Saffron Fixed Income Vault Primer

A quick run-through of how SFIV works.

Fixed Income Vaults are the newest DeFi product from Saffron Finance. They are closely analogous to the traditional finance concept of a reverse zero coupon swap. The first version of Saffron Fixed Income Vaults — or SFIV — is built on top of Uniswap V3 liquidity positions, which are the underlying assets that generate yield for the vaults. Here’s a quick primer on how they operate.

Reverse Zero Coupon Swap

Reverse zero coupon swaps are a type of financial instrument under the general umbrella of interest rate swaps.

An interest rate swap is an agreement between two parties, or “sides”, to exchange cash flows based on a fixed interest rate and a floating interest rate. Another common name for the floating side of this contract is “variable side”. A more specific type of interest rate swap is the zero coupon swap, where one party executes regular payments based on a variable interest rate to the other party, who in turn pays a fixed single payment at the end of the contract. This is equivalent to a fixed interest rate. In a reverse zero coupon swap, the fixed payment is paid upfront at the beginning of the contract, instead of at the end.

Reverse zero coupon swaps are a useful tool to decrease a portfolio’s exposure to risk due to market volatility. They also increase capital efficiency because they receive the entire payment of yield upfront that would normally be earned over time. Saffron Fixed Income Vaults are an implementation of a zero coupon swap in DeFi.

Fixed Income Explained in Terms of a Fish Farm

One way to think about a Saffron Fixed Income Vault in simple terms is to compare the variable side to a “renter”. The variable side in this case is renting cash-flow from the fixed side. Similar to any other rental agreement, the variable side pays a fixed amount up front to gain access to an asset for a set period of time. Readers of our Saffron Fixed Income Vault Preview post may have already begun to think about real world analogs, and today I want to expand on that further. I’ve found an easy way to understand Saffron Fixed Income Vaults is to break this concept down into a real-world scenario that anyone regardless of financial background can understand — in what we internally like to call the fish farm example.

• Alice owns a fish farm that has an estimated yield of 1 ton of fish, or $1,000 every month. Depending on various factors, sometimes the farm produces a lot more, but sometimes it produces a lot less.
• Bob enters into a reverse zero coupon, or “rental” contract with Alice, where the fish farm is the underlying yield producing asset that Bob is renting.
• Bob pays Alice $1,000 upfront for a signed agreement that he will obtain all of the fish produced from her fish farm for the next month.

It isn’t known to either party whether this upcoming month will be a high-yielding or low-yielding month. The fish farm could produce $1,000 worth of fish, it could produce $2,000 worth of fish, or it could produce $500 worth of fish. Bob either makes a profit or loses money depending on the outcome.

Easy enough right? Let’s replace Fish Farm with a Uniswap V3 pool, as is the case in the first version of Saffron Fixed Income Vaults.

• Alice owns a sizable position in a Uniswap V3 liquidity pool as a liquidity provider. She estimates that it will return approximately 5% yield per quarter.
• Alice creates a Saffron Fixed Income Vault to “rent out” her Uniswap V3 LP position at a 4.5% quarterly rate. This guarantees Alice a 4.5% quarterly return paid to her up front.
• Bob uses the Saffron vault to enter into a contract with Alice, and Bob pays the 4.5% premium upfront to Alice to access her position’s ability to earn yield for the next quarter.

In this scenario, Bob is renting Alice’s Uniswap V3 position for the duration of their contract, and he earns all of the yield as if he is the owner of her position — in exchange for paying Alice a premium upfront.

One benefit that Saffron Fixed Income Vaults (and DeFi protocols in general) have over the real-world fish farm example is that there is no risk of one side not fulfilling their obligations, because as soon as the agreement is made on-chain, all actions are automated entirely by smart contracts.

In a Nutshell

Saffron Fixed Income Vaults are a financial instrument that allow users to receive a fixed rate of return, or on the other side, open up opportunities to obtain yield from a larger position than they might have access to or want to risk themselves. We believe this will be an invaluable tool in decentralized finance for managing the risk and return profiles in a volatile environment. In our next article, we’ll go through practical examples of how Saffron Fixed Income Vaults help both the fixed and variable side navigate times of severe volatility by using correctly configured vaults to better manage outcomes.

Stay tuned for further details to come on how to access/use Saffron Fixed Income Vaults, which launch later this week.

Community resources

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