IPOR — DeFi Interest Rates Growing Up
There are a couple themes that I think are really going to take off in the next 1 to 2 bull runs in crypto: Fixed Rate Lending, Undercollateralized Lending, and Real World Assets. Today I want to focus on the first, Fixed Rate Lending.
Fixed Rate Lending, why its important, what we need
Fixed Rate Lending is going to be really important for the future of crypto and DeFi in general. Fixed Rate Lending means that one can borrow over a specific time (tenor/maturity) at a specified annualized rate, and someone else is lending out assets for that specified rate and period of time. For example, a protocol Treasury may want to borrow capital to fund the development of a new product. Or a DAO Treasury may have access to capital that it will not need for 6 months and is willing to lend it out for a fixed term, usually for a premium. For a deep dive into DAO Treasury Risk Management, check out this article by IPOR Labs Team.
Right now, most of the liquidity in borrow/lending platforms is floating rate liquidity (look at Aave and Compound as examples). Using our protocol that wants a fixed term loan as an example; this protocol has no idea what the actual cost of their financing/borrowing is going to be, because even though the interest rate right now may be 2.5% on USDC, it could fluctuate up or down at any moment. This protocol would most likely be happier to pay a slightly higher interest rate now, knowing that the rate will not change (i.e. locking in that rate for say 6 months). If the protocol could get a 6 month loan for 3%, they would know exactly the amount of interest they are going to pay (say if the loan is 1M USDC, they would pay interest of 15,000 USDC of interest total, usually in a term loan at the end of the 6 months).
Fixed Rate Lending is necessary to scale out useful, productive borrowing in DeFi. I can’t substantiate this claim, but I expect most borrowing in DeFi right now is for more degen-like activities: leverage, shorting, yield farming/harvesting strategies like folding, etc.
What we still need for fixed rate is more standardization and composability among protocols. There are some fixed rate lending protocols out there right now, but they are all isolated from each other and operate in their own vacuum. And what we really need is a yield curve and a standardized index that states what the expected interest rate is for a 6 month overcollateralized loan. And we need to know what the interest rate should be for 1 month loan, 2 month, etc. Once we have a standardized index, users/protocols/DAOs will have an idea of what to expect for their loans, and will be able to decide on what fixed rate lending platform to use. This will also help converge current fixed interest rates across an ecosystem.
Another helpful tool will be Interest Rate Derivatives (IRDs). IRDs are the largest derivatives market in TradFi. They are used by banks and market makers to hedge their books. They are used by companies to hedge their floating rate debt, or turn fixed rate debt into floating rate debt. They are used by institutions (like pension plans) to hedge their liabilities in a capital efficient way. Finally, they can be used by speculators to trade on the expectations of future interest rates across the swap curve.
IPOR Index
IPOR is the premier protocol building out DeFi Interest Rate Indices. Its goal is to become the benchmark reference rate for all DeFi protocols: fixed rate, derivatives, floating rate, structured products, etc. This reference rate can be used as the benchmark for all of DeFi interest rates.
Right now, there are 3 different IPOR Indices: a USDC index, a USDT index, and a DAI index. Each of these indices give users an idea of what the average borrow/lend floating rate is on the Ethereum Blockchain. The index calculation is thoughtful, updated frequently, uses multiple protocols (right now both Aave and Compound are used, weighted by liquidity), and will be updated through the IPOR DAO (i.e. new constituents added and existing constituents removed). The IPOR Indices are public goods to be used by anyone and any protocol. Anyone can invoke a public function to print an IPOR index on chain at any time (as long as they provide the necessary gas costs). The IPOR indices are composable, and its easy to see how other protocols will want to reference and use these indices.
As IPOR evolves, its also easy to see how there will be many different indices over time. There will need to be an index for different maturities for each token (a 1 month USDC Index, 2 month USDC Index, etc.) in order to build out a token’s yield curve. Different blockchains have different liquidity and different use cases, so it may make sense to build out a USDC IPOR Index on an L2 or different L1 versus the current Ethereum based chain. Each token will have its own set of Indices to reference (maybe a floating rate ETH Index soon??).
IPOR’s first product, the Interest Rate Swap
The IPOR team didn’t stop with just building out the IPOR Floating Rate Indices, they also built out their first product, the Interest Rate Swap (IRS). An IRS gives a user the ability to go long or short the floating rate of a specific token on the Ethereum blockchain. Going long means that you make money when the floating rate increases, going short means that you make money when the floating rate decreases.
