Interest Rate Swaps (IRS)

This article will delve into the reasons as to why TradFi first started using IRS’s and its place in DeFi. Derivatives are assets which accrue interest from underlying assets. Types of derivatives include: interest rate swaps, futures and options. To understand IRS in DeFi, we have to understand them in TradFi, where they were first introduced and the criticism it faces. IRS entails an exchange of one stream of income for another. From this, it is possible to identify current protocols, which provide varying streams of income and understand the impact from exchanging streams of income. By the end of the article, we hope to highlight the importance of IRS’s in the current DeFi puzzle.

TradFi: what’s IRS and history

Interest Rate Swaps are a derivative used in TradFi to hedge against large inflows of funds. They were first introduced as a currency swap between two large institutions. Around the 1980s the World Bank wanted to borrow (repay debt) in German marks and Swiss francs, however had reached the borrowing limit with European Banks. Whereas at the time IBM had debt which was in marks and francs, to the European Banks. Thus, the World Bank borrowed from the Federal Reserve (US) in dollars, and swapped that debt with IBM. Both parties got to repay their debts in preferred currencies, and got away from currency exchange slippage as well as different interest rates on the debt. Their popularity grew further because it’s a hedging mechanism for large capital over a long period of time.

— how is IRS unique to other financial products (mean reversion)

Difference in IRS products in comparison to other financial products, like stocks, is that it swaps interest rates. Economic theory strongly suggests that interest rates are mean reverting, meaning they may diverge in the short run, but revert back to the mean in the long run.

“according to economic theory it is plausible that interest rates are mean reverting, i.e. they revert to a long-term equilibrium level as time goes by”

Thus, interest rates can be swapped between parties over given periods of time, with less risk exposure. Depending on the party, their risk and reward preference, they may either hedge by fixing their rates or use leverage on variable rates. At the end it comes down to how well parties predict/calculate the average rate until maturity.

Moreover, the rate is controlled by SONIA, a bunch of people decide what rate should banks be borrowing at. The fixed rate to be traded at is set by SONIA, who use banks past borrowing rates to determine the present, which makes it better than the previous practice of using LIBOR.

— use cases

As mentioned above, interest rates are a good hedging tool, since they have a mean reverting property. However, to give a better view we will show a use case of IRS in TradFi. For example a company which provides mortgages, receives its monthly payments from borrowers as a fixed payment. On the other side, a bank is lending money to borrowers in return for variable rate repayments. These variable rates are set up as: premium + LIBOR rate = variable rate, as of now the LIBOR is changed to SONIA. Let’s assume the mortgage company has enough cash already, and wishes to speculate on the LIBOR rate, and assumes it will go up. This is when the bank could swap with the company for the fixed inflows and give its payback inflows to the company. Thus, both parties are exposed to the preferred derivative.

— critiques in TradFi

TradFi’s IRS product has flaws, some of the most notable are that third parties are involved in numerous occasions which create vulnerabilities. In the case of IRS’s the entire process is over the counter, meaning the deal has to be witnessed by a financial institution. The financial institution also has the platform to connect parties who seek an IRS deal, thus making them monopolistic market makers. There are also other parties such as risk assessors and inter-bank rate setters, who control the information based on which the swap parties need to make a decision about the swap. Risk assessors and financial institutions in TradFi are necessary to prevent counter party risk.

However, apart from third parties, IRS deals in TradFi only include two parties, meaning their liquidity is limited to the two parties involved. This leads to risks such as funding risk, default risk and collateral risk.

There is, also inherent risks to IRS such as having capital risk, when the underlying asset which accrues the interest losses value, and interest rate risk, when the Fixed Taker losses due to higher variable rates or vice versa for Variable Taker. Thus, some risks of IRS are inherent, but others arise due to third parties involvement and lack of liquidity providers.

DeFi: Why we need IRS in DeFi

Interest Rate Swaps are imperative for DeFi in order to succeed, it will be the instrument for risk management. As of now we have many protocols which utilise diverse strategies to accrue the different yield consequently variable interest rates. However, if the rates can be swapped between parties, it creates a new tool for both speculation and stability to coexist. Moreover, given the critiques of IRS’s having too many intermediaries, DeFi is the perfect solution!

