In-depth analysis of the application of interest rate derivatives in cryptocurrencies: interest rate swaps and interest rate futures

原文标题：《 利率衍生品在加密货币中的应用 》

Originally written by Neron

H.frost Ventures,Beam

Write in front:

At present, the main way to solve the liquidity problem in DeFi field is to use Lending agreements such as AAVE and Compound. Usually, the term and interest rate of such Lending behavior are uncertain, which is simple and effective, but fatal to large institutions and large funds.

This paper discusses two kinds of interest rate derivatives (interest rate swap and interest rate futures) to hedge interest rate risks, convert floating interest rate into fixed interest rate to a certain extent, and form effective control over the cost of capital. In order to facilitate communication, many professional terms such as Cap, Floor and Spread are not translated, but only defined. At the same time, reading this article requires certain knowledge of derivatives trading, interested friends can refer to "Options, Futures and Other Derivatives" and other related materials for a deeper understanding of Swap, Option and other derivatives related knowledge.

Derivatives have become very popular in cryptocurrencies, mainly in futures. These derivatives allow institutional investors to step in by allowing institutions to "hedge" themselves and reduce risk. So they are fundamental financial products, especially because the market is very volatile and subject to very strong trends. They can also be speculative products, but this article will not cover that.

In this article, we will focus on a family of derivatives that is almost undeveloped in the crypto space but very popular in TradFi: interest rate derivatives.

This article is not intended to be exhaustive or to provide all the answers to questions related to establishing such markets or liquidity. My goal is to briefly illustrate some strategies that can easily protect yourself from interest rate fluctuations.

When borrowing crypto assets, AAVE offers two options: fixed-rate and floating-rate. You can choose to borrow at a fixed rate that is very high but doesn't change (or change very much) over time. In this case, you will pay a security fee. On the other hand, you can choose a variable borrowing rate, which is lower than a fixed rate on average but subject to market risk. It leads to more efficient but riskier borrowing of capital. Therefore, it is important for large market participants to find ways to protect themselves from interest rate risk, which is characterized by undesired changes in borrowing rates.

Variable rates (purple) and fixed borrowing rates (blue) on AAVE

An interest rate derivative is a derivative that allows you to hedge against interest rate fluctuations, either up or down. In this article, we will discuss two main types of interest rate hedging instruments: swaps and options.

Unlike traditional markets, AAVE's interest rate does not depend on the price of the underlying asset, but on the availability of liquidity.

When most assets are available, interest rates are low to encourage borrowing. When assets become scarce, interest rates rise to encourage repayment of borrowings and increase deposits in the liquidity pool.

Formula for calculating AAVE borrowing rate Rt, where U = capital in capital pool

01 Interest rate swap

Interest rate swap/interest rate swap is a two-party contract between Alice and Bob. In the case of borrowing, the interest rate swap works as follows: Suppose Alice borrows an amount X at a fixed interest rate, while suppose Bob borrows an amount X, but this time at a variable interest rate. Then, on each interest payment day, the parties exchange the amount of interest they have to pay. So we have Alice, who chose the fixed rate solution, paying the variable rate, and Bob, who chose the variable rate option, paying the fixed rate. We have an exchange of interest cash flows.

But what is the point of such a product?

Let's say I borrow $20,000 a year from AAVE at variable interest rates ranging from 0% to 20%. The equivalent fixed rate for AAVE is 10 per cent. This means:

- If I were to borrow $20,000 at a floating rate, the interest I would have to pay would be between 0 and 20% of that $20,000, so, within a year, about $0 to $4,000.

- If I borrow 20K at a fixed rate (10%), I will have to pay $2000 in interest.

There is a big gap between the two APRs of these solutions. In the worst case, with a variable rate, I could end up paying 20% more each year. So the fixed-rate option seems more attractive in terms of risk, but 10% is still a lot! So how can this risk be reduced? In doing so, how can I take advantage of interest rates that are lower than the fixed rate? Well, that's the whole point of the swap.

BAT on Aave we notice that the variable rate (purple) sometimes exceeds

Fixed rate (blue) & NBSP;

Assume Aave borrows at a floating rate of 2% and a fixed rate of 10%. The current thinking is that interest rates will go up because a lot of people will want to borrow money. I believe floating rates are likely to surpass fixed rates. But we don't know when that will happen. So we want to borrow with a floating APR, as long as it's lower than the fixed rate. Thus, we can set up the swap as follows: we borrow at a variable rate (when borrowing = 2%) and the swap is activated when the variable rate exceeds the fixed rate (say 10%). This also means that if the floating rate never exceeds the fixed rate, the swap will never be activated.

That's what you could theoretically do. In practice, it's a bit complicated because you have to find a counterparty for the swap. Given the lack, or even non-existence, of liquidity in interest rate derivatives, this seems unlikely: no one would want to buy the opposite position, or would demand a very high premium to execute the trade.

02 Interest rate Option

This article will not discuss the "classic" options that allow you to secure positions in assets such as stocks, as they have been described in depth in other articles and are increasingly being used in cryptocurrencies. Deribit is the largest crypto options market, with daily trading volume approaching $500 million. Numerous decentralized exchanges specializing in options (Dopex, Squeeth, Hegic, etc.) have also emerged recently, but it is clear that total trading volume on all of them is still very low (around $200 million per day). The CBOE, by contrast, is one of the largest options markets, trading more than $10bn a day. The scale is totally different.

Size on Hegic (Hegic.co)

Interest rate options allow hedging against rising interest rates (Cap) or falling interest rates (Floor). The tool provides a strategic benefit to the buyer, who can choose which direction of change he wants to protect himself from. A lot of times, there's only one interest rate move that's good for the buyer. This can be determined by analyzing current conditions (rising or falling interest rates).

