What is DeFi interest rate swaps? Why has it become so popular?
DeFi refers to decentralized finance andhas been built on top of blockchain technology. DeFi interest rate swaps, in simplest terms, is a way of exchanging one stream of future payments for another. Two or more counterparties get into an interest rate swaps, a forward financial contract, according to some rules that are preestablished, or customised as desired by the parties so involved. These swaps are derivative contracts, and you can get an interest rate exposure through the same, when the cash flows have a fixed and floating rate interest.
One of the most common, known as ‘vanilla’ swaps liquid interest rate swaps. When you ‘vanilla’ swap, you exchange fixed-rate payments for floating-rate payments. These payments are based on London Inter-Bank Offered Rate (LIBOR), the interest rate charged by one high-credit bank to another for short-term financing.
Available Interest rate swaps are of three types-
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Fixed to floating – In a fixed to floating interest rate swap, two or more companiesenter into a contractual arrangement, in which one party swaps the interest cash flows of fixed-rate loan(s) with another party’s floating-rate loan(s). However, it does not exchange the principal of the underlying loans.
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Floating to fixed– When a company wishes to receive a fixed rate so it can hedge interest rate exposure, it gets into a floating to fixed interest rate swap. Companies with no access to a fixed-rate loan may also borrow at a floating rate, and swap for a fixed rate.
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Float to float - Also known as basis swap, in a float to float interest rate swap, the parties agree to exchange variable interest rate. If a company wishes to change the type or tenor of the floating rate index that they pay, they get into a float-to-float swap.
You can capitalize on a position, or hedge interest rate risk through interest rate swaps. It has become popular for obvious reasons.
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It helps hedge the rate for deposits and loans. Third-party loans are most often risky, and lenders are cautious of the same. These swaps help bring down the risk significantly because there’s a guaranteed interested on their deposit, while allowing borrowers to keep a borrowing rate locked up.
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Swaps also help lenders lock cash flows at different maturities. It is generally through fixed income instruments.
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Swaps are a means of rescue that benefits the lender with fixed rate deposits and benefits the borrower with fixed interest on the loan. In simpler terms, deposit-hedge corresponds to the loan-hedge in a swap.
You can count on the DeFi system in an interest rate swap. Who likes risks, and uncertainty, especially in a market that fluctuates too quick?