Introduction
“Understanding the Role of Debt in the Financial System” is currently one of my favorite papers. Written by the Finnish economist Bengt Holmstrom in the aftermath of the 2008 financial crisis, this paper defines and clarifies the role of debt in the global economy.
At Index Coop, our products are increasingly used as collateral within DeFi money markets. As the use of our products within the debt markets grows, we as a community need to develop our understanding of these markets and the role our products fill within them. I compiled these notes to help clarify my own thinking. I hope community members find these interesting and help shape a wider discussion around debt in our current system.
Debt Markets
“Money markets are fundamentally different from stock markets. Stock markets are about price discovery for the purpose of allocating risk efficiently. Money markets are about obviating the need for price discovery using over-collateralized debt to reduce the cost of lending.”
When thinking about the role of debt - I find it helpful to think about information sensitivity. Equity markets (interchangeable with the buying and selling of ERC20 tokens on AMM’s such as Uniswap) facilitate the rapid sharing of information between economic parties. New information is quickly incorporated into the price of tokens. Debt markets serve the opposite purpose. Instead of facilitating the rapid flow of information, they reduce the amount of information needed to provide liquidity.
In fact - debt markets and equity markets operate on diametrically opposed logic.
The purpose of money markets is to provide liquidity for individuals and
firms. The cheapest way to do so is by using over-collateralized debt that obviates
the need for price discovery
Holmstrom uses the example of a pawn shop to illustrate this logic. Think of the owner of a gold watch in a small town. If the watch owner has a liquidity need, he can either pawn the watch or sell it. By choosing to sell the watch, the owner runs into several problems. The small town probably does not have a very developed market for gold watches. It may be difficult to negotiate a good price. Or the owner may believe that some future event will positively impact the price of the watch.
The pawnshop solves this problem beautifully. The watch owner receives liquidity for his watch without the need for price discovery. The owner and pawnshop do not need to agree on a price for the watch; all that needs to be established for the watch is a price floor. As long as the pawnshop can be confident of the watch’s lower bound, the owner can access liquidity without the need for price discovery.
This same logic drives modern-day debt markets. If you need access to short-term liquidity but believe the value of Ethereum will go up over the long term, you can deposit ETH on AAVE and borrow DAI against it. Or, if you are a company that expects significant future revenues, you can issue bonds to generate short-term liquidity against future earnings.
The purpose of debt markets is to provide liquidity without the need for price discovery.
People often assume that liquidity requires transparency, but this is a
misunderstanding. What is required for liquidity is symmetric information about the
payoff of the security that is being traded so that adverse selection does not impair
the market.
If I wish to borrow against my $DPI on CREAM (thank you, @kiba!!!), both parties do not need to agree on the future price of the index. We only need to agree on a safe floor price. By minimizing the benefit of information gathering, symmetric information increases the flow of liquidity. Even in highly distressed markets like 2008, the least information-sensitive debt positions (think triple-AAA or Treasury Bonds) remained highly liquid.
Over-collateralized debt positions reduce market sensitivity to new information. A good way to think of this is the Loan - to - Value (LTV) ratio seen on popular DeFi money markets. A debt position with an LTV of 1.2 is susceptible to new information; any changes in ETH price can lead to liquidation. On the other hand, a debt position with an LTV of 5.0 is much more information insensitive and safe from liquidation.
Equity Markets
The main purpose of stock markets is to share and allocate risk. The first stock
market was set up in Amsterdam to share the risk of dangerous voyages to the Far
East.
The importance of price discovery in stock markets goes hand in hand with the
traders’ incentives to acquire information. Every piece of information about the
value of a firm is relevant for pricing its shares
Equity markets operate in a highly information-sensitive environment. Because the primary role of these markets is to share risk, every new piece of information is vital. While debt markets are intended to remain stable, equity markets are by design highly volatile. These markets also benefit from having many smaller participants sharing information, while debt markets rely on a smaller number of participants to generate and use liquidity.
The purpose of equity markets is to share risk.
stock markets are in almost all respects different from money
markets: risk-sharing versus liquidity provision, price discovery
versus no price discovery, information-sensitive versus insensitive, transparent
versus opaque, large versus small investments in information, anonymous versus
bilateral, small unit trades versus large unit trades
The two types of markets form a complete system. Debt creates liquidity used in equity markets to scale or reduce risk, which is then used to increase or decrease debt. Ever present in debt markets is the need for information insensitive collateral. Highly information-sensitive collateral, in turn, increases the information sensitivity of the debt and reduces liquidity. On the other hand, collateral that is information insensitive increases liquidity. By understanding this cyclical structure and unique attributes of both markets, we can better understand the roles our index products play in this ecosystem.
What does this mean for Index Coop?
Index funds share some characteristics of both debt and equity. A market-neutral basket approach makes these funds relatively information insensitive. While the value of the underlying may fluctuate drastically, this volatility is dampened across the entire portfolio. Holders of market-weighted baskets like $DPI reduce their exposure to risk and volatility while maintaining a degree of price discovery impossible in pure debt markets.
Index Funds make the perfect collateral for money markets. Their relative price insensitivity enables the creation of secure debt positions and easy access to liquidity for holders. As more and more money markets onboard our products, sell pressure on $DPI and $MVI will be significantly reduced as index holders generate liquidity without selling their tokens. This also increases long-term holding as our indexes are locked in debt positions and off the market.
Over the next few years, our products will become key collateral for DeFi and the global financial revolution. By enabling access to debt markets through passive investment vehicles, we will greatly expand the role of index products throughout the broader crypto ecosystem.
If you made it this far thank you, I hope you enjoyed reading this! 