The crypto market has picked up volatility again. Seeing $BTC and $ETH swinging +- 5% in a day suddenly seems normal again, and activity in DeFi is slowly returning. People are starting to become bullish again, and many of us are mentally preparing for the next bull run (hopefully).
Today’s newsletter is a sponsored deep dive into IPOR which has the mission of being the foundation layer of the DeFi credit markets. When most people think of DeFi, what they think about is yield and how to maximize it, but few users think of how to minimize lost yield, a hard lesson many learned from the last bear market. Not losing is winning. One area that is pretty unexplored though is the interest rate derivatives market in crypto. In the banking world this is a huge market ($450t), but because of immaturity and a general lack of risk management tools the big players, institutions, and whales have been reluctant to try out the interest derivative markets in DeFi.
Until now.
Let’s dig in and see why IPOR is a big-brain play.
IPOR: The heartbeat of DeFi
DeFi is moving forward. In the initial phases from 2017 - 2022, we’ve seen countless protocols that are focusing on trading, leverage, staking, and LP maximizing. We’re about to enter a phase where we’re seeing more real-world use cases. IPOR is at the forefront of this and is revolutionizing DeFi with its interest rate derivatives (IRD) protocol. One of the outcomes of IRDs could be fixed rates, and that's exactly the main use case for IPOR. Hedge your interest rate risk and create a fixed-rate product (or even more complex structured products).
Before we look at this, let’s take a look at the addressable markets today in the figure below. Crypto is sitting around $1.1t, while the biggest index in the US stock market is at $36t. Real estate is over $300t, while interest rate swaps (which is the market IPOR is targeting) are $450t. In other words, IPOR is entering a market that has huge potential in the crypto world.
Okay, anon. So why should you care about interest rates and fixed-rate lending at all? Isn’t this just what banks and institutions on Wall Street are using?
Not so fast.
Before we deep dive into the theory I just want to start off with one example of how you could use it. I’ve read countless reviews of protocols with plain theory without even understanding what the product is all about, and I don’t want you to suffer the same fate, anon.
Example of a user/protocol/whale/DAO using IPOR and Compound to borrow for 28 days for a fixed rate
A protocol wants to borrow $1 million $USDC, for 28 days. Right now they could go borrow on Compound for 2.33% annualized, but they have no idea if that rate will increase or decrease each block over the next 28 days.
So the protocol decides to borrow on Compound and enter into a fixed rate swap on IPOR to lock in a specific rate for 28 days.
This is how they could do it:
The protocol/whale/user has $2M worth of $ETH and decides to supply to Compound so that it has a safer collateral factor (ETH collateral factor is 82% right now, so at a minimum, the protocol must have $1,219,512 ETH deposited in order to have a debt of $1M $USDC.
The protocol/whale/user then enters into a fixed rate payer swap on IPOR with a notional amount of 1M $USDC. Since IPOR allows for a collateral deposit of 1,000x less than the notional, the protocol deposits $1,000 $USDC into IPOR (plus the fee and liquidation deposits). It’s worth mentioning that 1,000x leverage in this sense is not the same as if you go 1,000x long on an exchange. You won’t get liquidated on IPOR on a 0.1% move. On IPOR a 1,000x is about capital efficiency and isn’t necessarily degen. It’s so you don’t have to deposit that much to hedge your risk. More about this later.
Say you take a loan on Compound at 2.5 and the IPOR is at 2.0. If for the duration of the loan, the Compound rate is at 3.0 and the IPOR is at 2.5 you're hedged against the same volatility (50 bps).
In this case, the cost you would be paying would be the spread, so if the pay fixed was quoted at say 2.1% (IPOR + 10bps) your cost would be the 10bps + fees
Your effective fixed rate would be the Compound rate + spread + fees. To simplify we could say it's 2.6% fixed rate.
The protocol successfully locked in a fixed rate for 28 days on $1M borrowed $USDC. They should continue to monitor their health factor/collateral ratio on Compound and also make sure they will not get liquidated on IPOR, but it would really take a massive drop in rates for liquidation on IPOR to be possible.
As we saw in the example above you could use IPOR to lock in a fixed rate on the money you are lending out on Compound. For example, a DeFi protocol Treasury may want to borrow capital to fund the development of a new product. Or a DAO Treasury may have access to capital that it will not need for 6 months and is willing to lend it out for a fixed term, usually for a premium.
The rate on Compound in this example wasn’t the worst. But imagine you were doing the same at AAVE. A fixed-rate borrow there is at probably 12% so you're talking an order of magnitude more efficient to fix your rate with IPOR.
