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Yield derivatives are one of the most important products in finance today. Just one kind alone, Interest Rate Derivatives (IRD), has a notional value estimated at $488 trillion of which $5 trillion is traded daily. This is roughly equivalent to the total assets of financial institutions worldwide.
Signs are pointing to yield derivatives in DeFi being the next big thing:
- DeFi TVL has doubled in the last six months while cryptoassets such as Bitcoin are seeing unprecedented institutional adoption. These assets will seek on-chain sources of yield, and that yield will create demand for yield derivatives.
- On-chain yield-bearing assets, from GLP to synthetic dollars like Ethena to tokenized treasury bills, will continue to see rapid expansion as the only source of global yield accessible to anyone with an internet connection.
- Yield derivative dApps have seen breakneck growth, with Pendle alone growing its total value locked (TVL) by 10x since the start of the year to more than $2 billion today.
With so much potential, there is a real opportunity for the entrepreneurs who can take the proven model from traditional finance, replicate it in DeFi, and leverage DeFi’s inherent advantages (pg. 4-5) to outcompete and one day exceed the original.
As of right now, Radix offers entrepreneurs a $250m untapped opportunity to build the yield derivatives infrastructure for the current Radix ecosystem. But for those looking ahead to tomorrow, Radix offers entrepreneurs the only layer 1 infrastructure that has a safe enough user experience (and more) to go after the remaining $488 trillion.
What is a Yield Derivative?
A yield derivative is a financial contract based on the interest, coupon, or dividend payment from a loan, bond, stock, or other yield-generating asset. Yield derivatives allow future cashflows to be bought or sold without needing to own the underlying asset, allowing for the tailoring - and trading - of specific kinds of financial exposures. Common examples of yield derivatives include interest rate swaps, futures, and options.
With yield derivatives:
- Entities can hedge their risks and better control their future cashflows. For instance, a real estate company can hedge the risk of its mortgage payments going up if the central bank increases the base interest rate.
- Funds can more predictably manage their portfolios, e.g. a pension fund that needs to ensure that an investment returns at least a certain yield above or below some base rate.
- Speculators can bet on interest rate changes or future dividend payments and/or gain access to leverage.
- Companies can increase their earnings from unused assets, like cash in a bank, by entering into interest rate swaps. In these deals, they trade their interest earnings for other types of payments that better suit their needs over set periods.
In essence, yield derivatives allow for the creation of markets between those who need predictable cashflows, those that prefer variable or leveraged cashflows, or those that don’t need cashflows in future, but need cash now.
Yield Derivatives in DeFi Today
In DeFi today, yield comes primarily from five sources:
- Fees, such as traders paying a fee to Uniswap Liquidity Providers (LPs).
- Interest, such as borrowers paying lenders an interest payment on Aave or a funding rate on GMX.
- Newly minted tokens, such as a decentralized network’s Delegated Proof of Stake (DPoS) system minting new emissions as a reward for securing the network.
- Asset price increases that can allow financial dApps and products to pay yield.
- Real World Assets (RWA) that bring external yield on-chain, such as tokenized Treasury Bills that pay their holder the US federal funds rate.
With so many sources of on-chain yield, a new crop of dApps are stepping in to offer yield-related derivatives products:
Pendle
With $2.4 billion in TVL, Pendle.Finance is arguably the largest yield derivatives product in DeFi today. Pendle allows for an underlying yield-bearing token (such as a stETH) to be wrapped into two tokens: a Principle Token (PT), and a Yield Token (YT). Pendle calls this process yield-tokenization.
Each PT and YT has a maturity date:
- For the PT, holders don’t receive any yield before the maturity date, but they can redeem the full underlying yield-bearing token after the maturity date, and thus have access to the full underlying token, plus any future yields, after maturity. E.g. If you own 1 PT-stETH with 1 year maturity, you will be able to redeem 1 ETH worth of stETH after 1 year.
- For the YT, the yield from the underlying yield-bearing token is accrued up until the maturity date, after which the YT has no further value. E.g. If you own 1 YT-stETH and stETH has an average yield of 5% through the year, you will have accrued 0.05 stETH by the end of the year.
