The Growing Need For Interest Rate Swaps in DeFi
Last year, the Defi sector was largely limited to straightforward products like lending, but we’re now seeing composability unlock a variety of tools which can further extend permissionless financial primitives. In crypto markets, interest rates are much more volatile than traditional financial markets, which make for great derivative products like interest rate swaps. With the derivatives market making its way to Decentralized Finance, buyers should be aware of the workings of new financial products that have begun to appear in the market.
So, what is an interest rate swap? And, more importantly, what is its importance in Decentralized Finance?
A swap is a forward financial contract between two counterparties, in which one stream of future interest payments is exchanged for another, set according to some pre-established rules. When the cash flows are at a fixed rate interest and floating rate interest, the swap is called an interest rate swap, which basically is an unfunded way to get interest-rate exposure.
Interest rate swaps are a fairly straightforward way of capitalizing on a position or simply hedging interest rate risk. There are two sides to the trade:
1. One side is the borrower who pays a fixed interest rate and receives payment based on a floating interest rate.
2. The other side is the lender who receives the fixed interest rate and pays the other party based on the prevailing floating rate.
These instruments are traded against an industry benchmark interest rate such as the London Inter-Bank Offered Rate (LIBOR). A similar mechanism has been introduced to the world of crypto by projects like Zengo Swaps, Swap.Rates, CherrySwap, etc. However, the only difference is that in DeFi investors can be part of the liquidity and earn profit without requiring a large sum of capital.
What are the benefits of interest rate swaps?
- Hedging the rate for deposits and loans. Lenders are often wary of the risk associated with offering loans to third-parties. The swap is perfect when lenders want to receive guaranteed interest on their deposit while allowing the borrowers to lock up the borrowing rate. Both lenders and borrowers can run into a swap agreement by considering the typical differences between the deposit and borrowing rates.
- Perfect for arbitrage. Lenders can easily lock cash flow at different maturities from fixed income instruments by simply using swaps.
- Reliable DeFi ecosystem. It’s assumed that both the borrower and lender don’t like uncertainty and risks. In a swap, every deposit-hedge corresponds to the loan-hedge, which means the lender can enjoy fixed-rate deposits and the borrower can pay fixed interest on the loan.
- Competitive Advantage. Separating the funding of a loan from the management of interest rate risk through swaps provides pricing flexibility, usually allowing the lenders to be more competitive.
Interest rate swaps are one of the most traded derivatives contracts in traditional finance, which is just an agreement between two or more parties whose value is placed on an agreed-upon underlying financial asset like a security or index. Introducing derivatives contracts to the defi space will help in price discovery of rates and decrease the risks associated with lending.
With the commencement of derivatives to decentralized finance, it’s evident that in the coming years we can expect the landscape to become increasingly more complex – likely creating innovative products and tools, which go beyond what the legacy financial system offers today.