Admit it: DeFi has a Scale Problem

Let’s be real with ourselves.

What can we really depend on in DeFi?

When it comes to yields and rates, DeFi borrowing/lending has been a volatile landscape (to say the least). This is by design; all of the leading credit protocols use variable-rate models to manage interest rates with ostensible impartiality.

Different protocols might have subtle differences in their models — but they generally all factor total capital pooled for lending vs. total actively borrowed capital to arrive at a Utilization Rate. This utilization factor determines a point on the protocol’s standard interest rate curve, which dictates what borrowers pay and what lenders earn at this exact moment.

And only for a moment.

The concept is pretty simple: rates are constantly changing across every isolated market, adjusting for each incremental borrowing/lending action that happens. As any one market’s available capital becomes more utilized and less available, the interest rate both paid and earned increases in that market. When a market approaches and then surpasses the “optimal” utilization threshold its rate curve expresses a kink, and what had been a gradual increase in rate becomes a drastic one. For USDC on Aave pictured above, this utilization threshold kink is at 90% — and if that threshold seems a little arbitrary, that’s because it is.

The utilization model was an elegant first solution to the double challenge of what should the interest rates be at any given moment and how might markets be designed to self-manage. These variable rate models were objectively revolutionary and crucial to bootstrapping DeFi lending markets, and they deserve as much validation. But they still hinge on some unavoidably subjective factors, like what the optimal utilization of a market ought to be for it to have achieved efficiency.

But how efficient are they really?

These markets typically have what one might call “tapered efficiency” rather than resilient efficiency — they have tapered to an efficient balance between total and utilized capital that typically looks like the above. Active markets with meaningful demand generally get arbitraged around the rate kink until usually settling JUST below the kink for that given rate curve.

This tapered point is by no means robust; it’s inherently fragile. Any meaningful impact around key inputs of the rate function and suddenly this once-tapered balance can find itself very skewed, and that skew can have dramatic consequences.

If you happened to be lending back in 2022 during the ETH Merge there’s a good chance you remember just how fragile this tapered efficiency can be. As the Merge approached there was an air of uncertainty that triggered a flurry of onchain activity. Many users were aggressively borrowing ETH and shorting to hedge price risk. At the same time, many other users were rapidly exiting all smart contracts (including lending markets) due to the potential technical risks surrounding the Merge.

This was a one-two punch for the aforementioned interest rate model. When lenders rapidly withdrew available assets from a market while borrowers raced to take loans of any remaining capital, even the largest markets on Aave with billions in them went absolutely elastic:

With over $33B now amassed into DeFi borrow/lend protocols it’s easy to forget about these moments or dismiss them as a thing of the past. We want to assume that DeFi credit markets have started to mature. But due to the fundamental design of the variable rate model these markets are all fragmented, and as a result they are shockingly sensitive to anything that might trigger shifts in borrowed or offered capital.

That isn’t just a dig at the emotions of variable rate markets. Let’s take Aave’s USDC market on Base for example. This market has $30M USDC total (either offered or already on lend). At the “optimal” 90% utilization, the rate is a modest and reasonable 6.5%.

Wait… 6.5% today, in this global rate climate? Are we even talking about DeFi here?

Don’t worry, with a utilization increase of just $500K against that $30M, the interest rate rockets from 6.5% to 18.5%.

Ah, THERE’S the DeFi bit.

Another way to think about this is a 1.6% shift in offered/borrowed capital translates to roughly a 300% shift in interest rate. For one of the largest stablecoin markets with millions in it that’s a far cry from being efficient — or if that’s what efficiency is supposed to look like then perhaps it’s way TOO efficient. Either way, it lacks any kind of consistency you’d want to have to depend on.

Ironically, a couple million more USDC was just borrowed during the hour or so that this was being written. That pushed the utilization to 97% — thus sending the current interest rate over 50% APR.

That’s about 10x the rate it was an hour ago. Let’s hope all the borrowers were ready for that possibility, because it’s now their reality.

If you’re running a business, a hedge fund, or any DeFi strategy generally not classified as degen gambling, this uncertainty is untenable. This is DeFi’s scale problem: businesses and larger financial operations generally need some substantial predictability in outcome to allocate meaningful resources to any given opportunity. Predictability is impossible if your cost of capital or hedging costs can swing 30x overnight or 10x in an hour. Until financial operations can instrument with predictability they will not allocate to DeFi opportunities in significant size (read: TradFi-scale size). They will probably not be eager to build more elaborate products or derivatives on top of these rates if they might suddenly collapse due to their elasticity.

And until DeFi variable rate credit markets get substantially larger in size and thereby gain more depth, their rates will remain very fragile to any meaningful catalysts.

As a community of DeFi participants trying to understand these credit markets we find ourselves stuck on an MC Escher staircase in need of perspective. Why isn’t more capital active in these markets, the rates are unreal! Why do borrowers and lenders keep playing musical chairs; they’re breaking all the rates! Just because a rate might look good right now, or look good on a $10k position, that perspective ignores the fact that any headline rate is meaningless without the context of how much depth is available at that rate, and how much that rate could potentially vary and change throughout its duration.

Size Credit was created to solve this scale problem.

Size brings fixed-rate, fixed-term lending to DeFi — and with it, much-needed predictability. Rather than the balance act of tapered efficiency in variable rate markets, the credit markets on Size arrive at resilient efficiency the old fashioned way: through a continuous market of bids and offers on credit.

Lenders and borrowers list offers by dictating the rates and durations they would like, or they can take them instantly at market. A loan with a specific fixed duration and rate is executed once any borrower and lender intents match through the order book, thus aligned on terms.

So rather than just accepting whatever you can get from variable rate markets, on Size you can trade credit continuously through the order book — and the way you trade it can be as aggressive or passive as you’d like.

And we understand that flexibility and optionality trade at a massive premium in DeFi — as they should in this novel world. Just because Size loans are fixed-term does not mean that they are locked or illiquid until maturity: borrowers or lenders can exit a position at any time by trading its credit or debt back against the order book.

One way to think about it is that Size has created a market for the price discovery of certainty: is it suddenly worth a lot more today than it was yesterday? Wherever certainty might be trading today, there’s a credit trade for that. Leverage debt to offer new loans, lock in advantageous yields when variable rates get squeezed, refinance a skyrocketing loan you’re holding, make offers on both markets and capture rate spreads… or just secure a rate you’d be comfortable paying/earning for the long haul. Regardless of whether you’re working with $100 or $100M, on Size you can now dictate your terms and develop the exact credit portfolio that you want.

Sound more dependable than hoping it all works out with variable rates? We thought so too - try Size Credit today.