— current key protocols and uses of interest rates

Currently there are a few key infrastructure changing protocols, from which are AAVE, Uniswap, Curve, Maker and Balancer. All these protocols have a common pattern, in that they have all led to a lot of new protocols being built through their innovation. They all have established themselves at the bedrock of DeFi. However, I would like to make a case on how a protocol which truly brings IRS into DeFi will also become a bedrock protocol. All of the protocols listed above also use interest rates, variable interest rates in terms of yield. As the DeFi ecosystem is expanding and accumulating more value, there are all these variable rates all over protocols however there is no further use to them. With a swap this interest rate could be used to either hedge or speculate on, which creates a whole new dimension of use cases in DeFi.

— how is IRS going to boost DeFi

Yield from protocols comes in numerous ways, such as the natural demand for borrowing, exchanging risk, fees and equity growth. For all of these methods it makes sense to accrue yield in terms of variable rates, since unless you are exchanging risks, then your yields depend on the market's performance.

One of the best strategies to earn in DeFi is through ‘yield farming’, whereby you find high yield opportunities and switch between positions. Thus, acquiring high returns, however this method makes all yield bearing protocols risky. With risk-free derivatives users save from constant position switching, clear rewards at maturity and more sustainable rates can be made. Assuming the average unaware yield farmers start using the risk-free rates they can fix their returns, and the more experienced and risk taking yield farmers can trade against the rate with leverage. Thus, the introduction of this instrument will open new strategies for the DeFi ecosystem, whereby users will have access to risk-free derivatives as well as enhanced leverage trading for rates.

Introduction of risk-free derivatives means that the users fix their inflows through a risk-free fixed rate. Unlike the Anchors fixed 20% yield and its current UST depeg, the IRS instrument can deliver on its rate since there are variable rate traders on the other side speculating and using leverage*.* Given that currently large capital in DeFi is locked to accumulate yield, in variable terms, the IRS will allow them to trade the accumulating yield, either by fixing returns or betting on the yield with leverage. Thus, creating an ecosystem for DeFi to further expand into.

— Voltz

Voltz Labs has built an Interest Rate Swap Protocol, which is extremely capital efficient and can facilitate large swaps. Even having a protocol which facilitates IRS on blockchain is revolutionary, since it means no intermediary third party is involved, the assets (tokens) are locked and the rewards are released by the smart contract. To make it better Voltz has a few innovations which make it the perfect product to introduce IRS, the Margin Engine, VAMM and Liquidity Recycling. Margin Engine calculates the leverage and risks, VAMM uses concentrated liquidity from Uni V3 for price discovery and the Liquidity Recycling allows for the providers margin liquidity to be recycled (compounding). You can check the code, docs and try their testnet.

— critiques in DeFi

The biggest critiques for IRS in DeFi provided by Voltz are that we do not know how new yield bearing tokens will be added to the protocol, further liquidity fragmentation and lack of battle testing. Addition of new yield bearing tokens will be vital, given the amount of tokens and protocols in DeFi which accrue yield is immense, thus there will be many times when new tokens need to be introduced. The question is will this be governed by the Labs or DAO, or could they automate it such that any yield bearing token pool can be created. However, key will be to decentralise and deregulate more.

Second there is liquidity fragmentation, the pools are divided between different maturities, but have the same underlying. If the protocol can create a single pool for the same underlying tokens with different maturity dates, in a capital efficient manner, then another 0 to 1 innovation will be made. Lastly, a common issue for new primitives is the lack of battle testing. One of the most famous examples in DeFi is OlympusDAO, even though the protocol is very innovative, the unaware market began forks and its forks have become “ponzi” schemes. However, we do not know what kind of battle issues Voltz will face, thus we patiently wait and see.

Conclusion

In conclusion, the natural growth for DeFi seems to include a path through IRS, given how significant they are in TradFi and how much they are improved upon in DeFi. The majority of inherent TradFi hindrances are removed through a trustless system, however there is still room for IRS to be improved in DeFi. As of now, the Voltz Protocol allows for extremely capital efficient means to swap interest rates, such that you have some mind boggling leverage numbers. Once a market of players begins speculating on the interest rates, through protocols like Voltz, we will see a new primitive take place. Could be s00n …

— build on Voltz

From the above we can deduce that the IRS instrument provided by Voltz Labs will bring a lot of new opportunities to the space, however those opportunities are already available. There are numerous things you can already build on Voltz, such as Fixed Rate protocol or Max Leverage strategies, given how little people know of Interest Rate Swaps (for now) you have the first mover advantage. Great article with more in-depth explanations and examples is provided by Voltz Labs here: https://medium.com/@artur_79066/12-things-you-can-build-on-voltz-protocol-6b0fc9faf47c.

