Derivatives have quickly become very trendy in crypto-currencies with a volume mainly deployed on Futures. These Derivatives greatly condition the entry of institutional investors in this market. They are primarily financial products that allow institutionals to 'hedge' themselves, reduce their risks. They are therefore fundamental, especially since this market is very volatile and subject to very strong trend effects. They can also be speculative products, but this article will not deal with this aspect.

In this article we will focus on a family of Derivatives which is still almost unexplored in crypto, yet very popular in TradFi: Interest Rate Derivatives.

This article does not pretend to be exhaustive and not meant to provide answers to problems coming along with setting up such a market or liquidity related issues. The goal here is to simply illustrate some strategies that could be set up quite easily to protect oneself against the fluctuations of interest rates.

When it comes to borrow a crypto asset, AAVE offers two options: fixed rate borrowing, and variable rate borrowing. It is possible to choose a fixed borrow rate, which is very high but will not vary (or very little) over time. In this case you would pay for security. On the other hand, you can choose a variable borrow rate, which is on average lower than the fixed rate, but which is subject to the hazards of the market. It results a better efficiency of the borrowed capital, but at much higher risk. It is therefore important for big market participants to have a way to protect themselves against interest rate risk, which is characterized by an undesired change in the borrowing rate.

Interest Rate Derivatives are derivatives that allow you to hedge against the risk of interest rate fluctuations, either upwards or downwards. In this article, we will discuss two main types of interest rate hedging tools: Swaps and Options.

Unlike the traditional markets, interest rates on AAVEs do not rely on the price of the underlying asset, but on the availability of liquidity.

When an asset is largely available, interest rates are low to encourage borrowing. When an asset becomes scarce, interest rates are increased to encourage repayment of borrows and an increase in deposits in the liquidity pool.

Interest rate swaps

An interest rate swap is a contract between two parties Alice and Bob. In the case of a borrow, an interest rate swap is carried out as follows: Alice simulates borrowing a sum X at a fixed rate, and Bob simulates borrowing a sum X, but this time at a variable rate. Then, at each interest payment date, the two parties exchange the interest they have to pay. So, we have Alice, who had opted for the fixed rate solution, paying a variable rate, and Bob, who had opted for the variable rate option, paying a fixed rate. We have an exchange of interest flows.

But then, what is the point of such a product?

Let's say I borrow $20,000 for one year at variable rate on AAVE, with a rate that varies from 0 to 20%.  The corresponding fixed rate on AAVE would be 10%. This would mean that:

• If I borrow $20k at a variable rate, the interest I have to pay will be between 0 and 20% of $20k, so, over one year, somewhere between $0 and $4000.

• If I borrow 20k at a fixed rate (10%), I will have to pay $2000 in interest.

There is a big gap between the two APRs of these solutions. In the worst case, with the variable rate I could end up paying 20% more per year. The fixed rate option therefore seems much more interesting in terms of risk prediction, but 10% is still a lot! So, how to mitigate this risk? While doing so, how can I take advantage of rates lower than the fixed rate? Well, that's the whole point of a swap.

Let's say that the variable rate of a borrow on Aave is 2%, and that the fixed rate is 10%. The current thinking is that rates will rise because many people will want to borrow money. It is believed the variable rate is likely to exceed the fixed rate. However, we have no idea WHEN this is going to happen. So we want to take advantage of the floating rate APR as long as it is below the fixed rate. We could therefore set up a swap as follows: we borrow at a variable rate (rate = 2% at the time of the borrow), covered by an interest rate swap that is activated when the variable rate exceeds the fixed rate, e.g. 10%. This also means that if the variable rate never exceeds the fixed rate, the swap will never be activated.

That's what you could do in theory. In practice, it is a little more complicated, because you have to find a counterparty for the swap. Given the lack (or even the non-existence) of liquidity in the interest rate derivatives market, this seems highly unlikely to happen:  no one would want to buy the opposite position, or would ask for a very high premium to execute the trade.

Interest Rate Options

This article will not cover the 'classic' options that allow you to secure your position on an asset (for example a stock). These options are already described in depth in other articles, and are more and more used now in cryptos. The largest crypto options market is Deribit, with a daily volume approaching $500 million. A myriad of decentralized exchanges specialized in Options have also emerged recently (Dopex, Squeeth, Hegic to name a few) but it is clear that the combined volume of all these exchanges remains very low (around $200 million per day). In comparison, the CBOE, one of the largest options markets, alone represents more than $10 billion in volume each day. Not exactly the same magnitude.

Interest rate options allow to hedge either against the risk of rising rates (Cap) or against the risk of falling rates (Floor). This tool presents a strategic interest for the buyer who can choose which direction of variation he wants to protect himself against. Very often, only one direction of variation of the rates is favorable to the buyer. It can be determined by analyzing the current situation (upward or downward trend in rates).