Fixed Rate Lending is going to be really important for the future of crypto and DeFi in general. The DeFi protocol/whale/user in the example has no idea what the actual cost of their financing/borrowing is going to be because the interest rate could fluctuate up or down at any moment.
For institutions and big players in crypto, it might make sense to pay a slightly higher interest rate now, knowing that the rate will not change (i.e. locking in that rate for say 6 months).
Let’s say you could lock in a rate of 2% for 6 months on a $1m loan. This means that the user/institution would have to pay a $10k interest in total at the end of the 6-month period.
So by using IPOR you could obtain this fixed rate instead of being nervous by using Aave/Compound etc., while the rates can fluctuate wildly.
Okay, let’s take one step back and explain in more detail what IPOR is and how it works.
DeFi today and the credit market
Total TVL in DeFi is today approx. $50b, down from around $200b at the end of the 2022 bull market.
According to DeFiLlama, lending/borrowing apps account for approx. 30% of the total market, only beaten by dexes (decentralized exchanges). The TVL for IPOR today is $32m, in an uptrend and a great increase in 2023 so far.
When most people think of DeFi, what they think about is yield and how to maximize it. One area that is pretty unexplored though is the credit market in crypto. In the banking world this is a huge market as mentioned ($450t), but because of immaturity and a general lack of risk management tools the big players, institutions, and whales have been reluctant to try out the credit markets in DeFi.
In the real world, the credit markets are super important for businesses. Interest rates dictate the markets and you’ve probably seen that tech stocks increase a lot when the rates are low (think 2020 and until the start of 2021). The reason that tech stocks and businesses are performing well in low-interest markets is that they’re able to borrow money at low rates that they reinvest and earn bigger profits on. In other words, interest rates are the heartbeat of the financial markets. So what's the beating heart of the DeFi credit markets?
Businesses project their future cash flow and how much profit they will get based on these interests. For normies like you and me, interest rates are also important. Let’s say you want to buy a house. It is, in general, easier to get loans in low-interest environments because the banks need less security from the customer. Higher interest rates lead to more costs for the customer, and if they get high enough you might be forced to sell your house.
So in other words, the interest rates are leading the economy. See for example how big the CPI and FOMC events are. There’s always a lot of volatility in the market during these events because people know that they will have a major impact on the prices of assets and goods.
As you might guess this leads to a huge market of speculators in the money market that bets on interest rates to either go up or down.
Want to speculate? Meet derivatives
How can you bet on a price in an easy way?
Meet derivatives. A derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Primarily, interest rate derivatives are used as a tool for risk management.
If we go back to our example at the start you saw that you could get a floating interest rate by lending at Compound, and that you could hedge with a fixed rate at IPOR.
This is basically an interest rate swap. So that the person with the variable-rate loan (you) pays the fixed rate, while the other party pays the variable rate in hope of an upside. You get what you want (stability of a fixed monthly payment), while the risk taker with a variable rate could potentially get a lower interest rate.
The primary objective of an interest rate swap is to help hedge the risk. This has existed in traditional finance for a long time, but seeing interest swaps in DeFi is a big step forward for crypto. For reference, see the comparison of the markets in the figure below.
What if there was a way of bringing a huge TradFi market over to DeFi by taking well-known fundamentals from TradFi and combining them with the best that DeFi has to offer?
Meet the innovative DeFi protocol IPOR.
IPOR - the heartbeat of DeFi
DeFi isn’t perfect. Lending money in crypto has a very unpredictable loaning rate, and this is something that might scare TradFi from using DeFi. DeFi also lacks 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. Luckily, IPOR saw this problem and aims to help mature the money markets in DeFi that standardize interest rates across the board by building interest-rate derivative financial instruments.
The IPOR Protocol is built on the premise that if decentralized finance (DeFi) is a global disruptive sandbox, credit will be the catalyst. For the DeFi credit markets to evolve into the fixed-income markets of tomorrow they must provide the same risk management tools that traditional financial (TradFi) institutions require.
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, it is a mid-market rate.
IPOR is on a mission to help DeFi establish its own benchmark interest rates, that can act as the risk-free rates in DeFi. An important difference is that IPOR uses block-over-block instead of an overnight rate. Crypto is open 24/7, so it makes sense, and that’s why it’s called the heartbeat of DeFi. It’s like the pulse of the heart, the rate is always beating and always up to date.
Imagine this: in 5-10 years you could take a home loan from a decentralized bank. The rate is quoted as a premium on the IPOR, an IPOR IRD (interest rate derivative) is hedging the rate, and this process is completely invisible to the end user.
