Interest rate swaps -- those forward contracts in which one form of future interest payment is swapped for others based on a specific principal amount -- have found a home in the world of decentralized finance.
Voltz Protocol said Wednesday that it has launched DeFi's first synthetic, capital-efficient interest rate swap AMM, which will now provide the means for DeFi to compete with the interest rate swap marketplace in traditional finance, unleashing new possibilities for decentralized applications (DApps) to serve the financial needs of the world, especially for those in parts of the world with no access to traditional finance.
Automated Market Makers, or AMMs, are smart contracts that create liquidity pools of Ethereum ERC20-based tokens, which are then traded automatically by using an algorithm rather than an order book. AMMs enable the ability for cryptocurrencies to be traded in a decentralized (permissionless) way using liquidity pools that operate 24/7. AMM users supply liquidity pools with crypto, the prices of which are determined by a continuously calculating mathematical formula.
AMMs are becoming formidable competitors to one of traditional finance's institutional pillars, the derivatives marketplace, emblemized by the Chicago Mercantile Exchange Group, whose exchanges, on average, handle more than three billion contracts worth about $1 quadrillion annually. (Yes, that's quadrillion.)
Taking the volatility out of DeFi
DeFi may represent the future of finance to many people for its technical capabilities, but for Voltz's CEO and co-founder Simon Jones, it's a magical space that's limited by potential volatility.
In an exclusive interview with ZDNet, Jones said he believes the limitation of DeFi is that its technology produces a sector that's variable in nature. "If you go to the bottom to the proof-of-stake mechanics, you essentially have supply and demand dynamics, meaning that the rates that come out of nodes are variable. If you go to the protocol layer, the majority of protocols produce variable rates of return, and if you then try and build products and services on top of that, just by definition, you're going to end up with products and services that are variable in nature," he said.
And where there's variability, there's often volatility. "So, if we look at some of the lend-borrow rates on some of the major protocols, they have varied, within a month, from over 40% to under 2%," Jones said. That's fine for those undeterred by variability and volatility, but, Jones adds, "if we actually want DeFi to become the financial system for the whole of the world…we need to find a way to address that limitation. What interest rate swaps do at the most macro level is that they enable us to build products and services that have stability built into them, and that can serve the financial needs of the whole of the world," he said.
As part of its current "Alpha" launch, Voltz said its liquidity providers (LPs), which include Wintermute and Amber Group, can use the Voltz Protocol for interest rate swaps. There will be an initial cap on liquidity that can be provided as an LP of a $1.5 million margin per pool. Trading, however, will be unlimited. The cap will increase gradually until it's lifted entirely for the full public launch. Voltz Protocol will initially launch with Aave and Compound base stablecoin rates and will add more markets in the following months, including Lido's stETH token. The protocol is designed so that pools can be created for any asset with a variable rate of return.
Voltz Protocol's design includes a concentrated liquidity "virtual AMM" (vAMM) for price discovery, with the management of the underlying assets performed by the "Margin Engine." This combined structure permits counterparties to create and trade fixed and variable rates through a mechanism that's up to 3,000 times more capital efficient than alternative interest rate swap models while also giving liquidity providers and traders considerable control over their positions, the company said.
Because the Voltz Protocol is open-source and highly composable, developers can leverage it to build DApps for products, including on-chain fixed-rate mortgages, loans, savings accounts, risk management, DAO treasury management swaptions, IRS caps, and floors. "I'm really excited for us to act as a catalyst for a whole bunch of new products in this space," Jones told ZDNet.
The Voltz Protocol also removes the concept of "impermanent loss" for liquidity providers. (Impermanent loss is the amount of money you lose after you deposit tokens into a liquidity pool, and its price goes down a few days later.) It's a risk native to DeFi, until now. According to Voltz, the elimination of impermanent loss through single-asset LP-ing is a new dimension for DeFi, providing further opportunities for DApps to leverage the protocol to create new products.
Understanding the benefits of DeFi
If all of this talk of interest rate swaps, liquidity pools, and DApps has you confused, you're not alone. Even explaining the concept of DeFi to those new to digital finance can be a challenge. Jones, however, prefers approaching the concept from another perspective. "If you don't want to understand the details, then understand the benefits," he said. Compared with traditional, centralized finance, DeFi "is more equitable, more transparent, more anti-fragile, and more efficient."
For DeFi to become the financial system for all the world, per Jones's vision, the team at Voltz -- 15 so far -- will be building many more products and services in the year ahead with the help of more staff, working closely with teams who are building products and services that exist on top of the protocol.
"We want DeFi to become the financial system for the whole of the world. There are still 1.7 billion people that don't even have a bank account… it's about 25% of the population. Enabling everybody, no matter where they're born, to have the same equal access to a financial services system is something that like we personally want to see happen," Jones said.