The option buyer has the right to borrow (cap) or lend (floor) a specified amount at a fixed interest rate for a specified period. Both parties agree that one of them will pay a premium to the other in case of a difference between the reference rate and the rate defined in the contract. These contracts are often traded on the OTC (Over-the-Counter) market. They are instruments for hedging the risk of rate variations.

It is possible to resell a Cap before the scheduled end date (requires the buyer to pay a premium to the seller). The same applies to Floor.

Interest rate options can be illustrated simply like this (for this example, Alice would be the buyer & Bob the counterpart):

Let’s say Alice buy a Cap from Bob.

Characteristics:

• Exercise rate: ETH borrow rate on AAVE
• Reference rate: 5%.

If the AAVE rate is higher than the reference rate (i.e. >5%), Bob will have to pay Alice a premium equal to the difference between tAAVE and tReference.

If AAVE rate = 10%, Bob will pay 5% to Alice. If AAVE rate = 4%, Bob pays nothing to Alice.

Now, let’s say Alice buy a floor from Bob.

Characteristics:

• Exercise rate: ETH borrow rate on AAVE
• Reference rate: 5%.

If the AAVE rate is lower than the reference rate (i.e. <5%), Bob must pay to Alice a premium (equal to the difference between tReference and tAAVE).

If AAVE rate = 7%, the counterparty does not pay Alice any premium. On the other hand, if AAVE rate = 3%, Bob will have to pay Alice a premium equal to 2%.

There are 3 main types of Interest Rate Options:

Cap = call option the buyer decides on a maximum rate to borrow the desired amount, and the risk of exceeding (upwards) this rate is assumed by the seller (payment of a premium to the buyer). The buyer is therefore sure to be able to borrow at a lower interest rate than the strike rate during the period defined in the terms. (Equivalent to a call for interest rates).

• Contingent cap: the borrower hedges against rising interest rates by means of a cap, without being penalized by the payment of the premium in the event that this hedge does not serve him. The payment of the premium of the contingent CAP is not immediate and systematic, contrary to a traditional Cap. The premium is only paid if a defined rate is reached. Thus, the premium payment may only occur when the Cap is "triggered".

• Cap Spread: the buyer wishes to guarantee a maximum rate level while paying a lower premium than for a classic Cap. In return, the buyer accepts that his reference rate becomes variable again from a certain rate threshold (= sale of the Cap). He thus benefits from a rate differential which reduces his financing cost. This corresponds to the purchase of a Cap and the sale of a second Cap with the same characteristics as the first (amount, duration, variable reference rate) but at a higher rate.

• Up and Out Cap: the buyer wishes to guarantee a maximum rate level while paying a lower premium than for a classic Cap. In return, the buyer accepts a hedge limited to a rate interval that is determined in advance. If the rate of the exercise exceeds the limit rate, then the reference rate will again be variable and proportional to the rate of the exercise.

Floor = put option one decides at what rate one wishes to lend money in exchange for a premium, and the risk of exceeding (downward) this rate is taken on by the seller. The buyer is therefore sure to be able to lend money at a rate higher than the exercise rate. (Equivalent to a put for interest rates).

• Down And Out Floor: same principle as for the Cap Up and Out: the buyer accepts a hedge limited to a rate interval that is determined in advance. If the rate of the exercise exceeds the limit rate, then the reference rate will again be variable and proportional to the rate of the exercise.

Hybrid: Collar = mix of buying Cap and selling Floor OR buying Floor and selling Cap.

• The Corridor : allows to reduce or cancel the cost of hedging a borrow by renouncing to take advantage of the variation of the exercise rate compared to a floor rate.
  -Borrower tunnel: purchase of CAP and sale of FLOOR
  -Tunnel lender: purchase of a FLOOR and sale of a CAP

  In these two cases, the CAP and the FLOOR must have the same characteristics (amount, duration, variable reference rate).

As we’ve seen, IRD helps to control the risks of rate changes. These financial tools will eventually become prevalent. At the moment the market is facing several problems, which prevent the development of such 'institutional' instruments. One example is liquidity, which is, by far, the biggest issue the market has to tackle. The lack of liquidity in the market is (in my opinion) largely induced by the nature of stablecoins, which do not meet institutional standards (yet). They are currently identified as a major risk for institutions.  Efficient hedge against a loss of peg on stable coins is at the time impossible to achieve. Once the stablecoin problem solved, I think the market will finally be ready to receive a massive inflow of liquidity. Institutional type instruments will then become very, very prominent.

For the moment, we are quite far from that. However, I'm going to keep a very close eye on it, watching closely the development of Crypto Interest Rate Derivatives. I think this will be a major play in the months/years to come. I'm already excited to see how the market liquidity issues will be addressed. Until then, have fun!