Lending and borrowing protocols are a crucial piece of the entire decentralised finance (DeFi) ecosystem. The numbers are sufficient to prove this thesis. As of writing this article, according to DefiLlama, lending dapps account for ~28% of the total DeFi TVL of $50B. Yeah, it is more than significant. Category-wise, lending dapps come in second, only behind DEXes. As a result, a well-functioning credit market is pivotal to the continued growth and adoption of DeFi.
Despite the popularity of decentralised lending and borrowing, it has faced challenges in gaining acceptance beyond the crypto natives. Traditional institutions and other established players are reluctant to engage with these protocols. In addition to concerns about the technical and security risks associated with smart contracts, one of the main reasons for this hesitation is the overall market's immaturity and lack of sophistication.
It may not be apparent to you what I mean by a lack of sophistication in the decentralised lending sector. Allow me to explain…
See, the financial system relies heavily on credit markets as they serve as the cornerstone of economic activity. These markets dictate the movement of capital across the globe and provide a measure of the strength or vulnerability of the economy. Interest rates, in many respects, represent the pulse of these markets. They regulate the circulation of capital and provide a gauge of the prevailing conditions. For individuals, interest rates influence their financial decisions related to borrowing and saving, while for businesses, they aid in projecting future cash flows and profitability. Additionally, interest rates measure the risk of borrowers and determine the direction of capital flow within the economy. As such, in regard to interest rates, there’s much more than what meets the eye. I mean, a country’s monetary policy is majorly governed by altering interest rates - no wonder they’re an important lever for manoeuvring the economy’s direction.
Interest rate derivatives have emerged due to the crucial role of interest rates in the money markets. This financial derivative product derives its value from the underlying interest rate - no points for guessing that. Primarily, interest rate derivatives are used as a tool for risk management. However, speculators have developed various other strategies too. Interest rate derivatives constitute a majority of the $600 Trillion global derivatives market, with interest rate swaps (an interest rate derivative) making up almost $450 Trillion of the total derivatives market activity alone.
Here’s an ELI5 version of interest rate swaps, which again is the most popular interest rate derivative.
Let's say you have a toy car, and your friend has a toy train. You really want the train, and your friend really wants the car. So, you make a deal: you agree to let your friend play with your car for a while, and in exchange, your friend lets you play with the train. An interest rate swap is kind of like that, but with money instead of toys.
One person has a loan with a fixed interest rate, and another person has a loan with a variable interest rate. They agree to swap the interest rates so that the person with the fixed-rate loan pays the variable rate, and the person with the variable-rate loan pays the fixed rate.
Just like you and your friend each got something you wanted in the toy car/train swap, the people in the interest rate swap both get something they want: the person with the fixed rate loan gets a predictable interest rate, and the person with the variable rate loan gets a (potentially) lower interest rate.
Again, the primary objective of an interest rate swap is to help hedge the risk. Perhaps, the individual or company going from a floating interest rate to a fixed interest rate predicts that the variable component of their interest rate will rise in the foreseeable future. Whereas, the other individual or company, going from a fixed interest rate to a floating interest rate, is predicting the opposite.
Anyway, these intricacies allowed the traditional finance (TradFi) market to mature and become sophisticated. And trust me, there are more complexities. In a nutshell, allowing market participants to hedge interest rate risk is important for any money market to flourish. Despite that, we’re yet to see such an innovation in DeFi.
DeFi borrowing in its current form has some problems. For starters, these loans have a short floating rate, making them extremely volatile. Furthermore, we also lack a traditional risk-free yield curve, that is used for discounted cash flows. This means that it’s difficult to value a certain DeFi opportunity accurately.
The chads at IPOR identified these key problems. The need is to build a strong money market in DeFi that standardises interest rates across the board by building interest-rate derivative financial instruments.
In this article, I intend to explain what IPOR is, how the protocol works, the various products they’re building, the IPOR token, and much more. Strap in!
