# Why Sense?
# The DeFi Yield Ecosystem Today
If we rewind just a few years to 2019, Ethereum had captured the imaginations of many DeFi builders–but realistically there were extremely few ways to put crypto capital to use in generating yield. Since then, with special thanks to the pioneers of 2020’s “DeFi Summer,” there has been an explosive proliferation of yield-generating applications (opens new window) for capital in the Ethereum ecosystem. And now, with the advent of Ethereum staking, the ecosystem is also getting its own version of a risk-free rate (yield offered by the issuer of the currency in which the yield is denominated).
There are, however, very few tools to parse these yields — very few ways for yield-seekers to customize their exposure to their needs. We currently exist in an environment where crypto savers are holding double-digit APYs that could go away at any point, in tokens that can rise or fall 50% a week against the dollar, while they want to be able to cover their USD denominated mortgage payments without selling down their crypto assets. We have DAOs that hold their native token and don’t know if they’re going to have to sell 0.5% or 5% of their treasury to meet known payroll expenses next year. We have retail investors that are putting ETH into centralized risky lending applications for a tenth of the yield (opens new window) they could generate by earning yield from the Ethereum protocol itself. It’s great that we have achieved what we have so far in the development of the DeFi Yield ecosystem, but we have a long way to go.
If we create the tools for more customizable yield exposures, then give those tools both to the builders of the yield generating protocols and directly to the users of those protocols, users will have a better DeFi experience. DeFi will be a better tool for empowering individuals to be financially self-sovereign when those users can pick and choose what risks they are exposed to. DeFi protocols will attract more capital when they offer more curated risk exposures to different capital allocators. And, if we create decentralized infrastructure for borrowing, lending, and trading these assets against each other we will also create more transparent and efficient pricing of risk, which helps yield holders get adequately compensated for the risks they do take. Every design decision in the architecture of the Sense Protocol serves this goal.
# Designing Sense in Five Questions
# Why Fixed Income?
Providing permissionless infrastructure for turning variable yield products into fixed income products is not only a worthy goal in itself, but also a necessary step for the development of the DeFi ecosystem. In TradFi, fixed income (opens new window) is one of the largest asset classes in the world (~$120 trillion). But, DeFi and TradFi are different: that is kind of the point. To understand if fixed yield will be desirable in DeFi we have to understand why fixed yield is so desirable in TradFi. In short: knowing how much money you will make by holding yield-bearing assets, or knowing how much money you will have to pay to service debts, makes you better able to plan your future.
In TradFi some of the largest issuers of fixed income are governments and corporations. The benefit of fixed interest is that they know what their debt service costs will be going forward and can plan around it, versus being exposed to the possibility of spiking costs at any point. Major TradFi purchasers of fixed income like sovereign wealth funds and pension funds also benefit from having known yields they can plan around. Pension funds are an especially stark example of this: they have a pretty clear idea of the liabilities they are facing in the future and the purpose of their pool of capital is to ensure they have the assets to meet those liabilities — not just to maximize returns. When players in market want to ensure they get a particular amount of yield by a particular date, they are often willing to take a lower certain yield over a higher variable yield. Even if the variable yield will probably be more, players with fixed costs are often more concerned about eliminating the possibility that it might turn out to be less.
Governments and pension funds are hardly the drivers of DeFi — but there are plenty of reasons for DeFi users to want to know how much their borrowing costs and how much their interest income will be in the future. Known borrowing costs make leverage safer, increasing capital efficiency for borrowers. DAOs and crypto savers have known liabilities they would like to meet in the future, just like pension funds do. Furthermore, as we’ll discuss in the last section, fixed income lays the foundation for many more important developments.
# Why a Yield Stripping Application?
There is more than one way to approach creating fixed income markets — at a simple level one could just start a lending facility and make fixed loans. But, a yield stripping application is the best approach for the DeFi ecosystem. Yield stripping entails taking an underlying yield-bearing token and stripping it into two tokens (opens new window) with a defined “maturity” date: one lets you get back a fixed amount of “principal” at that date, and another that lets you collect any yield payments between now and then. The token that gets you a fixed amount of principal in the future is your fixed-income product, and the token that is just a claim on variable yield creates a capital-efficient way to get yield exposure. Three inherent features make yield stripping preferable to other approaches:
- Safety: The two tokens created are proportional claims to an existing yield-bearing asset held in escrow by a smart contract. In this sense, they are fully backed and carry no risk of default.
- Abstractability: Because any yield-bearing asset is, definitionally, a claim to some principal plus some yield in the future, this model can be applied to any yield-bearing target. We can make fixed-income yield-bearing instruments powered by the same engines that drive the yield of DeFi’s existing variable yield instruments.
- Flexibility: This model creates not just a place to lend or borrow at fixed rates, but completely separate assets for constructing variable yield or principal exposure for an arbitrary set of underlying assets. Those assets can be recombined, used in other protocols, or themselves borrowed and loaned.
