TLDR: Establishing a “risk-free” rate in digital assets is extremely important. However, Bitcoin’s reliance on external variables makes it hard to derive one, while the mechanisms of Ethereum’s Proof-of-Stake makes it a strong candidate to become Ethereum’s “risk-free” rate. 

If you skipped Branching Out 1, now’s your time to read it before coming back here. For those that did, welcome back! 

In this blog, we’ll dive into the concept of “risk-free” rates, one of the most important pillars in traditional finance, and explain why it’s equally important for digital assets to have its own. 

Considering the volatility of digital assets, the idea of “risk-free” might seem paradoxical. Risks are inherent in all aspects of life. However, society has recognized the importance of deriving a theoretical “risk-free” return, evident in its widespread use in financial markets today. 

Despite the dynamic growth in recent years, digital assets still lack universally accepted benchmark rates—”the safest routes,” if you will. Establishing such a benchmark is crucial for the wider adoption of the technology, but what could serve as this “safe road” in the rocky terrain of digital assets? 

The Road Most Taken 

Think of all the possible ways one may take to get from Point A to Point B. There are likely hundreds of routes: some might be slow, some quick, and some that are dangerous. The good news here is that this particular journey is extremely well-traveled, and drivers are well aware that taking highway 3[ree] is the safest and fastest route. 

Using this analogy, the “risk-free” rate is akin to highway 3[ree]. As long as anyone is taking this exact trip, there is no reason to use any other route as it may end up hurting the driver from either a cost (hey, gas fees are expensive) and/or time perspective. 

By definition, the “risk-free” rate is the theoretically safest yield anyone can earn for taking risk in a specific asset, acting almost like a floor for returns. From a risk-reward perspective, no rational person should accept any yield lower than the “risk-free” rate, especially if they partake in risky activities. 

In the USD market, the U.S. Treasury bond (USD borrowings by the U.S. government) is often assumed to be the USD “risk-free” rate. This is because the USD is backed by the full faith and credit of the U.S. government, which happens to own the sole right to print USD. This means that any other non-US Treasury investments involving USD should, in theory, yield at least more than the U.S. Treasury bond. 

With such a clear benchmark in traditional finance, it’s natural to wonder if a similar “risk-free” rate could exist in this rapidly evolving world of ours… 

A Bitcoin “Risk-Free” Rate? 

Ask anyone about digital assets, and the first thing that comes to mind is Bitcoin. So let’s dive deeper and see if there could be a Bitcoin “risk-free” rate. 

On the surface, Bitcoin’s Proof of Work (PoW) mechanism appears to meet crucial criteria for a “risk-free” evaluation: 

1. Systemic Importance: Bitcoin needs PoW to keep it moving. Miners solve complex math puzzles to validate transactions and keep the network safe. Without the PoW, Bitcoin would cease to exist. 

2. Mining Rewards – Rewards are paid out to miners in BTC for conducting their job in PoW. This makes it easy to figure out an associated yield to this particular job. 

However, if we were to look beneath the surface, the yield generation for Bitcoin primarily depends on external variables such as computational power and electricity. Similar to the gold mining industry, where the output of gold relies heavily on labor and machinery costs, this reliance on external factors detracts from the independence criteria needed for a reliable benchmark, exactly why you don’t often hear of a gold “risk-free” rate in traditional markets. 

Well, with Bitcoin being ruled out for the time being, let’s take a stab at Ethereum, the second largest cryptocurrency by market capitalization. 

What About Ethereum? 

Ethereum is a highly advanced computer that anyone across the globe can program. It’s like a decentralized supercomputer running complex transactions and applications autonomously. 

