IPOR

A benchmark for stable DeFi markets

The Interest Rates Derivatives Market is ~$400 trillion notional, and DeFi investors keep complaining about how they lack the necessary tooling to manage their risk. Investors currently can't secure their returns by fixing their cost of credit, which calls for instability during both bull and bear markets.

During the bull market, spikes in borrowing rates went from 3% to 10%, which means that the cost to borrow tripled during an "up only" market. However, during a correction, nobody knows how drastic or prolonged the bear market will be. If we are aiming for realistic institutional adoption, DeFi needs better instruments for risk assessment than the quick overview provided by DefiRate.

We know from experience that new investors come to DeFi attracted by the following reasons:

• Borrowing is more expensive than in Traditional Finance. The reason for that is because in DeFi users can pay off their loan any time they want (as long as they provide collateral).
• Lending rates are higher than in Traditional Finance.
• Users can pay off their loan any time they want as long as they have provided the required collateral.
• DeFi offers savings accounts and interest-bearing services that allow investors to optimize their interest-bearing accounts. Products like Compound already offer 4.00% APR, whereas traditional banks offer less than 1% APR and, since, 2008, their APR has never been above 4%.
• Financial instruments linked to the movements in the interest rate, such as derivatives. This is the main tool for institutions to use interest rates as a hedge, as well as to speculate on rate moves.

Furthermore, money deposits have already settled as the go-to choice for market participants to put their money to work and earn a passive income. Investors also use this as a hedge to outweigh their exposure to risk.

Why do Interest Rate Derivatives exist?

Imagine a market meltdown and its effect on interest rates, specially in Defi.
 The first thing we notice is a sudden disconnect across platforms (see comparison between AAVE and COMP below during the same time interval).

Contrary to traditional finance, where lenders take a fixed Interest Rate swap, an AAVE lender might go from earning a 15% on their stable to earning a 4%, which is less than 1/3. In Traditional Finance, the fixed interest rate swap ensures that, in case the return drops, investors can make up for the loss from the amount that they win from their contract.

What about interest rates in DeFi?

Does high interest lead to high risk?

Similar to depositing funds into a savings account and receive interest, DeFi investors lock up their funds or use them to provide liquidity on a Dapp in order to receive interest payments.
For example, one can compare BlockFi offerings on USD-based stablecoins by checking on loanscan and comparing that rate to the average interest rate for nationwide savings accounts. Institutional lenders such as Genesis, BitGo, and their Defi counterparts like Compound and Aave, have already brought a lot of liquidity into the market. Just like banks do with Fiat currencies, Defi lending protocols pay an interest on savers' crypto deposits from the margin generated from the loan issuance. These protocols can then be used by individuals or businesses to automate the process using a decentralized network and remove the third-party trust on an intermediary.

Most of the volume in DeFi is driven by lending and exchange services. Historically, credit markets drive growth. This has been the reason for higher liquidity and turns in asset prices. When the markets are in "up only" mode, speculators disregard the cost of credit and focus on the asset price outpacing the borrowing fees. Unprecedented arbitrage opportunities have started to appear in the markets as yield farming evolved and correction rates adjusted based on the sensitivity to volatility. At this point, investors started wondering how prolonged and how drastic corrections would be. As a matter of fact, the existence of a liquid Defi lending market calls for stability:

• Borrowers will be more sensitive to interest rates
• Lenders will be more sensitive to their rate of return
• Interest rates drop to new lows during the bear market (increased stablecoin accumulation)

What is the IPOR Index?

The IPOR index serves as a proxy for the risk-free rate based on the overcollateralized loans that are determined algorithmically by external protocols. Also, there be multiple IPOR Indices which represent different assets. For example there may be an IPOR USDT, IPOR USDC, IPOR DAI, IPOR ETH etc. This makes the index both adaptable and granular within the blockchain landscape: protocols rapidly evolving, the raises and the falls, new projects emerging… The Index calculation was designed to be updatable and modular to account for market condition and DeFi protocol changes. Its DAO is also helpful for the consideration of potential changes in third-party codebases, market dominance weights… all of this through a transparent and democratic on-chain governance handled by the DAO.

Who uses IPOR and for what?