To double click on the flexibility point for a moment: users can not only get a fixed return on their underlying, but also get customized yield exposures. The crypto saver mentioned in the first section could lock up some amount of his ETH into a fixed return to ensure that he will have the same amount of ETH a year from now. Because yields are a positive fixed return, he can ensure that next year he will end up with the same amount of ETH he has today by converting less than his total current ETH holdings into fixed income products from Sense. By doing this, he’s protected his principal ETH investment.
He could then take the remaining ETH and buy fixed amounts of yield (opens new window) in USDC terms at different maturities, which become claimable exactly when his upcoming mortgage payments are due. Now, his major liabilities are met, and his underlying investment in ETH is protected. Let’s say there’s still some ETH left, and he wants to use it for something riskier, with more exposure to upside. He’s comfortable losing this extra capital and wants to turn it into extra USDC income. He could put it into a variable USDC yield token (opens new window) to gain capital-efficient exposure to some unknown amount of extra spending money over the coming year — this last investment is much riskier (not protecting the principal), but he’s willing to take some risk and be exposed to greater upside now that his liabilities are met.
A single piece of underlying infrastructure has changed his situation from “a stack of ETH which he will have to sell down by some unknown amount every time he makes a mortgage payment” to “a stack of ETH he knows he will still have next year, that has also already covered his upcoming mortgage payments + provided a bit of supplementary income in USDC.”
# Why Permissionless?
Creating step-changes in the maturity of the DeFi ecosystem requires permissionlessness (opens new window). If the adoption of constant product AMMs’ had required the Uniswap team vet to every asset on the Ethereum network, and then build out custom integrations, Uniswap (and other AMM applications that followed) wouldn’t be competing with, and beating, centralized exchanges today.
The biggest problem with gatekeepers isn’t that they are necessarily evil or rent-seeking–it’s that they are a bottleneck on potential innovation. But, having gatekeepers often isn’t an ideological choice: it’s a technical barrier. Wanting to be permissionless isn’t enough. It requires building infrastructure that operates at a sufficient level of abstraction for a huge variety of different applications (in this case projects creating yield-bearing assets) to be able to work on top of it. This, more than anything else, is the fundamental technical innovation behind Sense Core.
The Sense Divider goes even further than abstracting away from the details of the underlying asset that is being divided: it also allows customizability around what exposures it is divided into–but that is a discussion for our smart contracts document. This means permissionlessness that includes both universality (any token can be used) and customizability (the protocol that is integrating can tweak for its use case).
That permissionlessness is the difference between building an application and providing infrastructure that will change the architecture of the DeFi ecosystem.
# Why Sense Space?
Global permissionless fixed income and variable yield token markets require decentralized exchange venues. And successful decentralized exchange venues require attractive yields for liquidity providers. For a variety of reasons that are explained elsewhere in our documentation (such as the value drift of properly functioning principal and yield tokens), traditional AMMs like Uniswap and Sushiswap do not work for tokens created by Sense’s stripping protocol.
This is why Sense created Sense Space (opens new window). Sense Space is an application of the Yieldspace Invariant pool model, that has been further adapted to allow both of the underlying assets to be yield-bearing. The underlying assets an LP provides to the pool are a target asset (an asset that the yield stripping protocol can strip) and the Principal Token of that asset (that asset’s fixed income equivalent)
The design of the Space pool has some beneficial features versus previous attempts at solving this problem:
- Attractive Yields: The LP provides a target asset (variable yield-bearing) and a Principal Token (fixed yield-bearing) of the same underlying asset. Both assets provided to the pool are yield-bearing themselves. On top of those two yields, they earn trading fees.
- Minimal Impermanent Loss: The two assets have the same underlying (e.g. a fixed income ETH token and a variable income ETH token), which means that they are heavily correlated in most market conditions. Furthermore, the Yieldspace Invariant pool design eliminates the impermanent loss caused by value drift of Principal Tokens.
- Underlying Principal Protection: From when an LP deposits their two yield-bearing assets as liquidity (as long as they hold until series maturity), no possible amount of impermanent loss will reduce the value of the LP tokens below the initial amount provided in underlying terms (e.g. ETH terms in the case above).
- 1 + 1 = 3: Because the Space Pools interact with the Stripping Application to strip or recombine Yield and Principal Tokens, providing just two underlying assets allows users to trade all three assets against the same pool: Yield Tokens, Principal Tokens, and the target asset.
# Why a Fuse Pool?
As Sense is providing tools for a new generation of rate products, a big part of being able to customize exposures will be borrowing and lending the rate products themselves. For this reason we are creating our own Fuse pool (opens new window), which will allow users to use Sense Space LP tokens, yield bearing target assets, and the fixed income Principal Tokens as collateral. Against those assets, users will be able to borrow Principal Tokens and target assets. This will allow users to leverage their LP positions to concentrate exposure to transaction fee yield and improve capital efficiency. It will also allow a fascinating toolbox of exposures such as borrowing at a protocol’s risk free rate and lending at a higher yielding riskier pool to collect a credit spread, or doing carry trades between shorter and longer duration Principals Tokens of the same target.
# The DeFi Yield Ecosystem With Sense
And, just to be clear, this is from a single application of the Sense Core contracts.
More to come.