Launch a Fixed Income Product Suite ($FIXED)

IIP: ##
Title: Launch a Fixed Income Product Suite ($FIXED)
Status: Draft
Author(s): @allan.g @ahuja @mringz @twoodward (Notional)
Created: 13 Jan 2022

Simple Summary

The Automated Indices Pod would like to propose that the Index Coop launch a suite of fixed income tokens that gives token holders passive exposure to high, fixed interest rates.

Abstract

The advent of fixed rate lending brought about by Notional has laid the foundation for crypto-native fixed income products and the infrastructure required for creating and managing a fixed income index product has been enabled by Set. As a result, the Automated Indices Pod would like to propose a suite of decentralized, fixed income tokens that give investors high, market-neutral yield on assets such as USDC, DAI, ETH, and wBTC.

Motivation

Establishing a fixed rate lending position today requires a certain degree of expertise and users are often forced to choose between earning a higher yield or keeping their assets liquid. By abstracting the complexity of managing this position and creating a secondary market for the index token to be traded, both of these pain points can be addressed. Holders also benefit from automated rolling accomplished during rebalancing, as opposed to manually initiating new lending positions after maturity and subjecting users to high gas fees and taxable events.

‌Rationale

In traditional finance, a typical portfolio is balanced between stocks and bonds, with 60% stocks / 40% bonds being the most prominent. However, in decentralized finance today, there are very few options for anchoring a crypto portfolio in the same way that bonds secure a traditional portfolio; available options also require a certain level of sophistication that average crypto investors may not have. While crypto markets are known for their volatility, there is an opportunity to offer the stability that a well balanced crypto portfolio requires.

Additionally, Index Coop products today are built for bull markets. In a bear market, holders of existing products may seek to de-risk their portfolios and sell into stables, creating a net outflow of capital for the Coop. With a market-neutral product earning stable, dollar-denominated yield, investors can cycle into lower risk positions and the Index Coop can retain accumulated capital.

This product suite delivers value to customers by…

  • filling a hole in a well-balanced portfolio where bonds would traditionally fit
  • offering a safe haven during bear markets or heightened volatility
  • offering a predictable, high yield that is unavailable in the leading lending markets
  • offering capital preservation and preventing loss of value within a portfolio
  • shielding holders from early withdrawal penalties by creating secondary market liquidity
  • abstracting the management and rolling of fixed rate lending positions
  • socializing gas costs associated with maintenance

This product suite delivers value to the Index Coop by…

  • leveraging out-of-the-box Set infrastructure with minimal development required
  • positioning us as a one-stop-shop for any investor’s needs
  • retaining accumulated capital if customers want to rotate out of existing products
  • expanding the yield bearing category of index products
  • diversifying our product offering

The benefit of a suite of products is that the same infrastructure and methodology can be applied to multiple products that differ in terms of maturity, investor preferences, and underlying assets. The follow list of potential products demonstrates this extensibility and is limited to assets supported by Notional v2 today:

  • USDC Short Term (<6 Month Maturity)
  • USDC Long Term (<12 Month Maturity)
  • DAI Short Term (<6 Month Maturity)
  • DAI Long Term (<12 Month Maturity)
  • wBTC Short Term (<6 Month Maturity)
  • wBTC Long Term (<12 Month Maturity)
  • ETH Short Term (<6 Month Maturity)
  • ETH Long Term (<12 Month Maturity)

Blended products (i.e. Diversified Stablecoin Index, ETH + BTC Index) are also possible in the event that investors want exposure to more than one stablecoin or blue chip asset. Notional will also be expanding available assets on their platform in the first half of 2022 so additional stablecoins and tokens can be considered in the future. More holistically, by building these stable, income-generating tokens, we enable the creation of meta balanced portfolio products and target date funds in the future.

Specification

Overview

‌The first index we propose launching is a Short Term USDC product (USDC-ST-FIXED). The underlying assets will be sourced and stored within Notional v2 and utilize Set’s battle-tested asset management infrastructure. The index will contain a small reserve of cUSDC, a larger backup reserve of fUSDC 3mo maturites, and a core allocation of fUSDC 3mo and 6mo maturities. Rebalancing will occur automatically as both reserves become over- or under-capitalized according to predefined bands. Tokens will be minted with USDC and redemptions will also be denominated in USDC.

Differentiation

Not only is this the first fixed income product proposed within the Index Coop, but it is also the first fixed income token in DeFi. Within the Coop’s product offerings, this suite would fit well into the broader category of yield bearing products like PAY, PINT, and LDI. The most explicit difference would be that holders receive a higher, predictable return on their assets. The interest earned on fixed rate maturities has been substantially, consistently higher in DeFi compared to the variable rates available on Compound and Aave, and this suite of products gives token holders access to those rates while also providing a secondary market for seamless exchange. Furthermore, from an implementation perspective, this product suite will only require integration with Notional v2 and it is largely compatible with out-of-the-box Set infrastructure.

