Vitalik Buterin had a thought-provoking tweet a few days
back about interest rates.
Lending DAI to Compound offers 11.5% annual
interest. US 10 year treasuries offer 1.5%. Why the discrepancy?
— Vitalik Non-giver of Ether (@VitalikButerin) August
23, 2019
Today's post explores what goes into determining interest
rates, not blockchain stuff. So for those who don't follow the blockchain
world, let me get you up to speed by decoding some of the technical-ese in
Buterin's tweet.
DAI is a
version of the U.S. dollar. There are many versions of the dollar. The
Fed issues both a paper and an electronic version, Wells Fargo issues its own
account-based version, and PayPal does too. But whereas Wells Fargo and
PayPal dollars are digital entries in company databases, and Fed paper dollars
are circulating bearer notes, DAI is encoded on the Ethereum blockchain.
Buterin points out that DAI owners can lend out their U.S. dollar lookalikes
on Compound, a lending protocol based
on Ethereum, for 11.5%. That's a fabulous interest rate, especially when
traditional dollar owner can only lend their dollars out to the
government—the U.S. Treasury—at a rate of 1.5%.
Why this difference, asks Buterin?
Interest rates are a lot of fun to puzzle through. I had to think this one
over for a bit—so let's slowly work through some of the factors at play.
Let's begin by flipping Buterin's question around. When the U.S. Treasury
borrows from the public, the bonds it issues are promises to pay back regular
dollars (i.e. Federal Reserve dollars). But what if the U.S. Treasury
decided to borrow DAI by issuing bonds promising to repay in DAI? What
would the interest rate on these Treasury DAI bonds be? Would it be 11.5% or
1.5%? Perhaps somewhere in between?
Credit risk
First, there's the question of credit risk. The U.S. Treasury is a very
reliable debtor. It won't welch. If it issues both types of bonds, it'll be
just as likely to repay its DAI bond as it will its regular dollar bond.
Since the market already requires 1.5% from the Treasury to compensate it for
credit risk (and a few other risks), the Treasury's DAI bonds should probably
yield 1.5% too. (I'll modify this later as I add some more layers).
Now let's look at Compound. A DAI loan made on Compound (for simplicity let's
just call it a Compound DAI bond) is surely much riskier than our
hypothetical Treasury DAI bond. Compound is a blockchain experiment. It could
malfunction due to buggy code. Maybe every single Compound borrower goes
bust. To compensate for this risk, a prospective bond buyer will require a
higher return from Compound DAI bonds than they will U.S. Treasury DAI bonds.
So Compound credit risk (Buterin's third option) probably explains a big
chunk of the huge gap between the 11.5% interest rate on Compound DAI bonds
and our hypothetical 1.5% interest rate on the U.S. Treasury's DAI bonds. But
not all of it.
Collapse risk
Buterin mentions a second risk: the chance that DAI, the entity that creates
blockchain dollars, collapses. Like Compound, DAI is a new monetary
experiment. The code could be buggy. It might get hacked. By comparison,
conventional dollar issuers—say Wells Fargo or PayPal—are far less likely to
malfunction.
How does DAI collapse risk get built into the price of a hypothetical
Treasury DAI bonds
The average market participant (I'm not talking about crypto fans here, but
large & smart institutional actors) should be genuinely worried about
purchasing a Treasury DAI bond—not so much because the Treasury is unlikely
to pay it back—but because the DAI tokens that the Treasury ends up repaying
could, in the even of DAI breaking, be worth 99% less than their original
value. Average bond buyers will expect some compensation for bearing this
risk. How much? Say 5.5% (I'm just guessing here).
Earlier I said that a Treasury DAI bond would yield 1.5%. But if we add 5.5%
worth of failure risk to 1.5% in basic risk, a Treasury DAI bond should yield
7.0% before the average investor is going to hold it.
Now let's go back and look at a Compound DAI bond. As Buterin pointed out,
they yield 11.5%, which is much higher than the 7.0% yield on our
hypothetical Treasury DAI bond. We've already assumed that DAI collapse risk
works out to 5.5%. If we subtract collapse risk from a Compound DAI bond's
11.5% yield, the remaining 6% is accounted for by risks such as Compound
failing (11.5% - 5.5%). Put differently, investors in Compound DAI bonds will
require 5.5% and 6.0% to compensate for collapse risk and credit risk
respectively, for a total of 11.5%. Again, these are hypothetical numbers.
