The Web3 Yield Curve
Introduction
The goal of this article is to take a reader from not knowing what “yield curve” actually means, to being excited about the Web3 Yield Curve created by the Sense Protocol.
First we’ll talk about yield curves in traditional economies, what they tell us about market expectations, and their impact on economic activity. Then, we’ll discuss how we’ve approached creating a similar financial primitive on-chain with the Web3 Yield Curve.
This base yield curve is the foundation for the future Sense is building: our vision is to create decentralized, transparent, fair factories for yield curves and other yield primitives on-chain along with fully decentralized markets for yield discovery. You don’t have to have a financial background to share our vision! Just give this article a read. Let’s dive in.
What Are Yield Curves And Why Do They Matter?
In a traditional economy, based on a currency managed by a central bank, you have something called a yield curve. This is the fixed interest rate you can make by lending to the government for a bunch of different periods (3 months, 6 months, a year, five years, etc.). Technically, there is a yield curve for any fixed rate asset with multiple maturities (e.g. corporate bonds). Still, people usually refer to the yield curve of the government bonds when they just say “the yield curve” in isolation. What makes the yield curve for government bonds special is that it’s the safest loan in the whole economy. The government is almost definitely going to be able to pay you back, because the government is the one who prints the money.
Yield curves are super useful, and tell us a lot about what the pools of capital in an economy expect for the future. The reason they work for this is that they represent the exchange rate between money today and money in the future, without any meaningful consideration of a risk of not being paid back.
For most people, if you lent them money, you might want some interest just to compensate you for not having the money on hand to do other things plus a bit more to compensate you for the risk that it doesn’t get paid back at all. Maybe you don’t trust them, but also maybe you do trust them but still acknowledge the future is uncertain. They could die! They could get wrongfully embroiled in a lawsuit that strains their finances. They could get robbed. Who knows?
With the US government you know they’ll be able to pay you–so you’d generally lend to the government for a cheaper rate. You want them to compensate you for not having access to your money, but you’re not worried about them not paying you back. How do you know you’ll get paid back? Well: they are the only borrower who can make dollars. They can’t “run out” of dollars to pay you back, because they can always print dollars.
This is why the rate from the government on a currency it can print is often referred to as the “risk-free rate” (RFR). It is not “risk-free” in a literal sense — governments collapse, the currency could become valueless, if you’re holding it in a bank account the bank may not honor your ownership of those bonds: heck, even if you physically hold paper bonds a mouse could eat them. There is always risk, but the rate offered by the issuer of the currency is the closest market proxy we have to a “risk-free rate”, a valuable metric in understanding the conversion rate between currency now and currency later. Every other borrower pays you the “risk-free rate” (the future value of the cash you give them) plus something to compensate you for risk.
You might not know the purchasing power of those future dollars you’ll get paid with, but you do know, with near certainty, that you’ll get those dollars next year.
What Is Priced Into The Yield Curve
Now, we all hear chatter about the Fed setting rates, but the Fed doesn’t set rates of these longer maturity bonds, per se (usually). They set the short-term rates. That means what the 1, 2, 5, 10 year etc. bonds are doing is implicitly pricing what the market thinks the short-term rates will be in the future. A ten year bond is just the implied average rate of 10 separate 1 year yields, or 40 separate 3 month yields.
Even crazier than that, because we have bonds expiring and being sold all the time, you can break down the priced-in rate for each period individually. You can calculate something like what the 1 year rate, three years from now is expected to be according to market prices.
Here’s a simple example of how that works with a 1 year and a 2 year bond.
*If you don’t want to puzzle through with specific numbers, basic idea is that if I know what the rate for a 1 year loan is, and what the rate for a 2 year loan is, I know what is priced in as the rate of a 1 year loan 1 year from now– it should make buying a one year loan now and buying a one year loan next year roughly equal to buying a 2 year loan now. Just skip the numbers if you want.*
Let’s say $100 payout 1 year from now cost $98 — so we have a rate of about 2% on the 1 year (2.04%). Now, let’s say $100 payout 2 years from now costs $94 for a total return of around 6% (6.38%) and an annual yield of around 3% per year (3.14%). With this you can figure out what the 1 year bond 1 year from now (the “1 year 1 year forward”) is priced to be.
If you took your $94 now and bought a 1 year bond instead of the 2 year, you’d end up with $94 * (1 + 2.04%) = ~$95.92 next year. The market thinks that if you keep lending to the government, that ~$95.92 with another year of interest should equal $100. So, around 4% yield is priced in as the 1 year yield 1 year forward (($100 — $95.92)/$95.92 = 4.26%)).
The market isn’t just saying that you’ll get 1% more yield per year by lending for 2 years, it’s saying that rates next year will be double what they are today! As you get more maturities on a yield curve, you get a higher resolution picture of what the market thinks will be the short-term rates for that asset at various points in the future.
So, the yield curve prices in what people think will be the rate set by the Fed for each period in the future. We have this variable set of future “risk-free rates”, which get priced into longer duration bonds and change as a function of expectations around macro conditions or behavior from the Fed.
Why The Yield Curve Affects The Economy
The yield curve is not only a reflection of expectations about the economy — it also in turn affects the economy. The higher yield I can get in risk-free lending, the less likely I am to lend to anyone else. To put some numbers on the above example —maybe I was willing to lend $100 to you for $105 back next year because I could only get $103 back next year by buying government bonds. You are riskier, but I’m willing to take that risk for an extra $2.
