Why is on-chain fixed-rate lending difficult to gain traction? "Interest rate spread" trading is the way forward

Title: Why fixed-rate lending never took off on-chain

Author: @nicoypei

Source:

Repost: Mars Finance

The demand for fixed interest rates mainly comes from institutional borrowers and cyclic strategy users. In the future, the on-chain lending scale will expand, but at this stage, most on-chain participants highly value the flexibility of “funds can be withdrawn at any time.” Therefore, instead of requiring lenders to accept “fixed terms,” a better approach is to build an interest rate swap layer on top of existing money markets (such as Aave) to meet the needs of fixed-rate lending.

Insights from Traditional Finance: The Fixed-Rate Market Begins with Borrower Demand

In the private debt market, fixed interest rates are mainstream because borrowers need certainty, not because lenders prefer them.

· Borrower perspective (corporations, private equity funds, real estate developers, etc.): Their main concern is cash flow predictability. Fixed interest rates can hedge against rising benchmark rates, simplify budgeting, and reduce refinancing risks. This is especially important for highly leveraged or long-term projects, where interest rate fluctuations can directly threaten their survival.

· Lender perspective: They generally prefer floating rates. Loan pricing is usually “benchmark rate + credit risk premium.” A floating structure can protect profit margins when rates rise, reduce “duration risk,” and earn additional yields when benchmark rates increase. Lenders will only offer fixed rates if they can hedge interest rate risk or charge sufficient premiums.

Thus, fixed-rate products are a response to borrower demand, not the market’s default mode. An important lesson for DeFi is: without clear and sustained demand from borrowers for “interest rate certainty,” fixed-rate lending will struggle to gain liquidity, scale, or sustain development.

Who are the borrowers on Aave / Morpho & Euler? Why do they borrow?

A common misconception is: “Traders borrow from the money market to leverage or short.”

In reality, directional leverage is almost entirely executed through perpetual contracts because of higher capital efficiency. Money markets require over-collateralization and are not suitable for speculative leverage.

However, Aave alone has about $8 billion in stablecoin loans. Who are these borrowers?

They can be broadly divided into two categories:

1. Long-term holders / whales / project treasuries: They collateralize their crypto assets (like ETH) to borrow stablecoins for liquidity, while avoiding selling assets (thus preserving upside potential and avoiding taxable events).

2. Yield cyclic traders: They borrow to recursively leverage yield-bearing assets (such as liquid staking tokens LST/LRT, e.g., stETH; or interest-bearing stablecoins like sUSDe). Their goal is to achieve higher net yields, not to speculate on price movements.

So, does anyone on-chain need fixed interest rates?

Yes. The demand mainly comes from two user groups: institutional-level crypto collateralized loans and cyclic strategies.

1. Institutional crypto collateralized loans require fixed interest rates

Take Maple Finance as an example. It provides over-collateralized loans to institutions, mainly lending stablecoins against blue-chip crypto assets like BTC and ETH. Borrowers include high-net-worth individuals, family offices, hedge funds, etc., seeking cost-predictable fixed-rate funding.

· Rate comparison: The cost of borrowing USDC on Aave is about 3.5% annualized, while fixed-rate loans on Maple with similar collateral yield liquidation returns between 5.3% and 8%. This means that switching from floating to fixed rates requires borrowers to pay a premium of approximately 180-450 basis points.

· Market size: Maple’s Syrup pool alone manages about $2.67 billion, comparable to Aave’s approximately $3.75 billion in outstanding loans on Ethereum mainnet.

It’s worth noting that some borrowers choose Maple to avoid (early DeFi) smart contract risks. But as protocols like Aave prove their security, transparency, and liquidation mechanisms, this perceived risk diminishes. If reliable fixed-rate options emerge on-chain, the premium for fixed-rate loans off-chain is likely to be compressed.

2. Cyclic strategies require fixed interest rates

Despite generating billions of dollars in demand, cyclic strategies often are unprofitable due to volatile borrowing rates.

A stablecoin cyclic borrower said: “As cyclic traders/borrowers, we cannot predict borrowing rates. Rate volatility can suddenly wipe out months of accumulated gains, leading to position losses.”

Historical data also shows that borrowing rates on Aave and Morpho are highly unstable, with annualized volatility exceeding 20%.

For cyclic traders, they earn fixed yields (e.g., via Pendle’s PT), but using floating-rate borrowing to sustain cycles introduces “interest rate risk.” If borrowing rates spike, they can wipe out all profits. If both borrowing rates and investment returns are fixed, capital risk is eliminated. Strategies become easier to evaluate, positions can be held with confidence, and capital can be deployed more efficiently.

