Building a Benchmark Rate and Interest Rate Derivatives in DeFi

Transcript

Well, we got a nice little audience here, so we'll make it a little more personal. Uh, who of you guys have heard of uh LIBOR? Any? Okay, so keep your hand up if you guys were actively involved in manipulating the LIBOR. Okay, maybe bad joke to start, but this is a this is a little bit of uh you know, kind of a history of bringing the Let's say the LIBOR back home, uh taking the IPOR and really transforming what is this benchmark rate for DeFi, uh taking the best of what we have in the blockchain market and making the market more transparent, open, auditable.

Uh so, a little bit about myself. I've been building in the crypto space for the last 11 years. Really happy to present to you IPOR. Uh and really like these are the base layer of the DeFi credit market. So, IPOR is really a protocol with two different parts. One, benchmark rate. Uh two, a suite of interest rate derivatives. So, if you guys are here, maybe you know a little bit about the DeFi credit markets. So, we won't talk about the innovation. Let's talk about maybe more of what is missing. So, we really lack this term structure. We really have these nice, very innovative, but very short-term debt markets, right? And this is really interesting, but it's not really useful, let's say, if you want to take a home loan from a DeFi bank.

Okay, so next, you lack a lot of rate transparency. Uh and that is a little bit because you have a fragmentation between different markets. But, what does that lead to? You have different rate uh rate behavior across different markets, and you really lack tools that manage risk and also allow you to arbitrage between these fragmented rates. So, if we're thinking about how we build this base layer of the DeFi credit markets, we're really looking at two things taking from traditional finance. One is a benchmark interest rate, and two are a set of interest rate derivatives that can underpin these credit markets.

Okay, so if we look at the traditional benchmark rate, so let's talk about the LIBOR, the SOFR. So, you really have these different banks or financial institutions that are self-reporting rates. And you know, if you look at the LIBOR scandal, we know that there's an issue in terms of trust and self-reporting. But, in the blockchain world, we have a much more transparent dynamic for this, which we'll get to in just a second. But, publication time for example, in the LIBOR, what is 11:00 a.m. BST? Is it this magical time that all credit markets should be based on?

Or if you look at something like the SOFR, you know, what is overnight? Someone's overnight is always someone's daytime. Uh and then if you look at like volume weighting, you can take like the BSBY, which volume weights for all of the transactions across the Bloomberg terminal. So, we can take these dynamics coming from traditional markets, and we can actually apply the DeFi mechanics to make it more transparent, real-time. So, for example, in the DeFi sense, from the LIBOR to the IBOR, in the IBOR, we swap out banks, we swap out financial institutions, and we replace them with protocols. And these protocols are transparent, they're smart contract-based.

So, instead of asking someone to self-report the rates, we actually just tap in to the smart contracts themselves to understand what is the rate in the market. In terms of publication, again, someone's overnight is always someone's daytime. So, instead of having this geographic-centric um publication time, we get what's the IBOR, or the inter-protocol over block rate. It's published and calculated block over block over block. So, it's the closest thing that we can get to real-time in DeFi. And then finally, the transactions, we can see very clearly, they're going across smart contracts across the Ethereum blockchain.

Uh so, for example, how is the IBOR index weighted? Well, again, it's a survey from these smart contract protocols. So, in its initial construction, it's taking from Aave and it's taking from compound. And it's not technically an offered rate, it's more of a mid-market rate because of how the rate dynamics are structured. So, it actually uh the the interesting part will be how does this uh index rate go and how does it evolve in the future? How do you ingest um let's say the rate behaviors from different protocols. Okay, so this also index is a public good. So, if we look at something like black box uh uh lack of transparency, you're looking at, you know, the the let's say the discontinuation of the LIBOR. You have

these long-dated instruments that need to be unwound, right? But you don't really have much insight into these. But in the blockchain perspective, we publish the I for rate is published block over block on chain, which means it's a public good. This public good can be used by other protocols as a smart contract call to another smart contract call. So, you can have this similar structuring of debt, of derivatives, of deals. And so, you can see these handshake deals or maybe a home loan or uh auto loan will be structured off of the I for index in the same way that you structure these borrowing for different stablecoins.

And really the value of it is this we call the I for the heartbeat of DeFi because it's keeping the heartbeat of the DeFi credit markets block over block. And as you have this uh very open data framework and you have these instruments that are pegged block over block, the real long-term value of the I for instrument is how many of these other instruments are pegging to it. What's the value, what's the volume, and what's the velocity of these external instruments that are very clearly making these smart contract to smart contract calls and this uh basically public good functions as the base of the DeFi credit markets.

