A Notional Thesis
June 16th, 2022

Over the last few months Lattice has been building a position in $NOTE, the governance token of Notional. Notional has been at the forefront of the fixed-rate lending market, pushing the vertical forward and driving the next wave of DeFi adoption. We’re excited to share our thesis more broadly.

Fixed-rate lending dominates the mainstream world

Fixed-income markets remain an integral component of economic growth, providing efficient, long-term, and cost-effective funding. The U.S. fixed income markets are the largest globally, comprising 38.5% of the $125 trillion securities outstanding across the globe ($48 trillion in 2020). The outstanding value of global bond markets is 17% larger than the global equities market.

Fixed interest rates are beneficial to financial investors: they offer predictable returns, lower the reinvestment risk (users cannot reinvest gained interest at a rate equal to or greater than their current return), and incentivize a set-and-forget mindset by offering longer timeframes, and making tax and accounting management easier.

On the other hand, investors can earn fixed amounts of capital over a predetermined period by locking their interest rates ahead of time. Government and corporate bonds are two of the most popular fixed-income products. Others include T-bills, T-notes, T-bonds, Treasury Inflation-Protected Securities, Junk bonds—you name it, the U.S. government has probably invented it. By being backed by “full faith and credit” of the US government, Treasury bonds are a good fit for investors looking for safety but traditionally offer low yields.

DeFi should follow the same trend

Early crypto adopters were not reluctant to ape into products offering variable yields. However, volatile yields are risky and complex. Clearly, we need fixed-rate-based financial products to onboard a new generation of aspiring crypto-natives. Today, the most widely used DeFi lending protocols are AAVE and Compound, with $110B+ and $100B+ of borrowing volume since they launched, respectively.

Interest rates on these protocols are variable and are a function of the utilization rate, which represents an indicator of the availability of capital in the pool. The interest rate parameters have also been calibrated per cluster of currencies with similar risk profiles.

Though we will not dive into how these models precisely work for simplicity, the short version is that rates accelerate when they go past 80% of the utilization rate to urge borrowers to supply money on the platform and lenders to reduce borrowing.

Given the historical volatility of DeFi interest rates, it’s clear that none of these protocols is a serious solution for long-term investors. Variable rates are fine for speculative purposes but for the B2B lending market, protocols will expect more predictable returns and rates.

We all know that many institutions are waiting on the sidelines to put money into DeFi – a trillion dollars could flood into DeFi if the world’s 100 biggest banks invested. However, for institutional money to come in, we need a trustworthy and efficient fixed interest rate DeFi protocol, which could become the new holy grail of DeFi. We believe that this is Notional.

Additionally, variable rates have progressively decreased over time within these large protocols. This has incentivized yield-seeking users to rotate their tokens onto other DeFi protocols, forcing them to pay (oftentimes high) gas fees. With yields on USDC hovering around 4-6% and 5-7% for different maturities on DAI on Notional, fixed rates don’t have to mean sacrificing yield.

There is no doubt that Compound and Aave are very cyclical platforms. Usage mostly comes from yield farming and leverage, which are naturally collapsing when the market slides. Obviously, Notional’s rates have been decreasing too, but are still 2%-3% higher than Compound and Aave. 

Lending on Notional is straightforward and offers a better rate than a majority of the other fixed-rate protocols. Additionally, because most other fixed-rate DeFi protocols do not also serve borrowers, yields on Notional consistently outperform and stand alone in the DeFi ecosystem. Indeed, Notional offers lenders high fixed rates via the premium paid by borrowers. Yield generation is “organic” because it comes directly from the platform.

Notional: The Fixed Income Market Leader

When Notional launched in early 2020, it was one of the first fixed-rate DeFi apps. Since then more than 20 fixed-rate DeFi protocols have launched. They have generally innovated on liquidity mechanisms and maturity dates, but very few of them have been focused on the borrowing side. The zero-coupon bond model – used by Notional – allows the lender to purchase these bonds at a discount and redeems the assets at the denomination on the maturity date, which makes it equivalent to borrowing at a fixed interest rate. 