What is IPOR?
IPOR stands for Inter Protocol Over-block Rate, which is named after prominent indices from traditional finance, such as the London Interbank Offered Rate (LIBOR) and the Secured Overnight Financing Rate (SOFR), and is adapted for use in DeFi. IPOR is a mid-market rate that is determined by block-over-block sourcing, which is the closest approximation to real-time possible on the blockchain. Unlike LIBOR and SOFR, IPOR is not an offered rate.
Simply, in the TradFi world, these rates are used to determine the short-term interest rate at which banks lend to and borrow from each other.
IPOR is a DeFi protocol that comprises a set of smart contracts. Its primary function is to establish a benchmark interest rate and facilitate user access to Interest Rate Derivatives on the Ethereum blockchain. This is made possible by combining three fundamental infrastructure components: the IPOR Index, the IPOR Automated Market Maker and liquidity pools, and the Asset Management smart contracts. I will explain these in more detail later.
Essentially, IPOR is on a mission to help DeFi establish its own benchmark interest rates, that can act as the risk-free rates in DeFi. Importantly, IPOR has implemented an over-block rate instead of an overnight rate. I reckon that is because crypto never sleeps, eh? Anyway, in the process, IPOR plans on becoming the heartbeat of the DeFi world.
The IPOR Protocol is founded on the belief that credit is the driving force for the growth and success of decentralised finance in the global arena. The credit markets in DeFi must progress and offer the same risk management tools as those that are available to traditional finance institutions to evolve into the fixed-income markets of the future. To that end, the IPOR Protocol introduces the IPOR indices and interest rate derivatives, including swaps that are linked to the indices. Interest rate derivatives are valuable in providing stability for fixed-income players by enabling them to manage their interest rate risk, and as such, they play an essential role in the evolution of DeFi credit markets. By providing these derivatives, IPOR aims to bridge the gap between the traditional financial world and the DeFi space, enabling the latter to attain a level of maturity that would allow it to gain widespread adoption.
IPOR aims to establish itself as the base layer of the DeFi credit markets, offering a transparent, public, and auditable methodology that is calculated and published on-chain. The IPOR indices are an open-source public good that anyone can utilise as a reference or foundation for building more complex financial products. The interest rate swaps that reference the IPORs can serve as inputs for developing the DeFi yield curve, which is a prerequisite for creating mature and liquid financial markets. Moreover, the Index and Derivatives provide an array of tools to other builders to create sophisticated financial products, thereby advancing the growth of DeFi.
Majorly speaking, IPOR has 4 product offerings:
- IPOR Indices
- Interest Rate Derivatives
- Asset Management
Let’s learn more about these in greater detail.
Multiple IPOR Indices will be available to represent different assets, such as IPOR USDT, IPOR USDC, IPOR DAI, IPOR ETH (coming up), and others.
Since external protocols determine interest rates algorithmically based on overcollateralized loans, the IPOR can act as a suitable proxy for the Risk-Free (Rf) rate because the collateral effectively mitigates credit default risk.
Furthermore, the index calculation will be adaptable and modular. Our industry is frantic, and as such, the index must be able to adapt to varied market conditions and account for sudden changes. The Index calculation is designed to be updatable and modular, able to account for new protocols to be considered for inclusion or removal, changes in weighting due to market dominance, changes to the third-party code base, or other potentially significant changes.
For each asset, time-based rates such as 1M, 3M, 6M, 1Y, and others will be established, allowing each asset to develop its own yield curve. This yield curve, in turn, will facilitate the growth and operation of the on-chain interest rate derivative market.
Interest Rate Derivatives
Regarding IPOR, an interest rate derivative could encompass any derivative instrument that uses the IPOR index as its contract reference. Nevertheless, as previously stated, interest rate swaps account for ~75% of the derivatives market. Interest rate swaps are the most commonly utilised instrument in financial markets so, IPOR will develop its own interest rate swap market.
The IPOR protocol's primary derivative product is the IPOR Interest Rate Swap (IRS), which enables market participants to take positions as Payers or Receivers by contracting with the liquidity pool.
To enter into a derivative smart contract, a Payer or Receiver must agree to a contract quoted by the Automated Market Maker (AMM), and pay the margin, contract fee, and relevant network fees (such as Ethereum gas fees). The liquidity pool will also post an equal margin in the same contract. The derivative smart contract will manage the positions and payouts over time, and once closed, will pay out the respective sums to the parties involved.
Common FAQ - as per the docs (Important)
Q. What is “Pay fixed and receive floating” or “Pay floating and receive fixed“?
- You are ' longing ' interest rates when you open a contract to “Pay fixed and receive floating”. Why? Because you are choosing to pay a fixed rate. Say the current IPOR Rate is 4%, and the floating rate goes up to, say 5%. You are receiving the floating rate, which means that you are getting paid 5% but paying 4%. “Pay floating and receive fixed” is the opposite.
Q. What is notional?
- Notional is the total value of the position that is taken by the market participant. This should not be confused with collateral. The notional value of derivative contracts is higher than the market value depending on the amount of leverage.
The AMM (Milton) is a pricing mechanism that provides quotes to users of the IPOR protocol for either paying fixed rates (receive floating) or receiving fixed rates (pay floating). To generate the quote, the AMM considers the current IPOR rate and adds a spread that factors in various parameters. These parameters include a trailing moving average, the size of the trade, the pool's risk exposure, current volatility, and reversion to the mean. The AMM adjusts these parameters dynamically to provide a fair and accurate quote to users based on market conditions.
The following parameters are considered to determine the fair market price for a swap:
- Recent trend
- Direction (long or short)
Liquidity Providers (LPs) are essential in providing the necessary capital to back derivatives (acting as swap underwriters). The liquidity pool can be considered a market maker that is constantly available to participate in trades. To facilitate a derivative contract on the other side of the trader (or taker), the IPOR protocol reserves funds from liquidity providers (makers) as collateral. When the derivative is successful for the trader, the liquidity pool's funds are utilised to settle the payout to the taker of the swap.
Utilisation is another important factor to consider when it comes to liquidity provisioning. The ratio between the aggregate collateral posted by the traders and the liquidity in the liquidity pool is called utilisation.
- 80% - up to 80% utilisation, the protocol will issue derivatives. Beyond 80%, no new derivatives can be issued.
- 100% - At 100% utilisation, the protocol will not permit the withdrawal of liquidity by LPs
When the utilisation is between 80 and 100%, no new derivatives can be opened, and liquidity can be withdrawn. This way, the protocol can ensure that liquidity providers can withdraw all their funds, including those used to underwrite derivatives, without interrupting already opened contracts.
Utilisation is used to set limits on how many derivatives the IPOR protocol can underwrite.
When an LP supplies funds to the pool, it will receive a liquidity token in exchange for its stablecoin. Each currency has its own specific liquidity token known as an “ipToken”, for example - ipUSDC.
Furthermore, LPs earn revenue in a few different ways:
- Fees charged when opening a derivative contract
- Fees charged when withdrawing liquidity
- P&L from traders
- Delegation of cash to the money markets via Asset Management (more on it later)
Finally, providing liquidity isn’t risk-free. You’re essentially a counterparty to the traders. As such, if a host of traders turn a massive profit, LPs will stand to lose. The pool’s funds cover the net payouts if the traders turn a profit. Spread and utilisation thresholds are the measures implemented by the AMM to control the risk of LPs.
It’s important to establish a working understanding of how the protocol i.e. the AMM works under the hood. The IPOR protocol is limited to facilitating basic interest rate swaps (“plain vanilla”), which restricts traders and LPs to engage in only two types of cash flows - fixed rate interest and floating rate interest. As a result, all of the trades on IPOR will be divided into two categories: a payer (long interest) or a receiver (short interest).
After a payer or receiver has accepted a contract quote provided by the AMM, they can proceed with their transaction. This requires them to provide the required collateral amount, which serves as their margin, pay the contract fee, and also cover the network's gas fee. Upon completion of these steps, the liquidity pool will allocate an equal sum of capital to guarantee the prompt fulfilment of all payoff responsibilities.
To calculate their profit or loss, the trader must determine the net difference between their payment and receipt. For example, if the trader has taken a long interest position, they must pay a fixed interest rate on the notional amount of the trade while receiving the floating interest rate from the AMM. If the trader pays less than they receive from the AMM, they will make a profit, while if they pay more than they receive, they will incur a loss.
Apart from the fees associated with liquidity provisioning, there are other protocol fees too:
- Opening fee: The fee charged for initiating a derivative position is referred to as the opening fee. LPs who bear the risk of the derivative receive this fee, which is calculated based on the trader's collateral. Initially, the fee is set at 1% of the collateral, but it can be altered by the DAO later.
- Base flat fee: The DAO sets a standard base flat fee for all transactions, which is intended to subsidize the IPOR oracle. As more means of supporting the oracle are developed, this fee will be gradually phased out.
- Liquidation deposit (refundable): The DAO sets the rate of the refundable liquidation deposit which is a fee charged when a swap is opened. This deposit serves as an incentive for traders or community liquidators to promptly liquidate a derivative if a liquidation event occurs.
- Income fee: The income fee refers to a fee that is levied when a derivative contract reaches maturity. A percentage of the profit generated by either the trader or LP is collected and then allocated to the DAO treasury. Initially, the income fee is set at 10%, but the DAO has the authority to adjust this fee later.
For the protocol to function as intended, the devs had to establish a working liquidation model. As IPOR interest rate swaps have a set maturity, liquidations must be exercised at some point. Swaps may also run into situations where the whole collateral is used up, and the derivative would enter negative equity. Efficient liquidations, therefore, are a must under those conditions.
At the inception of the IPOR Protocol, the devs opted for a liquidation deposit as this can be seen as the fairest and most efficient way to handle the process. It ensures that the trader’s collateral is utilised to the very last cent, without needing to worry about the accumulation of bad debt to the protocol.
Maturity is another element affecting liquidations. IPOR swap derivatives are initially set to mature after 28 days. Only 6 hours before maturity, the contract becomes available for liquidation. If a trader's collateral is insufficient to cover the drawdown of their position before maturity, the trader can get automatically liquidated. To prevent such automatic liquidation, traders can close their position at any time before maturity.
It is important to mention that the position will be automatically closed once the trader has either gained or lost 100% of their expected profit or loss. This means that if the trader's expected profit or loss reaches 2x or 0, the position will be closed automatically.
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When utilising the IPOR protocol, liquidity providers and traders deposit their stablecoins into custody with the AMM. These funds include the LP's stablecoins and the collateral provided by the traders. The funds are utilised to make payments between liquidity pools and the swap takers and must be kept in reserve to ensure contract solvency. However, the funds often remain idle, resulting in missed interest opportunities.
Asset Management (Stanley) offers a solution to this issue. Its primary function is to manage available funds at the lowest possible risk while earning interest. Initially, Asset Management will delegate stablecoins to AAVE and Compound, which are considered the most reliable, liquid, and secure platforms.
It’s always a fun exercise to evaluate who the potential users of a platform will be. It gives a good overview of the protocol and helps establish its value proposition.
Broadly, 3 major user groups will potentially want to make use of the IPOR protocol. They are:
- Hedging Interest Rates (Fix Your Rates)
- Speculation (And Leverage)
Hedging Interest Rates (Fix Your Rates)
To effectively manage basis risk and hedge loans using IPOR, it is important to recognise that IPOR is comprised of interest rates from several credit markets. This means that, in order to closely track IPOR, it may be necessary to distribute loans across multiple markets. Another option is to use interest-rate products that rely on IPOR. While it is possible to hedge a position in a single market, it is important to remember that the index may experience different movements than individual market rates.
Example: Let’s say you’re taking a USDC loan using a floating/adjustable rate. If the rate increases, you will have to pay more interest on your loan. You will need a product that will earn you interest if the rate increases. Hence you want to be “long“ interest rates, or in other words, you want to “pay fixed and receive floating“. This way, if the interest rate goes up - you will pay more in interest on your loan, but this will be offset by the earnings on the interest rate swap. Should the interest rates go down, your swap will lose, but those losses will be offset by the lower interest on your loan. This way, your interest rate is fixed, and you don't need to worry about it changing. If you want to hedge a deposit, then you reverse this structure: go “short“ interest rates or, in other words “receive fixed and pay floating“. This behaviour might be typical for a lender who does not want to lose potential income if the rate of return drops.
This example clearly outlines a very possible and realistic use case.
IPOR considers each stablecoin as a distinct currency because of their significantly divergent rate behaviours. As these behaviours fluctuate, it's common for rates between stablecoins to create opportunities for rate arbitrage.
Consider this example: assuming that any two stablecoins can be redeemed for the same value, this offers a chance to take advantage of different rates between divergent stablecoins.
Stablecoin A has an IPOR rate of 2.5%, while Stablecoin B has an IPOR rate of 5.5%. Though borrowing and lending rates between markets may differ, we will simplify this example by using only the IPOR rates.
Step 1: A trader could borrow Stablecoin A and enter into a "pay fixed" contract to secure the borrowing cost.
Step 2: The trader would exchange Stablecoin A for Stablecoin B.
Step 3: The trader would lend Stablecoin B and lock in the lending rate using a "receive fixed" contract.
By using interest rate derivatives, the trader can exploit a risk-free opportunity to arbitrage between two stablecoins. Yeah, certainly a big-brain play!
Speculation (And Leverage)
Speculators are able to also have long or short interest rates. With IPOR Interest Rate Derivatives this will be possible with leverage.
Yeah, this is your usual trading stuff. Think you can predict where the interest rates will go? Well, have at it!
Moreover, traders stand to earn (or lose) outsized amounts with leverage. As an LP, you’re hoping it’s the latter.
The IPOR token acts as the governance token for the IPOR DAO. It allows holders to vote on a variety of proposals, including things such as future protocol developments, fees, finances, and more.
The max. supply of the token is capped at 100 million tokens. The token allocation is as follows:
ShareWhoVesting Schedule30%DAO TreasuryGoverned by IPOR DAO.25% Liquidity MiningEmission of 1.5 tokens per block. Can be adjusted by the DAO.12.76%OperationsNo vesting. To be used by the DAO.20%Core TeamLinear vesting over 3 years. No cliff.11.85%InvestorsLiner vesting over 3 years. No cliff.0.39%Retroactive Rewards85,200 unlocked from 18.01.2023. 305,000 vesting 6 months from the same date.
The IPOR token’s inflation started with retroactive rewards for early protocol users, followed by IPOR’s liquidity mining program. The inflation rate starts at 10,800 IPOR tokens per day for the first 3 months. Can be altered by the DAO.
Power IPOR (Staked IPOR)
pwIPOR i.e. Power IPOR is simply staked IPOR. It acts as the protocol’s governance token. Furthermore, you aren’t required to time lock your IPOR to obtain pwIPOR. pwIPOR can be redeemed for IPOR at any time with no fee, however, there’s a 14-day cool-off period. Users can also unstake pwIPOR for IPOR immediately with a 50% fee.
Mechanism-wise, pwIPOR is a non-transferable token and is hard pegged to IPOR 1:1. Meaning that pwIPOR rebases @ of the % yield generated via revenue share, and your IPOR & pwIPOR balance will increase in tandem.
