Giraffe Paradise Discussion: Why has DeFi been able to offer double-digit interest rates in the past? Will a US interest rate hike increase DeFi rates?

The high interest rates in DeFi come from risk premiums or market inefficiencies? Will a rate hike by the Federal Reserve lead to an increase in DeFi rates? These questions were discussed by DeFi senior developer Chen Pin and researcher Yu Zhean yesterday in the Facebook group 【DeFi Giraffe Paradise】, and sparked a discussion.

Why has DeFi been able to offer double-digit interest rates in the past?

Chen Pin first revisited a Twitter poll by Ethereum founder Vitalik three years ago, when the lending protocol Compound had just launched. Users who lent stablecoin DAI on Compound could earn 11.5% interest annually. This was significantly higher than the 1.5% yield on the 10-year U.S. Treasury bond at the time, and Vitalik was curious about the community's views on the gap between the two interest rates.

"Is it due to market inefficiency, where people are unaware of the lucrative opportunities here, or is it about risk premium, where users are willing to take on the risk of new products potentially exploding in exchange for higher returns?" Chen Pin said.

Regarding this issue, Chen Pin stated, "Those with ideas often choose the latter without much thought, but in hindsight, it's actually the former that plays a dominant role. As a large amount of capital flows into DeFi, interest rates are getting closer to the external market."

How to explain the current interest rate crossover between the two markets?

However, looking at current data, the lending rate for DAI on Compound is around 1.09%, while the yield on the 10-year U.S. Treasury bond has increased to approximately 3.73% due to the Federal Reserve's ongoing rate hikes. DeFi interest rates have not only crossed paths with traditional financial market rates but have even gone lower. How can this be explained?

In response, researcher Yu Zhean pointed out that the returns in the two markets are not directly comparable.

"I dare say that for most crypto users, the risk-free rate or opportunity cost is not the government bond yield. Even if government bonds offer a 7% return annually, people still wouldn't buy them. If government bond yields are higher than bank deposit interest rates and DeFi, would you really invest in government bonds?" Yu Zhean said.

Therefore, if buying government bonds is not one of the options for cryptocurrency investors, the interest rate differential between the two markets would not be a driving force for investors to change their investment decisions.

Furthermore, Yu Zhean further explained that the flow of funds between the two markets is not determined by interest rates but rather by the incompatible nature of the systems in both markets.

"To this day, there is still no way for everyone to trade government bond collateralized financing on the same trading desk platform to match DAI investments or even use DeFi financing for government bond investments," Yu Zhean said.

At the same time, there are still numerous issues in the DeFi sector, such as legal, code, operational, wallet, and cybersecurity issues that need to be resolved. Until these issues are addressed, high interest rate differentials cannot attract professional investment institutions to transfer funds over.

Will a Fed rate hike increase DeFi interest rates?

In addition to the interest rate issue between the two markets, Chen Pin also explored the relationship between the DeFi market and a Fed rate hike. If the Fed raising rates increases the benchmark rate in the traditional financial market, will DeFi rates increase in tandem?

In response to this, Chen Pin stated:

"Those who consider themselves financially savvy will tell you that putting money in the bank is easy money. Everyone will definitely withdraw their money from the blockchain, so both sides will tighten simultaneously."

In other words, as borrowing interest rates in the market increase, it will cause a tightening of funds in the traditional financial market. Simultaneously, the rise in bank interest rates will attract funds from DeFi users, leading to a tightening of funds in the DeFi market, which in turn will require DeFi interest rates to follow suit and increase.

However, Chen Pin disagrees with this view. If we ignore the issue of whether funds in the two markets will flow back and forth due to interest rate differentials, he believes that since most DeFi lending is driven by mining, when the cost of funds rises, cryptocurrencies will plummet, and stablecoin interest rates will drop due to reduced lending demand.