Term Finance: Fixed-rate Loans Versus Variable-rate Lending

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March 19, 2024

In conclusion

As protocols, Dapps, infrastructure, and other forms of DeFi innovation continue to move at the speed of a neo-modern Chinese bullet train, part of our job is to help you keep track of interesting innovations in this space. It’s why you love us, and it’s why you enjoy reading and listening to all of the content we put out. But our job does not stop there. We’re also here to make you see the importance of certain protocols beyond token speculation amidst the noise horde.

When we brought Term Finance to your attention through the previous article, the goal was to describe who they are and how it works in the blocmates tone that you have come to love and enjoy – like, hey! this protocol (Term Finance) introduces collateralized, non-custodial, fixed-rate auctions on-chain; how cool!

Now, if you would pay us a bit of mind, we would love to interest you with why we think on-chain fixed-rate loans are important and why the Term Finance approach is superior vis-a-vis other on-chain variable-rate lending platforms!

You know, when we talk about it twice, then it is most likely worth your while.

Variable interest rate: The issues

If you're looking to pass the time on a leisurely Sunday evening, just strike up a conversation with your grandfather, who spent his younger years working on Wall Street. Ask him about the drawbacks of fluctuating interest rates, and you'll find yourself immersed in a lengthy discussion that could fill volumes of textbooks. And what’s quite important is that he would be right for the most part, with almost all of his reasons applicable to the way variable interest rates operate on-chain.  

Decentralized lending platforms operate in a pool-like manner wherein lenders deposit capital into a pool to allow borrowers to borrow money from the pool having deposited collateral (often overcollateralized) without a specific repayment period.

For most lending pools, the interest rate varies according to the utilization of the assets supplied to the pool. An example is Aave, which uses an algorithm to adjust interest rates based on the utilization of the assets in a pool. What this means is that rates vary according to supply and demand.

For example, imagine you draw out a loan from a pool with low demand, and by the time you decide to pay it back, the demand for the asset in that pool has gone up, causing a liquidity squeeze. As a borrower, you will end up paying much higher interest rates, quite above the rate when you took out the loan.

Source. Dune Analytics

The chart above shows the average, minimum, and maximum borrow rates observed on Aave for USDC on each day between November 1, 2023, and March 1, 2024. The chart shows that rates have been fluctuating between a 3%-20%+ range on a regular basis!

Going by the above, we can say that variable rates are not so advantageous to the borrower:

  • The borrower cannot predict rates as they are unstable and cannot plan their finances— they are constantly worried about borrowing rising costs.
  • Being in a constant state of worry over borrowing costs is hectic; borrowers have to monitor their positions in tandem with market conditions to avoid;
  • The looming risk of liquidation is more likely with fluctuating rates.

On the other hand, lending at a variable rate can also impact the lender adversely in falling rate environments, as fluctuations may result in reduced income earned by the lender, disrupting their financial plans as well.

Overall, variable rates do not factor in the time value of money in DeFi — a big loophole or a cog in the wheel of potentially more interesting financial blocks that can be built if rates are stable. Moreso, variable-rate lending protocols are prone to frequent and repeating liquidity shortages even more extreme than the daily fluctuations shown above, which can substantially affect actual funding expenses, with only a fraction of these costs being transferred to liquidity providers. More on this can be found in this blog post.

The alternative to variable interest rates is obviously that interest rates be fixed. However, the approach to building a platform for fixed-rate lending is equally as important as the very thought of it.

For example, interest rates can be fixed in such a manner that borrowers and lenders are matched via an order book. However, this process is likely to be highly inefficient as order books are built to be rapid, and the process of matching lenders and borrowers will inevitably be extremely slow —imagine waiting for three days for your loan request to match a lender. Ewww!

An alternative is to hold regular “call auctions” at predetermined intervals. Call auctions enable deeper liquidity by batching orders received over the solicitation period to clear at a single point in time and serve as a coordination mechanism to attract much deeper liquidity than would be available on a continuous basis.

Lending and Borrowing on your own terms

Term Finance makes on-chain fixed-rate lending as seamless and easily understood as possible. The process allows lenders and borrowers to agree on rates prior to execution.

