Without interest rate perpetual, Decentralized Finance can never be complete?

A missing piece in the DeFi ecosystem.

Written by: @defiance_cr

Translated by: zhouzhou, BlockBeats

Editor’s Note: The lack of interest rate perpetual contract tools similar to CME in DeFi has led to significant interest rate fluctuations and an inability to hedge risks. Introducing interest rate perps can help both borrowing and lending parties lock in interest rates, achieve arbitrage and risk management, and promote the integration of DeFi with TradFi, enhancing market efficiency and stability.

The following is the original content (for ease of reading and understanding, the original content has been edited):

At the Chicago Mercantile Exchange (CME), the daily trading volume of interest rate futures exceeds one trillion dollars. This massive trading volume primarily comes from banks and asset managers who operate by hedging the risks between floating rates and fixed-rate loans that have been issued.

In Decentralized Finance, we have established a thriving floating interest rate lending market with a total locked value exceeding 30 billion dollars. Pendle's incentivized order book has liquidity exceeding 200 million dollars in a single market, demonstrating strong demand for interest rate spot.

But we still lack a DeFi native tool like CME interest rate futures to hedge interest rate risk for both lending and borrowing parties (IPOR swaps do not count as they are too complex).

To understand why we need this tool, we first need to understand how interest rates work in Decentralized Finance.

Taking AAVE as an example, its interest rates are adjusted based on supply and demand dynamics. However, the supply and demand of AAVE do not exist in isolation, but are nested within the broader context of the global economy.

By comparing the smoothed floating rate of USDC for AAVE with the price of the 10-year Treasury futures from CME, we can see this macroeconomic correlation:

The USDC interest rate trend of AAVE is consistent with global interest rates, but there is a certain lag. The main reason for this lag is the lack of an immediate linkage mechanism between global interest rates and AAVE's rates.

It is precisely because of this dislocation that the supply and demand dynamics of the cryptocurrency market play a stronger role in interest rate formation. When we remove the smoothing treatment and directly compare the interest rate of AAVE with the global 10-year government bond interest rate, this phenomenon becomes even more apparent:

The interest rate of AAVE fluctuates very dramatically, and for most of the time, it has a significant premium compared to the interest rate of the US 10-year Treasury bond.

The fundamental reason for this premium is still the lack of direct correlation between these two markets. If there were a simple, two-way connection mechanism between the interest rates of DeFi and TradFi that could hedge or arbitrage, it would better integrate the two ecosystems.

And Perpetual Swaps are the best way to achieve this. Perp has already been validated by the market for product-market fit (PMF), and establishing a perpetual market covering AAVE rates and U.S. Treasury rates would bring about significant change.

For example:

For borrowers, they can take a long position in a perpetual contract that is anchored to the AAVE borrowing interest rate. If the annual borrowing interest rate spikes from 5% to 10%, the price of this perpetual contract will increase, thereby hedging against the risk of rising costs.

On the contrary, if interest rates fall, borrowing becomes cheaper, but the perpetual position incurs losses, which is like paying an "insurance premium." In this way, the borrower effectively locks in a fixed interest rate by borrowing + going long on the perpetual contract.

For stablecoin lenders, they can short a perpetual contract based on the stablecoin lending rate. If lending yields decline, the short position in the perpetual contract profits, offsetting the losses from reduced loan income; if yields increase, the short position incurs losses, but interest income rises, creating a hedge.

Moreover, these contracts can also use high leverage. A 10x leverage is a standard configuration in the interest rate market on CME.

Having a well-liquid interest rate market can also reduce the cascading effects during market pressure. If market participants hedge in advance, they will not be forced to withdraw or liquidate on a large scale due to interest rate fluctuations.

Moreover, this opens the door for truly long-term fixed-rate loans – if this perpetual contract is completely DeFi native, it can be used by various protocols for long-term interest rate hedging, thereby providing users with fixed-rate loans.

In traditional finance, hedging interest rate risk is a common practice, and most long-term loans have interest rate hedging instruments behind them.

Introducing this mechanism into Decentralized Finance not only enhances efficiency but also attracts more TradFi players into this market, truly bridging the gap between DeFi and TradFi.

We can make the market more efficient, and all of this requires the emergence of a perpetual interest rate contract.