So, actually the I for DAO may be one the most interesting places where there will be decentralized governance that's available to let's say keep something out like the manipulation of the LIBOR. So, for example, how do you add new protocols to the index? Well, that's a great question and you won't be asking me that. It'll actually be a governance decision by the Ipor DAO. Okay, so how do you remove protocol from the index? We know that DeFi protocols are innovative, they are fast-moving, and sometimes they get hacked. So, in the case of a large hack, how would you remove a rate from the protocol? How would you actually have this protocol go cross-chain and ingest rates from different money market protocols on another chain for example

outside of Ethereum, on Avalanche, on on Algorand? I mean, this is a this is something very interesting that it's it's it's it's a great case for decentralized governance. How do you re-weight the index? You know, how do you actually spin up a new index? So, right now there's Ipor rates for USDT, USDC, and DAI, but maybe there will be a new stablecoin that rises up that has an entirely different rate dynamics. Okay, and then finally the last part is talking about the risk management on the instruments themselves. So, the risk management, how do you change the constructs and the constants on the AMM features? How do you change the risk dynamics for how much risk the the protocol can underwrite? Again,

these will be decentralized governance decisions. Okay, so we consider that So, currently there's an interest rate swap that's live on Ethereum that we consider the first instrument that's actually referencing the Ipor. So, it's a 28-day peer-to-pool cancelable swap. Now, if you're coming from traditional finance, maybe it's a laughably short instrument and also the optionality is very strange, but it's something that actually matches the market behavior of the DeFi credit markets.

So, if we look at who are the parties in here instead of let's say you know a traditional swap which is typically bank-to-bank, you have a very fixed term structure and then you also have let's say the pricing done by an order book or by a broker. Well, we actually use the best that we have in DeFi. So, the structure in the iBorrow swaps and also how to bootstrap a market where there has never been one is we use a peer-to-pool construction. So, this passive liquidity pool is actually acting like a passive market maker and it offers these swaps that can be taken by the traders where the traders are the peer.

Instead of having this rigid structure, it's more similar to an RFQ or a request for quote. As soon as the trader takes the instrument, that starts the clock to the 28-day maturity. So, again this is designing an instrument that matches the let's say the temperament, the term structure, and the the behavior of the users of DeFi currently. And then finally the pricing is done by an automated market maker and really this is the secret sauce that really sets iBorrow apart. So, in building an automated market maker for interest rates which have a very different behavior than the say assets, we can't use the simple x * y = k pricing that you find let's say on on on Uniswap. Why? Because you're not

pricing a volume for demand. You're actually pricing a lot for volatility. So, we use we actually have or or are digging into the quant toolkit. So, we use something called Hull-White which is the traditional quant model for interest rate behavior. And then we borrow other models that actually match this DeFi behavior. So, for example, we use jump diffusion which models these volatility spikes and then mean reversion. And so, you can think of it as kind of a premium to the upside. And that is really interesting today because the iBorrow rate jumped from 2% to 40% and now hopefully it's mean reverting.

It's about 17% before I got on stage, but this is the model that we use to model for these particular jumps. And then we use Longstaff Schwartz, which is pricing for optionality. So, if you're running all these calculations off-chain, then you can do whatever you want, right? It's not reinventing the wheel. Really what's the beauty of designing this instrument on-chain is getting these very complex mechanisms into a good enough approximation to manage risk for the liquidity providers while cheap enough to do it on-chain. And so, taking an iPort swap right now is not much much more expensive than taking a Uniswap swap. And that's really the engineering beauty behind the iPort protocol.

Okay, so how do you test these models? Well, we only have about 2 and 1/2 years of really rate behavior in decentralized credit markets. So, again we go into the quant toolkit. We use something called the Hawkes process. So, what the Hawkes process does is snips out a set of data and extrapolates it over a long time period. So, we take this limited data set that we have, we recreate it over a number of different situations, and then we run the AMM models over these different sets to understand how it performs. And this is all done on a internal frame testing framework called the ITF that we use to backtest the models and how they would behave on-chain. And so, this is really the interesting process of marrying the quant, the on-chain to create this this

instruments. Okay, so the key takeaway is and it's probably horrible English, you have to pardon me, I am American, but it's really how you take the best known fundamentals from traditional finance, you marry them with all the capabilities that you have in DeFi. You provide something that's really useful and it's designed for the temperament of the people that you're addressing, but you also give the experience that the people are used to from the traditional markets. So, when institutionals are coming in to manage their rate risk in traditional finance into DeFi, then they get the same experience that they're used to.

So, what's the future of the iPor protocol? We see this iPor protocol as the base layer of the DeFi credit markets. So, if we envision it as a software stack, this data layer is really the underpinning. It's the transparent benchmark rate that everyone can peg to. We see this derivatives layer as this kind of stabilizing factor. And because DeFi is money Legos, you can really string them together in a couple of different contract calls to create structured products. And so, these are the DeFi Legos that will go into these structured products, different types of funds that will be building in the future.

And so, what's 5 years down the road? Maybe you're asking a DeFi bank for a home loan. And that loan is being quoted off of the iPor index, and there's these interest rate derivatives that are underpinning the loan. And maybe this entire process is completely invisible to the end party. And really, that's the goal that we have at iPor. Okay, really quick about the about the team. Our team comes from a deep background. So, for example, our quants have spent 20 years in traditional markets as quants in fixed income. Our Our software developers, they come from enterprise software development turn blockchain.

So, they've built banking systems. They've built payment. They've built in the insurance. So, building these robust scalable systems in DeFi is extremely important. Again, I've been building in the industry for 11 years. We have a very deep talent. And we have a great backing by Arrington, Gumi, CMT Digital, GSR. So, if you're interested in learning more about the iPor protocol, visit iPor.io. We have maybe some of the best documentation in the industry. You can check out the quant models behind the behind the AMM, behind the all the testing suites. Come talk to us. We have a booth in there. Thank you very much, and yes.

Mhm.