Everyone and their mom are talking about the ongoing banking crisis in the US.
Significantly sized banks are faltering in their obligations to their depositors and, as a result, are relying on intervention from other parties to save the day via bailouts and buyouts. The US Federal Reserve was left in a precarious situation and had to inject liquidity by expanding its balance sheet – although it’s different from the liquidity injection that we witnessed during the COVID times, this isn’t QE as we know it frens.
However, the mechanism may be different, but the impact could well be the same i.e. soaring inflation. This has pretty much undone some of the good work that the FED undertook to curb inflation. The CPI prints in the coming months will be something to look forward to. Exactly what’ll happen is anybody’s guess at this moment.
Furthermore, in the midst of this crisis (surprisingly), the Bitcoin narrative has caught steam – looks like it’s finally acting how it is supposed to. I hope I don’t jinx it. In case you’re living under a rock, Balaji Srinivasan, former Coinbase CTO, has predicted that BTC will hit a million dollars per coin in 90 days. Now more than anything, I’m interested in his thesis than if BTC hits the $1 million mark or not.
And no, I’m not a Bitcoin maxi, however, you cannot entirely fade this narrative either. Traditional banking as we know it has many flaws. Now, this may be an extremist view, but again, you cannot deny it completely.
The macro will heal itself in time (hopefully). What’s interesting to learn from this episode is the concept of interest rate risk, how failure in hedging against this risk resulted in the implosion of the Silicon Valley darling SVB, and what it means for DeFi and IPOR’s role in it all. Strap in!
Here’s an idiot’s rundown of events. This is my smol brain interpretation – don’t judge!
- SVB had a major influx of deposits post-COVID. As we saw the VC mania (with all the fresh capital injected, as money the printer goes brrr), startups were raising money left, right and centre. A sizable chunk of this money was deposited in SVB.
- SVB started lending out these deposits to generate a yield like any bank. Simultaneously, they also started investing in low-risk instruments like government bonds.
- Now, as the FED started hiking interest rates in order to control inflation, demand for loans started to decline.
- A bank doesn’t like idle cash, they want it working for them. As a result, SVB started investing in long-dated 10-year government bonds. Importantly, bond prices have an inverse relationship with interest rates. As interest rates rise, bond prices fall. For example, if I can subscribe to a fresh 5% government bond, the price of an old 4% issued bond in the secondary market will fall.
- In itself, the bondholder can wait till maturity and get the entire amount plus the interest rate. However, SVB was facing a liquidity crisis as depositors came asking for their funds and, as a result, had to sell some of its long-dated 10y bonds at a steep discount. This opened a hole in their balance sheet.
- Furthermore, SVB has very little retail exposure. As panic struck, a few large withdrawals were enough to shake things.
- Finally, the interest rate risk for SVB was amplified further, as it seemed that this risk was unhedged since last year. Bad move in hindsight.
Anyway, now the question is, will this entire sequence of events make interest rate swaps a mandatory risk management tool within DeFi?
With fractional reserve banking, no bank can withstand a full-blown bank run. It’s simply impossible.
Sure, the bank needs to utilise the depositor’s funds to generate a yield and turn a profit. However, poor risk management resulted in the bank’s sudden demise. That too boils down to two primary risk vectors:
- Duration risk
- Interest rate risk
Duration Risk: Duration risk is a type of risk that affects banks and other financial institutions that have mismatched assets and liabilities. This means that they borrow money for a short period of time (such as deposits) and lend money for a long period of time (such as loans or bonds). This is part of a broader field called ALM, which stands for Asset Liability Management.
Duration risk means that when interest rates change, the value of the assets and liabilities also change, but not by the same amount. For example, when interest rates rise, the value of long-term assets falls more than the value of short-term liabilities – which remains unchanged, at least when considering customer deposits.
Famously, 3AC was also in part exposed to this duration risk with the stETH and GBTC trade. In the hunt for liquidity, as 3AC faced margin calls, they had to sell their stETH and GBTC at a discount.
Duration risk is only a part of the risk. In regards to SVB, a significant portion of the risk came from failure in hedging against interest rate risk. It doesn’t take a scientist to figure out that as the FED raises interest rates, bond prices will fall. Furthermore, over the impending funding winter, as the FED worked tediously on draining liquidity, startups started flocking to their cash reserves held with SVB. And the rest is history! I’m sure you get the picture now.
Hedging Interest Rate Risk
We explored how companies hedge their interest rate risk via interest rate swaps in our introductory IPOR article. You can read it here.
Let’s learn how a bank could do the same with exposure to long-term government bonds.
But first, when anybody (in our case SVB) buys a treasury bond, they lock in a fixed yield, and rising interest rates are risky, as that will reduce the price of the bond in the secondary market. To hedge against this risk, a bank enters an interest rate swap. They pay a fixed yield and receive variable interest in exchange. This is essentially longing the interest rate and acts as the hedge.
Yeah, SVB didn’t do that! What a rookie mistake, or perhaps incredible levels of overconfidence – as hedging strategies increase the cost of doing business and affect the bottom line.
