This year, more than one-fifth of American adults have traded or used cryptocurrency, an astronomical increase since 2009, when Bitcoin broke onto the scene. This trend also introduced millions of people to a new iteration of finance, accelerating and popularizing new technologies that are making global financial services more equitable and accessible than ever before.
Decentralized finance (DeFi) is quickly expanding access to an array of financial services, including interest rate swaps (IRS), a derivative instrument for exchanging fixed and variable interest rates, which account for more than US$1 quadrillion in exchanged value per annum in traditional finance.
Just as the rise of smartphones and cloud computing changed banking and finance forever, DeFi is the next leap forward in global finance, reimagining a range of financial products for today’s investors.
This leap means centralized incumbent corporate gatekeepers of financial products and services are being replaced with decentralized, open and permissionless protocols. Interest rate swaps in DeFi serve as the tip of the spear aiming to disrupt TradFi’s dominance of global financial markets.
Interest rates swaps in global finance
Interest rate swaps are critical to the global financial system, helping governments, businesses and investors exchange a fixed payment for a floating payment, or visa-versa. These swaps are typically connected to a specific interest rate like Sterling Overnight Index Average (SONIA) or Secured Overnight Financing Rate (SOFR).
An interest rate swap can help companies operating in a global economy take advantage of better interest rates in different countries and help firms guard against interest rate exposure by revisiting or revising their debt conditions to account for shifting economic realities. Interest rate swaps are an essential tool for speculation, risk management and structured investment product generation as well as retail-focused investment products like mortgages and fixed-rate savings accounts.
The quadrillion dollars in notional value exchanged each year demonstrates the importance of this derivative instrument. However, interest rate swap products have only made limited inroads among DeFi platforms as the technological challenges and fundamental requirements have, to date, limited platforms’ ability to offer this service at scale.
Bringing interest rate swaps to DeFi
Automated market makers (AMMs) are one of the most foundational aspects of the cryptocurrency ecosystem and DeFi platforms, allowing users to exchange tokens and tokenized assets without locating a counterparty.
These autonomous protocols powered by smart contracts have allowed decentralized exchanges (DEXs) to thrive, eliminating intermediaries and unlocking new investment methodologies for DeFi users.
Unfortunately, efforts to leverage AMMs to facilitate interest rate swaps have generally been unsuccessful. This challenge is exacerbated by the fact that most DeFi rates, including lend-borrow protocols or staking rates from a specific blockchain ecosystem, are variable. Additionally, the lend and borrow rates for DeFi protocols can be highly volatile, ranging from 0.03% to 10%, and this uncertainty over potential returns or borrowing costs greatly hinders adoption from the broader market.
Other challenges include capital inefficiency and a lack of flexibility in AMM design, which would prevent traders from moving in and out of positions. It’s easy to see why DeFi platforms have too often been prevented from realizing the opportunities associated with interest rate swaps for their users.
Synthetic interest rate swaps can help solve these challenges, allowing DeFi platforms to remove the silos between fixed and variable rate products and enhancing potential trading leverage for certain assets.
AMM protocols that accommodate fixed and variable rate products can more effectively empower interest rate swaps across DeFi ecosystems. What’s more, DeFi platforms can leverage concentrated liquidity structures that greatly increase capital efficiency and liquidity provider autonomy.
Ultimately, when technical capability, accessibility and incentives are aligned, there will be a tipping point in interest rate swap volume away from TradFi structures and into DeFi platforms. Institutions and individual traders alike will realize the benefits of a range of new financial products and trading strategies, ushering in a new era of global finance.
The next frontier
Consumers, businesses and governments are increasingly embracing digital assets, decentralized ecosystems and distributed platforms. For many, they represent the best ways to protect their privacy, enhance functionality and navigate the digital-first present and future.
Many DeFi projects are ready to meet the moment, harnessing clear vision, incredible talent and investor resources to build the best platforms for their users. The success of these projects is predicated on their capacity to effectively attract critical mass away from existing, centralized institutions and toward DeFi platforms and services.
This new frontier requires that financial products are accessible, easy to use and offer real benefits to users. DeFi interest rate swap products have the additional challenge of educating users about a derivative that was previously inaccessible to them. Still, the massive trade volume and functionality of rate swaps make them a mission-critical part of the DeFi revolution.
In order for DeFi to become the global financial system of the world, the Great Interest Rate Swap Flippening needs to take place. The interest rate swap traders, platform builders and institutions that are working toward this goal are laying the groundwork for this historic and thoroughly disruptive event.