From DeFi’s Heartbeat to its Credit Hub: The Evolution of IPOR Labs
Deus Ex DAO (DED) began working with IPOR Labs late 2022, before their token generation event. We learned the team was sharp, constantly shipping and had a strong view on DeFi (Decentralized Finance) and how IPOR can contribute to it. Here’s a summary of the past 10 months, and a look into the future of IPOR.
A short history lesson
In August 2022, IPOR launched with the ambitious goal of bridging the gap between traditional finance (TradFi) and DeFi by introducing interest rate derivatives to the DeFi ecosystem. This move aimed to tap into TradFi’s massive market worth 450 trillion dollars.
By launching IPOR V1 with its interest rate indices and interest rate swaps, and subsequently introducing power tokens as a new tokenomics template in January 2023, IPOR demonstrated its commitment to innovating and expanding the DeFi landscape. These developments provided users with valuable tools for managing interest rate exposure, contributing to the overall growth and adoption of DeFi.
After 10 months of operating on mainnet, IPOR gained invaluable insights and experiences that paved the way for the development of IPOR V2. This new version will bring the following upgrades
- improved pricing mechanism
- RWA and LSD integration
- simplified yield products to make DeFi more accessible to a broader audience
IPOR index
IPOR V1 introduced the IPOR index, the interest rate benchmark for DeFi. It provides the volume weighted interest rate for assets such as USDC, USDT and DAI from DeFi’s most adopted credit markets, Aave and Compound. The IPOR index serves as the foundation for interest rate derivatives by tracking the underlying market-wide rates, transparently.
In TradFi, the most commonly used interest rates benchmark is the Secured Overnight Financing Rate (SOFR, previously known as LIBOR) and provides the base rates upon which most lending and borrowing agreements are anchored. These indices equip users with valuable insights into the overall market trends and allow them to make informed investment decisions. Now crypto can embrace those too. This IPOR primitive is an open-source public good and can be built upon by other teams.
Interest Rate Swaps
IPOR introduced Interest Rate Swaps (IRS), implemented here as cancellable swaps with a maturity of 28 days. An IRS allows traders to go long or short interest rates. Reasons to trade these could be a desire to hedge a variable lend or borrow rate at a credit market, or speculating on the direction of rates. The cancellability makes this an appealing product to newer rate traders. On the other hand, the cancellability adds flexibility/optionality, which requires more complex pricing and risk considerations for the market maker. Hence, cancellability is uncommon in TradFi markets. IPOR addressed this by pricing in a premium for the optionality. We’ll later get to the challenges of such a model, and how IPOR V2 tackles these.
IPOR facilitated a total volume of $3.75B in interest rate swaps.
Power Tokens
In January 2023, IPOR made further advancements by introducing a new tokenomics model known as Power Tokens, together with a liquidity mining program. This resulted in a peak TVL of ~$43m and established a core holder base of approximately 1000 members. The goal of the initial airdrop and liquidity mining period was to decentralize the ownership over IPOR. DED has assisted with architecting the DAO framework and infrastructure, which launched in March and is now being adopted by the community.
A terrific group of community contributors has emerged (the Iporians) who, as an initial project, have audited IPOR’s original liquidity mining phase and collaborated with IPOR Labs on optimizations for the next period. To reduce unnecessary emissions and reward farmers who are aligned with the protocol, emissions have been cut by 30% and LPs now need to hold at least 5% of their LP positions in pwIPOR to qualify.
Key learnings
Rate manipulation and extreme volatility events since launch
Traders tried to beat IPOR’s AMM by manipulating the underlying credit markets through market action. The first time they succeeded and made a small profit, but IPOR stepped in quickly using a guardian angel function. Any later manipulation attempts resulted in losses for the attackers.
A second event was the USDC instability following the SVB bankruptcy, where all rate markets in TradFi and DeFi became unstable. The USDC peg was tested and USDT IPOR swaps had to be paused altogether by the team.
These events underline the sensitivity of a peer-to-pool model that automatically prices interest rate swaps based on variables as complex as credit market liquidity and interest rate curves. Even at mainnet levels of liquidity, these can be gamed, especially in bear markets. Volatility increased the spread of the AMM and resulted in exploitable offers. We’re happy the IPOR Labs team intervened quickly and that the community is understanding of that role in these nascent stages of IPOR. But it has also shown that the AMM pricing model has to be updated.
Improved AMM needed
IPOR announced their V2 AMM which includes significant upgrades such as tighter spreads, dynamic leverage caps and increased swap tenors. To achieve this, the cancellability of swaps has to be removed. IPOR started with this rather unconventional design for the V1 to make it more friendly to novice traders. On the other hand, this optional callability is terribly hard to price effectively — and thus requires a thicker margin for the AMM to remain profitable. Wider spreads and safer pricing (for AMM LPs) resulted in fewer attractive trading opportunities for more sophisticated traders. The V2 AMM will become a better experience for crypto traders, guiding them to the world of professional interest rates trading. Consequently this improvement should drive more fees towards LPs.
Mainnet is expensive… wen L2?
Despite IPOR’s gas-optimized smart contracts, recent mainnet activity has resulted in high base gas prices. Doing any business on mainnet is expensive. Users have been asking “when L2?” for a long time. But one must realize it’s not that simple!
The IPOR indices source and volume weight their inputs from credit markets. As you just read, even on mainnet these could be manipulated. But L2 credit market liquidity is even thinner comparatively.
