DEFI BLOG SERIES
The Structured Products Opportunity for Cryptocurrency
Discover the Power of Yield Curve and Derivatives Structuring
Introduction
We learned that the yield curve provides trading and hedging opportunities in the previous article. In fact, it also enables structured products such as structured loans, bonds, and swaps. This article presents two kinds of structured products to reduce financing costs for corporate capital management. This is the fifth article of the DeFi blog series presented by Secured Finance.
Disclaimer: This is not financial advice. All information, assumptions, and scenarios provided here are created and simplified for educational purposes.
Structured Products
In traditional finance, wholesale banks such as Goldman Sachs and JPMorgan create structured products to provide custom-made solutions for their clients. The derivatives structuring department uses financial engineering to cater to diverse needs such as return enhancement, cost reduction, volatility control, and cash flow management. Secured Finance brings these business opportunities in the digital currency space. Such products are seasonal and highly dependent on the various market conditions.
Yield Curve
The yield curve plays a crucial role in building structured products. Building a yield curve is not as simple as making a pool to determine an interest rate for a specific protocol. It is a bit more complex because there’s a term structure of interest rates. However, if we build yield curves correctly, we can get accurate discount factors that enable flexible cash flow management. From here, let’s use two simple examples of the yield curve.
If the shape of the yield curve is normal and upward sloping, the discount factor gets deeper (smaller) along with maturity. Conversely, if the yield curve is inverted and downward sloping, the discount factor doesn’t get deep. We can utilize those characteristics to devise cost reduction strategies for loans.
Amortized Loan
A bullet loan has a standard cash flow: You borrow money initially, pay interest, and then return the principal amount at maturity. For amortized loans, part of the principal amount is paid together with the interest. Early repayment brings better cost-saving effects in the case of higher interest rates. So this loan is suitable when the yield curve is normal.
For a 5y bullet loan with a 16% interest rate, the net payment amount is 80%. If we amortize the loan based on the normal yield curve, each payment amount is about 28%, so the net payment becomes about 43%. By switching to amortized loan, we can save roughly half of the borrowing cost.
Accumulator Loan
Instead of borrowing 100% initially, the principal amount can be split and accumulated over the years. If the yield curve slopes downward, it’s better to borrow later. An accumulator loan is a combination of forward rate agreements (FRAs) and works well if the curve is inverted. You can save on borrowing costs with this loan compared with bullet loans or rolling short-term loans.
For a 5y bullet loan with a 7% interest rate, the net payment amount is 35%. For comparison, if we accumulate the loan and return the same amount as the bullet loan, each borrowing amount will be about 19%, and the net payment will be about 12%. In this way, we can cut the borrowing cost to one-third.
Hedge Accounting
We can also do amortization or accumulation in swaps. This is especially useful if you have existing loans. Cash flow swaps convert one cash flow to another, so they can be flexibly designed to fit your cash flow schedule. These derivative transactions are designed to hedge risks, where the underlying asset is the existing loan. Therefore, hedge accounting could be applied to make corporate accounting simpler, which may help corporations increase exposure to cryptocurrencies.
Conclusion
Structured products provide a way to reduce the borrowing costs of cryptocurrencies by allowing for amortizing or accumulating loans. The yield curve gives discount factors, which provides us with structuring of interest rate derivatives. A cash flow swap helps hedge risks associated with existing loans. Corporations may apply hedge accounting to manage cryptocurrency exposure. Secured Finance aims to provide a full-scale financial transaction platform to promote innovation in finance.
Next Articles
A practical guide for structured products in business practice
A handbook of Secured Finance derivative solutions
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