In the simplest terms, a yield curve is a chart of what fixed rates you can get from a given asset at multiple “maturities” (between now and multiple different dates in the future). If you have an asset that presents a claim to a fixed amount of some currency or cryptocurrency in the future, then the difference between the amount you pay for that asset now and the amount you will get at that future point implies a “fixed rate”: if I can buy a claim to 1.10 ETH 1 year from now for 1 ETH today, that means that I can get a 10% fixed rate on ETH. That “1 year from now” date is a “maturity”. If there are also assets to get claims to fixed amounts of ETH 2 years from now, 3 years from now, etc., then I can make a “Yield Curve” of the various annualized fixed rates I can get for those maturities (this gets slightly more complicated with bonds that offer coupons, but this is the simplest case and the principles are the same).
Yield curves exist for any fixed rate assets with multiple maturities. But, when people refer to “the” yield curve for a given currency, they usually refer to the fixed rates that can be collected by lending to the issuer of that currency. For example, most Americans refer to the rates offered by US government bonds as “the yield curve.” What is special about US government bonds? They are the rate you can collect by lending to the issuer of the currency, which makes them usually the least risky rate: lending to the institution that prints a currency generally carries less risk than someone else who cannot print it. This makes this yield curve special for a number of reasons:
With Ethereum staking, we get an important ingredient for creating a yield curve: yield offered by the issuer of a currency (the network) for parking capital (staking). A yield curve built on top of that could be used to price the return you can get with the least default risk - kind of like a government yield curve described above.
What we don’t have in the Ethereum network is 1 year, 2 year, 10 year, etc. bonds. Staking rates will vary in every 12 second block! This is where Sense comes in. To create these fixed rates, the Sense protocol provides decentralized infrastructure (smart contracts) that do “yield stripping“ on top of staked ether (wstETH). One reason for using this method is that there is no new debt created: the smart contract holds the wstETH to fully back the fixed rate holder’s future payment, and a market for future yield determines that rate. Because we think this is an important piece of market infrastructure for DeFi, the smart contract collects no issuance fee: it is free public infrastructure.
This, of course, is not a perfect proxy, but we think it is the best one possible. There is smart contract risk from the Sense contracts, there is smart contract risk from Lido, and since wstETH is a vault of stETH, there is risk that the stETH will not be exactly a 1-1 conversion for the ETH at all times. We will, in the future, add many more yield curves on top of many more assets, including more liquid staked ETH claims. Perfection is impossible: even holding bonds in your bank is not a perfect proxy for exposure to the US government yield curve (the bank presents its own counterparty risk), and yield curves aren’t exactly ever solely pricing in future “risk free rate” (at the very least there exists logical premiums for thinks like duration risk). But that makes the best market proxy for that no less important.