Interest rate swaps facilitate conventional financing. With a market capitalization of $1,000,000,000,000,000,000, it supports corporations, banks, and governments in managing their debt. Using this derivative, investors may swap the asset’s interest rate with another party. Fundamentally, it increases the scalability and complexity of the global financial system.
Some contend that the complexity of implementing decentralized interest rate swaps has hindered the DeFi industry’s ability to grow and become more complex.
The CEO of Voltz Labs, a pioneer in decentralized interest rate swaps for DeFi, explained more about the significance of interest rate swaps and the repercussions of its incorporation into DeFi.
What are interest rate swaps exactly?
In conventional finance, an interest rate swap is a derivative contract in which two counterparties agree to exchange one flow of future interest payments for another. Both parties agree that they prefer the other’s interest rate arrangement, so they enter into a contract to swap future interest payments. Swaps are often used to exchange a variable or “floating” interest rate for a fixed one.
If interest rates increase, variable rates will enjoy greater returns, while fixed rates would suffer lower returns.
Interest rate swaps’ efficiency
Whether or not you are familiar with such swaps, they are a necessary mechanism for many modern financial products.
Interest rate swaps “allow a variety of use cases including speculation, risk management, and product creation.” According to Jones, this includes structured solutions for firms and fixed-rate mortgages for households.
Without interest rate swaps, it would be far more difficult to “meet the financial needs of the system,” he said.
The challenge of integrating swaps into DeFi
Things work differently in the permissionless, decentralized environment of DeFi. Creating DeFi derivatives is a new concept that presents some unique challenges.
Jones said, “you cannot just copy and paste how it works in TradFi” when trying to replicate interest rate swaps in DeFi.
One of the reasons for this is the legal system that oversees counterparty risk in traditional finance. Such swaps carry the risk that the counterparty may default on their loan, preventing the other party from collecting what is owed. Traditional markets have a system of rules and regulations in place to handle such a situation, should it occur.
No such foundation exists for DeFi. However, industry leaders may develop technologies that render this organization unnecessary.
“In traditional finance, when you enter into a swap with another party, you incur counterparty risk,” Jones explained. To enable this, they devised a comprehensive legal system, which included the hiring of rating agencies. On the other hand, DeFi is rather distinct. Instead than having protocols for what to do when a counterparty fails, we’ve designed a system that removes counterparty risk, meaning it cannot fail.
In addition, he said that evaluating the utility of these instruments and developing techniques to “deliver the same benefit in a new situation with different limits” would need around six months of research.
What significance do DeFi interest rate swaps have for the market?
According to Jones, the creation of financial products is surrounded by “a spectrum of complexity.” The advent of interest rate swaps to DeFi will attract expert speculators, institutional investors, and individual investors.
Interest rate swaps in DeFi provide the simplest degree of complexity for fixed-rate products. Customers of DeFi may now convert variable-rate assets into fixed-rate assets for the first time. Prior to the recent past, DeFi clients seeking yield were subject to unpredictable interest rates.
Moving on to more complex financial instruments, Voltz Protocol may “unlock products like interest rate caps, floors, covered call payments, fixed-rate mortgages, and swaptions.” These allow clients of DeFi to access a wider range of financial services and trading opportunities.
Jones said that “teams are building many of these [DeFi financial products] alongside more innovative uses, such as using fixed-rate assets as a form of stablecoin collateralization.” With recent events in the cryptocurrency industry, new techniques of collateralizing stablecoins are certain to attract the interest of many. They might be very useful to the growth of decentralized markets.