Fixed interest rate vs. Fluctuating interest rate

Published in

SmartCredit.io & ChainAware.ai

4 min readOct 20, 2020

How do DeFi lending products work now?

DeFi Fixed Income is very much money-market-fund concept-based. The lenders deposit their assets into the pool and receive the shares of this pool. Then, the borrowers can borrow from this pool against the collateral.

The interest rates are fluctuating — they move up and down. When the market thinks that Ethereum is moving up, traders will borrow DAI — this drives the DAI interest rates up. When the market thinks, Ethereum is moving down; then the opposite will happen. As the market is a little bit in the herd movements, this translates into a fluctuating interest rate for borrowers and lenders.

The loan maturity for the borrower is variable (unlimited); the loan maturity for the lender is daily (as far as liquidity is available).

So the existing solutions are based on:

Pooling
Fluctuating interest rate
Variable loan maturity

How does the traditional fixed income market work?

There are four combinations for the fixed income:

The interest rate can be fixed or fluctuating
The loan term can be fixed or variable

Usually, the loans are either:

Fluctuating interest rate and variable term or
Fixed interest rate and fixed term

Then there are other combinations as well — one can translate the variable term into a fixed term with the interest rate derivatives. One can convert the variable loan term into a fixed loan term with the interest rate derivatives too.

Before we create too much excitement about the interest rate derivatives, let’s be aware — the spot market is always a primary market. The interest rate derivatives function on the top of the primary market. Therefore, the interest rate derivatives market cannot work without the underlying spot market (if it were so, then there would be no means for the arbitrage between the spot and derivatives market, meaning the market mechanism would not work).

Therefore, we will not focus here on the:

Variable Loan Term and Fixed Interest
Fixed Loan Term and Fluctuating Interest

The traditional fixed income market is described in the following image. The percentages show the relative market size:

Are fluctuating rates and variable terms all we need in DeFi?

Let’s continue with traditional finance. It has the concepts of:

Money-market-funds — these invest in fluctuating interest rate loans and the variable term loans
Fixed-income-funds — these invest into fixed interest and fixed-term loans

That’s described in the following image:

The market size of investable assets of money-market-funds to fixed-income-funds is 1:10.

This 1:10 ratio should answer the previous question — DeFi does not have real fixed-income funds, but DeFi needs them. In the same way, as borrowers and lenders need fixed-income funds in traditional finance.

This discussion shows the need for:

Fixed Term loans
Fixed Interest loans

What is the advantage of Fixed Term loans and Fixed Interest loans in DeFi?

Let’s think here on the borrower — what would be his advantages from the fixed term and fixed interest loans? Let’s think here on the lender, too — what would be his advantages?

Fixed Term loans allow reducing the borrower’s collateral requirements. If one knows the loan term, then it’s easier to forecast the collateral requirements. On the other hand, if one doesn’t see the loan term, this results in very high collateral requirements visible in Compound and Aave money-market-protocols.

Lower collateral requirements are essential — they mean the borrowers can borrow much more on the same asset basis. Lower collateral requirements mean higher leverage on the same risk to the borrowers.

Borrower’s choice is between:

High collateral requirements and variable term loan OR
Lower collateral requirements and fixed-term loan

The SmartCredit.io thesis is that “money talks,” i.e., borrowers will opt-in for the second choice and not for the first one. Borrowers will prefer fixed-term loans if they have lower collateral requirements.

Fixed Interest Loans advantage is obvious — it’s about having pre-defined interest rate payments. It’s about avoiding high fluctuating interest rate payments.

The current DeFi lending market focuses on the fluctuating interest rate and the variable loan term. SmartCredit.io thesis is that the same concepts, which exist in traditional finance, will be replicated into the DeFi.

The DeFi started with the fluctuating interest rate and with the variable loan term. It’s time to move to the next phase. It’s time to move into where the real fixed income market is — it’s in the fixed term and fixed interest loans.

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