What higher interest rates mean for DeFi
The decentralized finance sector has experienced massive growth in recent years. Investors have been happy to pump capital into the space to take advantage of returns far better than anything seen in traditional finance.
Like most risk assets, crypto performs best when interest rates are low and capital is plentiful. Historically low traditional interest rates and the Federal Reserve’s money printing have benefited crypto in many ways.
Heading into 2023, however, that narrative changes. We’ll soon see how sticky DeFi is for investors who now have other acceptable alternatives to generate reasonably safe and stable returns.
With the Federal Reserve enacting a fourth straight rate hike of 0.75% last week, interest rates are at their highest since 2008, a time when there was no crypto or DeFi, and rates are expected to rise by will continue to rise well into next year.
As traditional lending becomes more expensive, it becomes more difficult to access capital. More importantly, with the yield on US Treasuries rising above 4%, investors now have a safe and stable alternative to DeFi to earn solid returns.
We have seen moderate DeFi lending rates as the crypto space matures and becomes more stable. While lower rates aren’t ideal, more stability in the room is welcome. However, these lower rates are no longer as competitive with US Treasuries, and DeFi lending is seen as riskier compared to the safety of US Treasuries.
Thankfully, crypto markets have remained somewhat calm during this rate hike cycle, although over the past week we’ve seen a pullback following the Fed’s recent rate hike.
While interest rates paid on bank savings accounts remain pitifully low, rates for large crypto lenders are, on average, lower than rates available from Treasuries. Even three-month T-Bills are outperforming Ethereum and other crypto assets.
Even higher interest rates are coming
Fed Chair Jerome Powell has announced significantly more interest rate hikes in the coming months. The Fed is raising interest rates to curb US inflation, which is at its highest level since 1980.
The Chicago Mercantile Exchange’s FedWatch tool calculates market participants’ expectations for future federal funds rates. It can often be pretty accurate in the short term:
As you can see, the market believes interest rates will rise to at least 6% by June 2023.
Note that this is the Federal Funds rate, or the rate the Fed uses when lending to banks. Real interest rates (ie bank loans and government bond yields) will be slightly higher than the federal funds rate.
If fed funds hit 6%, short-dated T-bills are likely to return 6.25% or a little more. How will this affect DeFi markets?
What high interest rates mean for decentralized finance
Common sense tells us that investors should seek the highest returns with the lowest risk.
Considering that US Treasuries are considered one of the most risk-free assets on the market, it is surprising to see DeFi platforms attracting any type of capital. However, data shows that all DeFi platforms are still holding Total Value Locked (TVL) of $52.3 billion, although a close look shows that number has dropped.
The biggest drop came after the first major rate hike in May 2022. While things have leveled off a bit, we can see that in the past seven days since the Fed’s last rate hike, the TVL of most of the top ten DeFi platforms has fallen further. As traditional and DeFi rates diverge further, we should expect more capital to flee the DeFi marketplace.
It is also worth noting that the decline in TVL for DeFi platforms is leading to a decline in circulating stablecoins, which are commonly used in DeFi lending platforms.
For example, the circulating supply of USDC has fallen from $53.9 billion in June 2022 to $42.5 billion in early November 2022. This could be due to rising interest rates as the yield on USDC is well below 2% across the top three DeFi platforms. .
DeFi versus TradFi
A savings factor for DeFi has been suggested to be the difficulty in moving funds from DeFi platforms back into traditional finance. The question now is whether sustained rate hikes will pull capital out of stablecoins to the point where it has a meaningful impact on the DeFi ecosystem.
Even if we did see an impact, it probably wouldn’t mean the death of DeFi. It would simply mean interest rates need to adjust to the macro environment and less borrowing in the DeFi space. However, the underlying value of DeFi will remain regardless of traditional and DeFi rates.
In theory, lending rates on lending platforms will naturally increase as the circulating supply of stablecoins decreases. This increased rate is a supply/demand scenario that reflects the reduced availability of dollar-pegged assets. As friction between traditional and decentralized finance decreases, interest rates could come together as traders are more easily able to settle interest rate differentials between traditional and DeFi products.
While stablecoin lending may decline until friction between traditional and decentralized markets subsides, we could see a shift in lending towards Ethereum.
The move to Proof of Stake has already caused ETH lending rates to rise as the chain’s tokenomics shift to a more deflationary stance and demand for ETH increases.
Another potential trend that could boost interest in the DeFi space despite lower lending rates is fixed-rate lending.
So far, DeFi has only seen variable rate protocols as they are easier to implement. The addition of fixed rate protocols could attract more capital to DeFi, as companies typically look to set fixed rates to reliably predict expenses and cash flow.
The addition of fixed rate protocols would, in theory, help DeFi connect more closely to traditional finance, reducing friction between the two systems.
As traditional interest rates continue to rise, we expect less institutional interest in DeFi.
The staggering interest rates seen in the early days of DeFi lending are largely gone, and where they remain, they are met with much skepticism.
Higher traditional yields will make it increasingly difficult for DeFi to attract institutional money as these large funds and investors are now able to obtain better, near-risk-free rates in highly liquid bond markets.
Still, pure returns are not the real draw of DeFi. Rather, they are the innovations promised by DeFi that will bring the further growth of the arena.
There is obviously a market for decentralized finance products, and we are still early in figuring out how best to leverage DeFi. It’s not necessarily the high returns of the past that will drive interest in DeFi, but rather the innovation and freedom that blockchain technologies promise.