Original title: Interest Rate Perpetuals: DeFi’s missing piece
Original author: @defiance_cr
Original translation: zhouzhou, BlockBeats
Editors note: DeFi lacks interest rate perpetual contract tools similar to CME, which leads to large interest rate fluctuations and the inability to hedge risks. The introduction of interest rate perp can help borrowers and lenders lock in interest rates, achieve arbitrage and risk management, and promote the integration of DeFi and TradFi, improving market efficiency and stability.
The following is the original content (for easier reading and understanding, the original content has been reorganized):
At CME, interest rate futures trade more than $1 trillion a day, a huge amount of which comes mainly from banks and asset managers who hedge the risk of floating rates against existing fixed-rate loans.
In DeFi, we have built a thriving floating rate lending market with a total locked value of over $30 billion. Pendle’s incentivized order book has over $200 million in liquidity in a single market, demonstrating the strong market demand for interest rate spot.
But we still lack a DeFi-native tool like CME interest rate futures to hedge interest rate risk for borrowers and lenders (IPOR swaps don’t count because they are too complicated).
To understand why we need this tool, we first need to understand how interest rates work in DeFi.
Taking AAVE as an example, its interest rate is adjusted dynamically based on supply and demand. However, the supply and demand of AAVE does not exist in isolation, but is embedded in the context of the global economy.
We can see this macroeconomic correlation by plotting AAVE’s smoothed USDC floating rate against CME’s 10-year Treasury futures price:
AAVE’s USDC interest rate trend is consistent with the global interest rate, but there is a certain lag. The main reason for this lag is the lack of an immediate linkage mechanism between the global interest rate and the AAVE interest rate.
It is precisely because of this fault that the supply and demand dynamics of the crypto market itself play a stronger role in the formation of interest rates. This phenomenon is more obvious when we remove the smoothing process and directly compare the interest rate of AAVE with the global 10-year Treasury bond rate:
AAVEs interest rate fluctuates wildly, and most of the time, it trades at a significant premium to the 10-year U.S. Treasury bond rate.
The root cause of this premium is still the lack of direct connection between the two markets. If there is a simple, two-way connection mechanism between DeFi and TradFi interest rates, which can be hedged or arbitrage, the two ecosystems can be better integrated.
Perpetual Swaps are the best way to achieve this. Perp has been verified by the market for product fit (PMF), and if a perpetual market covering AAVE interest rates and US Treasury bond interest rates can be established, it will bring about tremendous changes.
For example:
For borrowers, they can go long on a perpetual contract that is anchored to the AAVE borrowing rate. If the annualized borrowing rate soars from 5% to 10%, the price of this perpetual contract will rise, thus hedging the risk of rising costs.
On the contrary, if interest rates fall, borrowing becomes cheaper, but the perpetual position loses money, which is like paying an insurance premium. In this way, the borrower is equivalent to locking in an effective fixed interest rate by borrowing + going long on the perpetual contract.
For stablecoin lenders, they can short a perpetual contract based on the stablecoin lending rate. If the lending income declines, the short position of the perpetual contract will make a profit, offsetting the loss caused by the reduction in loan income; if the income rises, the short position will lose money, but the interest income will increase, forming a hedge.
Moreover, these contracts can also use high leverage. In the interest rate market on CME, 10x leverage is a common configuration.
Having a liquid interest rate market can also reduce stampede-like chain reactions in times of market stress. If market participants hedge well in advance, they will not be forced to make large-scale withdrawals or close positions 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 completely DeFi native, it can be used by various protocols for long-term interest rate hedging, thereby providing users with fixed-rate loans.
In traditional finance, hedging interest rate risk is a routine operation, and most long-term loans have interest rate hedging tools behind them.
Introducing this mechanism into DeFi will not only improve efficiency, but also attract more TradFi players to enter this market and truly build a bridge between DeFi and TradFi.
We can make the market more efficient, and all it takes is the emergence of an interest rate perpetual contract.