Let’s look at the DeFi ecosystem and why we need an IRS product. Over the years, crypto space has grown exponentially, as the result of revolutionary protocols created by great minds. Protocols such as Maker, Compound, Aave, Uniswap, Curve (and many others) allowed DeFi to provide TradFi services in a decentralised and efficient manner, to be utilised in the open ecosystem of DeFi. However, as the space continues to grow, we see that not every user is a degen. For example, the recent rise of protocols such as Anchor that offer 20% APY in stable interest shows that, just like in TradFi,  DeFi has risk-averse users too. In addition, there is a growing need for new innovative instruments in DeFi, since the current protocols, such as the ones listed above, are already in full use.

The introduction of IRS instruments into DeFi has the potential to boost the current ecosystem, because there would be more use cases for the many interest-bearing tokens currently in circulation. As of now, there are many protocols, such as  Yearn, Aave, Lido, Compound and many others, that  offer variable interest. IRS would essentially allow greater flexibility for all users of interest-bearing tokens, because it would introduce new ways to speculate on the interest they currently receive. Thus I expect an increase in usage of interest-bearing protocols and new use cases, once there is a viable  IRS protocol in DeFi.

There aren’t many IRS protocols at present. The very few that I managed to find are: Voltz, Tempus, Swivel, Element Fi, Strips and Pendle. Almost all of them are very new to the market and have the above-mentioned potential to boost the DeFi ecosystem. This current infancy of IRS protocols in DeFi means that there is no one ‘correct’ way to build an IRS protocol. Therefore, we will delve into each one of them and look at their differences and possibilities.

Tempus:

How does it  work?

Tempus is a Fixed income protocol that follows the idea of splitting tokens. The idea is that interest-bearing tokens garner value through the interest that’s being accrued on the underlying asset and that the underlying assets value is also changing. Thus by splitting them, the single asset is turned into the Capital and Yield Tokens. The tokens then form a Tempus Pool that is dependent on underlying token and maturity date, and is connected to the Tempus AMM. The AMM and Pool allows the trade of Capital and Yield tokens against each other, and this in return makes Tempus more capital efficient as only the Capital and Yield tokens are required. The AMM is made up of Uniswap (x*y=k), Curve’s stable swap type AMM and the Balancer’s v2 Stable Pools. Overall, the AMM used by Tempus makes them twice (2x) more capital efficient than protocols like Pendle and Element Finance.

What does it mean for the user?

By trading your tokens through the TempusAMM you can fix your returns by acquiring Capital tokens with your Yield tokens. The AMM has a flat fee, therefore all LPs will be able to boost their rewards through fees. One of the useful things I found on Tempus was the flexibility to deposit and to redeem. This means that I can deposit the underlying token (of the interest bearing protocol) and can redeem either the backing or the yield token. For example, rather than providing stETH from Lido, I can directly provide ETH to Tempus and it gives me the same fixed APR.

Swivel:

How does it work?

Swivel also splits the tokens into Zero Coupon tokens (zcToken) and nToken. As is the case with Tempus,  zcTokens represent the underlying and nToken represents the accruing interest. zcTokens and nTokens have an inverse relationship. That is because zcTokens are only redeemable for their value at maturity, meaning they will be traded at a discount before the maturity. On the other side, nTokens are depreciating in value, because their interest is only accrued until maturity and interest (yield) rewards can be redeemed at any time. Thus, at maturity, there will be no more interest accrued by the token, therefore the nToken loses its value. In order to swap zcTokens for nTokens, Swivel created their own off-chain Orderbook, which serves as a  market maker for their tokens. One of the hindrances for the Orderbook system is the need for high transaction volume in order to reduce the spread.

What does it mean for the user?