Translator's Note:

Cap option, which caps the interest cost of a debt instrument with a variable or floating interest rate by capping the interest rate at a specified time in the future. It is customary to call it Cap, because Cap means Cap, figuratively representing a Cap on interest rates. Similarly, Floor means Floor, the Floor of interest rates. For the convenience of industry communication, Cap and Floor are not translated below.

The buyer of the option has the right to borrow (interest ceiling) or lend (floor) a specified amount at a fixed rate for a specified period. Both parties agree that if the reference rate is different from the rate specified in the contract, one party will pay the other a Premium. These contracts are usually traded in the OTC (over-the-counter) market. They are a hedge against interest rate movements.

The option Cap may be resold prior to the expiration date (requiring the buyer to pay the seller the premium). The same applies to floors.

Interest rate options can be stated simply like this (for this example, Alice is the buyer and Bob is the other) :

Suppose Alice buys a cap option from Bob.

Features:

- Exercise rate: ETH borrowing rate on AAVE

- Reference rate: 5%.

If the AAVE interest rate is higher than the reference fee rate (i.e. 5%), Bob will have to pay Alice a premium equivalent to the difference between tAAVE and tReference.

If AAVE is equal to 10%, Bob will pay 5% to Alice.

If the AAVE ratio = 4%, Bob pays nothing to Alice.

Now, suppose Alice buys a Floor from Boh.

Features:

- Exercise rate: ETH borrowing rate on AAVE

- Reference rate: 5%.

If the AAVE rate is lower than the reference rate (i.e. 5%), Bob must pay Alice a premium (equal to the difference between tReference and tAAVE).

If AAVE interest rate = 7%, the counterparty will not pay any premium to Alice. On the other hand, if the AAVE rate = 3%, Bob would have to pay Alice the equivalent of a 2% premium.

There are three main types of interest rate options:

Cap = Call option at which the buyer determines the maximum interest rate at which to borrow the required amount, and the seller bears the risk (in the case of the buyer, the payment of the royalty) of exceeding (up) that interest rate. Therefore, the buyer is certain to be able to borrow at a lower interest rate than the exercise rate for the period specified in the clause. (equivalent to a call option on interest rates).

Contingent Cap:The borrower hedges against rising interest rates by capping them and is not penalized for paying a premium if the hedge does not work for him. In contrast to traditional caps, contingent Cap royalty payments are not immediate and systematic. It is paid only when a specified interest rate is reached. Therefore, royalty payments may only occur when the Cap is "triggered".

Cap Spread:The buyer wants to guarantee the highest rate level while paying a lower royalty than the classic Cap. In return, the buyer accepts that his reference rate changes from some rate threshold to variable again. As a result, he benefits from interest rate differentials, which lowers his financing costs. This corresponds to buying one Cap and selling another Cap with the same option characteristics as the first Cap (amount, term, variable reference rate) but at a higher price.

Up and Out Cap:The buyer wants to guarantee the highest interest rate while paying a lower royalty than the classic Cap. In return, the buyer accepts hedges that are limited to a predetermined interest rate range. If the exercise rate exceeds the rate limit, the reference rate will again be variable and proportional to the exercise rate.

Floor = put options, which determine the interest rate at which a person wishes to borrow money in exchange for a premium, and the risk (downward) of exceeding this rate is borne by the seller. Therefore, the buyer must be able to borrow at a higher interest rate than the exercise rate. (equivalent to an interest rate put option).

Down And Out Floor:On the same principle as Cap Up and Out, the buyer accepts hedges within a predetermined interest rate range. If the exercise rate exceeds the limit, the reference rate will again be variable and proportional to the exercise rate.

Collar = mix of buying Cap and selling floor or buying floor and selling Cap.

Corridor:Allows the cost of hedging borrowings to be reduced or eliminated by forgoing variations in the exercise rate.

- Debit channel: Buy CAP and sell FLOOR

- Lender channel: Buy FLOOR and sell CAP

In both cases, CAP and FLOOR must have the same characteristics (quantity, duration, variable reference rate).

As we have seen, interest rate derivatives help control the risk of interest rate changes. These instruments will eventually become common. The market now faces several problems that hinder the development of such "institutional" instruments. One example is liquidity, by far the biggest problem the market has to deal with. The lack of liquidity in the market is (in my view) largely caused by the nature of the stablecoin, which does not (yet) meet institutional standards. They are now identified as major risks to institutions. Effective hedging to reduce losses on anchored staboins is now impossible. Once the stablecoin issue is resolved, I think the market will finally be ready to receive significant liquidity inflows. Institutional-type tools are going to be very, very prominent.

Right now, we're nowhere near that. However, I will be watching it closely and watching the development of crypto interest rate derivatives closely. I think this is going to be a big event in the coming months/years. I am already happy to see a solution to the liquidity problem in the market. Until then, have fun!

Translator's Note:

Most of DeFi's problems are liquidity issues, so the three carriages in DeFi field: DEX is responsible for liquidity exchange, Lending is responsible for liquidity pricing, and Staboin is responsible for liquidity anchoring. At present, floating rate Lending agreement has been able to meet the market's demand for liquidity and become the cornerstone of DeFi Lending. However, for the traditional financial sector funds, fixed rate loan product is the most basic form, so how to undertake large institutions through a more simple and effective way of big money, meet their demand for fixed costs and fixed income, break through the existing DeFi development in the field of the ceiling, may be a long time exploration direction in the future.

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