A recurring issue in DeFi is the persistence of at-or-below risk-free rates. This is largely due to a failure to originate debt, and it indicates several areas of dysfunction within DeFi lending markets. First, it’s helpful to examine why risk-free rates exist anywhere. Under normal circumstances, you primarily expect to see below-risk-free rates on cash (naturally), money market funds, and bank accounts. Cash is no mystery. Money market funds come with some administrative drag - you have to pay someone to run the thing after all. And bank accounts bundle a variety of transaction, custody, and ancillary services, so the standard bank account is not an investment. High-yield savings accounts do exist, of course, but they often pay at or slightly above the risk-free rate - there is no shortage of US banks that offer >4% on savings accounts or short-term CDs. And of course the funds are insured up to $250,000. But DeFi lending deposits aren’t cash, they aren’t the risk profile of a money market fund, and they don’t come with a bundle of transaction, custody, and ancillary services like a bank account. So they’re not a good risk-reward at below-risk-free rates (and I say this as someone with money sitting in them). Now let’s turn to the cause of the low rates in DeFi. Lending is cyclical, and DeFi goes through regular periods where loan demand is quite low. As I write this, the 1-month weighted average stablecoin supply APY across DeFi sits at 3.1%. And that’s including a very wide selection of lending opportunities up and down the risk curve - this is no money market fund with impeccable collateral or a bank account with insurance. It’s instructive to think about what a bank would do if it took in more deposits than it could profitably lend out. It would go out and buy treasuries, commercial paper, or loan portfolios from other lenders. In short, it would simply buy debt. DeFi protocols generally can’t and won’t do this. It requires credit expertise - which DeFi protocols completely lack in most cases, for reasons that will become clear below - and it requires access to purchasable assets. How can I say there is generally very little credit expertise in DeFi lending? Mostly because DeFi lending is structured to avoid the need for it. Debt in DeFi is mainly underwritten by the secondary market liquidity available to service instant liquidation. This requires liquidity modeling, but allows a risk consultant to be pretty agnostic to the actual asset. While some curators and protocols have attempted to do actual credit underwriting, they have mostly shown themselves to be bad at their job. The few exceptions don’t have enough years in the market to distinguish good luck from good underwriting. There’s a huge opportunity in this space, even if you’re a 4th-rate underwriter, by the way. You’d be delivering relative outperformance. Another trait of DeFi lending is just how primitive and unsophisticated it is. Almost all lending is pure margin lending. There are no tenors on the vast majority of DeFi debt, so rates of utilization are highly unstable, sometimes even on an intraday basis. The rates are also priced by utilization, rather than a model of expected loss and recovery. This is downstream of most underwriting being done on the basis of liquidity, and to the extent that lending within a vault or protocol continues to stay underwritten based on liquidity, that’s workable. Sell-into-available-liquidity functions similar to securitization in TradFi in that it standardizes the debt product from the investor’s perspective. But as soon as you begin to let actual credit underwriting (intentionally or otherwise) into the portfolio, utilization becomes a poor way to price debt, since it becomes heterogeneous. You will over time tend to lend more against the worst collateral, simply because other ares of the market are more sensitive to risk-reward and your mispriced risk create carry trades for the borrower. 1/2