Swivel allows users to trade interest bearing tokens through their protocol, which splits the token and allows the users to trade it through the Orderbook. This means that clients can either increase their exposure to variable rates or fix their returns by selling the nTokens in return for zcTokens, which have the underlying assets value at maturity.

Element Finance:

How does it work?

Element Finance also splits their tokens into Principal (PT) and Yield (YT) Tokens. Then, a “Pool” is established based on the underlying interest token, PT or YT and maturity date. This allows for creation of a secondary market. The AMM used by Element Finance is that of the Balancer protocol, meaning that all Pools actually run on Balancer. The AMM creates 2 pools within Balancer for the underlying asset with either PT or YT, the pools can be used for trades. If YT and PT are minted through Yearn Dai, you would then need the underlying (Dai) and either the YT or PT in order to then add liquidity.

Regarding the Principal and Yield Tokens after maturity date, the YT will lose its value at maturity date as it is no longer accruing interest. On the other hand, the PT will gain its full value and can be used as underlying again in a new pool with new maturity date or redeemed for the underlying asset.

What does it mean for the user?

The protocol can be used to fix your returns by acquiring the PT in return for your YT. You could also use the underlying asset to acquire discounted PT, that can then be redeemed at maturity. This way you can fix your returns with Element, whilst only using the underlying and not interacting with the interest-bearing token. The PT or YT can also be sold anytime through the app’s Dashboard.

Pendle:

How does it work?

Pendle is similar to the abovementioned protocols in that it also splits the interest tokens into Ownership and Yield Tokens. The protocol creates a new pool for each of the different Ownership and Yield tokens with different maturity dates and the tokens are then pooled against a stablecoin (USDC). Given YT is depreciating, the pool made up of YT-[stablecoin] would also be irrelevant after maturity (full depreciation). Thus , at the expiry of the pool, Pendle will chain the expired pool to the new pool (value of YT would be zero after expiry), .

Given the decaying nature of YT, the protocol made their own AMM which includes time as a factor. At the start of the Pool, the AMM will follow the standard formula of Uniswap v2 (x*y=k), but, as time passes, the curve will ease into a horizontal line. The AMM is a constant product function with a time-varying amplification parameter. This means  that, as time passes, parameters’ proportions change. The value of YT will be zero at expiry date, as there are no more rewards to claim/accrue.

What does it mean for the user?

Pendle creates pools with USDC and YT/OT, which allows the user to redeem USDC for their LP or swap for USDC. You can also trade using USDC in Pendle Pools, thus you can open positions in different yield bearing protocols directly through Pendle.

Strips:

How does it  work?

Unlike the other abovementioned protocols, Strips operates on an L2 (Arbitrum). The protocol also identifies itself as a perpetual IRS, meaning that interest is constantly accruing with no expiry date. Rather than split the yield bearing token, Strips lets you choose a long or short position on the interest you are receiving. For example, if you are currently receiving 5% APY, but you want to speculate that it will go even higher, then you would go long and vice versa.

Here, one of the interesting differentiations is the introduction of leverage. Strips allow users to have up to 10x leverage.  Positions are on  the Strips AMM and have an Insurance Fund for risks against losses when the users don’t have enough of the collateral. In order to enter a position the user needs to provide LP tokens as collateral. However, an issue is that the Insurance Fund may run dry in the worst case scenario, leading to all positions being auto-closed and flattened against the AMM. Insurance Fund grows from the following transactions: 5% of all realised profits of all market AMMs, 5% of all trading fees and the Liquidation profits. 

At present, the calculations of the Insurance Fund and AMM are not available.

What does it mean for the user?

The protocol lets traders use leverage in their speculation against the interest bearing token using USDC, therefore users can directly use USDC to open Long/Short positions on interest tokens. You could also provide liquidity to their different pools of interest bearing protocols, such as Insurance Fund (STRP-USDC) and AAVE-USDC lending. All in all, Strips looks more like an instrument for traders rather than your ‘Average Joe’ who wants to fix their interest rate.

Voltz:

How does it  work?

Voltz is a newIRS protocol offering innovation on multiple levels. First and foremost, rather than a simple AMM, Voltz decided to go with splitting it into two. These are a vAMM that is used for price discovery and the Margin Engine that is used  for calculations.