With on-chain infrastructure like Pendle’s PT passing over five years of security testing, demand for fixed-rate loans on-chain is growing rapidly.

Since there is demand, why hasn’t the market grown bigger? Let’s look at the supply side issues.

Flexibility is the “priceless treasure” for on-chain participants

Here, flexibility refers to the ability to adjust or exit positions at any time without lock-up periods—lenders can withdraw funds anytime, and borrowers can repay or redeem collateral at will, without penalties.

In contrast, Pendle PT holders sacrifice some flexibility. Even in the largest pools, Pendle’s mechanism cannot allow positions exceeding about $1 million to exit instantly without significant slippage.

So, how much compensation do on-chain lenders forgo by sacrificing flexibility? For Pendle PT, compensation can reach annualized rates of over 10%, and during YT token trading frenzy (e.g., on Arbitrum with usdai), it can exceed 30%.

Clearly, genuine borrowers (non-speculators) cannot afford a 10% fixed rate. This high rate is essentially a “premium” paid for giving up flexibility, which is unsustainable without YT token speculation.

Although PTs carry higher risk than basic lending protocols like Aave (adding protocol and underlying asset risks), the core conclusion remains: any fixed-rate market requiring lenders to give up flexibility cannot scale if borrowers cannot afford the exorbitant rates.

Term Finance and TermMax are examples: few lenders are willing to give up flexibility for a small, meager interest, and borrowers are unwilling to pay 10% when Aave’s rate is 4%.

The solution: don’t let fixed-rate borrowers directly match with fixed-rate lenders

Instead, fixed-rate borrowers should match with rate traders. Specifically:

Step 1: Protect lender experience

Most on-chain capital trusts only the security of Aave, Morpho, Euler, and prefers the simple passive experience of “deposit and earn” on Aave. They are not “seasoned managers” who evaluate every new protocol for a 50-100 basis point premium.

Therefore, for the fixed-rate market to grow, lender experience must be identical to current Aave usage:

· Deposit at any time

· Withdraw at any time

· Almost no additional trust assumptions

· No lock-up periods

Ideally, fixed-rate protocols should be built directly on trusted money markets like Aave, leveraging their security and liquidity.

Step 2: Trade the “interest rate spread,” not “principal”

Borrowers seeking fixed rates do not need another full-term loan. They only need capital willing to bear the “agreed fixed rate” versus “Aave floating rate” spread risk, while the rest of the principal can still be borrowed from Aave or similar.

In other words, traders are exchanging the expected difference between fixed and floating rates, not the entire principal.

A rate swap layer can achieve this:

· Hedgers can exchange fixed payments for floating income that perfectly matches Aave’s floating rate.

· Macro traders can express their views on rate movements with high capital efficiency.

Capital efficiency example: traders only need to post a small margin to bear rate risk, far less than the nominal loan amount. For example, shorting a $10 million, 1-month Aave loan at a fixed rate of 4% annualized might require only about $33,300 in margin—implying 300x implied leverage.

Given that Aave rates fluctuate between roughly 3.5% and 6.5%, this implied leverage allows traders to treat rates as a highly volatile “token” (e.g., from $3.5 to $6.5), with volatility far exceeding mainstream cryptocurrencies, closely correlated with overall market liquidity and prices, while avoiding the risk of liquidation common with explicit leverage (like 40x on BTC).

Go long on rate peaks, go short on rate valleys.

Long-term outlook: Fixed interest rates are essential for on-chain credit expansion

I foresee that as on-chain lending grows, demand for fixed-rate loans will also increase. Borrowers will need more predictable financing costs to support larger, longer-term positions and productive capital deployment.

· Institutional credit expansion: Projects like Cap Protocol are promoting on-chain institutional credit. They help re-pledge protocols provide insurance for institutional-grade credit stablecoins. Currently, rates are determined by utilization curves suited for short-term liquidity, but institutional borrowers value rate certainty. In the future, a dedicated interest rate swap layer will be crucial for supporting “fixed-price” and risk transfer.

· On-chain consumer credit: Projects like 3Jane focus on on-chain consumer credit. This sector is almost entirely fixed-rate loans because consumers need certainty.

In the future, borrowers may enter different segmented rate markets based on credit ratings or collateral types. Unlike traditional finance, on-chain rate markets might allow borrower groups to directly face market-driven rates rather than being locked into a single lender’s set rate.