The PT and YT tokens are liquid and can be traded on the Pendle AMM.
By separating principle and yield, Pendle allows users to create assets that can provide:
- Fixed yield (e.g. fixed yield on stETH)
- Long yield (e.g. bet on stETH yield going up by purchasing more yield)
- Earn more yield without additional risks (e.g. provide liquidity with your stETH)
Pendle has even sparked the creation of its own ecosystem, with projects such as Penpie or Equilibria building products on top of it.
Others
Other yield derivative dApps include Notional.Finance, which allows users to earn fixed, variable, or leveraged interest, by splitting the underlying yield-bearing token into fCash tokens (the principal) and cTokens (the yield token).
Timeless has a different twist - its yield tokens never expire. Timeless achieves this with a Perpetual Yield Token (PYT), whose holders receive the yield generated by user deposits, and a Negative Yield Token (NYT), whose market price moves in the opposite direction as the PYT.
Spectra.finance focuses on not only supporting fixed and variable rates, but upfront yield, borrowing and lending with principal tokens as collateral, and a yield marketplace.
The Opportunity on Radix
Today, 3.75 billion XRD is staked, yielding 300m XRD per year, or around 8% APY. With Radix’s Native Liquid Staking, that’s $250m of fully liquid yield-bearing assets looking for things to do in Radix’s DeFi ecosystem. Given that no yield derivative dApps are live on Radix yet, that’s a $250m untapped opportunity to create the yield derivative pillars for Radix DeFi, replicating and perhaps exceeding the success of Pendle.
But this is just the start. Multiple major programs this year will further ramp up the adoption of Radix by users, liquidity, and entrepreneurs, and there are likely to be more sources of on-chain yield - not just from staking - as the Radix ecosystem matures.
For those entrepreneurs eyeing the long-term prize, the $488+ trillion yield derivative market today, they must make a choice: build on an EVM, Solana, or Cosmos infrastructure that requires their userbase to be constantly wary of frequent wallet drains, revocation of spend approvals, blind signed transactions, and seed phrases; or build on a L1 infrastructure that has spent 11 years designing a stack that solves all of these challenges natively on the L1.
To elaborate, building on Radix means:
- Unmatched Transparency and Guarantees to Users provided by Native Assets and the Transaction Manifest, which removes the uncertainty of interacting with token smart contracts such as ERC20.
- Seed-Phrase Free Authentication and Recovery provided by Smart Accounts that obsolete the need for users to rely on single seed phrases.
- Standardized Asset Composability provided by Radix’s native assets, allowing yield derivatives dApps to easily wrap any underlying token into any derivative tokens, with standardization and guarantees on asset behavior provided by Radix Engine. This is in contrast to wrapping assets on Ethereum, Solana, and Cosmos, which introduces uncertainty as their smart-contract-as-tokens approach cannot guarantee that a token is actually safe and secure. See It’s 10PM: Do you know where your tokens are? and Rekt Retweet #9: The Transaction Manifest - Why the $14m Furucombo hack could NEVER happen on Radix to learn more.
- Reduction in Vulnerabilities and 10x Boost to Productivity: Radix’s Scrypto programming language and Radix Engine execution environment reduce the chances for hacks and exploits with native features for tokens, transaction accounting, and permissions. Testing so far with Scrypto developers has indicated that they have a 10x boost in speed to market vs Solidity. See The Problem with Smart Contracts Today to learn more.
- Peer-reviewed Roadmap to Linear Scalability, means that Radix will never run out of throughput, and never sacrifice the composability of its DeFi ecosystem. For the visionary entrepreneurs looking to build not just for DeFi today, but the DeFi that will one day exceed traditional finance, Radix’s peer-reviewed Cerberus consensus provides the linear scalability and composability required to power that vision for global-scale DeFi.
Get Involved - Scrypto Challenge
If you’d like to build the next wave of yield derivatives dApp on Radix, see here for a Scrypto Challenge. You can win a share of $15,000 in prizes. The challenge will end on May 3rd.
Further reading: