Interest Rate Swap

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8 min readOct 3, 2022

Interest rates are one of the most crucial concepts in the world of finance, representing the cost of money and is a key component of total returns for investments. In traditional finance, interest rate swap has proved useful in portfolio management. To analyze opportunities and its application, let’s start off with how an interest rate swap works.

What is an Interest Rate Swap?

An interest rate swap is a derivative contract where two parties agree to exchange one stream of future interest payments for another, based on a specified principal amount and period of time.

Interest rate swaps are traded over-the-counter (OTC) which refers to the process of how securities are traded via a broker-dealer network as opposed to on a centralized exchange.

OTC trading means two implications: the limited accessibility of the financial derivatives and low market liquidity. This leaves room for interest rate swap in DeFi to differentiate itself.

Rates to be swapped: Fixed Interest Rate and Floating Interest Rate

Like the name implies, a fixed interest rate is fixed during the entire term of the contract. On the other hand, floating interest rates fluctuate over time. Floating interest rate bonds are frequently used in interest rate swaps, with the bond’s interest rate based on the Secured Overnight Financing Rate (SOFR).

Fixed-to-Floating Swap

If a party enters into a fixed-to-floating swap, meaning the party prefers a floating rate over a guaranteed fixed interest rate that they are now entitled to receive. Under this scenario, the party expects the interest rate to rise and wants exposure from the increase in interest rate, thus a shift from fixed to floating rate.

Floating-to-Fixed Swap

On the contrary, a floating-to-fixed swap gives a party a guaranteed fixed rate payment in place of a floating rate. This means a full hedge for the party as the swap removes any fluctuations in returns that the party was subject to prior to a floating-to-fixed swap.

Interest Rate Swap in DeFi

Moving towards the DeFi world, interest rate swap is in its budding phase with plenty of room to grow compared to the $400 trillion market in traditional finance. Interest rates in DeFi offer a unique value proposition in a sense that it is accessible to retail investors as most protocols allow for leverage which enables a sizable return from a relatively small amount of collateral.

In traditional finance, interest rate swaps are used mainly by institutional investors or large corporations as OTC derivatives are not accessible to retail investors and it requires a sizable collateral to gain substantial profits from changes in interest rate which are basis point changes.

The first interest rate derivatives exchange in DeFi is Strips Finance which allows users to trade, speculate and hedge interest rates in many different DeFi yields and CeFi funding rates. For example, if you are receiving USDC as yield from AAVE, and you see the fixed rate on Strips for USDC is higher, then you can enter into a swap on strips to receive the fixed rate instead and benefit from the spread.

In building an interest rate swap protocol, builders can determine how their rates are derived. Automated market makers or traditional models such as vasicek model or cox-ingersoll-ross model can come in handy.

For instance, Voltz Protocol, an interest rate swap protocol, utilized a mix of vAMM and Cox-Ingersoll-Ross model. Alternatively, builders may create their own math models and mechanics to derive rates which proves suitable for the DeFi landscape and interest rate swap. Consequently, how traders calculate profit or loss on interest rate swap protocols may differ.

Use Cases in DeFi

Yields and rates can generally be categorized into three types to match with key use cases of the interest rate swap. It is noteworthy that these yields are pre-existing positions prior to swaps.

Float to fixed: For rates or yields that are volatile and the user wants to cap potential losses, floating-to-fixed swap as a risk hedge will prove effective.
Fixed to float: For rates that traders expect to rise and the user can tolerate risk from paying a floating rate, a fixed-to-floating will come in handy (the degree of risk and fluctuations depend on each market). This aligns with traders who expect an upside volatility.
Arbitraging: For rates that differ on protocols, an arbitrage will effectively capture the spreads between markets.

Use Case for Staking Returns

Use case for validator staking returns varies as pooled stakers accrue rewards differently, depending on which method of pooled staking chosen.

Take staking ETH on Lido for example, if the user currently receives a variable APR from staking ETH on Lido and wants to remove fluctuations on the staking return, the user can enter into a floating-to-fixed swap to stabilize the staking return. The same applies for other rates such as borrowing, lending rates, or trading fees.

On the other hand, If you are currently paying a variable borrow APY from AAVE and you can tolerate fluctuations in normal circumstances in a short-term borrowing, then you may not need a swap. However, in case of anticipating an event that renders the rate volatile, you can swap the rate to pay a fixed rate instead.

A trader can also speculate on yields when the rate is volatile, it will be profitable for traders to bet on the direction of the market fixed rate regardless of how high or low the APY.

If a user expects the funding rate of BTC to rise, the user can long the rate, meaning the trader pays a fixed rate and receives a floating rate. Traders then earn profits when the rate rises.

In contrast, in case the trader expects the BTC to fall, then the trader can short the rate to receive a fixed rate and pay a variable rate. However, in this case, the risk is not capped as the trader needs to pay any increase in BTC funding rate.

While the calculation of PnL may vary depending on the architectural design of protocols, PnL of interest rate swaps generally involve the difference between entry and exit interest rates, multiplying the notional amount of transaction.

For instance, if a trader longs BTC funding rate at 10% and exits the position at 11%, with the notional amount of $100,000. In this scenario, he gets trading PnL of (11%-10%)/10%=10%. Thus, get a trading PnL of 10%*100,000=10,000. The trading PnL will then be deducted by other fees the protocol may collect depending on its architectural design.

Interest Rate Swap as a Hedging Tool for Staking Volatility

xSUSHI is the token stakers earn when staking SUSHI. xSUSHI consequently earns a reward fee of 0.05% of all trades and appreciates its value while holding. If a user wants to retain voting rights without tolerating the variability of a token, the user can enter into a floating-to-fixed swap to receive a fixed payment and pay a floating rate to transfer the risk.

An interest rate swap is also useful for decentralized liquidity returns. In a bull market, for example, liquidity and trading volume decrease, you may want to fixate the return you get from trading fees before the bull market takes its toll on the rate, thus a floating-to-fixed swap will prove effective.

As for builders, Strips lays a foundation for a fixed income market in DeFi. Strips interest rate derivatives allow other protocols to build structured fixed-rate products on top. These swaps can also be designed as a loan in which the payment and rate caters to the needs of the borrower or lender.

Constructing a Yield Curve Using Interest Rate Swaps

The next milestone for the fixed income market in DeFi is the construction of the yield curve. Yield curve, a representation of the relationship between market remuneration rates and the remaining time to maturity of debt securities, plays a key role in the fixed market as it is indicative of investors’ expectation of future interest rate. With a yield curve, fixed income market products such as bonds can be constructed on top of the term structure.

There are many approaches and math models to derive a yield curve, contingent on the design of protocol. For instance, in Pendle Finance, interest rate swaps with different expiries can be used to construct a yield curve. Traders can also deploy strategies to capture the spread or react to the market expectation instantly with the curve.

Lending Rate Optimization Using Interest Rate Swaps

Other protocols aiming to either minimize or maximize rates would find interest rate swap an effective tool. A lending aggregator seeking to minimize borrowing costs can swap the variable rate for fixed rate if an increase is expected and vice versa.

For instance, Fuji DAO, a lending aggregator, now combines lending rates from different protocols for users. This can be plugged into interest rate swap to automatically switch positions for users to reach an optimal lending rate. Yield optimization, on the other hand, can also benefit from a fixed-to-variable swap under the same scenario.

The fixed income market is the largest financial market in the world and as the interest rate in the traditional finance world trends towards the lower end, investors are in search of better yields, posing ample opportunities for the DeFi fixed income market that is still a vast blue ocean.

References

Interest Rate Swap

Use Cases in DeFi

Written by Manassaya Ploynumpol