Summarized IPOR has a simple mission:
To be the base layer of the DeFi credit markets.
IPOR Labs is founded by crypto industry veterans with backgrounds in derivatives, quant finance, exchanges, risk management, venture capital, and enterprise software development. See the team below.
For IPOR Labs it would not be possible to make this protocol without the right mix of talent.
They are 3 quants, two of which have 20+ years in the fixed-income sector each + 3 PhDs,
As far as I know, they’re the only DeFi protocol to have its own quant library.
Check out their impressive research here: https://ipor-labs.notion.site/e592feae2660418a90c35434849f0c0b?v=d35d84b479204c26bc1bb30d2b8ace4a
What could you use Ipor for?
1. Trading/providing liquidity
Fix your interest rate or hedge your exposure by leveraging non-custodial on-chain IPOR derivative instruments.
This is similar to the example at the start of our text where we hedged our interest rate on Compound with a 1,000x leveraged position on IPOR. This may feel like a lot of “leverage”, and even though 1,000x may seem like a lot, your PnL is earned over time, it is not instantaneous like perpetuals. It is really allowing capital efficiency in the IRS (really useful for hedgers). Also, the PnL accrues over time, over the 28 days.
To go back to our example, let’s say you’re taking a $1 million $USDC loan using a floating/adjustable rate on Compound at 2,33%. If the rate increases, you will have to pay more interest on your loan.
That’s why you need a product that will earn you interest if the rate increases at Compound. In other words, you want to be “long“ interest rates (you want to “pay fixed and receive floating interest“).
This way, if the interest rate goes up at Compound – you will pay more in interest on your loan, but this will be offset by the earnings on the interest rate swap at IPOR. Should the interest rates go down, your swap at IPOR 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.
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.
The first example I used is the trader side, someone who takes the instrument. The LPs are the underwriters and essentially make the market.
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 utilized to settle the payout to the taker of the swap.
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.
LPs earn revenue when traders are opening a derivative contract or withdrawing liquidity (fees) and from the PnL of traders. However, providing liquidity isn’t risk-free. An LP is 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.
2. Ipor indices
Think of IPOR as the benchmark risk-free rate. What is risk-free? In DeFi we could say overcollateralized loans are the risk-free equivalent.
Therefore IPOR could be used for benchmarking a risk-adjusted yield.
If you're earning 6% on say an undercollateralized market and the IPOR is 2% for that same asset, you're returning an extra 4% in risk premium.
It's also a great way for anyone to see how their credit terms look against the rest of the market. It's a transparent on-chain data point anyone can see to see if they're getting a good or bad deal.
Toggle between currencies and see the current IPOR rate. Hover over the line and see it for the last 30 days. In the app, you can see a more detailed version, where you can see details from 24 hours up to a year.
Multiple IPOR indices is available to represent different assets, such as IPOR $USDT, IPOR $USDC and IPOR $DAI. The IPOR index can act as a suitable proxy for the Risk-Free (Rf) rate.
For each asset, time-based rates such as 1M, 3M, 6M, 1Y, and others will be established, allowing each asset to develop its own yield curve. This yield curve, in turn, will facilitate the growth and operation of the on-chain interest rate derivative market.
So basically you can use IPOR to either hedge interest rates, make money on arbitrage, or speculate.
We’ve already talked about hedging your interest rates (example with locking in your rate at Compound through IPOR).
Arbitrage
On IPOR we have three different stablecoins ($USDC, $USDT and $DAI). You can see that they have different interest rates on IPOR, and this is something that you can take advantage of.
Let’s say that $USDC is at a 2.5% IPOR rate, while $USDT is at 3,5%. You could borrow $USDC, secure the borrowing cost by doing a rate fix and then exchange $USDC for $USDT. Then you could lend out $USDT with a fixed receive contract.
Not bad!
So what happens if you can borrow in DeFi at 2% and lend in short-term treasuries at 3,5-4%? That's a DeFi/TradFi opportunity.
There are a lot of these instruments announced to come on chain so IPOR would be a natural place to trade the difference between these rates. Even if the paradigm reverses where DeFi rates are higher this process flows the other way.
This narrative plays strong now that so many projects are looking to bring in UST rates on-chain.
Speculation
If you want to trade and speculate in a normal way you could also just go long/short on interest rates with high leverage.
Trading on interest rates is for people who either are degens or think they know where the interest rates are heading next.
Okay, now let’s take a look at the governance token for IPOR.
