1/ Today is Saturday and that means its Thread day.🧵
I wanted to venture from the beaten path of options for a moment and write about something that I think will be another building block in the fortress that is Defi.
So today we are going to talk about Interest Rate Swaps.
I wanted to venture from the beaten path of options for a moment and write about something that I think will be another building block in the fortress that is Defi.
So today we are going to talk about Interest Rate Swaps.
2/ I’ve been thinking about creating decentralized Interest rates swaps (IRS) or a structured product for a while now. IRS’s allow one to swap a variable interest rate for a fixed interest rate. This is intriguing due to the astronomical volatility in defi interest rates (IR).
3/ Allow me to briefly explain an IRS. Let’s say we have Investor A and he takes out a $1M loan, in the trad world he might pay LIBOR (London Interbank Offer Rate) +1.75% to the lender. (I work with a product that offers this.)
4/ What does that mean, well if the IR is LIBOR (.25)+1.75, investor A will pay an IR of 2% in that period. Side note, lets take a moment to appreciate how cheap money is if your already wealthy, RIP to the rest of us plebs and poors.
5/ Anyway, that’s a total of 20k interest for that period. Now in year 2 let’s say LIBOR goes to 50bps, Investor A would now pay 2.25% or 22.5k per period. Make sense?
6/ Introducing Investor B, he also borrows 1M from a different lender, but he borrows it at a fixed rate of 4%, he is paying 40k for each period and because its fixed that won’t change. (Y2 is actually Y1 my bad.)
7/ But what if neither party was happy with the terms of their loan. Investor A hates that his IR is variable and changes so much because he cant plan as well as he would like for the future, Investor B feels like he is getting ripped off paying 4%.
8/ The reason doesn't matter, all that matters is that both parties are unhappy with their loan agreements but can’t get out of the contracts. What they can do is SWAP part or all of their IR’s with each other.
9/ To do this, Investor A can enter into an agreement with Investor B to pay 3% on a notional 1M loan. Meaning the 1M will never exchange hands but Investor A will pay 3% to investor B. In return Investor B agrees to pay Investor A LIBOR +1% on a notional 1M
10/ So what's this look like mathematically. Investor A was paying 2% a year or 20k on that 1M to the his lender. They still must do that, but after the swap they also have to pay 3% to investor B (30k), and in exchange they are going to get LIBOR + 1% from investor B or 1.25%.
11/ If you do some quick math, Investor A will pay 50k total, but receives 12.5k from B leaving him with an IR payment of 37.5k. Now lets look at what happens in year 2 when LIBOR increases.
12/
Year 2:
LIBOR increases 25bps, A pays 22.5k to his lender and 30k to B, for a total of 52.5k.
B now pays LIBOR (50bps) +1% to A, or in other words 15k.
Leaving A with a net 37.5k IR payment.
Year 2:
LIBOR increases 25bps, A pays 22.5k to his lender and 30k to B, for a total of 52.5k.
B now pays LIBOR (50bps) +1% to A, or in other words 15k.
Leaving A with a net 37.5k IR payment.
13/ See what he did, Investor A locked in his IR payment and is now paying a fixed rate.
14/ The opposite happens to investor B. They still pay their fixed rate to their lender of 40k (4%), and they receive 30k (3%) from investor A via the swap, but they also must pay an extra 12.5k (LIBOR + 25bps) via the swap. So year one they pay 22.5k in interest.
15/
Year 2:
When LIBOR goes up to 50bps it looks like this.
Pay 40k to their lender
Receive 30k from Investor A
Pay 15k to Investor A
Total Interest rate Payment of 25k
Now Investor B has the variable IR.
Year 2:
When LIBOR goes up to 50bps it looks like this.
Pay 40k to their lender
Receive 30k from Investor A
Pay 15k to Investor A
Total Interest rate Payment of 25k
Now Investor B has the variable IR.
16/ Now that we have a firm grasp on how IRS’s work, how would you apply them to Defi? Yield farming is the obvious use case, we have all seen our APY’s drop from 800%+ to 20% over the span of a couple week.
17/ Additionally, I’ve watched USD lending rates fluctuate between 100% and 2% on FTX during this last run, it would have been nice to lock in at least 40%. These are two scenarios in which Interest Rate Swaps would have been helpful.
18/ I’m not going to get into the mechanics of how this would work because this thread is already too long, but here is the TLDR.
19/ Imagine you put $1000 notional into a Solana pool paying 30% a year. You then go to the swap pool and sell $1000 notional of the same pool. The exchange would handle behind the scenes, their AMM would handle the passive liquidity.
20/ That swap pool you just went short would have a funding rate kind of like a perp. If the Solana pool started pay 35%, you would have -5% funding on your swap.
21/ This would bring you back down to a net 30%. Inversely if the Solana pool dropped by 10% (which is more likely), the swap pool would have a +10% funding rate, again bringing you back to 30%.
22/ I work with family offices, and HNW individuals keeping them up to date on the crypto/defi space, trust me, this is something that interest them greatly, because to be honest, they don’t care about crypto and they don’t want to learn it.
23/ They only want a stable/safe yield that they can count on.
24/ Products like this are already being built, and the space will continue to evolve, soon we will have structured products, Vol products, Interested Rate options, Bonds etc. Whoever is the first to do this on #Solana and do it well will be highly rewarded imo.
25/ Alright lets get a discussion going. Who is building stuff like this? What do you all think about the viability of these products on defi?
@TraderSkew @macrohedged @DylanMacalinao @tztokchad @laevitas1 @Mtrl_Scientist @CryptoNymph @PelionCap @samchepal
@TraderSkew @macrohedged @DylanMacalinao @tztokchad @laevitas1 @Mtrl_Scientist @CryptoNymph @PelionCap @samchepal
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