• IPOR rates are meant to be a public good. Everyone has access to the rate data (index rates are published via an on-chain oracle construction from different data providers). This also means that the on-chain components are meant for other protocols to build upon. In other words, any third party protocol developer can reference the on-chain index rates in their contracts
• Hedging interest rates (fixing your rates) is possible as well. Indeed, IPOR is a composite of the interest rates from multiple credit markets. One could use products that rely on the IPOR index as an interest rate, hedge his position on a single market, or hedge his loans to cover basis risk by distributing your loans between multiple markets to closely follow the IPOR.
• As the rate behaviors across each stablecoin can vary, there are often opportunities to capture the different rates between divergent stablecoins.
• Thanks to leverage, speculators are also able to long or short interest rates. Leverage on IPOR shares a similar functional to traditional leverage in the sense that it gives exposure to a larger capital position. However, IPOR leverage could be better described as collateralization. The ratio between the collateral and notional amount is what IPOR describes as leverage

The role of market participants

On the one hand, we have the standard retail investors becoming irrelevant in their willingness to affect interest rates. On the other hand, we have the crypto whales taking single-digit returns as acceptable in order to avoid selling and triggering capital gains. This is the beginning of a speculative ride that institutions have already experienced and will continue to notice. Institutions are bound to stricter risk management procedures which, at the time of this writing, don't yet exist. That's where IPOR comes in and introduces its offerings:

• Index: transparent index sourced directly from leading DeFi credit markets. This helps to avoid manipulable rates overnight. IPOR's index is the key for market participants to forecast future yield conditions, which will in turn open up the opportunity for a DeFi yield curve.
• Interest Rate Swap: a new set of DeFi primitives that, contrary to a swap between 2 market participants, introduces a pool of liquidity that guarantees a constant trade counterparty.
• Derivative AMM: Evolution of the AMM model adapted to a derivative interest rate mechanism that allows for accounting customization, protocol usability, and risk assessment tooling for every pool.

Stability and its correlation with liquidity

Institutional adoption calls for decentralized credit markets that provide them with the necessary instruments to assess their risk. IPOR uses Interest rate derivatives as an enabler for stability and predictability by forecasting income and cost of credit over a flexible time interval for each investor. Not only is IPOR a complement to existing spot lending platforms, but it also gives users the ability to fix their loan at a lower rate than the current fixed-rate products.

What does a benchmark borrowing rate across protocols actually mean?

The name of the protocol is not trivial, $IPOR stands for Interest Protocol Offered Rate. This benchmark can be used to see how serious the AAVE bankrun was to DeFi back in November 2021. We know from experience that the Cream exploit led to a cascade of fear reactions where other liquidity providers on other protocols started to withdraw their money. During the AAVE bank run, $IPOR risk was less than the average market.

The reaction to the above tweet by the market participants led to a spike in interest rates across the DeFi landscape. Effectively, the increase in interest rates in Aave was caused by the sudden drop in the available funds on the borrowers' side. In Aave, the rates increased from 5% to 20% in less than an hour.

Here is the comparison with IPOR:

In summary, sudden withdrawals of stables (less liquidity) lead to less capital available to borrow and, therefore, higher interest rates.
For instance, although Aave's interest rate had a sharp increase, it was due to a sudden withdraw in stables, which resulted in lower liquidity and lower available capital for borrowing.
Going back to the original acronym behind IPOR (Interest Protocol Offered Rate), we understand that IPOR is an average weighted by each protocol's liquidity. Indeed, in IPOR terms, AAVE's increase in rates was successfully offset due to the declining liquidity. This offset caused that, while the borrowing rates on Aave quadrupled, IPOR was able to remain at around 2x.

If we stop for a second to think about the scenario presented above, we can observe how big the arbitrage opportunity actually was.

This short window caused by the Aave bank run already presents the potential opportunity of 29 bps risk free value.

Bear markets call for successful long-term products such as IPOR. Once the bull market restarts and FOMO starts to kick in, specially among the institutions, stability will be the growth driver. Open finance and yield-bearing assets are the tools used by crypto proponents against rampant inflation and loose monetary policies that have led to a low or even negative yielding debt world.

To put it in a nutshell:

• Interest rates are the heartbeat for Defi
• IPOR offers an interest rate benchmark across Defi protocols in the form of a benchmark index. This allows investors to monitor all DeFi rates at once.
• IPOR stands for Interest Protocol Offered Rate.

In conclusion, IPOR thesis is simple. If DeFi is going to become a global disruptive force and take over traditional finance, credit is the catalyst.

You can find more on their whitepaper and twitter