The IPOR token
The IPOR token acts as the governance token for the IPOR DAO.
It allows holders to vote on a variety of proposals, including things such as future protocol developments, fees, and finances.
The maximum supply of the token is capped at 100 million tokens.
The token allocation is as follows:
Tokens are split into the following allocations:
30.00% DAO Treasury
25.00% Liquidity Mining
13.15% DAO Operations
20.00% Team
11.85% Investors
The token contract on Ethereum is: 0x1e4746dc744503b53b4a082cb3607b169a289090
You can learn more about the IPOR token in the dedicated Docs section of IPOR.
Power IPOR (Staked IPOR)
Now that we know IPOR, let’s look at the staked version of IPOR called Power IPOR ($pwIPOR).
$pwIPOR 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.
$pwIPOR is a non-transferable token and is pegged to the IPOR token 1:1. Meaning that $pwIPOR is generated via revenue share, and your $IPOR & $pwIPOR balance will increase in tandem.
As an LP you get an ipTOKEN, basically an accounting token with a fluctuating rate. Provide USDC, get ipUSDC. This ipUSDC should be able to be exchanged for more $USDC in the future.
The ipTOKEN yield is never affected by the pwIPOR yield.
ipUSDC will always yield $USDC from the underlying protocol. The pwIPOR dynamic only affects the pwIPOR Liquidity Mining returns, never the underlying real yield.
If you stake that ipUSDC, you are eligible for $pwIPOR liquidity mining rewards. These are not rebase tokens, they're always tradable 1 for 1 with $IPOR. If you want to maximize your $pwIPOR return you can use it to power up your staked LP position. All liquidity mining rewards are paid in pwIPOR.
If you are an LP you can delegate your $pwIPOR and receive a multiplier that will boost your yield. 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.
Another important thing to mention is that you use $pwIPOR (not the normal $IPOR token) to participate in voting for DAO proposals in the IPOR protocol.
Real Yield
The IPOR Protocol was designed at its core for real yield. IPOR LPs earn yield from fees, AMM operations, and asset management.
An LP deposits an asset to the pool (currently USDC/USDT/DAI), and Traders can open Interest Rate Swaps (IRS) against the pool. The AMM quotes a rate. At maturity or liquidation, the net payoffs return to the respective parties.
LPs currently earn in 3 ways which can also be viewed on the Pools page
1. Fees
2. SOAP
3. Asset Management (leveraged money market yield
Fees
Each time a trader opens an IRS, they pay a fee which is currently 1% of the collateral deposit. The entirety of the fee goes to the LPs.
Why would a trader pay to open a contract? Because they want to take a position against the rates. If nobody is interested in a contract, no fees. Here are some use cases for IRS.
SOAP
S.O.A.P. is the Sum of all Payoffs. You can think of it as a snapshot view of the unrealized profit and loss of the pool at any given time. If you’re curious about how SOAP is calculated, read more here.
In the IPOR IRS, both Traders and the LP will win and lose across a number of contracts. Again, these winnings and losses serve a purpose for the trader, hence why they open a contract and pay a fee. In the payoff sense, the pool is typically simultaneously long (pay fixed) and short (receive fixed) over a number of contracts. The net outcome becomes a realized profit or loss for the pool.
The AMM is designed to keep the pool risk neutral, in other words, it should be winning as often as it is losing. This is why SOAP is a core piece for the next instruments and iterations of the protocol so familiarize yourself and stay tuned.
Asset Management
LP capital underwrites swaps. Traders deposit stables. These funds are unutilized until they need to be paid off at the contract settlement.
What if you could put this capital to work in the money markets? This is exactly what happens. Collateral of both the LPs and Traders earn directly from AAVE and Compound while not being paid out.
This could be considered a leveraged money market yield for the LPs where they also get the return of the collateral deposited by the traders.
Why not allocate stables to potentially higher-yielding opportunities? First, the constituent credit markets of the IPOR Index were selected because of protocol quality over time, and consequently lower risk.
The Protocol design uses security and risk management to build for longevity. When considering a higher yield, the return calculation must be adjusted for risk, and given the unknowns of typically younger protocols that have higher yielding potential, the asset management prefers the leveraged yield approach in low-risk opportunities to higher immediate yield opportunities. Another benefit of allocating to the Index constituent protocols is that it reinforces the utility of the protocol by becoming a direct participant of the very credit markets from which it is derived.
From a LP decision perspective they could:
1. Provide liquidity directly to the money markets
or
2. Provide liquidity on IPOR which yields fees, SOAP, and leveraged money market yield
An easy choice IMO.