Fixed-rate protocols are more complex than variable ones. When an investor wants to get exposure to a fixed rate, another person must guarantee to pay a specific interest rate instead of interacting with a lending pool. To do so, you can rely on the fixed interest paid by the borrower or on the redistribution of interest among the lenders.

By providing yield to lenders from the borrowers on the opposite side of the platform, offering a wide selection of maturity dates, and lowering reinvestment risk (upon maturity, lending positions on Notional auto-convert to earning the variable interest rate) we believe that Notional has built the most thoughtful platform in the space. Beyond the product design, we are also excited by the upcoming Notional applications that we believe are solid catalysts for its adoption.

Catalysts for $NOTE

Levered Vaults

Notional has recently reached $500M in fixed-rate lending and borrowing volume, less than seven months after the V2 launch.

In particular, we are excited to see the team innovating and driving this volume up, notably by working on levered vaults. Today, a large majority of borrowing in DeFi is done to fund DeFi yield strategies: when a user puts down an asset to borrow another asset that is taken over to execute that yield strategy, he is no longer able to use that capital as collateral on the lending protocol. With levered vaults, users will be able to borrow from Notional and deposit that capital into a whitelisted smart contract that executes a specific yield strategy. 

By doing so, the users will earn the return between the returns of the strategy and the fixed borrowing cost on Notional. It will significantly increase the borrowing demand, as well as the interest rates for lenders. We expect the rates to get as close as the rates of return that sophisticated users get executing all these complex strategies that involve selling token incentives. Levered vaults will also increase fees for LPs and NOTE holders.

Composable Fixed Rate Lending

Then, Notional will soon be partnering with The Index Coop to launch the FIXED Suite, a suite of decentralized fixed-rate yield tokens offering high, market-neutral, dollar-denominated yield. This creative model would abstract complexity away from investors who would not have to manage their positions actively. It would also provide a secondary liquid market so that users don’t have to choose between earning yield (and potentially having to pay early withdrawal penalties) and keeping their assets liquid. This suite of products would enable users to get exposure to fixed rates without managing lending positions or paying fees. 

DAO Treasuries

This makes a perfect transition to another point that excites us: we think that Notional could be leveraged to become a privileged solution for DAOs to deploy their treasuries. DAO treasuries could utilize this ERC-20 token to earn high fixed yields on their stablecoins to cover expenses.

With $10.3B locked up in DAO treasuries (17x since June 2021) at the time this piece is being written, Notional has just begun to scratch the surface of an overlooked and massive market.

Top 20 DAO allocates only 7% of its liquid treasuries to earn yields. 6 DAOs even deploy 0% of their treasuries into DeFi protocols. We expect things to change over the next few months.

In early March, one of Angle’s co-founders proposed to invest some of the protocol’s reserves into Notional fixed-rate lending to benefit from higher rates than what AAVE and Compound offer by lending over longer maturities. In his words, “predictable yields allow for better risk-adjusted yields and attractiveness for veANGLE holders and Standard Liquidity Providers.

This was not the first apparition of Notional in the B2B space either. A month earlier, PoolTogether drafted a governance proposal to lend 500K USDC and 480K DAI from their v3 reserves to Notional to increase the yield obtained on treasury assets while keeping a low-risk profile.

The top priority for DAOs is to ensure that they will have sufficient capital to fund their operations over long periods, irrespective of market conditions. As Shreyas from Llama argues, DAOs must maintain an infinite time horizon while managing their treasury – the treasury should be structured to exist in perpetuity.  

Because crypto markets can be detrimental to the survival of DAOs, fixed-income products are the right tool for them to make informed investment decisions and plan the amount of yield they will generate over time. How DAOs spend their assets has become a concern and a key area that needs to be addressed to usher in new developments into the space. By offering maturity dates ranging from three months to 20 years, we believe that Notional is the best-positioned protocol to help DAOs capitalize on DeFi yields and stay afloat amidst tumultuous market conditions.

 Beyond DAOs, Notional has been onboarding a few large lending desks and is planning to expand this institutional user base. Volatile yields offer too much friction and risk for traditional players. 

 At Lattice, we believe that fixed-rate yields are needed for the next wave of adoption and are proud to be supporting Notional in that mission.

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