Cash-Flow Instruments pt 2: DeFi Cash-Flows
Part 2, Interest-Rate Derivative Use-Cases Within Web3
In our last article of this series we briefly discussed some of the historical use-cases and incentives behind interest-rate derivatives as a whole, while taking a closer look at the most liquid cash-flow instrument, interest-rate swaps.
Today, we’re shifting back to web3 and taking a look at a few immediately apparent use cases and opportunities interest-rate derivatives are bringing to decentralized finance.
Risk Management:
As general as it sounds, the primary use case of interest-rate derivatives would be the management of risk.
That said, the specific context in which one manages risk varies significantly. Whether borrowing or lending, participants have personalized risk-tolerances and risk-profiles, in addition to access to variable degrees of credit.
Our goal then at Swivel is to address this range of participants and in the process create the building-blocks for an interoperable market of predictable cash-flows.
Lending:
When lending, risk is generally viewed from two lenses, one being the potential for counterparty default, and the other being potential variability in risk adjusted returns.
With the introduction of decentralized money-markets, counterparty risk is largely addressed, however as clearly seen over the past year, rates themselves are highly variable.
Decentralized interest-rate derivatives enable lenders to customize their risk profile and ameliorate the risks involved with volatile money-markets, leaving smart contract vulnerability as the primary concern.
The most straight-forward example of this risk management is a standard fixed<>floating swap (or strip sale). With these instruments, a lender that would otherwise receive a floating-rate can instead lock in a collateralized fixed-yield.
Borrowing:
When traditionally borrowing, your primary risks similarly surround variability in funding costs as well as variability in underlying currency value.
And yet again, interest-rate derivatives ameliorate both. While Swivel isn’t immediately tackling FX(currency) swaps, a borrower who wants to reduce their funding risk can do so by purchasing supply side money-market exposure in the form of interest-coupons.
In doing so, a borrower can ensure that should their funding rate increase, their debt exposure is offset by the yield generated with interest-coupons, effectively borrowing at a “fixed” rate.
Leveraging Money-Market Exposure:
While leveraging exposure to money-markets like Compound clearly involves an extension of risk, many reasons may justify extending risk in a given direction, including as mentioned above, the actual reduction of risk in an overarching strategy.
Marginal Rate-Speculation:
There is an expectation that a fixed-yield derived from any given money-market will come at a discount when compared to its underlying money-market. For example, if the rate for USDC on Compound is 8%, Swivel’s market might sit around 5%.
With this expectation, those purchasing exposure will always profit from the marginal difference between the underlying and derivative markets assuming underlying rates remain stable. In the example above, one purchasing exposure would actually have a 60% APY as opposed to the 8% they otherwise would receive through Compound.
Return-To-Mean & Correlational Speculation:
While significant volatility exists in underlying money-market rates, that volatility tends to be bound between ~2-15%. That said, actionable trends have begun to concrete themselves, leaving significant opportunity for speculators to profit off of these movements through the use of derivatives.
This speculation can then generally be categorized as either speculation based on the assumption of a mean reversion within money-market rates, and/or based on correlative factors established between underlying money-markets and their derivative’s pricing.
Short-Term Speculation:
One may also wish to purchase money-market exposure in the form of interest-coupons if they feel they have any unique knowledge/edge surrounding utilization rates and/or liquidations.
With knowledge of either one can easily profit off of the short term derivative movements and utilize their edge in a way otherwise not possible.
Hedging Consensus Variability:
One less often mentioned use case of interest-rate derivatives is actually the ability to reduce the risk involved with consensus variability depending on blockchain and money-market platform architecture.
Some platforms, Compound included, assume each Ethereum block takes exactly 15 seconds, and each year contains 2102400 blocks. However, the each block currently takes an average of ~13.1 seconds to produce, actually leading to higher rates than advertised.
This disparity can be easily accounted for and priced into any derivative instrument, meaning lenders can either insulate themselves from the risk that blocktime might increase, or otherwise speculate on its variability.
Utilizing low-yielding collateral:
Lending rates for commonly used collateral like ETH and BTC have declined over recent months, with many citing the falling Greyscale premium (now discount) and therefore reduced arbitrage opportunities as one large contributing factor.
With that accepted, one potential use case of derivatives would be the utilization of now low-yielding collateral for the maintenance delta-neutral derivative liquidity provision or trading.
When providing liquidity to any market the largest risk tends to be the management of inventory. When then interacting with rate markets, the only thing necessary to manage this inventory risk and neutralize exposure is collateral.
For example, should a liquidity provider or cash-flow market arbitrageur hold a $1000, 5% lending position for 1 year on Swivel, all that would be necessary to neutralize this position is enough collateral to borrow an equivalent $1000.
In then borrowing this $1000 using collateral like BTC, one is now utilizing what would otherwise be low-yielding collateral as now part of an overall high-yielding strategy.
What’s Next:
This article primarily covered a few of the opportunities (nowhere near all) that projects like Swivel, Element, Pendle, and APWine can enable.
That said, there are a number of differentiators/differences between each protocol, and an entire sector of exchange that will be enabled over the coming months.
In the upcoming article of this series, we plan to discuss a few of these differences (+ a few of the more niche interest-rate instruments that Swivel can facilitate), however we’re most excited to discuss the larger conversation revolving around the cross-protocol cash-flow exchange that can be enabled and network effect that we can materialize with proper industry collaboration.
Keep your eyes peeled for part 3, if you haven’t read part 1 give it a go!
Don’t forget to keep checking out our kovan testnet, submitting and bugs/feedback you have on our discord!
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Citations:
DeFi Pulse: DeFi Lending: Stats, Charts and Guides. DeFi Pulse | Stats, Charts and Guides. (n.d.). https://defipulse.com/defi-lending.
Ethereum Average Block Time Chart. Etherscan. (2021, May 10). https://etherscan.io/chart/blocktime.
Patel, R., Ballensweig, M., & Lim, J. (n.d.). Genesis Q1 Market Observations. Genesis Lendig. https://f.hubspotusercontent00.net/hubfs/6024551/Genesis%20-%20Quarterly%20Reports/Genesis21Q1QuarterlyReport-H%5B2%5D.pdf.