USDC market on Aave V3 on mainnet: $535m TVL
USDC market on Aave V3 on Arbitrum: $61m TVL
Therefore, those markets are even more susceptible to manipulation. This risk is especially high when utilization is around the “kink” of the borrow rate curve. A relatively small amount is enough to sway interest rates. Creating an Arbitrum interest rate index therefore isn’t so appealing. However, what could be possible is publishing the IPOR indices on Arbitrum based on mainnet pricing. This would require a deployment on such a L2 however and managing the possible presence of liquidity mining and pwIPOR management there.
Ethereum staking as DeFi’s risk free rate
The same way Grayscale and the Chicago Mercantile Exchange (CME) try to bring DeFi toTradFi via ETFs and standardized futures, IPOR V1 was the first iteration of bringing interest rates derivatives to DeFi.
Nevertheless, with the success of of the largest crypto ecosystem upgrade in April, Ethereum’s Shanghai, the ETH staking yield can be considered the base interest rate against which all yields must compete, the same way US Treasury yields are the benchmark for all yield curve and bond issuances in the world. IPOR’s indices can be expanded to include non-stablecoin assets — and ETH (Liquid) Staking Yield seems to be the prime candidate as it is seeing increasing adoption.
Bridging traditional finance rates
Some of you will have noticed the persistent discrepancy between DeFi and TradFi interest rates on money (or pegged assets). There are multiple reasons for it:
- First, DeFi does not have convenient access to the safest yielding products such as US Treasury Bills, which now stand at 500 basis points (100 basis points = 1%).
- Second, DeFi’s variable credit rates are mainly driven by leverage, which there’s less demand for in bear markets.
- Third, Circle, the issuer of USDC, potentially earns a return against the USD holdings backing USDC emission, through a combination of cash and short-term, high-quality assets, including U.S. Treasuries and other similar instruments. But these returns are not transferred to USDC holders.
A variety of projects such as Ondo, OpenTrade, OpenEden, FWDX and Maple’s recent treasury pool are working on solving some of these issues through securities tokenization or bridging term structures.
IPOR sees an increase in utility through those developments being a yield bridge for any type of DeFi or TradFi fixed income product. We could envision a customization of the user risk profile (floating or fixed rate, extending or reducing duration, change of underlying cryptocurrency of your investment or liability) through a single “Zap” or a one-click action.
Vault strategies
Trading interest rate derivatives comes with a steep learning curve, especially when coming from a more crypto-native product like perpetuals. While TVL has seen a significant uptrend, swap volumes couldn’t keep up, leading to lower fees for LPs. The initial hurdle of understanding interest rate swaps has shown to hinder adoption.
To make it easier for users to earn yield, for example through rate strategies or yield arbitrage, and keep markets more efficient, the V2 will come with vaults. These are pre-defined strategies with different risk profiles that users can passively deploy capital into. For IPOR, it means increased usage.
IPOR: Credit hub of DeFi
The IPOR contributors have crystallized these learnings into a strong vision of becoming the Credit Hub of DeFi. A foundation upon which projects can build and integrate.
Deus Ex DAO is captivated by the possibilities envisioned by IPOR to be part of a fully developed capital market on-chain. Imagine the power of having on-chain products that gain utility through their ability to be combined in unique ways, catering to the tailored needs of both individuals and institutions.
Let’s dive into an example for a moment:
Tokenized Treasury Bills or Bonds denominated in ETH with floating rate exposure. Suppose I can buy a tokenized T-bill using a stablecoin like USDC, with a specific maturity in mind, let’s say the last business day of June. In this envisioned market, I should be able to swap my initial cash flow in and out of USDC, then convert it into another token (e.g., ETH) that represents the interest rate paid by the bill. Furthermore, I would like the option to use an ETH interest rate swap to convert my fixed-rate exposure in ETH into a floating rate. This way, I can tailor my tokenized T-bill into an ETH floating rate bill. The needs are infinite, the combinations should be too.
Such a market would thrive as investors and liability hedgers grow in tandem.
By embracing this vision, IPOR can democratize access to financial instruments traditionally available only through the opaque OTC market.
This vision should lead to further developments from the IPOR team, and no doubt they can deliver.
First, we need a DeFi yield curve with term structure, showing the connection between interest rates and maturities. Leverage is what drives our modern economies and markets. To use leverage at scale, sophisticated parties must be able to use derivatives to hedge their rate exposure and use leverage in a precise way. With that infrastructure in place, these sophisticated players on their part can abstract away and offer simple products to end users, such as fixed rate loans for different maturities.
IPOR V2 is tackling the challenges faced by the V1, for example by upgrading the risk engine to prevent price manipulation and to offer righter spreads. Moreover, since the foundational pieces have been built, the team is expanding its vision to other categories.
This vision could include 1-click fixed-rate borrowing or lending solutions through predefined vaults for predetermined terms, being a back end to Tradfi. For instance, for swapping tokenized securities.
Leverage as a key driver of activity could be introduced via increased utility of the IPOR LP tokens (ipUSDC, ipUSDT, ipDAI and any other ipToken that IPOR could be indexing) in the lending/borrowing market. For example, borrowing against LP tokens
As mentioned at the start, interest rate derivatives are a $450T market. Classic Interest rate swaps are only one part of that. Additional derivative instruments can increase the flexibility for users and allow teams to use the tools to abstract away more complexity for end users. Other derivatives can include:
- Spread trades (intra and inter crypto-currencies)
- Swaps on futures dates
- Swaptions (or options on the level of IPOR swap at a future date)
IPOR is a specialized platform that could act as a lego builder, offering diverse components for custom products. Users combine lego-like pieces to design transparent structured products.
This is how IPOR plans to move from being “the heartbeat of DeFi” to “the credit hub of DeFi” — the place users interact with (directly or indirectly) for all things related to credit and interest rates
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(Any views expressed in the below are my personal views and the product of our own research, it should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions. Do your own research.)
