Why do DeFi users reject fixed Interest Rates?

null

The original text is from Prince

Compiled | Odaily Planet Daily Golem (@web 3_golem)

The failure of fixed-rate lending in the crypto space is not solely because DeFi users reject it. Another reason for its failure is that DeFi protocols adopted money market assumptions when designing credit products, and then deployed them into a liquidity-driven ecosystem; the mismatch between user assumptions and actual capital behavior has kept fixed-rate lending in a niche market.

Fixed-rate products are unpopular in the cryptocurrency space.

Today, almost all mainstream lending protocols are building fixed-rate products, largely driven by RWA. This trend is understandable, as fixed terms and predictable payment methods become crucial when credit is closer to the real world. In this context, fixed-rate lending seems to be the inevitable choice.

Borrowers crave certainty: fixed payment methods, known terms, and no unexpected repricing. If DeFi is to operate like real finance, then fixed-rate lending should play a central role.

However, each cycle is exactly the opposite. The floating rate currency market is huge, while the fixed rate market remains sluggish. Most “fixed” products ultimately perform like those niche bonds held to maturity.

This is not a coincidence; it reflects the composition of market participants and the way these markets are designed.

TradFi has a credit market, while DeFi relies on the money market.

Fixed-rate loans are effective in the traditional financial system because this system is built around time. The yield curve anchors prices, and changes in benchmark interest rates are relatively slow. Some institutions have clear responsibilities to hold duration, manage mismatches, and maintain solvency during one-way flows of funds.

Banks issue long-term loans (mortgages are the most obvious example) and fund them with liabilities that do not belong to “profit-seeking capital.” When interest rates change, they do not need to immediately liquidate assets. Duration management is achieved through balance sheet construction, hedging, securitization, and a specialized deep intermediary layer used for risk sharing.

The key is not the existence of fixed-rate loans, but that there will always be someone to absorb the mismatch when the terms of the borrowing parties do not align perfectly.

DeFi has never built such a system.

DeFi is more like an on-demand money market. The expectations of most fund providers are simple: to earn returns on idle funds while maintaining liquidity. This preference quietly determines which products can scale.

When the behavior of borrowers resembles cash management, the market will settle around products that feel like cash rather than those that feel like credit.

How do DeFi lenders understand the meaning of “borrowing”?

The most important distinction lies not in fixed rates versus floating rates, but in the withdrawal commitment.

In floating rate liquidity pools like Aave, providers receive a token that essentially represents a liquidity inventory. They can withdraw funds at any time, rotate their capital when better investment opportunities arise, and typically use their positions as collateral for other purposes. This option itself is a product.

Lenders accept a slightly lower yield for this. But they are not foolish; they are paying for liquidity, combinability, and the ability to reprice without additional costs.

Using a fixed interest rate would disrupt this relationship. To obtain a duration premium, lenders must give up flexibility and accept that their funds will be locked for a period of time. This trade-off is sometimes reasonable, but only if the compensation is also reasonable. In practice, the compensation offered by most fixed-rate schemes is insufficient to offset the loss of optionality.

Why do highly liquid collateral assets pull interest rates towards floating rates?

Nowadays, most large-scale cryptocurrency lending is not traditional credit in the conventional sense. They are essentially margin and repurchase lending supported by highly liquid collateral, and such markets naturally adopt floating interest rates.

In the traditional financial sector, repurchase and secured financing will also continue to be repriced. Collateral has liquidity, and risk is priced at market value. Both parties expect this relationship to adjust at any time, and the same goes for cryptocurrency lending.

This also explains a problem that lenders often overlook.

In order to obtain liquidity, lenders have effectively accepted economic benefits that are far below what the nominal interest rate implies.

On the Aave platform, there is a significant interest rate spread between the amount paid by borrowers and the returns received by lenders. Part of this is due to protocol fees, but a large portion is because account utilization must be kept below a certain level to ensure smooth withdrawals under pressure.

Aave One-Year Supply and Demand Comparison

This interest rate spread is reflected in the decrease in yield, which is the cost that lenders pay to ensure smooth withdrawals.

Therefore, when a fixed-rate product appears and locks in funds at a moderate premium, it is not competing with a neutral benchmark product, but rather with a product that deliberately lowers yields while being highly liquid and secure.

Winning is far more than just offering a slightly higher annual interest rate.

Why do borrowers still tolerate floating interest rate markets?

Generally speaking, borrowers prefer certainty, but most on-chain lending is not like a home mortgage. It involves leverage, basis trading, avoiding liquidation, collateral looping, and tactical balance sheet management.

As @SilvioBusonero demonstrated in his analysis of Aave borrowers, most on-chain debt relies on revolving loans and basis strategies rather than long-term financing.

These borrowers do not want to pay high premiums for long-term loans because they do not intend to hold them for a long time. They hope to lock in interest rates when it's convenient and refinance when it's not. If the interest rates are favorable to them, they will continue to hold. If problems arise, they will quickly close their positions.

As a result, there will ultimately be a market where lenders require a premium to secure funds, but borrowers are unwilling to pay this fee.

This is why the fixed rate market continues to evolve into a one-sided market.

The fixed interest rate market is a one-sided market problem.

The failure of fixed interest rates in the crypto space is often attributed to the implementation level. Comparisons between auction mechanisms and AMMs (Automated Market Makers), comparisons between rounds and liquidity pools, better yield curves, better user experiences, etc.

