What is an Interest Rate Swap?
This article was written by Tomas Di Mauro under the Tempus Grants Programme.
Let’s see why this mechanism is so used and how it helps manage credit risk.
Why is it essential in DeFi? An interest rate swap (IRS) is the exchange of fixed-rate interest flows for variable-rate interest flows in the same currency.
It is widely used in traditional finance and allows you to cover against market volatility or speculate on lower interest rates.
For example, in the image, Lender A would swap its variable rate loan to Lender B, which has a fixed rate.
Lender B, receiving the variable rate, would benefit from an increase in interest rates, and Lender A would benefit from a decline.
The IRS is how financial institutions handle credit risks and helps you access more favorable financing conditions than those obtained directly in a loan.
Let’s take a closer look at how this could be important to apply in DeFi, and how it works.
Why is it essential in DeFi?
Interest rate swaps are one of traditional finance’s most traded derivatives contracts. Introducing derivatives contracts to DeFi will help in the price discovery of rates and lower lending risks.
Compared to traditional finance IRS, they’re complex, non-collateralized based on trust, and it takes days to make a contract. DeFi can solve it faster, collateralized (eliminating trust risk), more accessible, and less bureaucratic.
The IRS is part of our life; when, e.g., you take out a mortgage, or a fixed-rate loan, the lender (bank/institution) may be doing an IRS with another bank/ institution, allowing you to get a fixed rate.
According to the Triennial Central Bank Survey1, the IRS market turnover is $4.1T (USD). (per month)
If we compare IRS volume to the monthly DEX volume (According to The Block), that’s at ~84B; its 49.33 times more extensive.
It also experienced growth from $1.86T to $4.14T between 2016 and 2019, much higher than in previous years.
How do Interest Rate Swaps work?
As mentioned at the beginning, an Interest Rate Swap (IRS) is an exchange between a variable interest flow, which can be indexed to a reference rate such as LIBOR (managed by the Intercontinental Exchange), SOFR (operated by The New York Fed), among others, and to which a percentage is usually added to or subtracted from it, for a fixed interest flow, over a period of time.
The one who takes the fixed interest speculates interest rate decreases, and the other party speculates that rates will go up.
In an interest rate swap, the only thing that is exchanged is the interest payments; the debt is not traded, nor do they pay the amount of interest; they pay the difference through a contract.
It is traded on OTC markets and is a customized financial product.
This type of transaction is handled directly between two parties through a template contract settled by the ISDA (International Swaps and Derivatives Association), the ISDA Master Agreement (1992 or 2002 versions).
Also, The Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) outlines eligibility and suitability requirements for any parties entering an interest rate swap agreement.
In practice, it is unlikely that both parties will agree simultaneously with equally opposing positions.
So instead, large institutions warehouse IRSs, swapping with one counterparty, hedging the interest rate risk until a counterparty wanting to take an opposite part is found.
IRS involves two principal risks, interest rate, and counterparty risk, the chance that the other party default on their responsibility
IRS is a sector that has grown enormously in recent years, useful to eliminate the uncertainty of market variations and thus manage credit risk, reduce the cost of financing, or speculating or arbitrage.
The use of interest rate derivatives concentrates on the United States (32.2%), the United Kingdom (50.2%), and Hong Kong (6%); many countries do not yet have comparable volumes.
The application of IRS in DeFi can, through smart contracts, eliminate the risk of counterparty default that exists in traditional finance and in a decentralized way. In addition to bringing fixed-rate products to DeFi.
There is still a lot of innovation ahead, and DeFi has a lot to offer.
- (2019) Triennial Central Bank Survey — OTC interest rate derivatives turnover in April 2019
- DEX Volume, (Jun 2022) https://www.theblock.co/data/decentralizedfinance/dex-non-custodial/dex-volume-monthly
- IRS volume , other source (Mar 2019): https://www.cmegroup.com/ education/cme-volume-oi-records.html
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