But they help us puzzle things out.
Two different blockchain dollars: USDC vs DAI
Interestingly, Compound doesn't just facilitate DAI loans. It also expedites
loans in another blockchain dollar, USDC.
We'll refer to these as Compound USDC bonds. As Buterin points out later on
in the thread, the rate on Compound USDC bonds is 6.5%, quite a bit lower
than Compound DAI bonds.
What might explain this discrepancy?
Not credit risk, since in both instances the same creditor—Compound—is
responsible for creating the bonds. Which leaves varying levels of collapse
risk as an explanation. USDC is a regulated stablecoin (i.e. it has the
government's approval). DAI isn't. And USDC has genuine U.S. dollars backing
it, whereas DAI is backed by highly volatile cryptocurrencies. So the odds of
USDC collapsing are surely lower than DAI.
How much interest do USDC bond holders require to compensate them for
collapse risk? Assuming that Compound's risk of failing is worth 5.5% of
interest (as we already claimed), that leaves just 1% attributable to the
risk of USDC failing (6.5%-5.5%). Put differently, investors in Compound USDC
bonds will require 5.5% and 1.0% to compensate for credit risk and collapse
risk respectively, for a total of 6.5%.
Oddly, the yield on a Compound USCD bond is less than the hypothetical
yield on our safe Treasury DAI bond (6.5% vs 7.0%). Why is that? Even though
Compound is riskier to lend to than the Treasury, a DAI-linked return is
riskier than a USDC return. Another way to think about this is that if the
Treasury were to also issue USDC bonds, those bond would only yield 2.5%. To
account for credit (and other) risks investors would require a base 1.5% with
an extra 1.0% on top for the risk of USDC breaking.
The convenience yield
Let's bring in one last layer. Something called the convenience yield
is lurking behind this.
When you lend me some tokens, you need to be compensated for more than just
credit risk i.e. the risk that I won't pay back the tokens. You are also
doing without the convenience of these tokens for a period of time. The
replacement, my IOU, won't be very handy. For instance, the convenience of a
dollar bill can be though of as the ability to mobilize it whenever you need
to meet some pressing need. But if you've lent a $100 bill to me then you've
given up all that bill's usefulness. Instead, you're stuck with my awkward
$100 IOU. You need some compensation for this. (Unconvinced? Head over to
Steve Randy Waldman's classic ode
to the convenience yield).
So when we break down the components of the interest rate on DAI bonds, there
must be some compensation required for forgoing the convenience of DAI, its
convenience yield. Earlier I attributed the big gap between rates on Compound
DAI and USDC bonds to varying odds of each scheme failing. However, the gap
could also be explained by varying convenience yields. If the convenience
yield of a DAI token is higher than that of a USDC token, we'd expect an
issuer of a DAI bond to pay a higher rate than on a USDC bond, in order to
compensate DAI holders for giving up on those superior conveniences.
If DAI's convenience yield is higher than USDC's, what might explain this
gap? DAI is completely decentralized and can't be monitored. USDC isn't. It
is less censorship-resistant than DAI. So perhaps USDC just isn't as
handy to have around.
So some of the 11.5% rate on Compound DAI bonds—say 2%—may be due to the
convenience yield forgone on lent DAI. If DAI had the same features as USDC,
and thus had a lower convenience yield, a Compound DAI bond might only yield
9.5% (11.5% - 2.0%). If so, the discrepancy between the Compound DAI and USDC
bonds—9.5% vs 6.5%—wouldn't be as extreme.
Summing up, let's revisit Buterin's tweet:
Lending DAI to Compound offers 11.5% annual
interest. US 10 year treasuries offer 1.5%. Why the discrepancy?
— Vitalik Non-giver of Ether (@VitalikButerin) August
23, 2019
If my line of thinking is right, the discrepancy is
accounted for a messy mix of the higher risk of lending to Compound (3), the
danger of DAI cracking (2), and whatever convenience yield one forgoes when
one no longer has DAI on hand (4-other). And of course, Buterin's first
option is right too. I'm assuming that people are rational and can easily buy
and sell various assets. But the sorts of large institutional players who set
market prices may not be operating in crypto markets.