TLDR: Building fixed income products on Ethereum has been challenging without reference rates. Treehouse Protocol’s DOR mechanism aims to change this through its first DOR, the ESR curve. In addition to Interest Rate Swaps (IRS), DOR is key to unlocking a whole suite of new fixed income instruments in digital assets!
Hold the Door, Hold the DOR, HOL[DOR]
In our previous blog, we briefly explored the mechanisms of Decentralized Offered Rates (DOR). As the first DOR, the Ethereum Staking Rate (ESR) curve can potentially serve as a benchmark rate for a multitude of new financial products.
In this article, we will delve into one specific use case, the interest rate swap (IRS), before diving into our next steps!
Interest Rate Swaps: Your Way to Peace of Mind
IRS provides investors the ability to foresee and hedge against potential financial ebbs and flows, rendering them a crucial tool in the digital assets market.
By definition, an IRS is a contract by which two parties agree to exchange interest rate payments, typically involving the swap of fixed interest rate payments for floating interest rate payments, or vice versa.
Since its introduction in 1981, IRS have become foundational to institutional trading, becoming the largest and most popular derivative contract used today with over $500 trillion outstanding.
In traditional finance, banks that offer depositors a fixed return can effectively manage their risks associated with floating rate loans by entering into an IRS agreement.
For a practical example, consider the following scenario involving you being the CEO of a company called Squirrel, which sells nuts:
Squirrel has taken a loan with a fixed interest rate of 5%. Over time, it becomes apparent that the company’s revenues are insufficient to cover these 5% interest payments. Further analysis reveals that Squirrel’s revenue correlates directly with interest rates: as interest rates increase, so does its revenue, and vice versa.
After thorough analysis, you decide that floating through financial ups and downs is better than being stuck on a fixed branch, Squirrel opts for an IRS, making its financial life a bit less squirrely, swapping its fixed interest obligation for a floating rate.
As a result, the floating rate payment now aligns the company’s interest expenses with its revenue patterns. When interest rates rise, increasing both revenue and interest expenses, the company can handle the higher payments. Conversely, when interest rates and revenues decline, the company benefits from reduced interest expenses, thus maintaining a more stable financial position.
Think of a squirrel with a large acorn, when the tree shakes, the squirrel adjusts its grip instead of falling off!
Challenges in Developing Products like IRS in Crypto Today
So far, fixed income products in digital assets have been limited to extremely simple agreements, and integrating products like IRS has been challenging for a number of reasons:
- Volatility: Cryptocurrency interest rates can change very quickly and unpredictably compared to traditional markets.
- Lack of Data: Unlike traditional finance, where data can often be obtained from centralized sources like banks or government reports, DeFi operates on a decentralized model that relies on multiple sources. This can lead to inconsistencies and reliability issues.
- No Term Structures: In finance, a term structure is a way to show different interest rates or yields for different durations for the same debt (loan, bond, etc.), usually depicted in a graph form. In DeFi, consistent term structures for interest rates often don’t exist because the field is still developing and lacks standardized durations for lending or borrowing.
F[IRS]t and More to Come!
By using the Treehouse Protocol consensus mechanism, the digital asset space is able to build reference rates that are optimized for accuracy and decentralization, two aspects that will revolutionize the way benchmark rates have been set throughout society.
Reliable benchmarks are crucial as they help improve market efficiency and allow for enhanced risk management. More importantly, IRSs are just the tip of the Treehouse canopy, we foresee a Cambrian explosion of new fixed income instruments from the likes of floating rate notes, range accrual, swaptions, perpetual notes, callable notes, term loans, and more!
We are excited about the upcoming launch of tETH and DOR and eagerly anticipate a diverse group of operators, panelists, and delegators to participate in our ecosystem. Fully expect to see more partnership announcements over the coming months!
Looking further into the future, Treehouse will also be expanding our offerings beyond Ethereum to include other tAssets. Join us as we build the future of DeFi, by setting new benchmarks, and being the Tree that keeps growing.
Ready to embark on a mission with us? Click here to get started.
For readers interested in a more advanced reading on fixed income and Treehouse, jump to One Rate to Rule Them All.
FAQ
What is an interest rate swap (IRS)?
An IRS is a contract where two parties exchange interest rate payments, usually involving the swap of fixed for floating rates or vice versa. It helps manage risks and has become a key derivative in institutional trading.
How can IRS benefit the DeFi space?
An interest rate swap (IRS) benefits the decentralized finance (DeFi) space by providing a tool for managing interest rate risks, allowing participants to hedge against fluctuating rates. IRSs also enable more sophisticated financial products and enhance market efficiency.