Given that we’ve explained how this works thoroughly in the first article, here’s a brief overview of Term’s process:

Term Auctions are done weekly. The auction date is set in a predictable manner (mostly Wednesdays and Thursdays) to make things easier for participants or users. When an auction is open, lenders can specify the amount they intend to lend and the minimum rate they intend to lend at. Likewise, borrowers can deposit their collateral and specify the amount they intend to borrow and the maximum interest rate they are willing to pay.

At the end of the auction period, the clearing rate is determined by finding the rate that maximizes the number of borrowers and lenders that can be matched.

The advantages of Term’s Fixed-rate loans

Variable rate protocols offer users seeking flexibility in on-chain lending and borrowing. Aave's enduring popularity in the crypto space attests to this fact, given its widespread daily usage. Nevertheless, the slight edge in market share held by fixed-rate (over variable rate) loans in the Trad-fi collateralized lending market scene proves that, in the aggregate, people have a slight preference for the ability to plan their finances in advance without disruptions from rate fluctuations.

Fixed-rate loans offer this stability to borrowers, and what's more, Term's method of offering these loans uniquely addresses many of the pain points of DeFi borrowing and lending.

  • The duration of auctions is predetermined, and there are no delays in announcing the results; everything is structured to ensure that borrowers and lenders retain complete control over the terms.
  • Term Finance operates predictably in any market condition (bull or bear). There is zero increase in funding cost (or decrease in income earned) over the term of a loan, as interest rates are predetermined and fixed for both parties. There is also no slippage and spread as both parties (lenders and borrowers) transact at a single clearing price.
  • The fear of sudden liquidation due to on-chain liquidity squeezes is mitigated over the term of a loan. Liquidation can only occur should the market price of the collateral fall below the maintenance collateral ratio.

And preserves the same benefits of many of the newer lending primitives that sought to improve on the Aave/Compound model:

  • Isolated collateral pools - Like Silo, Term Finance mitigates shared risk by creating one pool for every collateral token, with each pool limited to a unique token for each loan maturity.
  • Customizable terms - Like Morpho, Term Finance loans can be initialized to accommodate any ERC-20 collateral token with any oracle, collateralization ratio, and/or liquidation incentive.
  • Dynamic liquidation factors - Like Fraxlend, Term Finance implements soft liquidations. Borrower collateral is only liquidated to the point necessary to bring their position back to health with a reasonable buffer.

In addition, Term's fixed-rate lending model introduces new financial primitives, where lenders receive ERC20 receipt tokens that can be seamlessly integrated across various DeFi protocols. For instance, Hourglass utilizes Seaport’s technology to establish an order book for secondary trades of receipt tokens and incorporates Term lender receipt tokens as a tradable instrument.

Term Finance within the broader ecosystem

Term Finance's strategy isn't to oust variable interest rate protocols from the market but rather to coexist with them, offering an alternative to variable-rate lending.

It's fascinating to note that as participation in Term Finance auctions continues to grow, it could actually foster more favorable conditions for the overall DeFi lending space during a bull market. Term auctions can serve as a release valve to satisfy chunky borrow demand without triggering sharp and sudden spikes in variable-rate supply utilization, resulting in decreased volatility in interest rates during liquidity squeezes.

To illustrate, consider the comparison between Term Finance and Morpho Labs below, where Term offers approximately 4% lower interest rates than Morpho Blue on the same asset. This exemplifies the tangible benefits of fixed-rate lending solutions, setting a precedent for greater stability and predictability within the DeFi lending markets.

WETH/weETH auction on Term Finance.

WETH/weETH pool on Morpho Blue

Concluding thoughts

Term Finance’s model’s efficiency in creating a stabilized interest rate market for decentralized on-chain lending is spectacular. So far, we’ve seen continuous growth in the usage of the platform. But the Job’s not done.

The goal for the project is to become the “go-to” platform for fixed-rate lending in such a way that catches up with the likes of Aave ( a powerhouse for variable rates).

We believe that Term Finance has what it takes to achieve its long-term goal, especially because they are structured to meet the demands of long-term and short-term market participants (lenders and borrowers).

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