Author: Neron

Translator: Beam, H.Forest Ventures

Derivatives have become very popular in cryptocurrency, primarily reflected in futures. These derivatives provide conditions for institutional investors to enter the market, allowing them to "hedge" themselves and reduce risk. Therefore, they are fundamental financial products, especially because this market is highly volatile and strongly influenced by trends. They can also be speculative products, but this article will not cover that aspect.

In this article, we will focus on a series of derivatives that are almost undeveloped in the crypto space but very popular in TradFi: interest rate derivatives.

This article does not aim to be exhaustive, nor does it intend to provide all the answers related to the establishment of such markets or liquidity. My goal is simply to outline some strategies that can easily protect oneself from interest rate fluctuations.

When borrowing crypto assets, AAVE offers two options: fixed-rate borrowing and floating-rate borrowing. You can choose a fixed borrowing rate, which is quite high but does not change over time (or changes very little). In this case, you will pay a security fee. On the other hand, you can choose a floating borrowing rate, which is, on average, lower than the fixed rate but is subject to market risks. This leads to higher efficiency in borrowing capital but also higher risk. Therefore, it is important for large market participants to find ways to protect themselves from interest rate risks, characterized by undesirable changes in borrowing rates.

Variable interest rate (purple) and fixed borrowing rate (blue) on AAVE

Interest rate derivatives are derivatives that allow you to hedge against interest rate volatility, whether up or down. In this article, we will discuss two main interest rate hedging tools: swaps and options.

Unlike traditional markets, AAVE's interest rates do not depend on the price of the underlying asset but rather on the availability of liquidity.

When most assets are available, interest rates are low to encourage borrowing. When assets become scarce, interest rates rise to encourage repayment of loans and increase deposits in the liquidity pool.

Formula for calculating the AAVE borrowing rate Rt, where U = capital in the pool

01 Interest Rate Swaps

Interest rate swaps are bilateral contracts between Alice and Bob. In the case of borrowing, the interest rate swap works as follows: suppose Alice borrows an amount X at a fixed rate, while Bob borrows an amount X but this time at a floating rate. Then, on each interest payment date, both parties exchange the interest they must pay. Thus, we have Alice, who chose the fixed-rate solution, paying the floating rate, while Bob, who chose the floating rate option, pays the fixed rate. We have an exchange of interest cash flows.

But what is the point of such products?

Suppose I borrowed $20,000 at a floating rate on AAVE for a year, with rates ranging from 0% to 20%. The corresponding fixed rate on AAVE is 10%. This means:

• If I borrow $20,000 at a floating rate, the interest I must pay will range between 0% and 20% of $20,000, so over a year, it will be approximately between $0 and $4,000.

• If I borrow $20,000 at a fixed rate (10%), I will have to pay $2,000 in interest.

There is a significant gap between the two APRs of these solutions. In the worst case, using the floating rate, I might end up paying an extra 20% per year. Therefore, in terms of risk, the fixed-rate option seems more attractive, but 10% is still a lot! So how can I reduce this risk? How can I take advantage of rates below the fixed rate? Well, that’s the whole point of the swap.

On Aave, we notice that the variable rate (purple) sometimes exceeds

the fixed rate (blue)

Suppose the floating rate for borrowing on Aave is 2%, and the fixed rate is 10%. The current thought is that rates will rise because many people will want to borrow money. It is believed that the floating rate is likely to exceed the fixed rate. However, we do not know when this will happen. So we want to borrow at the floating rate APR as long as it is below the fixed rate. Therefore, we can set up the swap as follows: we borrow at a floating rate (when the borrowing rate = 2%), and when the floating rate exceeds the fixed rate (for example, 10%), the interest rate swap will be activated. This also means that if the floating rate never exceeds the fixed rate, the swap will never be activated.

This is theoretically what you can do. In practice, it is a bit more complicated because you have to find a counterparty for the swap. Given the lack of (or even non-existence of) liquidity in the interest rate derivatives market, this seems unlikely to happen: no one is willing to take the opposite position or will demand a very high premium to execute the trade.

02 Interest Rate Options

This article will not discuss "classic" options that secure positions on assets (such as stocks), as these options have been thoroughly described in other articles and are increasingly used in cryptocurrency. The largest crypto options market is Deribit, with a daily trading volume close to $500 million. Recently, numerous decentralized exchanges specializing in options (Dopex, Squeeth, Hegic, etc.) have also emerged, but it is clear that the total trading volume of all these exchanges remains very low (around $200 million per day). In contrast, the Chicago Board Options Exchange is one of the largest options markets, with daily trading volumes exceeding $10 billion. The scale is completely different.

Scale on Hegic (hegic.co)
Interest rate options allow hedging against the risk of rising interest rates (Cap) or falling interest rates (Floor). This tool provides buyers with a strategic benefit, allowing them to choose which direction of change they want to protect themselves from. Often, only one direction of interest rate change is favorable to the buyer. This can be determined by analyzing the current situation (trends of rising or falling rates).