An example composition and expected return for a Short Term USDC index are provided below:

Asset Portfolio % Yield Type
fUSDC 6mo (core allocation) 30.00% 9.35% Fixed
fUSDC 3mo (core allocation) 45.00% 9.83% Fixed
fUSDC 3mo (backup reserve) 20.00% 9.83% Fixed
cUSDC (reserve) 5.00% 3.03% Variable
Deposit $10,000.00
Annual Return $934.60
Realized APY 9.35%

Example composition

The first product, Short Term USDC, will contain a small reserve of cUSDC, a larger backup reserve of fUSDC 3mo maturites, and a core allocation of fUSDC 3mo and 6mo maturities. A fraction of the portfolio will be held in cUSDC, a Compound-native, variable-interest-bearing token that will function as a liquid reserve for servicing low cost issuance and redemption. To provide some background, fCash positions vary depending on date of maturity (3, 6, or 12 months) and each maturity may have a different fixed rate depending on prevailing market conditions at time of origination. The secondary or backup reserve will be composed of near term fUSDC 3mo maturities in order to minimize early redemption fees in the event that the cUSDC liquid reserve is exhausted. The index’s core allocation will be distributed amongst 3mo and 6mo fUSDC positions, with preference shown to the highest yielding maturity. Note that the core allocation is not constrained to achieving a specific average maturity/duration target nor is it restricted by a min or max allocation % for a specific maturity type.

The expected annual return for this particular composition would be 9.35%, and it matches the tables within the “Differentiation” section above.

Size of opportunity

In traditional finance, the outstanding value of global bond markets was over $123 trillion1 in 2020, which is ~17% larger than the global equities market the same year. Since their inception in 2002, bond ETFs have been the fastest growing category of fixed income products; in the last year alone, global bond ETF AUM has increased by over +50% 2. There are a variety of bond and fixed income instruments besides bond ETFs - like bond mutual funds or index funds - but they typically require active management because of their complex compositions and/or limited automation opportunities. Additionally, YTD returns for US Bond ETFs have been negative which could drive institutional investors to crypto to seek above average returns compared to traditional financial products 3.

However, because of the programmable nature of digital assets, there is a compelling opportunity to create an automated bond product that minimizes costs and maximizes value for customers. In DeFi today, there are no fixed income ERC-20 tokens, though there are several protocols that enable fixed rate lending through a variety of mechanisms. The TVL for the three largest fixed rate lending protocols on Ethereum at time of writing are as follows:

  1. Notional: $511m
  2. Element: $199m
  3. Ondo: $97m

It is worth noting that in late November 2021, the collective TVL across the three protocols listed above exceeded $1.25B. Additionally, Notional v2 launched in November 2021 (less than 3 months ago) and amassed nearly $1B in AUM before more recent market corrections.

Market & Customer Research

Target Customer

This suite of products is targeted towards investors who want high, predictable returns on their assets. Within the largest protocols like Aave or Compound, lenders are subject to variable rates that can fluctuate wildly and have also gradually decreased over time; this forces users to take their tokens elsewhere in pursuit of higher yields and incur gas fees while doing so.

Additionally, within the leading fixed rate protocols, users must manage their own lending positions and manually roll forward anything that matures, which also costs additional gas and may create a taxable event to be managed. Lenders are subject to high redemption penalties if they choose to close positions before maturity, creating a lock-in effect that limits user’s access to liquidity. Certain fixed rate lending protocols can also require a certain level of expertise and financial fluency to understand and operate, which is a hurdle for a large number of less sophisticated users.

Simply stated, this suite of products enables investors to get immediate and predictable exposure to fixed rates without the friction and fees associated with managing fixed rate lending positions. It’s as simple as buying a token!

User stories

As a user, I want predictable yield on my stable coins so that I can have more stability in my portfolio and not have to worry about variable rates.

As a user, I want access to higher fixed rate lending yields without forfeiting immediate access to my assets or subjecting myself to high, early redemption fees.

As a user, I want my fixed rate lending position to automatically roll after maturity so that I don’t have to worry about doing it manually and paying fees.

As a DAO, I want to diversify my treasury so that I can reduce risk during downward markets.

As a DAO, I want to earn high fixed yields on my stablecoins so that I can predictably cover operational costs.

As an institution, I want to earn above average interest compared to the traditional finance options.

Methodology

Token inclusion / exclusion criteria
Depending on the index at hand, a product will contain a series of fCash and nToken tranches. For example, a Short Term USDC index will be comprised fUSDC 6mo, fUSDC 3mo, and cUSDC positions. A Long Term USDC index will be comprised of fUSDC 12mo, fUSDC 6mo, and cUSDC positions. The same parameters apply to other stablecoins or assets supported by Notional v2.

