Comment on page
Filing the Gap
Product Market Fit
Decentralized finance (DeFi) creates an environment for material interest rate discrepancies across different protocols and networks. For extended periods of time, a given asset could be borrowed at substantially lower rates than those offered to depositors by other projects. These arbitrage opportunities are caused by short-term supply/demand imbalances, economic incentives (liquidity mining programs), and/or different levels of technical/operational risks associated with the products.
As the DeFi ecosystem matures and the protocols with a competitive advantage expand their market share – namely by developing economies of scale and nurturing loyal communities – the rates across the board are steadily converging, thus pushing investors into more complex strategies in their pursuit for yield.
Still, there is a mismatch between the yield generation opportunities available across centralized trading venues and their DeFi counterparties. This divergence stems from, among other things, differences in the use cases, duration, and structure of the respective products:
- The funding rates on the derivatives markets are quite volatile and move from positive to negative territories depending on the risk appetite of the market participants.
- CeFi lending platforms offer stable rates for a predefined set of assets but generally lack collateralization and transparency.
- Market makers are looking for inventory to perform their day-to-day business operations. Typically, they need a broad range of inventory, try to avoid price exposure, and are sensitive about the capital efficiency (levels of collateralization) of the credit lines secured. Institutional investors source various tokens to execute their directional views on the market.
As a result, the market players described above usually source liquidity twofold – either by tapping existing DeFi protocols or by borrowing in a peer-to-peer fashion via centralized over-the-counter (OTC) desks, acting as intermediaries between borrowers and lenders.
Touching on the centralized options, the OTC desks have a range of weak points:
- Come with counterparty risk and lack of transparency: Exposure to black box companies, typically running a proprietary trading desk on the side. The result is a cross-industry leverage and multiple rehypothecations of the same assets. It takes one rogue participant to pull back the industry as a whole (e.g the Three Arrows Capital fiasco is not possible on the chain).
- Have limited availability: Servicing high net worth investors and institutions only, following a lengthy onboarding process. The typical DeFi user with $10,000 in total assets under management is generally not welcomed by the large OTC desks.
- Are time-inefficient and quoting based on existing relationships: The negotiations involving rate and collateralization happen in a chaotic manner over private Telegram groups. The quotes given are typically influenced by historical business relationships and opportunity costs.
- Involve margin calls and liquidation risks: The market is not regulated. Each deal comes with lengthy paperwork that is hardly useful when it comes to legal actions during court hearings over disputes.