Transforming the Bond Market with DeFi
DeFi Bond Market
Let's start by clarifying the concept that a bond represents a commitment by the borrower to repay the lender their principal and interest on a loan at a later time, terned the maturity date. The bonding mechanism of OlympusDAO is not a real bond. By accepting $DAI or LP assets, OlympusDAO gives back $OHM at a discount and the principal asset does not need to be payback. This is just a method of selling its tokens.
Zero-Coupon Bond and Convertible Bond
Solv Finance and Porter Finance are the two leading players that aim to build the infrastructure for DeFi bond market. Both of them offer Zero Coupon bonds and convertible bonds, two traditional bond instruments.
A zero-coupon bond is a bond that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value.
Convertible bonds are bonds with the embedded call option. A call option gives the holders the right to buy the project tokens at a specified price (the strike price).
The holder of a convertible bond can convert their bond into a fixed amount of native tokens when the underlying's market price reaches the strike price. This gives the investor upside potential if the project token rises in value.
Solv Finance and Porter Finance - Different Approach to Create a Bond
The two projects use a very different approaches to represent a bond, Solv uses NFT, and Porter represents a bond in ERC-20. In traditional finance, a bond is a legal contract. The contract states all the elements of a bond such as an amount to borrow, maturity date, interest rate, etc. Intuitively, NFT seems to be a good choice to represent a bond by recording all these attributes into an NFT through smart contracts.
Solv Finance - Financial NFT
Solv Finance is a platform to create and trade financial NFTs, it offers products including vesting vouchers, convertible vouchers, and bond vouchers. Here, I will focus on the bond voucher.
Above is a sample convertible bond voucher as a NFT from Solv Finance. Like the majority of convertible bonds, the bond voucher has a face value, maturity date, and strike price.
The bond voucher can:
- Receive and lock an amount of issuer native token collateral (it is required to put sufficient tokens to exercise the embedded call option while issuing party can also put more tokens as collateral to increase credit quality)
- At maturity, charge the issuer stablecoin for principal repayment and accrued interest (at current stage, use multi-sig wallet, will be a automatically process in the future)
- Pay back stablecoins to investors
- Pay back the investors in native tokens if the call option is exercised
The call option is fully collateralized by the issuer's native tokens, while the zero-coupon bond can be purely by credit or partly collateralized by the issuer's token. Considering the price volatility of the issuer's token could be substantial and it won't be liquidated even the value drop significantly below the bond amount, it is more reasonable to view the bond as unsecured. The repayment ability will rely on the borrower's credit profile. I will discuss in the next section what mechanism is in place to ensure the repayment of principal and interest.
Porter Finance - ERC-20 Token as Bond
Porter Finance uses a completely different approach, equating a single bond into a number of identical bonds, each of which is a fungible ERC-20 token. For example, a DAO issues a 1 million $USDC bond, this will correspond to 1 million bond token.
The pros of this approach are that once bond tokens are issued, they can be added to the AMM DEX in a trading pair with a stablecoin secondary market. On the other side, this approach lacks the flexibility that an NFT can provide.
At this stage, Porter Finance only support overcollateralized bond. The first bond is proposed for Ribbon Finance, the bond will be collateralized by 500% of Ribbon's native token $RBN.
Case Study - Solv Bond Voucher Issuing
There have been several successful issuing of Solv bond vouchers. The question is how to ensure the repayment of principal if part of the bond is collateralized by volatile prototcol's tokens or only backed by credit.
Here, I will give an explanation about the iZUMi Finance bond issuing this May, some well-structured mechanisms are in place.
iZUMi Finance is a Liquidity as a Service protocol for Uniswap v3. It issued two bonds with a value 3 million $BUSD and 5,000 $WBNB. The entire proceeds of the bonds will be used to add liquidity to iZiSwap's liquidity pool in the form of the WBNB-BUSD and WBNB-USDT trading pair. The raised fund is controlled by the following mechanism:
- The raised funds will be stored in the multi-sig wallet co-managed by Solv, iZumi, and Cobo. The funds can only be used for a pre-determined purpose. At maturity, the funds will be claimed through this wallet ensuring the transparency of the usage of the fund.
- iZUMi collateralizes $10 million USD worth of $iZi tokens and iUSD tokens, which is twice the funds raised.
- iZUMi use the Treasury wallet to sign a Promise to Repay statement via EthSign.
EthSign is a Web 3 native agreement signing and execution platform.
In the current version, the signing by treasury wallet via EthSign is only a Promise to Repay statement. EthSign is working on an execution platform called Smart Agreement. It will allow users to execute signed agreements via smart contracts based on a predetermined condition.
In traditional finance, it is difficult to control the use of funds for a bond or a loan, and sometimes the borrower uses the borrowed fund to conduct speculative activity rather than normal business needs. This kind of behavior could seriously harm the repayment ability.
From the above example, we can see smart contracts enable the full control of the use of bond proceeds, the on-chain transaction is transparent and the borrower can only utilize the fund according to pre-defined terms.
In the future, automatic execution of the smart agreement which is now being developed by EthSign could allow an automatic deduction from the issuer's signing treasury wallet for the repayment of the bond.
The constant pursuit of higher yields in DeFi won't help make the world a better place, but lowering the cost of bond issuance through various DeFi infrastructures, and thus creating a more efficient financial market, can ultimately help improve the overall efficiency of our society. In my view, this should be the future of DeFi, and indeed the blockchain industry.