Traders may want to go long or short a specific interest rate in order to try and speculate on the future path of the interest rate (and try to make money). Hedgers may want to go long or short a specific interest in order to hedge their existing trading book, or to offset an existing fixed rate or floating rate loan. My favorite use case of IRS is detailed more below, but it is a way of borrowing on Aave/Compound for a great fixed rate for a 28 day term.
The actual terminology used is fixed rate payer and fixed rate receiver.
Fixed Rate Payer
A fixed rate payer swap, going long the interest rate, means that the trader/hedger is locked in to pay a specific interest rate to pay, and will receive the unknown floating rate in the future. The trader makes money when the floating Index rate increases. The hedger locks in a fixed rate. My favorite use case for this is protocols and DAOs wanting to borrow in a capital efficient fixed rate way (see the example at the bottom of this article in Appendix I).
Fixed Rate Reciever
A fixed rate receiver swap, going short the interest rate, means that the trader/hedger has locked in a specific interest rate to receive, and will pay the unknown floating rate in the future. The trader makes money when the floating Index rate decreases. The hedger offsets an existing fixed rate liability with floating rates. In TradFi, fixed rate receivers are like going long bonds, because bonds’ market values increase when interest rates decrease. These receiver swaps are common instruments used in pension lability matching portfolios (LDI/ALM). It also was a big cause of the UK Pension Crisis in Q3 2022 (poor collateral management).
Capital Efficiency
IPOR allows users to deposit collateral up to 1000x less than the notional value of the IRS. This may feel like a lot of ‘leverage’, and even though 1000x may seem like a lot, your P&L is earned over time, it is not instantaneous like perpetuals. It is really allowing capital efficiency in the IRS (really useful for hedgers). Also, the P&L accrues over time, over the 28 days. So even a sudden shock in interest rates would only slowly occur positive or negative P&L. It gives traders plenty of time to react to changing and dynamic floating rate environments, with low possiblities of liquidations. And these IRS are cancellable at any time. This is key for trader risk management. Check out the example of the daily P&L calculation in Appendix II.
Perpetuals are constantly adjusting your P&L based on the perp price on the exchange. There is no time value concept like there is with IRS. A 50% change in the interest rate on an IRS (say moving from 2% to 1%) even at 1000x leverage will not get you liquidated. But a 50% move with 2x leverage on a perp means you lose all your collateral immediately(honestly you would be liquidated well before then).
Real Yield on IPOR; Depositing into a Liquidity Pool / Liquidity Provision
The rates you can earn on IPOR by depositing into one of their Liquidity Pools (LP)are top notch. Normally, when you see higher rates than elsewhere in the ecosystem, you need to ask yourself, what is this yield and where is it coming from. Is it coming from emissions/farming tokens? Am I the yield for someone else?
This is not the case when you deposit liquidity into an IPOR LP. The team has amazing documentation explaining where this yield is coming from.
- Fees from traders/hedgers opening up Interest Rate Swaps
- Fees from other LPs withdrawing their liquidity (currently set to a 0.5% withdrawal fee)
- P&L from the trades (both realized and unrealized)
- Unused capital from both LPs and traders’ collateral being deployed through the IPOR Asset Manager to Lending Protocols (i.e. Aave and Compound)
The first two ways the LPs earn yield are pretty self-explanatory. Lets focus on the P&L in point 3. LPs take the other side of every IRS that is opened by a trader/hedger. So when a trader opens up a fixed rate payer IRS, the LP takes the fixed rate receiver/floating rate payer side. When a trader opens up a fixed rate receiver, the LP takes the fixed rate payer/floating rate receiver side of the trade. Each trade has its own Profit or Loss (P&L/PnL). When you sum up all the profits/losses for all trades against that LP, you get the Sum of all Payments (SOAP). IPOR has great documentation on it, definitely take a look.
Assets that are sitting in the LP and that are not being used as collateral for the other side of a trade, are lent out to different borrow/lending protocols (right now Aave and Compound). Also, some of the traders collateral will also be lent out a well. This effectively allows LPs to earn levered yield on the money market accounts since not only will their tokens deposited into the LP be lent, but part of traders collateral as well. This is all governed by asset management logic.