Index weight calculation
In order to avoid unnecessary rebalancing, the underlying allocations will be allowed to fluctuate within bands rather than reverting to a fixed percentage. For example:

  • cUSDC reserve
    • NAV target weighting: 5%
    • NAV acceptable band: 2.5-7.5%
  • fUSDC 3 month maturity backup reserve
    • NAV target weighting: 20%
    • NAV acceptable band: 15-25%
  • fUSDC 3-6 month maturities core allocation
    • NAV target weighting: 75%
    • NAV acceptable band: 67.5 - 82.5%

Rebalancing will be triggered any time that the primary cUSDC reserve becomes over or under capitalized. For example, if the cUSDC reserve is less than 2.5% of NAV, 3mo maturities in the backup reserve will be liquidated into cUSDC until the primary reserve reaches 5% of NAV. Additionally, if the cUSDC reserve is more than 7.5% of NAV, fUSDC positions will be minted with excess cUSDC until the primary reserve falls back in range.

On-Chain liquidity analysis of underlying tokens
USDC can be easily converted into cUSDC through Compound, and fCash positions will be minted directly within Notional so there is not a need to rely on secondary market liquidity for the underlying components of the Short Term USDC index.

There are however secondary markets for relevant maturities within Notional’s AMM in the event that liquidity is required for rebalancing or redemption. Underlying fCash components will be minted directly in Notional v2 as capital flows into the product, and cToken reserves will be used to facilitate redemptions. In the event that the cToken reserve is exhausted, fCash closest to maturity will be sold via Notional’s AMM to top up the cToken reserve and execute redemptions.

Index maintenance
The Short Term USDC index will rebalance automatically. Further information will be provided once technical implementation details are better known.

Rebalance transactions and other interactions with the Notional AMM will occur with bite sized pieces at fixed time intervals. This will be optimized to avoid any significant slippage based on the AMM characteristics defined in Notional for various maturities.

Costs

Cost to customer
Holders will pay a 0.49% streaming fee, and those seeking to mint or redeem will be subject to a fee of 0.25%.

Rebalance frequency
Automated, pending technical implementation details

Gas fees for rebalancing will be paid by the Index Coop from the streaming fee.

Meta / intrinsic productivity
Token holders stand to benefit from the intrinsic productivity enabled by the underlying, interest-bearing assets issued by and held within Notional v2.

There are no metagovernance rights available with this product as it holds stable coins and stablecoin equivalents.

Liquidity

A given index product will be paired with the matching underlying asset. In the case of Short Term USDC, the pair would be Short-Term-USDC / USDC. It is worth noting that LPs would have limited impermanent loss because of the stable nature of the product and more certainty around potential profitability brought about by trading fees.

Seed liquidity will be provided by the Index Coop per budgetary allocations defined for 2022 and deployed on Uniswap v3 (main net).

‌Author Background

The Automated Indices Pod is composed of interdisciplinary contributors who are dedicated to the creation, management, and growth of automated products since May 2021.

Marketing support / distribution / partnerships

Though the Automated Indices Pod is the methodologist for this product suite, there is an opportunity to work with an external partner for branding and distribution efforts. This section will be updated closer to DG1.

Revision history

Describe any modifications to this proposal since the original post on the forum

Copyright

‌Copyright and related rights waived via CC0.

23 Likes

Excited about this, looks sweet

10 Likes

Congrats on a very nice proposal. What’s the approximate gross profit margin taking into account only streaming fee income and gas costs, ie, ignoring LMI? With only a 0.49% fee I would expect the profitability to be low or even negative. I appreciate that minting instead of swapping will help control the rebalancing gas costs.

5 Likes

Hey Joseph - great question around the product’s profitability. We’re still hammering out the finer details of the rebalancing (which will incur the largest share of gas fees), but the goal is to minimize rebalancing as much as possible so that the general operational costs for these products are low. One nuance working in our favor is that fCash positions automatically convert to cTokens at maturity so there isn’t an intermediary trade required to, say, convert a fUSDC 3mo position at maturity into cUSDC before we can purchase the next batch of fUSDC positions.

There’s a lot of backtesting ahead of us to determine what the lowest streaming fee can be at a conservative AUM level with rolling maturities and gas fees factored in. Personally, I’ve had to reframe how I think about streaming fees a bit for this type of product. For example a 0.95% streaming fee is more than reasonable for a composite index that can return +50% in a year, but that same 0.95% streaming fee applied to this type of product returning a predictable ~9% a year would amount to a much larger hair cut for customers (~10% of their return vs ~2% for a composite index). I’m ignoring the fact that the streaming fee is - well - constantly streaming :smile: throughout the year and not collected at a single point in time, but the concept still generally applies. That said, I do believe we can strike a balance between cost to the customer and profit for the Coop, it’s just a matter of doing the modeling!