To us, Ethereum also mirrors the structure and function of a democratic government in several compelling ways: 

  • Independent Currencies: Ethereum operates with its gas tokens, much like how sovereign states manage their currencies. These tokens are essential for conducting operations within the Ethereum network, akin to how currencies facilitate economic activity in countries.
  • Governance Mechanisms: Just as citizens in a democratic system participate in governance through voting, Ethereum allows stakeholders to engage in decision-making processes via staking governance tokens. This staking not only influences decisions but also helps secure the network, aligning stakeholders’ interests with the network’s health. 
  • Financial Infrastructure: Ethereum’s structure includes sophisticated financial protocols akin to traditional financial institutions. It hosts decentralized exchanges and money markets, supporting a complex ecosystem of financial transactions and innovations, similar to a country’s financial system managing its economic flows. 

When we compare how Ethereum operates to how democratic governments function, it’s clear there are key similarities that make Ethereum a standout candidate to have its own “risk-free” rate. 

Think of Ethereum as a mini-country that uses staking to decide on important rules and how to manage its digital currency, much like governments use central banks to decide on financial rules and manage the money supply. 

While Ethereum doesn’t directly operate like any specific central bank, such as the U.S. Federal Reserve, the basic idea is the same. Both Ethereum and governments adjust certain rates to control how much currency is floating around: Ethereum makes changes in its protocol influenced by Staker votes, while governments tweak policies through their central banks. 

Conclusion 

Here’s the takeaway for blog 2. Ethereum’s Proof-of-Stake (PoS) yield is a solid pick for an ETH “risk-free” rate. 

Why? Because the rewards from staking Ethereum are predictable, stable, and systemic, much like the returns you expect from super-safe government bonds. Without the ability to stake ETH into PoS, Ethereum would cease to exist! 

To put this into perspective: imagine choosing between lending out your ETH to two friends, one who is a gambling degenerate and the other who is using it to fund his education to get a swanky new job. 

What interest should you charge? With a baseline ETH staking yield of 3.5% a year (nice, a reference we can use!), regardless of where you put your ETH investment, we now know it should be at least 3.5%. If you happen to be a rational investor, you’ll also prioritize lending your friend who wants an education (maybe at 4% a year?). But if you do decide to lend it to your gambling addict friend, make sure you’re charging interest (maybe at 69% a year?) that properly corroborates with the risk of him gambling it all away!

With all this in mind, it’s obvious how “risk-free” rates can be helpful in DeFi, serving as a benchmark to returns. The issue in deriving one, however, is that interest rates are extremely fragmented today. 

In Branching Out 3, we’ll dive into the challenges of fragmented rates and explore Treehouse’s strategy to establish a unified benchmark rate. 

For readers interested in a more advanced reading on fixed income and Treehouse, jump to One Rate to Rule Them All. 

FAQ 

What is a “risk-free” rate in finance? 

The safest theoretical yield for an asset. The “Risk-free” Rate is a crucial metric for investors to price financial instruments, compare returns, calculate the cost of carry, and more. Traditionally, this is often represented by the yield on government bonds, such as the U.S. Treasury bills, which are considered safe due to its government backing. 

Why is it challenging to establish a “risk-free” rate for digital assets? 

Digital assets lack a central authority like a government to back them, making it hard to define a universally accepted “risk-free” benchmark. The decentralized nature of these assets adds to the challenge. 

Why isn’t Bitcoin suitable as a “risk-free” benchmark? 

Bitcoin mining rewards, while predictable in their issuance, require significant investment in hardware and energy. These external factors introduce risk, such that different users may receive different returns, making it hard for parties to agree on a unified benchmark. 

Why can’t Stablecoin lending yields be used as a digital asset “risk-free” rate? 

While theoretically stable, stablecoins carry risks such as potential de-pegging from their target currency value and the variability of lending rates across different platforms, which can fluctuate significantly. Stablecoin are also ultimately backed by their respective monetary policies. 

What does Treehouse propose as a “risk-free” rate? 

Treehouse suggests using Ethereum’s native staking yield as the “risk-free” rate within the Ethereum ecosystem. This is based on its role in supporting network operations and security, similar to how government bonds support national financial health. 

What is Treehouse Protocol’s goal with Ethereum’s “risk-free” rate?

Treehouse aims to establish a standardized “risk-free” rate for Ethereum (as a start) to help create reliable and consistent fixed-income products within the Ethereum ecosystem.