This piece was written in collaboration with Samuel Shadrach. You can follow him on Twitter here or subscribe to his Substack here.
Yesterday, FinTwit got all excited about Interest Rate Swaps on the blockchain.
Maybe not all for the right reason
But we thought we would bridge the gap and talk about these products from both perspectives.
Introduction to Interest Rate Swaps
A swap is a contract between two parties to exchange cash flows at specified dates in the future according to prearranged rules. A agrees to pay B cash flows based on a fixed interest rate in exchange for receiving from B cash flows in accordance with a specified floating interest rate. Both are based on a notional principal and a specified number of years. These instruments can be used to speculate, hedge, and manage interest rate risk.
Who uses Interest Rate Swaps?
A large range of players e.g. hedge funds looking to speculate on interest rates, pension funds looking to hedge interest rate risk.
Example: Pension funds need to fund liabilities (payouts to retirees) and are required to calculate the present value of liabilities. If interest rates decline then that increases the present values of future liabilities. One way to hedge interest rate risk is for the pension fund to enter into a swap agreement where they agree to receive fixed payments in exchange for making floating payments. By entering into this agreement, if interest rates decline then the value of future floating payments the pension fund has to make decreases.
The Pendle Example
Yields in stablecoins are trending down, hence there is demand to lock in yields today.
Cue Pendle, a protocol that allows the trading and hedging of future yield.
Today if you deposit USDC into Compound or AAVE you receive yield of ~2%. Where does this 2% come from? It’s demand for leverage — others are willing to borrow USD to speculate on crypto e.g. get more ETH, or fund speculative yield farming.
What Pendle does is to split up the underlying USDC into what’s called an ownership token and a future yield token.
Underlying = USDC or DAI
Split into
Ownership Token (OT)
Future Yield (YT)
YT and OT have expiration dates — currently 29 Dec 2022. After expiry, YT holders will no longer receive the yield so the price of YT trends towards 0 over time.
OT works like a zero coupon bond where you get back the underlying if you hold it to maturity.
However, despite the expiration dates, you can actually redeem your underlying at any point so long as you have both OT and YT.
Ok here comes the mind-bender
How did a user make 18% selling future yield on an underlying that is yielding 2%?
(I just checked it’s closer to 13–14% now)
Why would anyone be willing to pay an extra 11–12%?
This is because Pendle is incentivizing users to provide liquidity to the YT / USDC pool. How? By compensating them with PENDLE tokens. As State.eth puts it, it is creating inorganic demand for the Yield Tokens
Currently YT / USDC LP is giving you ~300% APR (variable)
You can check it here https://vfat.tools/pendle/
Different strategies that can be attempted. None of this is investment advice and you can lose ALL YOUR CAPITAL — read the Risks section before attempting anything.
It’s NOT a risk-free 18%..
Since the Underlying = OT + YT
You can
1.Bet on YT going down
If fair value of YT is $0.02 then
Price of YT should go down and price of OT should go up
Mint OT+YT, sell your YT for $0.17, wait for the price of YT to fall.
Then buy back YT at a lower price. Take OT and YT and redeem for the underlying — you can do this at any point before expiry.
2. Bet on OT going up (extension of 1)
In this example the user locked in his YT gains and then put them into OTs, levering up on the same trade.
3. Be contrarian and bet on YT going up (Because, markets can remain very irrational, right?)
Buy YT on Pendle
4. Bet on OT going down (extension of 3)
Mint + sell OT
5. Provide Liquidity (earn PENDLE)
But comes with risk of (Im)permanent Loss
Provide liquidity to the YT / USDC pool and make the 300% APR.
Guide here https://medium.com/pendle/pendle-is-live-23589c8b14dc
Caveat — if YT does fall in value then you suffer (Im)Permanent Losses providing liquidity.
What are the risks??
I mean, you don’t expect to make 18% without risks right?
And there are plenty
Smart contract bugs — Ethereum harbours a strong “code is law” philosophy, this means all protocols are written as EVM program code, and if there are any bugs in it, there is no one you can complain about that to. Your yield may be locked in, but your principal is still stuck in the protocol for at least a year, assuming you don’t want to close your position before maturity of the interest rate swap. Hundreds of millions of dollars have been stolen from such exploits. Two things can help. The first is expert auditors and peer reviews of the code to ensure there are no bugs. The second is the test of time, where if a protocol has enough money in it for enough time, you can assume that if they were hackable they would have been hacked already. One could argue that Aave and Compound have undergone this test, while Pendle is still in the process of doing so.
Default risk — Aave and Compound have a small probability of defaulting, due to collateral not being liquidated properly. Various factors impact this, but some include:
- unexpectedly high volatility of assets — potentially due to major market moves, or any systemic reasons
- insufficient liquidity on decentralised exchanges to liquidate collateral
- Ethereum congestion due to high gas prices — ethereum has limited transactional capacity (called gas) which is auctioned out, so market moves have higher gas prices. This can impact liquidation of smaller loans
Aave and Compound both promise to take on the risk as a protocol if a default occurs — by issuing new governance tokens (pseudo equity) of their own. How much value they are able to insure by such measures will depend on public confidence in Aave or Compound to continue functioning normally after such an event
Oracle risk — Aave and Compound rely on an external price feed provided by Chainlink to help process liquidations. They do this because doing computation directly on Ethereum is expensive, so it is hard to query prices while smoothing out any inorganic “price wicks” or manipulation of prices. This task is hence delegated to Chainlink. Additionally Chainlink queries centralised exchanges such as Binance and FTX to query prices — this enables more accurate price data to be used. Chainlink is run by about 21 parties — mostly anonymous — who publish these prices in a timely fashion because they’re incentivised using LINK payments to continue their business. One needs to ensure they have more to earn from playing by the rules, than by colluding to publish incorrect prices. There may also be other issues — such as natural events that cause them to go offline or any attack on their infrastructure by third parties.
Ethereum-related risk — Ethereum too relies on its own economic incentives to ensure everyone follows Ethereum’s rules and runs smart contracts honestly. Currently Ethereum miners secure the network, after the Merge (scheduled to happen in Q1-Q2 2022) it will be validators who stake ETH who do this. Miners and validators are also expected to behave honestly because they’re kept in check by a “social coordination” process which will secure the network if they don’t, to their detriment. Users of the network can potentially come together and agree on harsh punishments for dishonest validators — such as burning all the tokens of the validators via a fork. However this process can take days or even weeks to occur, which is more than enough time to impact irreversible damage on all decentralised trading infrastructure. Such a process has never been required in ethereum’s history; most forks have been due to disagreements within the community itself, and before the advent of decentralised trading.
A less nefarious possibility is a bug in Ethereum’s code — this too will require a fork that can take hours or a couple of days to resolve — again harming trading infrastructure.
Stablecoin-backing risk — USDC is backed by and redeemable for dollars stored in Circle’s reserve bank accounts. These accounts go through periodic attestations — however users are exposed to the possibility of fraud on the part of Circle.
DAI is a decentralised stablecoin created by MakerDAO. It relies on both USDC and crypto loans to ensure backing, in a complex process compared by some to the pegging of the Hong Kong dollar to USD. These crypto loans are largely ETH loans, and they too have their own smart contract bug risk, default risk, oracle risk and so on. MakerDAO runs its own price feeds (oracles), and has its own collaterals and liquidation policies (which are a bit more conservative than those of Aave or Compound).
After reading all of this and if you still want to try it out, leave a comment and let us know how it went!!
