Understanding Strips in One Article: An Innovative Attempt to Bring Interest Rate Markets into DeFi

Written by: Ether Boy

Source: Deep Tide Tech Flow

Interest rates are the meta-rules of finance, with a daily trading volume of $6.5 trillion in traditional finance. The interest rate trading market is 26 times larger than the stock trading market.

The TVL of DeFi has reached $200 billion, but in fact, interest rates (APY) are the meta-drivers of TVL. You deposit money in AAVE for the interest rate, participate in liquidity mining for high APY (interest rate), and provide liquidity on Curve and Uniswap for transaction fee income. However, interest rate trading has always been a missing piece in DeFi.

Strips has built the first decentralized interest rate swap platform, deployed on Arbitrum. It integrates oracles to extract floating interest rates from DeFi protocols in real-time, as well as contract rates from CEX. On Strips, users can trade interest rates with leverage of up to 10 times. Strips will provide all kinds of interest rate derivatives, structured products, and fixed income products.

The Strips mainnet went live on February 12 and has launched liquidity mining and trading mining rewards. (See details)

A Brief Introduction to Strips

What is an interest rate swap? As the name suggests, it is the exchange of fixed rates for floating rates.

In an interest rate swap, going long = paying a fixed rate and receiving a floating rate. Conversely, going short = paying a floating rate and receiving a fixed rate.

Going long: paying a fixed rate and receiving a floating rate.

When swapping interest rates on Strips, the only two factors that affect your trading profit and loss are: profit/loss = funding pnl + trading pnl.

To understand funding pnl + trading pnl, let's start with leveraged mining on Strips:

What is funding pnl: Going long on interest rates (paying a fixed rate and receiving a floating rate) is essentially equivalent to leveraged mining. For example, if the current fixed rate is 1.91% and the floating rate is 11.38%, if you go long on interest rates with 10x leverage, it means you can earn (11.38%-1.91%) x 10 = 94.7% in returns every 30 days, equivalent to a daily return of 3.1%.

As the floating rate fluctuates every hour, the profit margin from mining will also change. For instance, if the floating rate rises, the daily return will far exceed 3.1%. The funding pnl is the profit margin that is credited to your account every hour during leveraged mining.

What is trading pnl? The factors affecting trading pnl are the differences in market fixed rates when you open and close positions. Suppose you have been leveraging mining for a while and accumulated some funding pnl and plan to close your position.

At this time, the market fixed rate is 3%. Since you went long on the fixed rate, the trading pnl you can still earn is (3%-1.91%)/1.91% = 57%. With your 10x leverage, you can earn a return of 570% just by correctly predicting the direction of the interest rate (excluding slippage). This portion of the profit is the trading pnl.

Your total profit equals funding pnl + trading pnl.

It can be simply understood that leveraged mining mainly focuses on funding pnl (floating - fixed every hour), and the longer the time, the greater the proportion of funding pnl.

Betting on the direction of interest rates mainly focuses on trading pnl (the main influencing factor is the current market price of the fixed rate). The shorter the time, the greater the impact of trading pnl. The main factors affecting interest rate returns are the counterparties in the market for going long or short on interest rates.

Funding pnl looks at the long term, while trading pnl looks at the short term. From this, we can derive hedging (mining hedging, futures interest rate hedging); arbitrage between the interest rate differences of two different protocols, etc. advanced strategies.

How to Use Strips?

• Leveraged Mining:

As mentioned in the first part, the leveraged mining tools available in the market are essentially borrowing mining. In Alpaca, you can leverage up to 3 times, and the borrowing rate for ETH can be as high as 14% (and the borrowing rate is floating).

Let’s understand leveraged mining; essentially, leveraged mining is about mining interest rates. In Strips, going long on interest rates (paying a fixed rate and receiving a floating rate) is leveraged mining.

The difference is that in Strips, the maximum leverage can go up to 10 times, and you only need to pay the market's fixed rate. (Of course, it should be noted that there will be trading pnl when closing positions.)

• Speculators (Betting Dogs):

Simply betting on the rise and fall of interest rates, with leverage up to 10 times.

• Mining Hedging:

During liquidity mining, you can short on Strips (paying a floating rate and receiving a fixed rate). This converts the potentially declining high APY into a fixed rate, locking in your mining profits in advance.

• Contract Rate Hedging:

In addition to DeFi protocols, Strips also provides interest rate swaps for BTC perpetual contract rates on Binance and FTX. For CEX traders, Strips allows them to lock in contract rates as fixed rates in advance. This is in high demand among traders.

• Arbitrage (there is arbitrage space between different funding rates):

In the image:

Orange: Annualized funding rate for OMG Perp on FTX

Green: Annualized funding rate for OMG Perp on Binance

Dark blue: The difference between the two funding rates.

The rate on FTX is significantly higher than the same rate on Binance, resulting in a 10.7% difference. Currently, there is no simple way to short interest rates. However, on the Strips platform, traders can: go long on the rate on Binance and short the rate on FTX. Once the rates are equal, they can close their positions for profit.

How AMM Captures "Token Value"

The mainnet beta has established AMMs for Binance > BTC-PERP; FTX > BTC-PERP; Aave-LENDING, and insurance pools.

The AMM of Strips is noteworthy:

In Strips, the AMM for trading interest rates is not USDC, but rather formed by users staking USDC-STRP LP from Arbitrum's Sushiswap (similar to vAMM). This serves a dual purpose, as LP equals liquidity on Sushi and provides TVL for interest rate trading on Strips.

For example, when the Strips mainnet goes live, it will establish AMMs for Binance > BTC-PERP; FTX > BTC-PERP; and AAVE USDC lending rates. Suppose the TVL of the four markets is 20m; 20m; 15m; 15m, which means that Strips has at least 70m in liquidity on Sushi for USDC-STRP.

This design, combined with trading mining rewards and staking mining rewards after the mainnet launch, further amplifies its sophistication:

Once liquidity mining is activated, USDC-STRP on Sushiswap will have good depth, and the depth for purchasing STRP on Sushi will be excellent.

Quickly attracting enough TVL to the AMM on Strips to provide liquidity for interest rate trading.

Capturing token value, if the total TVL of the four markets in Strips is 70m, it means that $70 million worth of USDC-STRP LP is staked across the four markets. This implies that $35 million worth of STRP has been staked.

A classic snowball effect. Besides trading mining rewards, trading fees and slippage also directly contribute to the AMM's revenue. (Assuming a TVL of 20m, if a user closes a position worth $200,000, it would generate about 1% slippage, resulting in $2,000 flowing into the AMM).

Users seeing such high AMM APY will buy large amounts of STRP from the market to form LP and stake in the AMM. → STRP price rises, leading to an increase in LP price → AMM TVL increases → slippage decreases → AMM revenue decreases, staking declines, and AMM reaches dynamic equilibrium.

(Of course, in the long run, the support point of this spiral lies in the real trading demand for interest rates. As long as there is interest rate trading, there will be transaction fees and slippage. As long as there is USDC income, the AMM will have APY, and with incentives, users will buy STRP and stake in the AMM.)

In Conclusion

Strips has an innovative AMM that captures token value, built on Arbitrum, with low trading fees. By establishing an efficient interest rate derivatives exchange, it can provide real price discovery for fixed rates. On this basis, Strips can construct structured fixed rate products, such as bonds and debt markets.

If decentralized finance is to become the future of finance, who will establish a transparent market for interest rates in DeFi? What sparks will emerge in the construction of DeFi Legos in the interest rate track, which has mastered the "meta-rules" of finance?