Is Interest Rate Perpetual Swaps the Missing Puzzle Piece in DeFi Ecosystem?
This article is sourced from a research tweet by @defiance_cr, compiled and rewritten by Zhouzhou, BlockBeats.
(Background: A review of nine DeFi protocols that have yet to issue tokens for “liquidity mining”)
(Supplementary background: Analysis: What type of on-chain player are you? Airdrops, DeFi, or trading—what suits you?)
Editor’s Note:
The lack of interest rate perpetual contract tools similar to those of CME in DeFi has led to significant interest rate volatility and an inability to hedge risk. The introduction of interest rate perpetuals could help borrowers and lenders lock in rates, achieve arbitrage and risk management, and facilitate the integration of DeFi with TradFi, enhancing market efficiency and stability.
Original Content:
At the Chicago Mercantile Exchange (CME), the daily trading volume of interest rate futures exceeds one trillion dollars. This massive trading volume primarily comes from banks and asset managers who operate by hedging the risks between floating rates and fixed-rate loans that have been issued.
In DeFi, we have established a thriving floating-rate lending market, with a total value locked exceeding 30 billion dollars. Pendle’s incentivized order book has shown liquidity exceeding 200 million dollars in a single market, demonstrating a strong demand for interest rate spot trading.
However, we still lack a DeFi-native tool akin to CME’s interest rate futures for hedging interest rate risks between borrowers and lenders (excluding IPOR swaps due to their complexity).
To understand why we need this tool, we must first comprehend how interest rates operate in DeFi. Taking AAVE as an example, its interest rates are adjusted based on supply and demand dynamics. However, AAVE’s supply and demand do not exist in isolation; they are nested within the larger context of the global economy.
By comparing the smoothed floating USDC interest rate of AAVE with the CME’s 10-year treasury futures price, we can observe this macroeconomic correlation:
The trend of AAVE’s USDC interest rate aligns with global interest rates but exhibits a certain lag. This lag is primarily due to the lack of an immediate linkage mechanism between global rates and AAVE rates.
It is precisely because of this disconnect that the supply and demand dynamics of the cryptocurrency market play a stronger role in rate formation. When we remove the smoothing and directly compare AAVE’s rate with the global 10-year treasury rate, this phenomenon becomes even more evident:
AAVE’s interest rate fluctuates dramatically, and for most of the time, it has a significant premium compared to the US 10-year treasury rate. The fundamental reason for this premium remains the lack of a direct correlation between these two markets. If there were a simple, two-way connection mechanism between DeFi and TradFi interest rates that could hedge or arbitrage, it would better integrate the two ecosystems.
The Interest Rate Perpetual Swaps are the optimal way to achieve this. Perpetual swaps have already been validated in the market for product-market fit (PMF). Establishing a perpetual market covering AAVE rates and US treasury rates could bring about monumental changes.
For instance, for borrowers, they could go long on an interest rate perpetual swap pegged to the AAVE borrowing rate. If the annual borrowing rate surged from 5% to 10%, the price of this perpetual contract would increase, thus hedging the risk of rising costs.
Conversely, if the rate decreases, borrowing becomes cheaper, but the perpetual position incurs losses, akin to paying an “insurance premium.” As a result, borrowers effectively lock in an efficient fixed rate through borrowing + going long on the perpetual contract.
For stablecoin lenders, they could short an interest rate perpetual swap based on the stablecoin lending rate. If lending yields decline, the short position on the perpetual contract profits, offsetting losses from reduced loan income; if yields rise, the short position incurs losses, but interest income increases, providing a hedge.
Moreover, these contracts can leverage high amounts. A 10x leverage is a common configuration in the interest rate markets at CME.
Having a well-liquidated interest rate market can also reduce cascading effects during market stress. If market participants hedge in advance, they won’t be forced to make large withdrawals or liquidations due to interest rate fluctuations.
More importantly, this also opens the door to truly long-term fixed-rate loans—if this interest rate perpetual contract is fully DeFi-native, it could be used by various protocols for long-term rate hedging, thus providing users with fixed-rate loans.
In traditional finance, hedging interest rate risks is a standard practice, with most long-term loans backed by interest rate hedging tools.
Introducing this mechanism into DeFi would not only enhance efficiency but also attract more TradFi players into this market, truly bridging the gap between DeFi and TradFi.
We can make the market more efficient, and all it takes is the emergence of an interest rate perpetual contract.
