The entire DeFi vertical has been reeling from the widespread collapse of yields across the board. With this in mind, a very interesting trend is starting to emerge – risk mitigating DeFi protocols.
Risk mitigating protocols help investors and traders hedge their exposure to a crypto asset. For example, options help mitigate risk because an investor with long exposure to ETH can buy put options and reduce their downside risk.
As this theme of risk mitigating protocol furthers, several players are gearing up to launch. But this week, an existing financial primitive that’s finally made its way to DeFi caught my attention.
Barnbridge is a new project bringing collateralized debt obligations (CDOs) to DeFi. For those who’ve watched The Big Short or followed the 2008 GFC, you probably think CDOs are financial products from hell. In reality, they’re insanely useful to minimize risk when used correctly.
What they do is effectively cut up exposure to financial instruments into siloed baskets, called a “tranche”. The senior most tranche carries low risk and low returns; the junior most tranche has high risk and high returns. Say we divide exposure to ETH into three tranches: junior (high risk;high return), mezzanine (medium risk;medium return), and senior (low risk;low return).
As ETH’s price swings, the junior tranche absorbs a disproportionate amount of the risk and returns. The senior tranche bears a very small amount of risk and is rewarded with just a small slice of the rewards. For risk-averse investors who don’t care to stomach the wild spurts of volatility crypto has become infamous for, this is the perfect way to minimize risk while still being exposed to crypto’s upside potential.
What I described above is Barnbridge’s Smart Alpha product that allows for exposure to crypto assets. But the protocol has another product called Smart Yield which I think is far more interesting.
Simply put, Smart Yield gathers investment from interested investors and deploys it across various yield bearing assets. On their website, Barnbridge lays out an example of how such a portfolio could be structured.
Before digging into the implications of this product, it’s important to understand how the yield comes about. So here’s an example portfolio with a gross yield of 6%.
After a year, the APY in the above table reflects the average return per asset. Once again, this investment is divided into tranches, so how do the returns look for each tranche if we cut up the portfolio?
Assuming the fixed yield for the senior and mezzanine tranches were guaranteed (at inception of the pool) 3% and 5.5% fixed yields respectively, the junior tranche gets a fairly juicy 19.5% return. The senior and mezzanine tranches have a guaranteed yield, so returning capital to these investors is prioritized.
It’s worth noting that if the total return from the Smart Yield product was just $4,275 (guaranteed returns for senior and mezzanine tranches), the junior tranche would receive nothing. But because the returns in this example were far beyond the minimum required, junior tranche investors were rewarded handsomely.
From a risk minimization perspective, Smart Yield covers several bases. The first and most obvious is that it offers conservative investors a way to reduce principal risk (losing their invested capital). Second, it diversifies the portfolio amongst six different assets, three of which are stablecoins implying minimal price risk. And finally, it allocates capital across a number of DeFi protocols.
The last point is particularly interesting because up until now there’s been no easy way to diversify platform exposure through a tokenized instrument. With Smart Yield, if Aave or Compound blow up, the maximum loss to the pool is limited to 1/6th of the total principal, or $20,000. While this is obviously not ideal, it’s much better than having the entire $120,000 in a single DeFi platform.
Yields in crypto are superior to yields in the traditional debt market, even after the yield farming hype died down. If and when DeFi yields return to their former glory, something like Barnbridge could witness massive demand as speculators and investors look to gain exposure to this high yield without biting off the entire risk curve.
Retail investors have previously been deprived of these kinds of risk mitigating instruments. CLOs and CDOs in TradFi are trillion dollar markets completely consumed by institutional investors. With the advent of DeFi, retail investors are gaining access to financial instruments that the gatekeepers of TradFi never allowed them to.
Notably, Barnbridge has been getting tons of attention on social media. The obvious culprit – Barnbridge launched its yield farming program on Oct 19 (Monday) and has already amassed $200 million of capital. Interested parties can deposit USDC, DAI, or sUSD in Barnbridge’s pool to receive BOND tokens at the end of the epoch (one week). On Oct 26 (next Monday), the project will launch it’s “pool 2.” Farmers will be able to earn BOND by providing liquidity to the BOND-USDC pool on Uniswap.
But having $200 million in capital to farm the token doesn’t necessarily imply there’s demand for the product itself. Considering risk-seeking degens make up the majority of the DeFi investor base at the moment, it’s very possible that Barnbridge’s product launch will be underwhelming compared to the token farming event.
A more likely scenario is that there’s limited demand for senior tranches because return-hungry DeFi investors are all piling into junior tranches to secure the largest chunk of yield they can. All while still minimizing their downside to an extent. The product undoubtedly provides a useful service, but one could make the case that it’s a bit early for institutional grade products in DeFi.
Another potential concern is that there’s about three months between the launch of the token and Barnbridge going live on the Ethereum mainnet. The token’s price discovery during this period could be geared to the downside since there are no immediate catalysts – just currently unusable governance tokens being mined. Given the speculative mania that engulfs DeFi alongside current market conditions, it seems likely that BOND’s price will trend lower as more tokens hit the market.
On the bright side, Barnbridge is a community focused project, launching with a DAO from the get-go. The project is also allocating a generous 68% of its total supply of 10 million tokens to the community via yield farming, liquidity provision rewards, and usage rewards.
A cutting edge project that’s expanding financial primitives that exist in DeFi coupled with a community oriented token distribution and launch mechanism. Barnbridge is certainly a project to keep an eye on in the near future.
Note: BOND distribution allocated to yield farming includes rewards to the stablecoin pool and the BOND-USDC Uniswap pool. BOND to Smart Alpha and Smart Yield is based on the assumption that the protocol goes live at the end of Jan 2021 and distributes rewards over a 100 week period.
Disclosure: The author is farming BOND
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