The transparent, composable and deterministic nature of decentralized finance (DeFi) has enabled the creation of complex financial instruments incorporating multiple layers of yields wrapped up into pegged assets.
A pegged asset, is when one asset attempts to be closely tied to the price of a highly liquid base asset, through a combination of mechanisms. A pegged asset can be viewed a bit like a new form of bond. Take for example Ethena’s USDe:
The user in effect, has a claim to 1 dollar and receives a continuous stream of payments. In many ways, this is very similar to a bond, which is why Ethena brands itself as the “internet bond”.
Pegged assets are perhaps the most successful use case of DeFi. Stablecoins and liquid staking tokens which are the biggest pegged assets, have a market cap of over 190b$ and is growing rapidly. USDC is a simple example of a relatively safe pegged asset, however, in pursuit of additional yields there is a plethora of new assets that take the concept of further to generate higher yields and censorship resistance.
Take for example Liquid Restaking Tokens built on-top of Eigenlayer, that have in the past three months gobbled up approximately 2.5m Eth (~8b$). These are a form of Eth denominated bond with multiple layers of risks.
Both yield bearing pegged assets, as well as literal bonds, are increasingly gaining traction on-chain. In the future, it is likely a big part of bond markets will settle on-chain.
Sometimes new and speculative pegged assets spectacularly fail, such as Terra Luna that resulted in 40b$ in investor losses. Even assets like DAI, USDC and stEth have all at times faced major depegs, though they eventually recovered. Many investors would like to take part of the yields offered by on-chain “bonds”, but are not comfortable with the depegging risks that come with this yield.
From a market structure perspective, when there is significant outflows from pegged assets, there is a high likelihood of a depegging event. In traditional finance central bank swap lines are deployed to buffer liquidity shocks and within fixed income markets investors can leverage an important piece of bond market infrastructure: Credit Default Swap. These swaps enable investors to gain access to bonds, without taking on default risks. However, in crypto there is a gap in the need for liquidity facilities and credit default swap type instrument to hedge against depegging event. This limits institutional adoption of on-chain yield bearing assets and imposes meaningful limitations on how such assets can be used as collateral in DeFi.
Depeg Swaps are a new form of primitive allowing market participants to buy a guarantee that a pegged asset can be exchanged 1:1 for a base asset. As a result, a pegged asset with a depeg swap, inherits the security and liquidity of the base asset. The design of the protocol allows for any pegged asset to create a depeg swap, that can either be used to hedge exposure or speculate on a depeg event. The primitive adds an additional liquidity buffer and creates a new market to price depegging risks. Depeg swaps will help grow on-chain “bond” markets, by inviting new more risk averse capital to take part of yields, as well as create completely new forms of lending and leverage opportunities for pegged assets.
The protocol works as outlined below: