Swap Rate - Underlying Primitive For The Financial System
Talking with Andrey Belyakov about DeFi, derivatives market, and why interest rate swaps it is one of the most important instruments in the fixed income market.
Hello! What’s your background, and what are you working on?
Hello, I am Andrey Belyakov, CFA, and I’m the founder of Opium Protocol, which is behind Swap Rate and several other exciting projects, including The Art Exchange. I am also a professional fund manager and derivatives trader. During my time as a trader, one of my hobbies was analyzing and investing in fintech and crypto startups. Being part of the financial sector, I have seen just how inefficient it can be, and I began betting on innovative startups. One of the investments was the ICO of Ethereum. Since then, we have been following its development closely, and I actually quit my “normal” job as a trader in order to build an innovative “investment bank on-chain.”
In the Opium Team, we have built a professional protocol for trading derivatives, and there have already been several applications of it. One of the first products based on the protocol was Swap Rate. This is an interface used to trade interest rate swaps, and it is one of the most important instruments in the fixed income market.
Interest rate swaps are amazing instruments that counterparties can use to exchange the risk of the variable rate being too high or too low. Everybody can exchange variable returns into the fixed or vice versa. The two types of players in this market are hedgers and speculators. Speculators want to generate significant income by trading expected variable rates or by providing liquidity to the market. Compared to speculators, hedgers have a natural need for the swap. Let’s look at a couple of examples:
One sees that the fixed interest rate is currently quoted at 7%. If I think that it’s not, in reality, going to be more than 5%, I can invest $100 into the interest rate swap that receives a fixed 7% and pays the variable rate. If I’m right and the variable rate will be 5% on maturity, I will make a 20% return [(7% receiving - 5% paying)*10 leverage] on my investment amount (annualized number). Due to the natural leverage of 10x, I have a really nice return.
Here, the underlying motivation is different. Suppose that I want to fix the interest rate on my compound deposit. I would need to get a “paying floating-receiving fixed” swap. At maturity, I would need to pay the effective floating rate (as implied from the name of the swap), which I receive from my compound deposit at the same time, and I then receive fixed interest from the swap. So, effectively, I will end up with fixed interest for my deposit on Compound!
Who is my natural counterparty in the case of hedging? Why are swaps naturally needed?
Somebody who is playing a variable interest rate for his loan at Compound would like to run into the opposite swap (with paying fixed and receiving floating interest rates, so that receiving the floating rate on a swap would offset paying the floating rate for a loan). The only trick is that these two natural hedgers have swaps that are based on different rates. Indeed, the first swap is for the supply rate, and the second is for the borrowing rate of Compound. However, it’s both super cool and interesting that the two rates are very correlated, and the difference between them is almost a fixed number. That allows market makers to run their algorithms and provide liquidity for both sides. At this stage, one or two market makers are working on our platform.
We deployed Swap Rate recently, but we have already had a lot of interest in market making and have also seen a natural demand for hedging. I believe that, after a period of time, interest rate swaps will be a fundamental part of the DeFi community. They are an underlying primitive for the financial system and DeFi will be no exception. Interest rate swaps allow us to build fixed income products and help to make the whole system very stable. Indeed, imagine a situation where the variable rate is very volatile. With swaps in place, people will not be able to run away from their deposits and loans because they will be hedged. At the same time, swaps can help to get rid of inefficient pricing in the fixed income world. In other words, it’s a perfect instrument for arbitrage on more complex products. I’m sure that DeFi will see many sophisticated initial products, and interest rate swaps will always stay as underlying primitives.
What’s Swap Rate backstory?
First, we started to build custom derivatives on the Ethereum blockchain. We chose derivatives because this is the biggest market in the world, and more importantly, derivatives can be conveniently programmed in the Ethereum blockchain. Yes, there is another reason that I have traded them all my life (laughing). I knew that it is also costly and untransparent, with many legal points of failure, to create derivatives. With the core team, we have started to design the instruments as futures, options, CDSs, and so on. Interestingly, we realized that, at some point, we write the same pieces of code all the time. Indeed, most of the features for decentralized derivatives are the same:
- Two or more parties have to downplay the collateral into the system (otherwise, the payment is not guaranteed).
- There is a secondary market until the instrument matures.
- At maturity, downplayed collateral will be redistributed to (possibly new) token holders, according to a certain logic.
All the steps are the same, but what is different is that:
- The oracle of the underlying price.
- The redistribution formula at maturity.
We have decided to put those two parameters outside of the equation, as well as everything else that we combined in the Opium Protocol.
In short, the Opium Protocol allows everyone to build derivatives in just five minutes. You need to define or choose only two things: the underlying oracle and the type of instrument. Then you will automatically have a ticker (token) that can be created, traded, and matured in the professional ecosystem of derivatives. Every ticker (token) has a list of parameters, such as its maturity date, margin requirement, etc.
Once we have created the protocol, we have started a professional-looking exchange that looks somewhat like Bloomberg. We found out very fast that a professional exchange with many derivatives is quite a complicated product for many users. Therefore, we have decided to build a derivative as a separate product. We chose interest rate swaps because, at that time, variable interest rates were already popular in the community, but there were no fixed rates. The real markets operate in the following way: you initially have variable interest rates, and, based on them, there is an expectation market for variable rates, called interest rate swaps. Swaps help the participants to exchange variable interest rates for fixed rates and the other way round.
We present the Swap Rate website and have also combined our swaps with compound deposits in one transaction interface, which allows users to have fixed-rate deposits based on Compound with one click. Amazingly, you can still keep your risk in Compound but receive the fixed interest rate for your deposit or pay the fixed interest rate for your loan.
So far, we have funded the projects ourselves. We have got lots of experience in finance, programming, and mathematics in our team. I’m a professional fund manager who has managed tens of billions of USD in my portfolios. Our chief of analytics is a world champion in mathematical competitions, and our CTO has more than ten years of experience. I believe very strongly that the team is a major factor in our success, especially in this innovative and volatile area where everything moves so fast, and people play essential roles. We all have a real passion for what we do, and I believe that we are building great tools for the community.
What went into building the Swap Rate?
As Opium Protocol is the underlying on-chain logic, it took us six months to release the first version on mainnet, and then another six months to adjust it to the modern needs of DeFi and get it audited.
It took us about a day to build, test, and deploy interest rate swaps. Then we decided to build a dedicated website for it (Swap Rate) with an easy to use interface. I am not sure if we have achieved the ideal interface in terms of ease of use yet, but we are continually working to improve it.
Of course, during the development of the Opium Protocol, we faced several changes in the cryptocurrency landscape. When we started, there were no stable coins nor good oracle solutions, and so we had to be creative. But once we had decided that our protocol would not depend on specific oracle solutions or specific stable coins, we only benefited from the community development that took place.
During the development, we were considering having better UX and security in the first place, as well as the current needs of DeFi ecosystems.
Technically, Swap Rate completely utilizes Opium Protocol on the on-chain layer and Relayer, as well as Meta Transaction techniques on the off-chain layer. Our users do not even require ETH for trading derivatives because we send transactions for them.
We have successfully passed an audit by SmartDec to increase the security of funds and confidence of our users.
What’s your business model?
The business model for Swap Rate is the following: commission is now zero because we want our clients to have a better experience, and we plan to make more money with market-making and hedging other instruments with swaps, etc. Basically, everyone can join us and become a kind of hedge fund, as everybody is equal on Opium Protocol! How cool it is to start your hedge fund for DeFi! And I believe that the people who start now will still be on time. As for our Opium Protocol, the business model is simple. Everybody who builds derivatives on Opium Protocol can charge a fee from the profit makers at maturity. Users can see this fee upfront, and these fees are ultralow. Opium Protocol will also hold a 1/10th of the fee to maintain the protocol.
We have seen several initiatives that create interest rate swaps, and most of them attempt to create automatic market makers on-chain. We don’t see it as a competition and would like to exchange liquidity with them. Our order books are run on meta-transactions and are quite efficient.
Speaking of DeFi protocols in general, the Market protocol is quite similar to Opium, but with some differences. For example, Opium doesn’t have a utility token, and it allows for custom derivative logic, not only futures. Besides, we don’t deploy new smart contracts for each position token; all tokens are stored in one ERC721o contract. We support meta-transactions, pulling logic, portfolios, affiliate fees, immediate premiums for contract sellers, and some other professional features. We are trying to build a protocol that is very close to the real financial markets. Our contracts are standardized and can, therefore, be traded in the secondary market in a standardized way.
We believe that DeFi is a perfect market for Swap Rate. It has a natural demand for fixed interest rates and swaps when it comes to more complex financial instruments. So we bet that DeFi will continue to grow. The target market for Opium Protocol is the developers of financial instruments, including other companies and startups.
What’s your position on the regulatory landscape today?
We closely watch the regulatory landscape because we believe that regulation is good. Problems occur when there are too many regulations, as is the case in the current financial system. When I was working for a fund, we had hundreds of regulators. Like other comparable projects, we accept the only crypto and will not fall into direct regulation at the moment, but we are closely watching what is going on.
We have proudly started a joint venture project called The Art Exchange, which is related to both art derivatives and tokenization. Regulation is more important for this area, and we have put a lot of effort into figuring out the right jurisdictions and frameworks. We would like to be fully compliant with all the applicable regulations there are, but we assume it will be easier and more transparent for the art market and tokenization.
What are your goals for the future?
Our goals for the future are to grow together with Decentralized finance and build a solid basis for more sophisticated products. In my opinion, we should all be more client-centric by thinking about the client to a greater extent. A lot of smart people are building protocols and products, but the end-user needs a simple solution to his problems. People want to have easy and secure ways to invest their money with better and cheaper financial products. Most of our users don’t generally want to know about blockchain or cryptography. I believe it will not be too long before people understand the direct financial benefits, although it will require some education.
What are your future thoughts for the DeFi market?
Decentralized finance has enormous potential. I believe it will grow fast, but it will have to go through many challenges first. Hacks, attacks, and flash loans will all make the system stronger. As long as the risks of decentralized finance are not correlated with each other, and single failures do not result in a catastrophic event, the system will become stronger. And yes, participants should learn from mistakes. Fortunately, some brilliant people are developing DeFi.
It may take a while before decentralized finance becomes mainstream, but I believe it’s unavoidable. Think about it this way: the financial sector is both the biggest and the most conservative at the same time. However, technology has been booming over the last ten years. At the moment, we have enough innovation for the next ten years of implementation. Changes will happen because they will simply save money and make the system more stable, transparent, and efficient.