You can read more about Real Yield and Risks in IPOR Protocol here:
Navigating through the IPOR website
Let’s go to: https://app.ipor.io/ and click “Portfolio”. You will see the picture below.
Next, click on “Swap”.
Here you can see the different metrics for the 3 different stablecoins.
IPOR USDC index- The IPOR rate of USDC. IPOR rate weighted average interest rate of Aave and Compound borrow interest rate. IPOR can add/remove more protocols from this rate in future.
Median value: What is the median of the rates (average IPOR rate).
Pay fixed: How much do you need to pay as a fixed rate if you swap? (pay fixed is going long against the rate)
Receive fixed: How much will you receive as fixed interest if you swap? (receive fixed is going short against the rate)
Some explanation of the actual swap
Let's keep in mind some points before doing the actual swap.
There is a 1% opening fee, which is given to liquidity providers
There is a refundable liquidation deposit of $25. Which will be refunded if no liquidation happens.
Your positions will be automatically closed when you are in 100% profit or loss. So maximum gain is 2x for the time being.
10% of the profit will be deducted as income for the IPOR DAO.
Leverage - You can choose up to 1,000x
Minimum leverage - 10x
Maximum deposit- $100,000
Maximum deposit per wallet as LP - $50,000
Maximum deposit in an LP- $300,000
All these values are at the inception of IPOR which will be changed by governance.
Swap collateral - The collateral you have to put to make the swap.
Leverage - The leverage you wish to take
Notional - The amount you wish to hedge for. For example, if you took a loan of $100,000 notional is $100,000. If you set leverage to 1,000x then collateral should be $100.
Swap direction - The swap you want to execute.
Maturity - How long the contract is valid, currently it's 28 days.
IPOR rate - The base rate. Calculated as the median of Aave and Compound rates.
Spread - Difference between floating and fixed rates paid to LP.
These keywords and explanations above should help you through and let you feel comfortable opening your first position on IPOR.
Also, I found this video very great in explaining how IPOR works:
Just to end this deep dive into IPOR, I wanted to mention some updates from IPOR that were just launched.
$IPOR Emission Reduction
The first proposal went into effect April 25th and the effect is that it will reduce the daily LM(liquidity mining) emissions from 10,800 pwIPOR to ~7,560 pwIPOR. The change leads to a significant extension in the distribution of all liquidity mining rewards (25m) — from 6.34 years to 9 years.
Update of the pwIPOR boosting curve
The protocol will increase APRs for liquidity providers with pwIPOR to staked ipTokens ratio higher than 5% and decrease returns for LPs with lower ratios. Preference is given to liquidity providers who have an aligned long-term position with the Protocol.
You can read more about these announcements here:
IPOR v2 is coming soon
IPOR also released a new blog post talking about IPOR v2 (the updated version of v1 which is live now). IPOR v2 will most likely be released during ETH CC in July this year.
IPOR v2 focuses on several key themes including:
New interest rate derivative markets;
Expanded yield generation vault strategies — from rates strategies to yield arbitrage;
Product simplification and one-click solutions;
Improved AMM spread model pricing, expanded rates tenors, and removal of optionality;
Expanded data for market-driven decisions;
Marketing overhaul with a focus on simplification and conversion;
Architectural upgrade.
Check out the blog post here to read about all the updates for v2:
Conclusion
IPOR is innovative. No doubt.
They are trying to break into a market that is huge in TradFi, but almost unexplored in the DeFi world.
The concept of interest swaps is not easy to understand initially, but I tried my best to ELI5 it without dumbing it down too much. Lots of cool stuff can be built on top of IPOR, which we haven’t seen yet in Defi. This can bring new interests and liquidity to Defi from big players, which we are all longing for.
In summary, we can say that IPOR is like the GMX for credit markets. Following the path of TradFi, credit markets are still an unexplored area in crypto. But interest rate derivatives (IRDs) are a $450 trillion market in TradFi. Imagine what would happen if even 1% of TradFi started using IPOR. I believe the best is yet to come for them.
Overall this is a great product for both institutions and individuals that want to hedge interest rate risks. As the DeFi market matures and we’re getting closer to the Bitcoin halving in 2024, I expect institutional demand for the IPOR protocol going forward.
Btw, there’s an $ETH IPOR rate currently being developed. Super interesting in my opinion!
We will definitely hear more about IPOR in the coming years.
To be continued, anon ;)
Thank you for reading, and see you again next week!
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IPOR: The heartbeat of DeFi
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