Importantly, as a liquidity provider, you can delegate your pwIPOR and receive a multiplier that will boost your yield. As you’d expect, the multiplier is calculated based on the ratio between the amount of liquidity a user has provided and the amount of pwIPOR they’ve delegated to the particular stablecoin which they’ve provided liquidity for. Also, the multiplier is calculated in a manner that starts very steep and then flattens out. This ensures that small and medium-sized LPs stand to benefit the most from increased APRs, it also helps with equitable token distribution and overall protocol decentralisation.
As of writing this article, pwIPOR serves two purposes within the IPOR ecosystem.
- Governance: To participate in the voting for DAO proposals in the IPOR protocol, it is necessary to obtain Power IPOR tokens. Merely owning an IPOR token does not confer the right to vote. Interestingly, users can also delegate their voting rights to another address. By doing so, you won’t be able to participate in governance, however, you can still utilise pwIPOR for liquidity mining. This delegation may promote some interesting dynamics.
- Liquidity Mining: With the liquidity mining incentive program, LPs can acquire IPOR and then stake those to receive additional yield. Essentially, this system allows the LPs to increase the weight of their liquidity.
With the liquidity mining program, pwIPOR is crucial for the continued growth of IPOR. The incentives have propelled IPOR to the #5 spot of derivatives protocols in DeFi by TVL.
It is important to note that as a user, you will have to decide where to delegate your Power IPOR.
Power Tokens: A modular public DeFi primitive
Finally, it is crucial to access the potential use cases and utilities of Power Tokens - separately from IPOR and beyond it. Power Tokens are a new modular DeFi primitive that aims to improve upon existing liquidity mining incentives for decentralised protocols. They are a public good that can be incorporated by any protocol that wants to optimise for the decentralised distribution of their token and align the interests of liquidity providers and token holders.
Power Tokens are built on top of the traditional ve model and make some significant changes to improve the liquidity mining incentives mechanism. These are:
- No need to lock tokens: If a user wishes to increase their multiplier, they can do so by delegating (powering up) more Power Tokens to the liquidity pool. To convert Power Tokens into a liquid ERC20 token, the user needs to execute a redeem function (with a 14-day cooling-off period).
- No hard cap on multiplier: As the ratio of delegation to liquidity increases, the effect of delegating more Power Tokens on the multiplier will gradually decrease i.e. diminishing returns, however, the multiplier will keep rising. By balancing their delegation and liquidity, users can achieve the optimal effective APR for their specific position. This provides users with greater control and transparency, making it easier to assign a dollar value to the utility of each delegated Power Token.
- Separate module for each token utility: Each of the main token utilities (such as multiplier, voting power, and revenue share) has a dedicated logic module. This approach provides protocols with greater flexibility to customise these modules to achieve their specific objectives.
You can learn more about Power Tokens here.
The folks at IPOR take decentralisation and community-driven governance seriously. This will be achieved through progressive decentralisation.
The first step is set by IPOR Labs who are building the core protocol. In the second step, 3-6 months later, IPOR labs will create a snapshot voting page to allow the community to vote on modifying IPOR and developing new products. Finally, IPOR then plans to mature into a fully community-driven DAO. IPOR Labs will transfer ownership into the IPOR DAO, and complete ownership and control of the IPOR protocol will be in the IPOR token holders. IPOR labs will continue to participate and make proposals; however, the ultimate approval will be in a decentralized manner via the DAO.
IPOR is building an innovative and unique protocol in the DeFi space. They’re pushing the boundaries of innovation in DeFi - which is commendable. Implementation of interest rate derivatives on-chain will bring a level of sophistication and maturity to decentralised credit markets. Furthermore, I love how they look at the IPOR indices akin to a public good. The risk-free yield curve will help establish a benchmark rate. The open nature of the protocol will allow other builders to build on top and deploy a host of unique products. More DeFi fun, eh?
Well, that’ll do it for today, frens. Take it easy out there!