If all of a sudden I can get $106 back next year from a government bond, there’s no way I’m going to lend to you for $105 and take on that unnecessary risk. Suddenly, it gets way more expensive for everyone in the economy to borrow money, and many people will no longer be able to borrow at all because they couldn’t realistically expect to pay back the interest on a more expensive loan.
This ever-changing exchange rate between present-money and future-money affects other asset prices in the same way it affects people’s willingness to lend. If 1 dollar today goes from being worth 1.03 dollars next year to being worth 1.06 dollars next year, all things denominated in future dollars have lost value versus present dollars. So if nothing else has changed, an equity investment that I expect to pay out $X in dividends in the future is now worth less in present dollar terms (meaning, number go down) if the yields on government bonds have gone up.
This kind of explicit yield curve exists in any economy where there is a risk-free borrower to whom you lend a currency that they print, and for which liquid markets are pricing those lending rates.
In an economy that doesn’t have this, there is still a non-explicit yield curve — there exists some ratio by which people, in aggregate value present money more than future money — but no one knows what it is. This means some people will make risky investments for a rate of return that they could have gotten on far less risky investments. An explicit yield curve for the RFR crystallizes all this information in a market and provides a transparent and available “risk-free” yield for anyone who is not trying to take on any additional risk with their capital. This provides an extremely important base rate by which all other loans (or any asset that is a claim to some future cashflows) can be valued.
But we’ve been talking about currencies issued by governments–how can we approximate something like that in crypto?
Making The Web3 Yield Curve
In the crypto world, we don’t have a central bank and a government as central issuers and borrowers of a currency. We have decentrally verified protocols, which operate as central issuers, and generally don’t have any reason to borrow from the economy built on top of them.
But, in some cases, that protocol requires the staking of tokens to align incentives for verification. And, as it turns out, rewards for staking on the protocol network are similar enough to a variable short-term risk-free rate set by the Fed that you can build a fixed income market (and therefore a yield curve on) top of it. The tricky thing is that those rates are usually variable on extremely short time frames — there is no 10 year fixed staking return built into the protocol.
How Is Staking Comparable To The Fed Rate?
Staking provides a variable return depending on number of people staking, network activity, etc. Short-term government rates are also variable: they depend on what the Fed says they are at any given time. As the US government is the wellspring of dollars themselves, the Ethereum network is the printer of ETH. Neither can default. If either did default, it would imply that the currency itself had collapsed. So, in terms of the economy denominated in that currency, they are both “risk-free” sources of yield because they print the underlying currency.
What we don’t have in the Ethereum network is 1 year, 2 year, 10 year, etc. bonds. You can stake and get whatever you get, but you cannot get a fixed return over a period of time from the risk-free borrower. Your rate will vary in every 12-second block!
We need a way to exchange a fixed number of ETH today for a fixed number of ETH in the future with that ETH return backed by yield from the one source (the network) that will never default. Since that staking return is based on the yield provided by the printer of the currency (the network) a yield curve built on top of that could be used to price what the lowest risk return on the currency (staking yields) is expected to be in various future periods.
As it turns out, we can totally do that with a bit of slicing and dicing of the risk exposures of ETH stakers. To create these fixed rates, the Sense protocol provides decentralized infrastructure (smart contracts) that do “yield stripping” on top of staked ether (wstETH). We go into more detail on this elsewhere, but one reason for using this method is that there is no new debt created: the smart contract holds the wstETH to fully back the fixed rate holder’s future claim and creates a separate riskier derivative asset (yield tokens) whose market pricing dictates how big that fixed rate will be (which prices in what the market thinks the average staking yield will be).
This, of course, is not a perfect proxy, but we think it is the best one possible. There is smart contract risk from the Sense contracts, there is smart contract risk from Lido, and since wstETH is a vault of stETH, there is risk that the stETH will not be exactly a 1–1 conversion for the ETH at all times (in the future when it is redeemable that will likely be a much tighter exchange rate). We will likely make equivalents for other liquid staking tokens, but for any version of that, the staking infrastructure behind that claim to staked ETH will always be a source of risk. To be fair: holding bonds in your bank is not a perfect proxy for risk-free rate either; as we explained before, the bank may not actually be able to give you the bonds you “own” in the end.
The Future Of The Web3 Yield Curve
With the Merge, the Ethereum economy will change significantly in that there is an actual rate paid by the issuer of ETH. By making a decentralized marketplace to price fixed rates, we will create an important tool for pricing all other ETH-yielding assets and a transparent projection of what the market expects to be the staking reward (basically the monetary policy) of the ETH network in the future.
With this as a basis, we also unlock the possibility of on-chain pricing for credit default swaps, forward currency swaps, and any other markets that require an on-chain oracle for the ETH RFR in the future.
We expect that the Web3 yield curve will be as essential a part of the Web3 economy and markets as the TradFi yield curve is for traditional economies. And we are working to build the decentralized, permissionless, transparent infrastructure needed for its creation.
If you’re excited about this vision and want to help build it, join us. We’re actively hiring and are always on the lookout for top talent. Join our community on Discord to get involved, and follow us on Twitter for updates!