Impact on DeFi
Well, the implosion of the traditional banking system doesn’t have any material impact on decentralised finance (DeFi) – at least not until the entire thing collapses. The only cause for concern is the alleged “Operation: Chokepoint 2.0”. Essentially, there’s consensus on CT that this may well be a targeted attack on crypto in the hopes of prohibiting crypto companies from banking services. This will inevitably drain liquidity from the crypto markets, as to this date, money enters crypto through traditional banking systems via centralised exchanges or on-ramps. No doubt there could be truth to this, however, we’re gonna leave conspiracies for next time.
DeFi does not have well-developed term structures yet. Most markets are liquid and do not require locking up funds for a fixed period of time. Even the futures markets do not have an expiration date. Some protocols offer fixed-income products with longer-term and more rigid structures, but they have low liquidity, probably because of the term structure itself.
In contrast, SVB has a duration mismatch that lasts for years. In DeFi, duration mismatches in the money markets happen when there is 100% utilisation, such as when USDT pools were preferred over USDC pools during the crisis or with stETH until the Shanghai hard fork.
One of the challenges that decentralised finance faces is the lack of mature term structures. Term structure refers to the relationship between interest rates and time to maturity for different types of debt instruments. In traditional finance, term structures are important for pricing bonds, hedging risks, and managing liquidity. However, in DeFi, most markets are liquid and have no lockup period, meaning that users can deposit and withdraw funds at any time. Even the futures markets are perpetual, meaning that they have no expiration date and are settled periodically based on an index price. This implies that there is little incentive for users to commit their funds for longer periods of time or to take into account future interest rate changes.
However, for DeFi to meet its potential and transform into a mature and sophisticated financial market of tomorrow, we’ll need these term structures.
The thesis is that for DeFi to grow and attract the big dogs i.e. institutions and other large entities, term structures must mature. Such a mechanism will help establish a risk-free yield curve for DeFi that will be based on different tenures.
The IPOR protocol is poised to play a pivotal role in the formation of term structures and a DeFi native yield curve. You can learn more about IPOR through our introductory guide here.
At present, the IPOR Indices represent immediate rates or the expense of capital based on the existing block height. In the upcoming period, IPOR rates will be available for durations of 1, 3, and 6 months, and extended timeframes.
This development will provide market participants with insights into the varying capital costs for distinct time periods and offer an array of tools for managing rate-related risks.
As explained in the introductory article, a major use case of the IPOR protocol is hedging against interest rate risk through the interest rate swap product. Sure, traders can speculate and trade i.e. long or short interest rates based on an investment thesis, but undeniably sophisticated DeFi participants will benefit the most from this complex product.
In a nutshell, IPOR offers two things:
- A reference interest rate for popular stablecoins (and soon ETH) in DeFi
- Interest rate derivative instruments
The primary function of the Index is essential for integrating a term structure into DeFi lending markets, while the second feature provides users with the necessary instruments to effectively manage their exposure to interest rate fluctuations.
Interest Rate Derivatives can be compared to earthquake insurance. It’s only effective if you obtain coverage before the event occurs. You can’t purchase insurance when the ground is already shaking and expect to be protected.
If there is a widespread shift toward a more accommodative monetary policy and risk assets experience a rally, DeFi interest rates could skyrocket. We may witness another historic rate inversion similar, but opposite to the one that happened last July:
The USDC IPOR rate and TradFi rate crossed last July. Link to the original post.
Participants in the DeFi market can utilise the IPOR Index to evaluate the price of credit and engage in swaps to hedge against fluctuations in their borrowing expenses or returns.
To entice traditional fixed-income investors, the industry must establish some form of term structure.
The evolution of credit markets is crucial for DeFi to become a prosperous financial ecosystem.
The IPOR Index will play a critical role in developing both a term structure and yield curve within the DeFi space. Interest Rate Derivatives can be employed to prevent the financial collapses we are currently witnessing.
In the end, let’s first hope the entire TradFi system doesn’t collapse. As for SVB, poor risk management ultimately led to its sudden demise – ain’t got no one to blame. Thankfully, depositors won’t lose anything. However, the FED had to intervene, which isn’t ideal.
This entire episode perfectly illustrates that interest rate risk is real and dangerous. As such, sophisticated market participants in the TradFi world rely on tools such as interest rate swaps to mitigate risk. Thus, no wonder we need a thriving market for trading interest rate swaps in DeFi. Furthermore, with IPOR Indices, DeFi will be able to establish a defacto benchmark rate – which will inevitably allow for the creation of a risk-free yield curve. The future’s bright!
That’ll do it for today, dear frens! Once again, I hope you found this article useful.
This article was written by Shaurya – Shaurya is working full-time in crypto and has been involved in the space for over 2 years now. He’s passionate most about DeFi in the web3 industry. In his writing, he is a master at breaking down complex topics in an easy-to-understand language. Go give this legend a follow on Twitter.