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Sense Finance: The DeFi Fixed Income Market

Establishing a risk free rate for Ethereum lending

Frequent readers of Frogs Anonymous will know that we have a soft spot for DeFi protocols that allow you to speculate on yield. Over the last few months, we’ve released articles on Voltz Protocol and Timeless Finance, both super fascinating projects. I strongly recommend reading them.

Today, we add a third protocol to the yield speculation collection, and it might be the coolest yet: Sense Finance.

What Sense does is enable users to “strip” yield-bearing assets into their principal and yield components, turning them into two fixed-term, maturing assets, a Principal Token (PT) and a Yield Token (YT).

Let’s discuss why this is game-changing for DeFi.

The Yield Curve

To understand why Sense is so revolutionary, you first need to understand the importance of yield curves.

Today’s traditional economies are based on a currency managed by a central bank, better known as fiat money. These central banks set the fixed interest rate, which determines what you can earn from lending to the government by buying bonds. The yield curve is the visual representation of this interest rate over several different timespans.

Normal Yield Curve

Normal Yield Curve

Why is this important? Well, let’s think about government bonds.

The government bond is the safest loan one can make, as the government is almost guaranteed to pay you back. Makes sense; how can the person printing the money run out of money? This is why the government bond is referred to as the “risk-free rate” (RFR).

Because the government bond is so safe, the RFR affects every other interest rate. It’s riskier to loan money to someone besides the government, so I need higher interest payments to incentivize me to make the loan.

This means that the RFR, and by extension the yield curve, is crucial to understanding the conversion rate between money now and money later. By representing this conversation rate, the RFR affects all assets in the economy.

Suppose the RFR is very high. Suddenly, interest rates on private loans must also increase, which makes borrowing money much more expensive. This makes money today more valuable, as it is now worth more money in the future. In turn, this makes everything priced in future dollars less valuable.

In degen terms, number-go-down for your investments.

Of course, the opposite is true when the RFR is low. That’s when the money printer go brrrr.

The important thing to know is that the RFR and the yield curve provide investors with knowledge of how to value present money versus future money. Without an RFR, investors can easily take on unnecessary risks.

Unfortunately, that is the current state of affairs for DeFi.

A DeFi Risk-Free Rate

DeFi doesn’t have a central bank. Makes sense. A central bank doesn’t fit into “decentralized” finance.

For the most part, this is a good thing. It’s part of the reason we all joined this wacky world in the first place. No central bank, however, does mean that there is no RFR.

That has changed now that Ethereum is proof-of-stake.

Ethereum staking is pretty similar to a central bank printing money. Ethereum is the printer of ETH in the same way that the Fed is the printer of USD. This makes default virtually impossible. If either were to default, we would have much bigger problems than the RFR.

The main difference is that Ethereum doesn’t offer fixed-return bonds. Instead, staking returns a variable rate. This creates problems for creating a dependable RFR and yield curve.

To create a DeFi RFR, you need a way to exchange a fixed number of ETH today for a fixed number of ETH in the future, plus interest. Then, you could create a yield curve to price all other ETH-yielding assets and project what the market expects the ETH staking reward rate will be in the future.

Enter Sense’s yield stripping application.

Yield Stripping

As we’ve established, the goal is to exchange a fixed number of ETH today for a fixed number of ETH in the future, plus interest.

This is where Sense’s yield stripping application and the Principal Tokens (PTs) and Yield Tokens (YTS) we mentioned in the introduction come into play.

The yield stripping application enables users to split yield-bearing assets into PTs and YTs, which, as you will soon see, allows for creating an RFR and yield curve.

PTs represent the yield-bearing asset’s underlying principal. At maturity, they are redeemable 1:1 for the underlying. So if I strip 1 ETH, my PT is guaranteed to give me 1 ETH at maturity. It is fixed.

YTs represent the yield-bearing asset’s yield payouts. They continuously accrue the yield that the underlying would’ve gained. So if we use my previous example of 1 ETH, my YT would pay me the variable yield earned from staking that 1 ETH.

For my visual learners out there, here it is in picture format:

Source: https://docs.sense.finance/docs/core-concepts/#yield-stripping-application

Source: https://docs.sense.finance/docs/core-concepts/#yield-stripping-application

The Implied Fixed Interest Rate

Because the yield-bearing asset is stripped into PTs and YTs, the PT price + YT price will always = the underlying price.

This means that because PTs represent a fixed amount of the underlying, and YTs are never negative because yields are never negative, PTs will always trade at a discount to the underlying before maturity.

Why is this important? Because it means you can buy fixed amounts of the underlying in the future for a known price today.

That discount between the PT and underlying creates an implied fixed interest rate.

In other words, buying a PT grants a fixed rate of return.

This fixed rate of return is key to how the market prices PTs and YTs.

Pricing PTs and YTs

On a high level, PTs and YTs are priced similarly to how assets in a traditional economy are priced: by implied yields.

For PTs, the higher the implied fixed interest rate, the more valuable the PT. A PT that grants me access to 1.05 ETH is more valuable than a PT that gives me access to only 1.03 ETH.

PTs typically gain value as maturity nears. This is because as YTs pay out their yield payments, they decrease in value. As YTs decrease in value, PTs increase in value. However, if the market starts pricing in a higher yield, the YT will gain in value, and the PT will decrease in value.

For YTs, the higher the implied yield, the more valuable the YT. This implied yield takes into account both percentages and time. For example, a YT that pays 6% is more valuable than one that pays 3%, but a YT that pays 3% for the next 12 months is more valuable than one that pays 6% for just the next month.

The above example clarifies why YTs typically lose value as maturity nears. As the YT completes its payments, it becomes less valuable.

Simple as that.

Yield Speculation

Because PTs and YTs are priced off of yield expectations, they present a way for degens to speculate on future yields.

Let’s think about why by recapping how PTs and YTs are priced.

PT and YT Pricing

PT and YT Pricing

If you buy PTs, you are shorting the future implied yield. This is because PTs gain value as implied yields decrease. Sense provides a nice example of how you profit from buying PTs and shorting implied yield.

Source: https://docs.sense.finance/docs/use-cases/#trading-future-yields

Source: https://docs.sense.finance/docs/use-cases/#trading-future-yields

The beautiful thing about buying PTs is that you not only have some upside, but the worst thing that can happen is you earn a fixed yield. You profit no matter what.

If you buy YTs, you are longing the future implied yield. This is because if you buy a YT and the yield increases, you earn that extra yield at a discount. Not only do you earn that extra yield, but the YT itself also becomes more valuable, which presents an opportunity to sell it for a profit.

Sense once again provides an excellent example to illustrate this.

Source: https://docs.sense.finance/docs/use-cases/#trading-future-yields

Source: https://docs.sense.finance/docs/use-cases/#trading-future-yields

The downside with this method is that you are exposed to some downside risk. If the yields decrease, not only do your YTs lose value, but you also could earn lower yields than the rate you bought at. In other words, there is a possibility that you will lose money buying YTs.

Conclusion

Although The Merge has not yet lifted us out of poverty like many expected, it has changed DeFi for the better.

The creation of an RFR and fixed income market is big. Besides enabling gambling addicts to get their fix by speculating on future yields, knowing how much money you can safely make is a game-changing development.

The fixed income market created by Sense allows big accounts to feel safer when investing in DeFi. It makes taking leverage and borrowing less risky. It enables better pricing of yield-bearing assets. It allows people to plan their financial future. And, of course, it opens up a whole new world of degenerate gambling.

I can’t wait to see where Sense goes from here.

Published on Oct 12 2022

Written By:

TheHeathen22

TheHeathen22

@TheHeathen22
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