In my previous article “Interest Rate Swaps meet DeFi” I focused on explaining how “competitors” of Voltz operate and how Voltz is a true Interest Rate Swap (IRS) protocol. Given that the size of the IRS's market is estimated at $1 quadrillion in TradFi it seems like the IRS instrument being introduced to DeFi is not being noticed and talked about enough. Thus I decided that given that the IRS are not a common concept, I would like to take this opportunity to explain about them in detail as well as elaborate on how they are extremely bullish for Decentralised Finance.

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.