People have tried many different mechanisms. Term Finance conducts auctions, Notional has built clear term tools, Yield has attempted a term-based automatic position-building mechanism (AMM), and Aave has even tried to simulate fixed-rate lending in a pool system.

The designs are different, but the outcomes lead to the same conclusion; the deeper issue lies in the underlying thought patterns.

The debate ultimately shifted to market structure. Some argue that most fixed-rate agreements attempt to make credit feel like a variant of the money market. They retain funding pools, passive deposits, and liquidity commitments, while merely changing the way interest rates are quoted. At first glance, this makes fixed rates more readily accepted, but it also forces credit to inherit the constraints of the money market.

A fixed interest rate is not just a different type of interest rate; it is a different product.

At the same time, the claim that these products are designed for future user groups is only partially correct. People expect that institutions, long-term savers, and credit-native borrowers will flood in and become the pillars of these markets. However, the actual inflow of funds resembles more of active capital.

Institutional investors appear as asset allocators, strategists, and traders; long-term savers have never reached a meaningful scale; there are indeed native credit borrowers, but borrowers are not the anchors of the lending market; it is the lenders who are.

Therefore, the limiting factors have never been purely a distribution issue, but rather the result of the interaction between capital behavior and flawed market structures.

In order for the fixed interest rate mechanism to operate on a large scale, one of the following conditions must be met:

The lender is willing to accept the funds being locked.

There is a deep secondary market where lenders can exit at reasonable prices.

Some are hoarding long-term funds, allowing lenders to pretend to have liquidity.

Most DeFi lenders reject the first condition, the secondary market for periodic risks remains weak, and the third condition quietly reshapes the balance sheet, which is exactly what most protocols are trying to avoid.

This is why fixed interest rate mechanisms are always cornered, barely able to exist, yet can never become the default storage place for funds.

The division of deadlines leads to fragmented liquidity, and the secondary market remains weak.

Fixed-rate products create a division of terms, and the division of terms leads to liquidity dispersion.

Each expiration date corresponds to different financial instruments, and the risks vary as well. A bond maturing next week is completely different from a bond maturing three months later. If the lender wants to exit early, they need someone to buy that bond at that specific point in time.

This means either:

There are multiple independent funding pools (one for each maturity date).

There is a real order book with real market makers quoting across the yield curve.

DeFi has yet to provide a durable version of a second solution for the credit sector, at least not on a large scale at this time.

What we see is a familiar phenomenon: liquidity deteriorates and price shocks increase. “Early exit” has turned into “you can exit, but you have to accept a discount,” and sometimes this discount can swallow a large part of the expected returns for lenders.

Once the lender experiences this situation, the position no longer resembles a deposit, but instead becomes an asset that needs to be managed. After that, most of the funds will quietly flow out.

A specific comparison: Aave vs Term Finance

Let's take a look at the actual flow of funds.

Aave operates on a large scale, with lending amounts reaching tens of billions of dollars, while Term Finance is well-designed and fully meets the needs of fixed-rate supporters, but its scale is still quite small compared to money markets. This gap is not due to brand effect, but reflects the actual preferences of lenders.

On the Ethereum Aave v3 platform, USDC providers can earn an annual yield of about 3% while maintaining instant liquidity and highly composable positions. Borrowers pay an interest rate of about 5% during the same period.

In comparison, Term Finance typically completes 4-week fixed-rate USDC auctions at mid-single-digit interest rates, sometimes even higher, depending on the collateral and conditions. This seems better on the surface.

But the key is from the lender's perspective.

If you are a lender considering the following two options:

A yield of approximately 3.5%, similar to cash (withdraw anytime, rotate anytime, can use positions for other purposes);

An approximate yield of 5%, similar to bonds (held to maturity, unless someone takes over, liquidity is limited upon exit).

Comparison of Aave and Term Finance Annual Yield (APY)

Many DeFi lenders choose the former, even though the latter is higher in value. This is because numbers do not represent all the gains; total gains include option gains.

The fixed-rate market requires DeFi lenders to become bond buyers, while in this ecosystem, most capital has been trained to be profit-driven liquidity providers.

This preference explains why liquidity is concentrated in specific areas. Once liquidity is insufficient, borrowers will immediately feel the impact of decreased execution efficiency and limited financing capacity, leading them to reselect floating rates.

Why fixed rates may never become the default option for cryptocurrencies

Fixed interest rates can exist, and they can even be healthy.

But it will not become the default place for DeFi lenders to deposit funds, at least not before the fundamentals of lending change.

As long as the majority of lenders expect to obtain par liquidity, value composability is prioritized as much as yield, and there is a preference for positions that can automatically adjust, fixed rates remain structurally disadvantaged.

The reason floating rate markets prevail is that they align with the actual behavior of participants. They are money markets provided for liquidity, rather than credit markets for long-term assets.

What needs to be changed for fixed rate products?

If a fixed interest rate is to take effect, it must be viewed as credit rather than disguised as a savings account.

Early exits must be priced, not just committed; the term risk must also be clear; when the direction of fund flows is inconsistent, someone must be willing to take on the liability of the other party.

The most feasible solution is a hybrid model. A floating rate serves as the foundational layer for capital storage, while a fixed rate acts as an optional tool for those who clearly wish to buy and sell duration products.

A more realistic solution is not to forcibly introduce fixed interest rates into the money market, but to maintain the flexibility of liquidity while providing a way for those seeking certainty to opt in.