Translator's Note:

Cap option refers to a cap option that sets a maximum interest rate for debt instruments with variable or floating rates over a specific future period to determine the upper limit of their interest rate cost. It is called a Cap as a customary term because Cap means a hat, symbolically representing the upper limit of the interest rate. Similarly, Floor means the floor, representing the lower limit of the interest rate. For convenience in industry communication, the terms Cap and Floor will not be translated below.

The option buyer has the right to borrow (at the upper interest rate) or lend (at the lower interest rate) a specified amount at a fixed rate within a specified period. Both parties agree that if there is a difference between the reference rate and the rate specified in the contract, one party will pay a premium to the other party. These contracts are usually traded in the OTC (over-the-counter) market. They are tools for hedging against interest rate fluctuations.

Options can be resold before their expiration date (Cap requires the buyer to pay a premium to the seller). The same applies to Floor.

Interest rate options can be simply illustrated as follows (for this example, Alice is the buyer, and Bob is the counterparty):

Suppose Alice buys a cap option from Bob.

Features:

• Strike Rate: ETH borrowing rate on AAVE

• Reference Rate: 5%.

If the AAVE rate exceeds the reference rate (i.e., >5%), Bob will have to pay Alice a premium equal to the difference between tAAVE and tReference.

If the AAVE rate = 10%, Bob will pay 5% to Alice.

If the AAVE rate = 4%, Bob does not pay Alice anything.

Now, suppose Alice buys a Floor from Bob.
Features:

• Strike Rate: ETH borrowing rate on AAVE

• Reference Rate: 5%.

If the AAVE rate is below the reference rate (i.e., <5%), Bob must pay Alice a premium (equal to the difference between tReference and tAAVE).

If the AAVE rate = 7%, the counterparty does not pay Alice any premium. On the other hand, if the AAVE rate = 3%, Bob will have to pay Alice a premium equal to 2%.

There are three main types of interest rate options: Cap = Call option, where the buyer decides the maximum interest rate at which they want to borrow the required amount, and the seller bears the risk above (upward) that rate (which is the payment of the premium for the buyer). Therefore, the buyer is guaranteed to borrow at a rate lower than the strike rate within the specified term. (Equivalent to a call option on interest rates).

• Contingent Cap: The borrower hedges against rising interest rates through the cap, and if this hedge does not work for them, they will not be penalized for paying the premium. Unlike traditional Caps, the premium payment for a contingent Cap is not immediate and systematic. It is only paid when the specified rate is reached. Therefore, premium payments may only occur when the Cap is "triggered."

• Cap Spread: The buyer wants to guarantee the highest rate level while paying a lower premium than a classic Cap. In return, the buyer accepts that their reference rate will revert to a variable rate from a certain rate threshold. Thus, they benefit from the interest rate difference, reducing their financing costs. This corresponds to buying one Cap and selling another Cap with the same option characteristics as the first Cap (amount, term, variable reference rate) but at a higher price.

• Up and Out Cap: The buyer wants to guarantee the highest interest rate level while paying a lower premium than a classic Cap. In return, the buyer accepts a hedge limited to a predetermined interest rate range. If the strike rate exceeds the rate limit, the reference rate will revert to variable and be proportional to the strike rate.

Floor = Put option, which determines the interest rate at which one wants to borrow money in exchange for a premium, with the risk above this rate borne by the seller. Therefore, the buyer is guaranteed to borrow at a rate higher than the strike rate. (Equivalent to a put option on interest rates).

• Down And Out Floor: The same principle as Cap Up and Out, where the buyer accepts a hedge within a predetermined interest rate range. If the strike rate exceeds the limit rate, the reference rate will revert to variable and be proportional to the strike rate.

Mix: Collar = A combination of buying a Cap and selling a Floor or buying a Floor and selling a Cap.

• Corridor: Allows for reducing or eliminating the cost of hedging borrowing by foregoing the benefits of changes in the strike rate.

  - Borrower Corridor: Buy CAP and sell FLOOR

  - Lender Corridor: Buy FLOOR and sell CAP

  In both cases, the CAP and FLOOR must have the same characteristics (amount, term, variable reference rate).

As we can see, interest rate derivatives help control the risk of interest rate changes. These financial tools will eventually become widespread. Currently, the market faces several issues that hinder the development of such "institutional" tools. One example is liquidity, which is by far the biggest problem the market must solve. The lack of liquidity in the market (in my view) is largely caused by the nature of stablecoins, which do not yet meet institutional standards. They are currently identified as the main risk for institutions. Effective hedging against losses from pegged stablecoins is currently not achievable. Once the stablecoin issue is resolved, I believe the market will ultimately be ready to receive a significant influx of liquidity. Institutional-type tools will become very prominent.

We are still far from that. However, I will keep a close eye on the development of crypto interest rate derivatives. I believe this will be a significant event in the coming months/years. I am already pleased to see solutions to the market liquidity problem. Until then, have fun!