DeFi Explained – What are Interest Rate Swaps?

A less common practice than fixed rate or floating loans is the interest rate swap, also known as “refinancing,” primarily as it is used in real estate mortgages. Interest rate swaps are derivative contracts between two parties, usually exchanging or “swapping” fixed-rate interest payments for floating-rate interest payments. Other swaps include trading one floating rate for another, commodity swaps, and credit default swaps. 

All swaps occur over a set period called the “tenor,” commonly for one year but sometimes extending to several years. The contract may be shortened if interest rates become unusually volatile. Swaps originally traded over the counter (OTC) have begun moving to centralized exchanges. Today we stand on the precipice of the next generation of these powerful financial tools with an innovative DeFi market, paving the way for decentralized interest rate swaps. 

In a vanilla swap, the “seller” swaps their adjustable-rate payments, while the “payer” swaps their fixed-rate payments. The “notional principle” is the value of the loan. This amount is always the same size for both seller and payer. The two parties exchange only interest payments, not the notional principle. 

The floating interest rate is based on a short-term benchmark rate like the Fed Funds Rate or LIBOR (the London Interbank Offered Rate). This is the rate banks charge each other for short-term loans. This will change, however. As part of the complicated reference rate reform move from LIBOR into a more reliable interest rate benchmark, the “Secured Overnight Funding Rate” (SOFR) will be used worldwide by mid-2023.

Market makers have traditionally been big banks putting swaps together for sellers and payers. The banks act as either the seller or the buyer to either party. In this situation, each counterparty only concerns themselves with the creditworthiness of the bank — not of their counterparty. In payment for service, banks set up bid/ask prices for each side of the deal. An administrative fee is also charged for creating the contract between the two parties. Interest rate swaps are so popular among institutions that 92% of the world’s Fortune 500 companies use them.

Current Problems of Interest Rate Swaps

The interest rate swap market hasn’t changed much since 1984. Its greatest risks are interest rate risk and credit risk, called “counterparty risk.” If one party defaults, unable to meet its obligations under the interest rate swap agreement, following the legal process may prove a long and tedious process.

More problems faced by the interest rate swap market today include:

  • Monopoly institutions control access to the market 
  • Extensive fees charged by banks 
  • Almost a complete lack of access to individuals  — limited only to institutions
  • Need to be registered and licensed into each country
  • High settlement costs for cross-border transactions
  • Settlements only in local currencies
  • Antiquated systems 
  • Human error
  • Insider trading
  • Market manipulation by individuals or monopoly institutions, resulting in fraud and even financial collapse

DeFi Revolutionizes Interest Rate Swaps with EQIFI

The DeFi community has long sought a comprehensive and scalable interest rate swap. EQIFI is developing a decentralized protocol for pooled lending, borrowing, and investing for ETH, ERC-20 tokens including wBTC, Stablecoins, and select fiat currencies. 

Although traditionally, interest rate swaps involve exchanging a fixed interest rate for a floating rate, in the case of DeFi, the best use case offers stability in the marketplace by providing competitive interest rate swaps to reduce the variable rates’ volatility to fixed-rate products. The DeFi Interest Rate Swap Product will bridge the gap between variable and fixed interest products, giving hedgers and speculators a sustainable route to scale the capitalization of the DeFi community.

Once appropriately regulated, the EQIFI Interest Rate Swap protocol will connect two or more counterparties under the EQIFI smart contract system to automate the terms of the interest rates swap, reducing the time to create a swap from days to minutes. All users of EQIFI may exchange variable returns into fixed rates or vice versa, meeting the needs of both those seeking better returns as well as those looking to reduce exposure to a particular protocol. Users may also generate income trading expected variable rates or providing liquidity to the market, furthering the needs of hedgers and speculators.

At its core, it is a smart swap contract matching one offer of a fixed or floating interest rate with another. The protocol requires both parties to deposit a certain percentage of the funds swapped to provide a clear incentive for both parties to finish the contract after the tenor. 

Either party may then close the swap. At that point, the contract computes the difference in terms of interest rates and debit or credit both parties’ correct amount. Crediting and debiting will be made primarily out of the deposit initially created for a seamless experience for both parties. Allowing both parties to close the swap at the end of the swap period incentivizes both to do so.

The smart contract also provides a way to swap funds in other coins for a fee in a decentralized manner. Users will not have to swap funds themselves if they want to offer fixed interest rates into multiple markets but only have one base asset.

As more users offer fixed interest rate swaps in the system, a self-regulating market price for all offered pairs develops, allowing a more stable exchange rate for new users. 

EQIFI innovates new financial products for a decentralized world. By bringing familiar, valuable products such as Interest Rate Swaps onboard, making them available in a new way to users worldwide, it helps create a more equitable world for us all. Explore more and get involved in this community-powered global financial solution at EQIFI. Find out more about other convenient options at EQIBank, the global digital bank powering EQIFI.

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