Interest Rate Swaps in DeFi: Benefits, Risks, and Challenges

Marcel Deer
By Marcel Deer
Edited by Staff Editor

Published August 1, 2022.

Graphs on paper with piles of coins stacked on them

You may have heard the term “interest rate swap” before, but you may not understand it. In traditional finance, an interest rate swap is a derivative contract between two parties agreeing to swap one series of payments for another.

So, what are the benefits and risks of interest rate swaps?

What Is an Interest Rate Swap?

When cash flows are fixed rate and floating rate interest, the swap is referred to as an interest rate swap. This translates to an unfunded option to receive interest-rate exposure. These swaps are a relatively straightforward tactic to capitalize on a position or hedge against interest rate risks. There are two parts to this trade, hence the term “swap”:

  1. One part is the borrower The borrower pays a fixed interest rate and earns payment based on a floating rate.
  2. The other part is the lender The lender receives the fixed interest and pays based on the floating rate.

How Interest Rate Swaps Work

Interest rate swaps involved swapping a variable (floating) interest rate for a fixed rate. The idea is that one party reaps the rewards of hedging the risk associated with their security, while the other can benefit from the potential earnings. Regardless, if one party is winning, the other is losing. So, while interest rate swaps can neutralize and mitigate some risk, one of you will be losing money at some point.

Interest rate swaps are traded OTC on crypto lending platforms; if your company opts to swap interest rates, the two parties involved must agree on two pressing issues:

  1. Duration of the swap Establish a beginning date and an expiration date for the swap.
  2. Terms and conditions of the swap Be clear about your terms before you agree.

Benefits of DeFi Interest Rate Swaps

Some of the reasons why you’d want to engage in an interest rate swap include:

  • Commercial reasons Some companies need to meet specific financing requirements, and interest rate swaps can help managers meet their goals. In addition, banks and speculative hedge funds may be able to benefit (and profit) most from these swaps.
  • Comparative upper-hand Companies can sometimes receive fixed or floating rate loans with better rates than most borrowers. It may not be perfect or exactly what they are looking for, but they may be able to come out on top after an interest rate swap and fulfill those preferences they were seeking.

Swaps allow banks, investment funds, and companies to capitalize on loan types without breaking the rules concerning their liabilities and assets. If you want to earn interest from your assets without opening a trading position, crypto margin lending is the right choice.

This is a big difference concerning interest, loans, or lending in DeFi and TradFi. Traditional finance is often much more restrictive and unbending. DeFi also typically offers lower interest rates in general compared to traditional finance. These are all reasons why you should borrow crypto, as well as lend it. In addition, many opt to borrow crypto with compound as it supports a variety of cryptocurrencies.

Risks and Challenges of DeFi Interest Rate Swaps

While interest rate swaps can be an excellent opportunity for some companies, they also come with risks that users shouldn’t ignore. Those risks include:

  • Unpredictability Floating interest rates are inherently unreliable and create a risk for both parties involved in the swap. One party will almost always come out ahead in an exchange, and the other will lose out. The party obligated to make floating rate payments will profit when the variable rate drops but will lose when the rate increases, and vice versa.
  • Counterparty risk This risk adds another layer of complexity to the scenario. This risk is usually low. If one party defaults, they won’t be able to make payments. Legal action to recover that money is costly and counterproductive.

How to Invest in Interest Rate Swaps

If you’re looking to get your foot in the door and start swapping interest rates, do your research, and ensure that you know what you’re getting into before you agree to anything. Users can expect that two parties will trade, or “swap”, a fixed rate for a variable interest rate. Details beyond this will depend on your specific situation, terms and conditions, and with whom you are swapping interest rates.