DeFi Credit Rates - IPOR

Decentralized LIBOR Rates take us to credit market maturity.

The growth of the Decentralized Finance industry comes with the inevitability of disrupting the traditional financial market. Among the largest markets in the financial industry is the Interest Rate Swaps that account for roughly $600 trillion. It has been largely untested by DeFi protocols as you can’t simply copypasta how it works from a TradFi standpoint to our on-chain wild west. But before we get started, it is paramount that you understand what an interest rate swap is and how they work.

What is an interest rate swap?

An interest rate swap is defined as “an agreement between two parties to exchange one stream of interest payments for another, over a set period of time.” They are over-the-counter exchanges with derivatives contracts. However, that might not be intuitive for someone not familiar with the traditional financial market so let’s make it even easier.

Note: If you have a good grasp of this you can skip this.

Imagine we have two lenders: Borrower A & Borrower B.

Borrower A takes out a 1M dollar loan with a variable interest of 2% on top of LIBOR.

In this scenario, LIBOR is 3%.

LIBOR: London Inter-Bank Offered Rate - benchmark rate calculated by leading banks in London.

This would lead to a total variable rate of 5% that the borrower pays to the lender. 5% * 1,000,000 = 50,000 in the first period. However, since LIBOR is variable, it can increase or decrease, making it difficult to determine how much you will pay in advance every period.

Borrower B takes out a 1M dollar loan with a fixed rate of 6%. Fixed-rate loan means that LIBOR doesn’t have to be taken into account. 6% * 1,000,000 = 60,000 in the first and following periods.

If neither borrower is happy with their terms: borrower A might not like the uncertainty of changing rates and borrower B thinks he’s paying over price and thinks the LIBOR will decrease, they can swap their interest. The notional value of the loan ($1 million) will not change party but the parties can exchange the interest rate payment on a short-term basis. That is how an interest rate swap works and it allows the parties involved to hedge themselves from interest rate risk. View it as the exchange of cash flow between two parties.

This is where IPOR comes in as they aspire to bring this concept on-chain.

What is IPOR?

IPOR is a DeFi protocol that aims to provide a benchmark lending interest rate on-chain by querying a series of smart contracts that opens up for the usage of Interest Rates Derivatives. IPOR stands for Inter Protocol Over-block Rate and is the DeFi native version of the abovementioned LIBOR.

Credit markets are the backbone of the financial industry and IPOR deems that it will need similar hedging tools to reach a more mature state. Considering the crypto industry is well in tune with rates which can be observed by how diligently the crowd follows President Jermane Powell’s every move and how it will impact the market, providing a medium to become as in tune with the credit market within DeFi is a natural progression. The current DeFi lending market experiences floating rates based on risk/demand that aren’t tracked by the average market participant.

IPOR aims to become the foundation of the DeFi credit market that currently stands at a combined TVL of $22.21B The global lending market is worth $8682.26 billion in 2023. DeFi has captured a meager 0.25% of that market. Considering the size of the Interest Rate Swaps market worldwide, targeting that and trying to bring it on-chain can provide immense value to the industry.

IPOR aims to achieve its mission through three pieces of core infrastructure: IPOR Index, IPOR AMM, and Asset Management.

IPOR Index
The IPOR index is central to the protocol and is sourced from the DeFi lending markets that have aggregated users and reliable liquidity. It provides a fair market cost of money throughout DeFi and will initially provide market rates for USDC, USDT, and DAI.

The IPOR Index provides you the capability of longing and shorting interest rates by “betting” that the variable interest rate will increase in value against the fixed rate or vice versa. If you decide to pay a fixed rate instead of a variable one —> you assume that the variable interest rate will increase (and become more costly).

If you decide to pay a variable interest rate over a fixed one —> you assume that the variable interest rate will go down in value compared to the fixed one (otherwise you would rather pay a fixed one with a more steady rate).

IPOR AMM
The IPOR AMM facilitates contracts for interest rate swaps between two parties. The users deposit a collateral fee that acts as a margin and determines how much leverage they want to take on in order to decide what the notional value (total value of position) will amount to.

When the parameters are set the AMM facilitates vanilla swaps that let you exchange the variable rates and fixed rates as mentioned above.

If you decide to pay the fixed rate, the AMM pays you the floating rate → if the floating rate falls below the fixed rate → you pay more than you receive, and vice versa.