Another aspect to consider is that our pod is operating as the methodologist for this suite, so a larger share of gross revenue will make its way to the community coffers compared to previous fee splits with external methodologists.

3 Likes

Thanks both. I’ll look forward to the profit calculation.

3 Likes

This seems like a promising product. I could definitely see this being a great product to encourage DAOs to diversify their treasuries into as part of a risk management strategy. It could help DAOs reduce reliance on their own token, while earning a better yield than holding stablecoins. It is also helpful to have a product that may perform better in a bear market compared to current Index products. Excited to keep an eye on this

(Disclaimer: copper owl quest post)

7 Likes

I would buy this on day 1! :slight_smile:
Looking forward to seeing how this pans out (along with $JPG).

6 Likes

This component sounds excellent, a product that is a key fit in the portfolio. Reaching and educating DAO treasuries is a heavy lift. What kind of support is going to be needed to engage this audience? (this may be more of a question for the Growth Nest).

2 Likes

This is an amazing capability that Notional has built. At the moment, it looks like Notional is limited to USDC, DAI, ETH, and WBTC. FEI as a stablecoin has an interesting model that might add decentralized credibility with growing market interest. Additionally, I do see value in partnering with teams like FEI to help reach hard to convince customers like DAO treasuries. @twoodward; does Notional have the ability / capacity to add in other early stablecoins to your solution set so it may be included in the the $FIXED portfolio in the future?

1 Like

Yes sir! Notional can and will list other stablecoins to lend and borrow. Stay tuned :eyes: @shawn16400

6 Likes

If anyone would like to understand the “why” behind this product suite in more detail, I’ve published an article that breaks down the broader need in DeFi for bond products.

4 Likes

Hey shawn - another great question. There are quite a few products coming down the pipeline that may appeal to DAOs (ex. PAY, FIXED, REAL) and it will absolutely take a concerted effort on the part of the Coop to engage and educate these customers on what these products could do for their treasuries.

@Mringz is in a better position to comment on this, but BD and Growth will play a critical role in the success of all these products. I see a future where we engage different DAOs with a consolidated catalog of yield-bearing products along the risk spectrum, but that’s not necessarily my domain :grinning_face_with_smiling_eyes: .

Regardless, we will need a strong distribution strategy for this suite, especially if we decide to launch without a branding or distribution partner. More to come on this, would welcome your feedback in the future too!

1 Like

Great proposal. This is a much-needed product within the DeFi ecosystem.

3 Likes

Really excited for this concept!

I’ve a bit of a concern though, about having the entire fixed income allocation of the Index on only one fixed rate platform, and only one stable asset. I feel like there would be much more value in an Index that really diversified exposure to both the underlying stablecoins and fixed rate products.

Would you be open to discussing the addition of other fixed income platforms and/or assets? These are some fine candidates:

  • Tempus Finance
  • Element Finance
  • Pendle FInance
  • APWine
  • 88mph

This would also open up diversification options to other assets like DAI, alUSD, LUSD, etc.

Hey @LazyMicrobe - You’re right that there’s a larger opportunity to branch out across different assets and underlying protocols! This proposal actually represents a suite of stable yield products, and the first product we would like to launch within the suite would be the short-term USDC product. That said, the same core strategy can be applied to other underlying assets and various maturities to accommodate customer preferences related to risk and diversification. Here’s an excerpt from the “Rationale” section of the proposal:

The benefit of a suite of products is that the same infrastructure and methodology can be applied to multiple products that differ in terms of maturity, investor preferences, and underlying assets. The follow list of potential products demonstrates this extensibility and is limited to assets supported by Notional v2 today:

  • USDC Short Term (<6 Month Maturity)
  • USDC Long Term (<12 Month Maturity)
  • DAI Short Term (<6 Month Maturity)
  • DAI Long Term (<12 Month Maturity)
  • wBTC Short Term (<6 Month Maturity)
  • wBTC Long Term (<12 Month Maturity)
  • ETH Short Term (<6 Month Maturity)
  • ETH Long Term (<12 Month Maturity)

Blended products (i.e. Diversified Stablecoin Index, ETH + BTC Index) are also possible in the event that investors want exposure to more than one stablecoin or blue chip asset. Notional will also be expanding available assets on their platform in the first half of 2022 so additional stablecoins and tokens can be considered in the future. More holistically, by building these stable, income-generating tokens, we enable the creation of meta balanced portfolio products and target date funds in the future.

In terms of protocols, Notional is our preferred partner for this suite because of their commitment to security, their success in the fixed-rate space, and the exceptional support their team has provided thus far. There are also many exciting developments on Notional’s roadmap that will allow us to support more assets and access additional lending markets. We will definitely be keeping a close eye on the space, but Notional is the preferred protocol for this suite of products!

2 Likes