The IPOR Spread in IRS
The goal of each LP is to have essentially no exposure to the interest rates, so that the P&L from fixed payer traders offsets the P&L from fixed receiver traders. Why? Because IPOR wants to incentivize people to trade/hedge! If they made trading/hedging too costly (i.e. really beneficial for LPs), no one would use the protocol. If they made trading/hedging too cheap, LPs may lose too much money. So IPOR has spent a large amount of time and research thinking about how they quote the fixed rate that a trader/hedger will receiver or pay. That fixed rate is based on the current IPOR rate plus/minus a spread. The calculation of the spread includes pretty complicated logic. It looks at historical volatility, as well as current volatility. They use a Jump Diffusion Model (Hull White Jump Diffusion Model) as well to help smooth out big jumps in the IPOR Index. Also, they use a model that helps adjust the spread price for the optionality that traders have (using Longstaff-Schwartz Model). Traders can close the swap (its a cancellable swap) at any time. This option (only given to traders not LPs) needs to be accounted for as well. There is an amazing research paper here for those technically inclined. Finally, the reference rate (before the spread) also will look at an Exponential Moving Average to help smooth out any spikes in the IPOR Index.
All of this is really to say that the team is made up of a bunch of really smart people. And they understand the need to balance making swaps attractive for traders/hedgers without hurting the performance of LPs. Future logic may be included to help balance out any LP that has outsized exposure to the the floating rate (i.e. if the LP is net long the USDC rate — has more exposure to fixed rate payer/floating rate receiver, maybe the spread will be less attractive for traders to enter into fixed rate receivers and more attractive to enter into fixed rate payers… to help offset the LPs net position).
Conclusion
As per usual, I apologize for the long article. There is a lot to cover here, and I hope I did it justice. You can tell I am very excited for IPOR Labs Team to keep building. They really have caught my attention. I have deposited USDC into their USDC LP, and have opened up a USDC Fixed Rate Payer Swap as well. I think IPOR will continue to grow, and build out the necessary infrastructure for DeFi Interest Rates!
P.S. Check out their statistics page!
Appendix I
Example of a user/protocol/DAO using IPOR and Aave or Compound to borrow for 28 days for a fixed rate
A protocol wants to borrow 1M USDC, for 28 days. Right now they could go borrow on Aave for 3.04% annualized or Compound for 2.33% annualized, but they have no idea if that rate will increase or decrease each block over the next 28 days. So the protocol decides to borrow on Compound and enter into a fixed rate payer swap on IPOR to lock in a specific rate for 28 days.
- The protocol has $2M worth of ETH it decides to supply to Compound, so that it has a safer collateral factor (ETH collateral factor is 82% right now, so at a minimum the protocol must have $1,219,512 ETH deposited in order to have a debt of $1M USDC.
- The protocol then enters into a fixed rate payer swap on IPOR with a notional amount of 1M USDC. Since IPOR allows for a collateral deposit of 1000x less than the notional, the protocol deposits $1,000 USDC into IPOR (plus the fee and liquidation deposits)
- The protocol has now locked in a fixed rate of 1.7583% annualized (1348.83 USDC = 1M * 1.7583% * 28 / 365). They will also have to pay/receive the small spread between Compound borrow rate on USDC and the IPOR floating rate (which right now is 2.33% — 2.083% = 0.247% annualized). If that spread stayed constant for the 28 days, the additional cost would be $189.48, for a total of $1538.31. The annualized total rate is 2.0053%.
- The protocol successfully locked in a fixed rate for 28 days on 1M borrowed USDC! They should continue to monitor their health factor/collateral ratio on Compound and also make sure they will not get liquidated on IPOR, but in all honesty, it would really take a massive drop in rates for liquidation on IPOR to be possible.
Appendix II
Example of IPOR Daily P&L Calculation
Let’s continue with the protocol above who locks in a $1M USDC loan at 1.7583% for 28 days. Lets pretend like immediately after they lock in their IRS, the IPOR Index drops by 1% (a big drop) to 0.7583% and stays there for 1 day. What is their P&L over that 1 day?
P&L = (0.7583% — 1.7583%) * $1M / 365 = $-27.40
If the IPOR stayed there for all 28 days, the total loss would be = $-767.12. This is still below the collateral deposited. So even this big 1% drop in rates, that stayed there for 28 days would not cause a liquidation.
Furthermore, the protocol can close this IRS anytime! If they felt like they no longer wanted to have this IRS, or reestablish a new floating rate and /or fixed rate loan, they could do that anytime!
About Marco
I am in the Kitty Farmer Committee for Minswap Labs. I am an active community member and Iporian at IPOR. I am also an active community member of Optim Labs. I am part of the Calculated Finance CALC Strategy DAO. I am a co-founder of Osmium DAO.
This is not Financial Advice!
I would love to hear your feedback/questions/comments. Reach out to me on Twitter… Marco_112358, or Discord… marco_112358 in Wonderland#2400