If you pay the floating rate, the AMM pays you the fixed rate → if the floating rate rises above the fixed rate → you pay more than you receive, and vice versa.

Interest payments are determined by the notional value when the swap was entered and the profit/loss is the difference between the fixed and floating rates during an opened position. The swaps also have a 28-day maturity.

Asset Management & Hedging

Asset Management puts the capital that users and LPs deposit into the protocol to work. It will be deposited into Aave and Compound to generate an additional source of revenue for the protocol. However, not all capital will be used as the protocol need to remain solvent to operate properly. This is only related to a surplus that exceeds the required reserve and the additional income generated for this will be used at the DAOs discretion.

IPOR provides DeFi treasury managers (and degens) the opportunity to become more sophisticated lenders. By taking a loan on a blue chip lending protocol you can hedge it by opening an interest swap by paying a fixed rate and receiving a variable rate. This works because when you take an overcollateralized loan on a DeFi protocol, you are paying a variable rate that is susceptible to movement based on demand and increased/decreased stablecoin float in the industry (which is why we saw DeFi rates fall below Treasury Bills.)

Depending on the cash flow model deemed suitable IPOR allows you to adjust accordingly.

Tokenomics

IPOR is the native token of the protocol and will be used as a governance token for IPOR DAO as it strives for full decentralization. IPOR launched with an initial total supply of 100M and no more tokens will be minted. The supply distribution is as follows:

Along with this, early platform users will be rewarded with an airdrop prior to the liquidity mining taking place with an emission rate of 10,800 tokens per day for the first 3 months.

The core team and investors have linear vesting over 3 years with no cliff.

The IPOR token can be staked for Power IPOR (pwIPOR), a non-transferrable token that can be used to vote on DAO proposals and additional utility not announced by the protocol yet (although they have hinted at value accrual or token buybacks). It can be redeemed 1:1 for the IPOR token.

Value accrual

The protocol makes money through 3 different methods:

• Opening fee on swaps - every swap that users open is charged a small fee of 10$ and 1% of deposited collateral. A $25 liquidation deposit is also required that gets refunded upon a non-liquidated position being closed.

• LP risk fee - Liquidity providers have to be rewarded for the risk they are taking by facilitating and underwriting risk that enables swap. Without fairly rewarded LPs there are no interest rate swaps. This fee amounts to 1% of the notional value size.

• Income fee - The fee that is incurred when a position is closed. It is based on a user’s profit and takes up to 10% (which can be altered by the DAO).

• Spread - The protocol carefully manages its spread that factors in volatility to price in risk accordingly and adjusts the utilization rate to not risk bad debt for the liquidity providers → leading to a profitable LP experience that makes LPs more willing to deposit further liquidity.

It is yet to be seen how potential revenue generated from these methods will be used by the protocol apart from bootstrapping their treasury for further growth. While they have alluded to token buybacks, it has been criticized among actors in the industry for being an inefficient use of capital that could be spent on further building out the protocol instead.

However, one could argue that users that don’t want to deal with further headaches concerning crypto taxes rather would opt for buyback tokens than yield distributing tokens. Each to their own.

Security

IPOR has gone through 6 audits with Ackee Blockchain and Zokyo with the two latest ones coming on December 23, 2022, and January 11th, 2023. During the audit that took place in December critical vulnerabilities were encountered which were improved upon in the most recent one that passed with flying colors.

However, while both organizations are not the most reputable auditing firms in the industry they have worked with many large clients in the industry and are competent. Still, precaution should always be in consideration when interacting with new smart contracts and DeFi protocols.

Conclusion

We’re currently in a phase where we are seeing proper DeFi innovation that is building on top of the first generation of protocols and providing further value to the industry. We are seeing new tools that enable the average DeFi user to become more sophisticated with their hedging strategies with protocols such as Y2K, Gammaswap, and now IPOR which bodes well for the growth and maturity of the industry.

There will only be a matter of time before copypastas appear of these protocols and imitation is the sincerest form of flattery. Take into count that first mover advantage is normally crucial in this industry which puts IPOR in a pole position to dominate interest rate swaps if it can rise in popularity among DeFi users. Considering the IPOR index is a public good that is based on the DeFi credit market it provides a reference point for the industry to build upon.

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Disclaimer: All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity. Nothing on the site constitutes professional and/or financial advice, nor does any information on the site constitute a comprehensive or complete statement of the matters discussed or the law relating thereto. I am just a random degenerate sensei sharing an opinion.