Cash-Flow Instruments pt 1: History
Part 1, Traditional Use-Cases and Potential Application Within DeFi
The market for cash flow instruments, such as credit and rate swaps, represents roughly 75 times the notional size of equity-linked derivatives.
More specifically, interest-rate derivatives represented a considerable $559 Trillion in yearly notional value transacted as of December 2019 while raw market value has since seen a significant 40% rise in the first half of 2020 according to the Bank of International Settlements.
Demand for these instruments is driven by a diverse base of users/use cases, as individuals/institutions attempt to hedge cash-flows and meet a variety of investment, risk management, treasury and funding needs.
This diverse base of users then demands individualized risk-management strategies and niche cash-flow structures, creating new markets for an equally diverse set of interest-rate derivative instruments.
Regardless of overall demand, these cash-flow markets have been largely restricted to large institutions and firms that have the credit and overhead to participate actively, and the treasury and corporate financial functions to benefit from the risk-management that they provide. Further, this market is intermediated by large banks who charge significant fees to participants who might otherwise be able to transact directly.
Swivel plans to shift this paradigm and democratize access to these integral cash-flow instruments by creating a transparent order-book driven marketplace where participants may freely exchange cash flow instruments without the need for an intermediate broker.
We are not alone in this vision, however decentralized cash-flow markets have only just begun to see light, leaving many structured products/use cases yet to be developed and profitable opportunities still limited to large institutions.
We’ll dive into a few examples of structured DeFi use cases in our next post, but first a look at the historical use of swaps.
Synthetic Financing:
Traditionally, interest rate swaps were largely used by firms to change the effective maturity, rate or level of risk of interest-bearing assets or liabilities.
Suppose a firm has short-term bank debt outstanding. At the start of each period this firm refinances its debt at the prevailing short-term interest rate. If short-term market interest rates are volatile, then the firm’s financing costs will be volatile as well. However, by entering into an interest-rate swap, the firm can change its short-term floating-rate debt into a synthetic fixed-rate obligation.
In this way firms can utilize interest-rate swaps to change floating-rate debt into synthetic fixed-rate financing or, alternatively, a fixed-rate obligation into synthetic floating-rate financing, however the incentives behind these conversions are more complex.
Common Use Case Incentives:
Theory of Comparative Advantage:
Suppose there are two companies with different credit ratings.Â
Company A can borrow in the fixed-rate markets at ~10% or the six-month LIBOR at LIBOR + 0.35%.
Company B can borrow fixed at 11.25% or the six-month LIBOR + 1% .
Both companies would like to borrow $10 billion over 10 years.
Company A borrows at a 10% fixed-rate and B borrows at LIBOR + 1%.
Company A agrees to pay B interest at the flat six-month LIBOR and receives a fixed rate of 9.9% in exchange.
The result is that Company A is really borrowing LIBOR + 0.1%, or 0.25% less than a direct debt to floating-rate lenders. Company B is really borrowing at a fixed rate of 10.9 percent (the 1% on LIBOR and 9.9% to A), which is 0.35% less than a direct fixed loan.
The two companies have then arbitraged their advantages and both mutually benefit from improved debt pricing.
Corporate Financial Hedging:
While there is still debate around the topic, many may feel that a firm’s financing decisions have a direct effect on its market value. Fundamental economics illustrate that a firm that successfully optimizes its funding delivers higher returns to shareholders.
This being the case, it follows that some firms may seek risk-management instruments in order to stabilize their market value. Moreover, tax laws sometimes favor the use of certain derivative instruments to restructure cash flows.
Transaction Costs:
Interest rate swaps can help to reduce the capital spent on transactions costs, and eliminate the substantial overhead and opportunity costs of renegotiating new lending transactions
As an example, in many cases it may be cheaper both in cost and time value of money to sell an interest rate swap than to call and refund outstanding fixed-rate debt.
Arbitrage:
AAA firms that act as floating-rate payers often issue fixed-rate notes, and then sell the corresponding prepayment by selling swaps to swap dealers.
Some argue such transactions result in cost reduction because the prepayment attached to fixed-rate debt may be underpriced. Thus part of the incentive behind paying a floating-rate is the arbitrage opportunity created by the mispricing of prepayment for corporate bonds.
Whats Next?
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Stay tuned for part 2 of this series as well as a community update later this week!
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Citations:
OTC derivatives statistics at end-June 2020. The Bank for International Settlements. (2020, November 9). https://www.bis.org/publ/otc_hy2011.htm.
BIS Statistics Explorer: Table D7. (n.d.). https://stats.bis.org/statx/srs/table/d7.
Fixed Income Protocols - The Next Wave of DeFi Innovation. Messari Crypto News. (n.d.). https://messari.io/article/fixed-income-protocols-the-next-wave-of-defi-innovation
Kuprianov, A. (n.d.). The Role of Interest Rate Swaps in Corporate Finance. richmondfed. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/1994/summer/pdf/kupnov.pdf.
Visvanathan, G. (n.d.). Who Uses Interest Rate Swaps? a Cross-Sectional Analysis - Gnanakumar Visvanathan, 1998. SAGE Journals. https://journals.sagepub.com/doi/abs/10.1177/0148558X9801300301.