regardless if you lock for 1 month or a year. There is no term structure of interest rates yet. 

This means that a benchmark yield cannot be constructed (such as the 10-year Treasury in traditional markets) which is essential for pricing other more complex products. 

Such a complex product is a Collateralized Debt Obligation (CDO) and even though it has obtained a bad name since it created the 2007-2008 crisis, it allows for the transfer of credit risk to an investor or a third party without the need for the lender to sell the loan. 

A CDO, in essence, allows a bank, for example, to sell upfront the cash flows of the loans it has in its balance sheet, which gives the bank the ability to issue more loans to businesses and people that need it, which creates more economic opportunity and growth, while at the same time, investors could buy CDOs to diversify their equity exposure or to minimize the volatility of their portfolios. 

Such products could also be very useful in the DeFi market since they will create new opportunities for investors while at the same time give the ability to DeFi platforms such as Compound and Aave to create new products with new forms of collateral and thus give more loans.

We are lately starting to see such attempts to construct a more efficient debt capital market in DeFi.

Yield, for example, is one of the projects that do fixed rates bonds. As they describe in their whitepaper, their solution is not a user-oriented protocol, but a primitive for other applications to start building products on top of them. Yield falls into the zero-coupon bond category.

Other projects like BarnBridge, Benchmark, and Mainframe's fixed-rate loans are introducing the CDO model. 

Barnbridge, a fluctuation derivative protocol securitizes/create derivative products from fluctuations. Examples include interest-rate sensitivity, fluctuations in underlying market price, fluctuations in predictive market odds, fluctuations in default rates across mortgages, fluctuations in commodity prices. Through such products, it offers a way to optimize risk instead of optimizing returns, the same as Yearn does. 

On the traditional financial market, CDO products are more suitable for institutional investors and not directed to retail investors. But as we’ve seen in crypto, thanks to platforms like the above or VEGA every developer will be able to build such services and every investor/speculator will be able to participate.

Besides CDOs, other forms of collateral have been introduced by platforms like Fairmint.

Here is an example: Let’s say that an investor/user has $100K worth of a company's CAFEs (tokenized future equity), technically they could use their CAFEs as collateral to borrow USDC and take a loan without selling their CAFEs.

It would also make it possible to build indexes, create derivatives, and so on. Investors could also create (on their own) permission-less wrapped CAFEs that would not give direct access to equity but would allow people to speculate on the value of the company.