In the world of traditional finance, interest rates have been going up for a year. These rate increases have been driven by the US Federal Reserve as it has increased the Federal Funds rate ten times between March 2022 and May 2023. While the Federal Reserve is the main driver of TradFi interest rates, rates in DeFi (decentralized finance) are driven by supply and demand within the bounds of individual crypto tokens. In comparing DeFi lending rates versus TradFi rates, how are they set, how much do they fluctuate, and how do these rates affect business operations within the given financial system?
Lending Rates in Traditional Finance
In order to understand how DeFi rates are set and especially to understand the differences between TradFi and DeFi rates, it is useful to start with the more mature financial system. Lending rates are interest rates. One person or business lends money to another. This can be a bank depositor putting money in their bank account. They receive interest on that money and the bank gets to use it for loans and other business. Another person borrows money to buy a home. The bank receives interest payments on the person’s mortgage. Rates are affected by the Federal Reserve but also by demand volume for loans and creditworthiness of the individual borrower.
Short Versus Long-term Interest Rates
Short term interest rates are for three months up to a year. These are the rates most affected by changes in the Fed Funds rate. The Fed Funds rate is the rate commercial banks charge each other for overnight loans and is determined eight times a year by the US Federal Reserve Open Market Committee. The Fed Funds rate is the main tool the Federal Reserve uses to slow the economy and reduce inflation or stimulate the economy and increase employment.
Long-term Interest Rates
Interest rates on five, ten, twenty, or thirty-year bonds are less and less dependent on the Fed Funds rate the longer the maturity of the bond. Long term interest or lending rates are determined by the perceived security of the issuer of the debt. US Treasuries and AAA corporate debt (Microsoft and Johnson & Johnson) are issued at lower rates of interest than “junk bonds” issued by companies (or nations) whose ability to repay the debt is questionable. Those who purchase longer term bonds will, however, expect a higher rate of interest for tying up their money for years instead of months.
TradFi Yield Curve
Because those who invest in long term securities expect a higher interest rate for longer term investments, there is typically a steady rise in rates as money is tied up for longer and longer. This is called the yield curve. There can be an inverted yield curve in certain circumstances. In other words, long term bonds can sell for lower interest rates than short term securities when a recession is expected. In the world of decentralized finance the lending system is not as developed and much of this does not apply. For example, nobody is offering 30-year Bitcoin denominated bonds yet.
How DeFi Lending Rates Are Set
DeFi lending rates are set differently than in TradFi. DeFi rates are pretty much set by supply and demand with no central bank or other authority setting benchmark rates like the Fed Funds rate or LIBOR (London Interbank Offer Rate). Factors that affect DeFi lending rates include the supply of USD-backed stablecoins, market arbitrage, and events within the crypto realm.
The size of an individual crypto token lending pool and the utilization rate of that token will affect its lending rate. Unlike rates in the TradFi world, crypto rates from token to token are independent. Because utilization rates tend to vary over time, so do DeFi lending rates. As the DeFi system matures, lenders and borrowers are interested in having fixed rates for what they lend or what they borrow. Fixed rate protocols like TrueFi, Goldfinch, and Maple are all only a year or so old. As fixed rates become more common so will the use of credit scores, loan size, loan duration, and comparison to the TradFi market as lending rate. Lending rates that are based on risk, length of loans, and the overall market are likely to become the norm as the DeFi system matures. It remains to be seen if regulators end up forcing crypto lenders to follow rules like commercial banks do where overnight lending rates are determined by an agency like the Federal Reserve.
DeFi Lending Rates Versus TradFi Rates – SlideShare Version
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