​​In the following article we will delve into Interest Rate Swaps (IRS, not the best abbreviation lol). Generally speaking, IRS is huge in TradFi  -  the size of the interest rate derivatives market is estimated at over $1 quadrillion. IRS in TradFi is where users can swap their derivatives to match their risk preference. Given the fact that each user has a unique risk preference, the IRS product allows for the user to swap their current position to the one that matches  their risk preference better. It could be that the user is risk averse and thus wants Fixed rates, or instead the user wants a speculative position and is seeking risk taking which may push them towards Variable rates.

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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