There are 3 novel concepts being introduced by the protocol: the Virtual AMM (vAMM), Margin Engine and Liquidity Recycling. The vAMM works based on Uniswap v3, meaning that there is concentrated liquidity and thus meaning that whenever the price of fixed tokens or variable tokens goes out of range the LP won’t support those trades.

Margin Engine ensures that the protocol is collateralised, which in turn allows for the use of leverage . In order to calculate the minimum required collateral, the engine calculates using the worst case scenario for a given pool. The engine looks at it as follows, assuming the variable rate drops to 0, the fixed taker (FT) is still getting paid a fixed amount. However, to cover the fixed amount paid out to FTs the Margin Engine will use collateral from the protocol to cover FTs until maturity. 

All of the users must provide margin in order to trade or lp on Voltz. As a further caution, the engine also calculates the minimum margin required, this ensures the protocol has a cap on the amount of leverage. By combining all of the above, the engine caps the leverage FTs and VTs can take.

Voltz introduces the concept of Liquidity Recycling for providing liquidity. Liquidity Recycling implies Fixed and Variable swaps cover themselves without utilising  the liquidity from the pool. Given that Voltz IRS pools are made of single underlying assets, this allows users to provide liquidity through a single asset, which in turn means that users are not exposed to Impermanent Loss.

Keeping the above in mind,  Voltz really does appear to be 3,000x more capital efficient than other models.

What does it mean for the user?

The idea is that the protocol will let users either fix their returns or give them the opportunity to trade with 10-15x leverage. Therefore, both the risk-averse and the true ‘degens’ can utilise the protocol. You could also provide liquidity within custom ranges, and thus get paid fees if users are trading within your range.

“Voltz Use Cases” : https://medium.com/voltz/voltz-use-cases-tl-dr-96140759be29

Conclusion

Overall, the DeFi space is expanding and as we introduce more of the TradFi instruments to it in an efficient manner, the more of the TradFi market share we can eat up and see more TradFi players join the DeFi revolution. The interdependent nature of DeFi means that the introduction of IRS protocols will give more use cases to many other protocols. As of now, there is no one established way to do interest swaps and there is also a lack of choice in which interest assets can be used in the abovementioned protocols. The fact that all of these protocols have different approaches (such as the use of Orderbook, vAMM x Margin Engine, adjusted AMMs and even liquidity provision) means that innovation is happening. The complexity of IRS assets makes this instrument harder to establish, but innovation is hard.

The abovementioned protocols are all tackling the subject in their own way, which means that we can expect some interesting growth in the entire space.

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Acknowledgement: Thank you @catch-22.eth (Goodwoolsociety) for helping!

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Lets be very basic, an AMM essentially manages the inflow and outflow for the pool of assets, in order to make sure we can all trade with the pool (remember x*y=k). In case of Voltz, the AMM is divided into 2 parts the Virtual AMM (vAMM) and the Margin Engine.

Interesting note

The vAMM is used for price discovery only, this means we decide on the price through the VAMM, however the execution is completed on the Margin Engine. This is how Voltz can achieve the insane 3000x efficiency and flexibility.

Now let’s check Interest Rate Swaps, I will try explain why we need them in DeFi. One of the biggest pillars of TradFi is that it can give us fixed interest rates on borrowing or depositing, which allows us to plan and predict our money supply. However, that is not quite possible in DeFi, this is where Voltz comes in and gives the opportunity to swap those variable rates of ours in DeFi. I see this unlocking two huge opportunities, clients can plan their interest earnings with fixed rates thus more stability for the average joe and second is, this unlocks arbitrage and new tools for the variable takers who want that risk (the degens).

TradFi:

• Imagine you have a mortgage, on Voltz you can trade the mortgage interest rate either as Fixed Taker or Variable Taker. Given you are paying variable rates, you can swap them for fixed rates, thus paying fixed interest rate got your mortgage.

DeFI:

• Lets say we are supplying on compound and get cTokens (which constantly accrue variable interest rate), this variable rate can be swapped for a fixed rate on Voltz. Thus giving you a piece of mind on your asset returns, rather than speculate on the variable rates on Compound.

I hope you can more clearly see why Voltz is such a crucial infrastructure component for the entirety of DeFi.

PS.

Obviously my TradFi example is not possible for Voltz (yet)