A Dive Into Debt Finance & Fixed IR in DeFi

Innovations in DeFi bonding by Olympus DAO has opened up the flood gates to debt financing available for DeFi protocols.

In TradFi, companies can sell fixed income products such as bonds to investors to obtain capital. The investor loan (principal) is repaid at a later date and because it provides a fixed income, it is generally considered less volatile than purchasing the company’s shares outright.

The Current Market for Debt Financing in DeFi

Users mint vesting tokens at a discount through generating the tokens at the “fixed interest rate” for the duration of the bond. Protocols sell their tokenized-bonds to generate capital and purchase their own LP, but rebasing mechanism can be disastrous to investors.

The Future of DeFi Lending

DAO treasuries have been growing in orders of magnitude over the years. As DeFi naturally emulate OTC TradFi markets (IPO-IDO, Bonds, IRS), DAOs will increasingly deploy efficient debt financing smart contracts and on-chain DAO-DAO lending will grow exponentially. The inherent requirement of stability for further growth forces a robust fixed IR market into existence.

Imagine a black swan event that wipes out Uniswap protocol’s backstops and requires short term loans to prevent solvency. Uniswap DAO can borrow funds from a variable rate lending protocol and encode a contract to pay off the loan through % revenue received from staking Uni. UniDAO can then hedge the variable IR risk with a fixed rate IR on STRIPS FINANCE.

The stability of fixed rate IRs are essential for the unfettered growth of DeFi and temporarily shifting volatility to tokenized assets is not the answer. Strips Finance is creating a robust fixed interest rates marketplace, where there is a fixed rate for every trade desired.

Debt Financing vs. Interest Rates

Some investors in debt are only interested in principal protection, while others want a return in the form of interest. The rate of interest is determined by market rates and the creditworthiness of the borrower. Higher rates of interest imply a greater chance of default and, therefore, carry a higher level of risk. Higher interest rates help to compensate the borrower for the increased risk.

Debt Financing vs. Equity Financing

The main difference between debt and equity financing is that equity financing provides extra working capital with no repayment obligation. Debt financing must be repaid, but the company does not have to give up a portion of ownership in order to receive funds.

Most companies use a combination of debt and equity financing. Companies choose debt or equity financing, or both, depending on which type of funding is most easily accessible, the state of their cash flow, and the importance of maintaining ownership control. The D/E ratio shows how much financing is obtained through debt vs. equity. Creditors tend to look favorably on a relatively low D/E ratio, which benefits the company if it needs to access additional debt financing in the future.