Overview

Interest rate swaps are financial derivatives commonly used in Traditional Finance (TradFi) to manage and mitigate interest rate risk. They are agreements between two parties to exchange interest rate payments over a set period of time. These contracts allow entities to transform the terms of their debt or investments to better suit their specific needs and risk profiles.

In a typical interest rate swap, there are two legs:

1. Fixed leg: One party agrees to pay a fixed interest rate on a notional amount throughout the life of the swap. The fixed rate is predetermined at the inception of the swap.
2. Floating leg: The other party agrees to pay a variable interest rate, typically tied to a reference rate such as LIBOR (London Interbank Offered Rate) or an interbank lending rate, on the same notional amount. The variable rate is reset periodically, often every three or six months, to reflect changes in the reference rate.

The key objective of interest rate swaps is to allow participants to manage interest rate exposure and cash flow uncertainties. Some common reasons for using interest rate swaps include:

1. Hedging: Businesses can use interest rate swaps to protect themselves against adverse interest rate movements. For example, a company with a variable-rate loan might swap it for a fixed-rate obligation if they expect interest rates to rise, thereby locking in a predictable interest expense.
2. Yield enhancement: Institutional investors may use interest rate swaps to increase their overall investment yield by exchanging a fixed income stream for a potentially higher variable income stream.
3. Asset-liability management: Financial institutions can use interest rate swaps to better match the duration and interest rate characteristics of their assets and liabilities, reducing potential mismatches and risk.
4. Speculation: Some market participants may use interest rate swaps as a speculative tool, taking positions on future interest rate movements.

DeFi Landscape

There are mainly two mechanisms to implement interest rate swaps on-chain.

1. Utilize CDPs to mint expiring derivatives known as “fyTokens” implemented by Yield Protocol.
2. Mint two tokens to represent the principal and yield, “pTokens” and yTokens” , effectively splitting the yield-bearing assets as implemented by Pendle.

Purpose and Functionality

• Yield Protocol: Yield Protocol is a platform that enables users to create and trade interest rate derivatives. It allows users to mint fixed-term, fixed-rate debt tokens called fyTokens by depositing collateral (usually stablecoins). These fyTokens represent claims on the underlying collateral plus interest. Users can trade these fyTokens, enabling them to manage and speculate on interest rate exposure.
• Pendle: Pendle is a protocol that facilitates the creation and trading of tokenized future yield streams. It allows liquidity providers (LPs) to lock their tokens, such as those obtained from providing liquidity on Automated Market Makers (AMMs), into smart contracts called Yield Tokens (yTokens). These yTokens represent future yield generated by the locked assets. Users can trade these yTokens, allowing for more efficient capital utilization and yield optimization.

Assets Supported

• Yield Protocol primarily supports stablecoins or other assets that can be used as collateral for creating fixed-term, fixed-rate debt tokens.