The Impossible Triangle of DeFi Lending
Author: Anthony Bowman
Compiled by: Jiahua, ChainCatcher
There is a real demand for fixed-rate lending on-chain. The obvious response is to issue fixed-rate loans, but there is no matching demand for fixed-rate lending in the market.
The vast majority of on-chain funds are chasing yields and crave instant liquidity. Therefore, issuing fixed-rate loans merely transfers interest rate risk from borrowers to lenders. When the lender is a treasury that commits to instant liquidity, it creates an asset-liability mismatch.
In variable-rate lending, interest rates fluctuate with capital utilization and market conditions, and borrowers directly bear the cost of this volatility. This is a tangible cost, but it is clear and transparent, terminating upon liquidation.
Assume a lender holds a fixed loan with an interest rate of 3% for a term of 6 months. If interest rates rise, the same loan yield would now reach 5%. Mark-to-market (MTM), the value of the old loan has diminished. With new loans offering higher yields at the same risk, no one would buy the old loan at its amortized value.
The mark-to-market loss on a single independent loan remains on paper because the lender can hold it to maturity and receive full repayment. It only becomes extremely dangerous when the loan is placed in a system that requires continuous pricing.
Morpho's V2 treasury is currently the most representative design publicly available, incorporating fixed-rate loans into a treasury system that commits to instant liquidity.
Excerpt from: Morpho Fixed Rate Market: Unlocking the Potential of On-Chain Loans
From publicly available information, this design includes three components:
Morpho Blue: Existing variable-rate lending protocol. Lenders deposit funds into an isolated market, and borrowers pay an interest rate that fluctuates with capital utilization, with positions able to be opened and closed at any time.
Morpho Midnight: Fixed-rate, fixed-term lending realized through zero-coupon bonds (ZCBs). The lending parties are matched by an intent engine, with each loan being a bond with specific collateral, term, and interest rate. These zero-coupon bonds are permissionless and support any combination of collateral, term, and parameters.
Morpho V2 Treasury: A treasury managed by curators, allocating deposits between Blue and Midnight based on yield. Depositors withdraw and deposit according to the treasury's share price.
Image from Morpho V2 Treasury documentation
Imagine two competing treasuries denominated in USDC: Treasury A allocates funds to both Blue and Midnight, while Treasury B allocates only to Blue. Treasury A allocates 30% to Blue (variable, 3%) and 70% to Midnight (fixed, 3%).
A rate shock raises the variable rate to 5%, while Midnight's position remains locked at 3%. Treasury A's mixed yield rises to 3.6% (5%×30%+3%×70%). The purely variable-rate Treasury B rises to 5%. This 140 basis point gap creates conditions and incentives for a bank run on Treasury A.
Depositors in Treasury A do not need to calculate mark-to-market losses, nor do they need to be aware of their existence. The yield gap itself serves as a coordination mechanism. Funds flow from A to B in pursuit of higher rates, withdrawing through A's only liquid portion (the variable-rate module).
This will first drain the portion with the highest on-paper yield, causing Treasury A's mixed yield to fall further and accelerating the bank run. What remains is a pool of illiquid, below-market-rate fixed loans that can only wait until maturity.
Now, the situation reverses. When interest rates decline, Treasury A's fixed positions are above market levels, and depositors enjoy mark-to-market gains but cannot retain them. Depositors in Treasury B, sensing Treasury A's higher mixed yield, will rush in to deposit in hopes of sharing in the spoils.
New funds enter at the current share price, proportionally allocated to existing balances. This means new money enjoys the same proportional rights to those positions above market rates as the original depositors. This portion of yield is thus diluted.
Both paths lead to dead ends. Rates rise: depositors flee, treasury runs. Rates fall: yields are diluted by newcomers.
The fundamental issue lies in the pricing of bonds. Although the accounting treatment of amortized zero-coupon bonds varies, putting that aside, the real problem is that external interest rate changes alter the actual value of the bonds, while amortization-based pricing fails to reflect this reality.
If bonds are priced at amortized value, the aforementioned asymmetry will follow. An obvious solution is to create a secondary market, which theoretically would allow the treasury to price bonds at their true value.
However, around permissionless zero-coupon bonds with arbitrary collateral, terms, and parameters, a secondary market cannot form because each bond is essentially unique, lacking a liquidity benchmark for pricing.
Even if a secondary market were truly formed, pricing the treasury based on it would only mask one problem with a worse one. Share prices would be subject to external trading data of customized, illiquid bonds. Anyone able to influence this data could manipulate share prices and arbitrage when entering and exiting the treasury.
The expressive power of zero-coupon bonds and a treasury that commits to instant liquidity are structurally contradictory. Perhaps there exists some resolution within this framework, but I have yet to see a relevant description and am quite curious if Morpho has a countermeasure.
However, I personally believe that directly issuing fixed loans is not the solution, at least not in the current short-term outlook of over-collateralized lending. If borrowers want fixed rates while lenders crave instant liquidity, then interest rate risk must be transferred to those willing to take on this directional risk exposure.
If the underlying variable-rate benchmark curve can become more efficient and robust, buyers of interest rate risk can provide better fixed rates. As I discussed in this article, we are far from reaching the final form of variable-rate market design.
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