In 2020 we witnessed the explosive growth of decentralized finance (DeFi). What started as a small, insular movement is slowly reaching the mainstream. The benefits for users are hard to ignore: users are able to seamlessly lend, borrow and exchange tokens within a financial system that is secure, transparent, and globally accessible. According to DuneAnalytics more than 1m unique “users” have interacted with DeFi applications to date. The Total-Value-Locked in DeFi is approaching $17b with no signs of slowing down anytime soon.

While the stars seem well-aligned for DeFi, it is also evident that a couple of financial primitives are still missing before this system can be considered fully mature. One of these primitives is fixed rate financing.

What is fixed term financing and why is it needed?

Until now, most DeFi lending platforms like Compound, Cream, Aave etc. offer variable interest rates for lending and borrowing. Since they work with liquidity pools, the interest rate for every asset is determined algorithmically.

If a lot of lenders deposit assets into the pool and there is little borrowing demand for the asset, the interest rate will be low. If the borrowing demand then increases, the interest rate will automatically surge to incentivise more lenders to supply more of the asset into the pool. As a result, interest rates are changing all the time on a block-by-block basis.

The reasons why fixed interest rates are crucial for DeFi adoption are quite evident. Users who lend their assets want to have certainty. It is simply more desirable to know how much interest you’re going to receive if you deposit your assets for a certain time period. In absence of fixed interest rates, DeFi users have to manually chase the best interest rates themselves, by withdrawing their assets and sending them to a higher-earning lending platform, which is both time and resource expensive.

On the borrowing side, which is mostly composed of large traders, the need for fixed rates is even more urgent. These users borrow assets to pursue lucrative trading strategies. In essence, they borrow assets to put them to productive use and achieve a return on investment (ROI) that is higher than their cost of borrowing. If the cost of borrowing suddenly surges, the whole trade strategy could backfire.

How Notional Finance works

From a user perspective, the process is quite intuitive, especially if you’re already familiar with other DeFi lending platforms. Since Notional is still in beta, the only asset you can borrow is DAI and the maximum amount you can borrow is capped at 997 DAI (these caps will be lifted in the next 2 weeks!)

1. Select a maturity for your loan (3 weeks or 3.5 months)

2. Select the amount you want to borrow

3. Choose how much collateral you want to deposit (min. 140%)

4. Confirm

Like on any other DeFi lending platform, the borrowed amount is paid out automatically to your Ethereum wallet once you have confirmed the loan.

Your loan position is reflected in the Notional dashboard. You can repay your loan at any point or extend it (“Roll”) to a longer maturity date if you wish.

That’s pretty much it. Although the process is intuitive, the result is quite impressive! We were able to get a fixed loan at a 3% interest rate until April of 2021!

One last thing to note: although the interest rate is fixed, this doesn’t mean you’re liberated from having to ensure that your collateral level stays at a healthy level (min. 140%). To that end, you can deposit or withdraw collateral as you see fit in the Portfolio section.

How does Notional Finance work under the hood?

The most important building block of the Notional system are fCash tokens. They are transferable tokens that represent a claim on a positive or negative cash flow at a specific point in the future. Essentially an internal accounting unit to keep track of who is owed what at any given time.

1. Positive fCash balances: are assets that can be redeemed for currency at maturity.

2. Negative fCash balances: are obligations or debt, where the owner has to provide currency at maturity.

These different obligations are tokenized and traded in Notional’s custom AMM implementation. Think Uniswap but using a special liquidity curve that has been designed to minimize slippage when trading fCash tokens. This detail is crucial for Notional, as small changes in the exchange rate can cause large changes in the interest rates.

Every user in the system interacts with Notional’s liquidity pools. Furthermore, each maturity date has its own liquidity pool to ensure that lenders and borrowers have somewhere to buy and sell fCash at a good price. Let’s consider the fDAI pool with a maturity date of December 1 2020.

The Lender

A lender who deposits 100 DAI in notional effectively buys positive 105 fDAI (equity). The 105 fDAI are redeemable for 105 DAI at the maturity date. The exchange rate that the user gets implies a fixed interest rate on the loan between the moment of purchase and Dec1 2020.

The Borrower

A user who borrows 100 DAI at a fixed interest rate, mints negative 105 fDAI (debt) and sells it for 100 DAI. By selling fDAI for currency, he/she receives the DAI up front in exchange for the obligation to repay a fixed amount on December 1 2020. This all happens under the hood in one transaction for the borrower.

The Liquidity Provider

The last missing piece in this system are the liquidity providers. Liquidity providers deposit the currency (in our case DAI) into the liquidity pool and ensure that there is always enough liquidity for lenders and borrowers to exit the system.

Like other AMMs, returns on the Notional AMM are driven to a large extent by trading volume, total liquidity in the pool, and the fees charged on trading. The more trading on a given liquidity pool, the greater the amount of fees accrue to liquidity providers. For more in-depth information on how liquidity providing works check out Notional’s docs.

Conclusion

The ability to provide fixed-rate lending makes the DeFi space more accessible for mainstream users. Fixed rate borrowing on the other hand, will be a relief for institutional investors and traders and make crypto investing more similar to traditional finance.

It will be interesting to see if Notional will be able to attract enough liquidity to bootstrap the system and allow users to lend & borrow large amounts.

Notional is currently getting ready for their full launch and will be running user interviews with the DeFi community over the next week. If you are keen to help Notional, you can sign up for an interview here and earn $20 for your time if selected.