Trading Interest Rate Derivatives on the Blockchain

Principle

— 7 min read

Table of Content

Context

Interest Rate Derivatives are a multi-trillion dollar daily market, with most trading between large financial institutions, corporations, and asset managers. Corporations use them to hedge their interest rate risk on loans, bond issuance, and other liabilities. Asset managers use them to express views on the direction of interest rates.

The market is regulated in the US by CFTC under the Dodd-Frank act and in Europe by ESMA under the EMIR regulation. The regulation is prescriptive on the daily margining and clearing requirements for transactions between large and sophisticated counterparties while applying a light touch on smaller transactions and where corporations' total volume falls below certain thresholds.

This regulatory split between sophisticated and less sophisticated counterparties is intentional to limit the build-up of system risk in the market from large institutions while simultaneously avoiding the regulatory burden on smaller corporations and financial institutions - who often don't want to maintain a large back office workforce to deal with daily margining and collateral exchange.

Not doing daily margining, however, comes at a cost. On trades without daily margining, the financial institutions with whom corporates trade need to add extra fees to compensate them for the additional risk and cover the extra capital costs the regulators oblige them to hold on these trades. This is a suboptimal solution as this adds extra costs to both sides, and both the corporates and the financial institutions would prefer to have all trades daily margined. A win-win that is being held back by an operational burden of managing daily margin effectively. Both sides would benefit greatly from doing daily margining on all their trades if this was operationally feasible.

Our platform will bring daily margining and collateral onto the blockchain and turn the daily process into a few clicks. Corporations will be able to settle the trades on the blockchain and have the daily margin switched on automatically. They will monitor the market value of their positions and corresponding margin requirements in a dashboard and, at the end of the day, post more margin from their crypto wallet or redeem margin into their crypto wallet. This will all be done on a Blockchain that supports private transactions.

A working proof-of-concept with corporations will show regulators, and the decision-makers at large financial institutions the benefits of adopting blockchain for these products and advance the conversation of how blockchain can improve the logistics of trading between large and sophisticated counterparties.

After completing the build of settlement and margining of Interest Rates Derivatives on the blockchain, we will then build an Exchange where counterparties can trade these products with a liquidity pool, similar to how thousands of crypto tokens trade on decentralized exchanges (DEXs). This will democratize the Interest Rate Derivative market and give access to smaller participants who are currently priced out due to minimum ticket sizes that are beyond the needs of many. The decentralized exchange will match passive market makers with clients and automate some of the work currently done by financial institutions when providing liquidity.

Building Blocks

We will build a platform for counterparties to settle and manage the margin requirements of Interest Rate Derivatives on a blockchain. We will do this in three steps:

  • Build a platform for settling and margining Synthetic Futures
  • Extend it to FRAs and FX Forwards
  • Extend it to Interest Rate Swaps

The settlement will happen between known counterparties at pre-agreed levels. The platform will include a risk engine that will determine how much margin needs to be exchanged at the end of each day. Smart contracts will codify the terms sheet of the trades and control the margin requirements.

We will add complexity in iterations as we go from more straightforward to more complex products.

Once the platform for settlement and margin is delivered, we will then build a decentralized exchange with market makers providing liquidity at different FRA tenors and corporates trading with the liquidity pools. This will create a market for bespoke swaps and FX Forwards that anyone can execute without calling a broker/dealer and automated settlement and collateral management.

Building blocks: a suitable blockchain, the smart contract, a risk engine, and the platform front and back end.

A Blockchain

A suitable public blockchain with smart contract capability. One that is decentralized, secure, and where transactions are fast and inexpensive.

  • Ethereum - decentralized and secure, transactions are 12 seconds, can be expensive for smaller transactions.
  • Cardano - decentralized and secure, transactions are 1 to 20 seconds and relatively cheap.
  • Layers 2 solutions and other blockchains that rely on the Ethereum Virtual Machine (EVM), such as Polygon, Avalanche, Fantom, and Binance Smart Chain. Cheap transaction costs at a compromise of decentralization

Smart Contracts

Smart contracts will codify the terms of Synthetic Futures, FRAs, FX Forwards and Interest Rate Swaps. In addition, they will determine the tenor, term, notional, rate, and other elements of the term sheet. Execution of the smart contracts is guaranteed; once a trade is registered, there is no ambiguity on the dates and margin conditions. Margin is revalued daily, and if the counterparty does not post additional margin, then the contract is resolved, and the remaining margin returned to each counterparty.

Risk Engine

A risk engine will determine how much margin counterparties need to post for the transactions and revalue daily how much extra margin needs to be posted or if the counterparty can withdraw margin.

Interest Rate Derivatives are margined trades, where each counterparty needs to put up a margin at the start of the trade, which is typically just a tiny fraction of the notional amount. For example, on a 3-month Forward Rate Agreement with 10mn notional, the initial margin might be less than 5%

This margin will vary during the life of the trade, and a risk engine is needed to decide how much initial margin needs to be deposited into the smart contract by each of the counterparties and how much this margin will change over time.

Front-end and Back-end

A front end through which the user will interact with the Smart Contracts. The front end is built to abstract the technicalities of a blockchain from the end user. The back end is the layer between the front end and the blockchain. Because blockchains are highly optimized for efficiency, they need to offload the role of manipulating data into different data structures to a back-end. The back end also manages crypto wallets.

What We Will Build

We will build a platform that lets two counterparties settle synthetic Interest Rate Futures on the blockchain with daily margining. These futures are synthetic because they mimic the behavior of the same Future traded on an exchange but with settlement on the blockchain rather than on an exchange.

Then we will extend the functionality to Forward Rate Agreements (FRAs), an OTC instrument. The FRAs will also be daily margined.

Then we will extend the functionality to Interest Rate Swaps (IRS). Swaps are made up of a sequence of FRAs; therefore, the hedging of IRSs can be done with FRAs.

Synthetic Futures

Taking the example of 3-month SOFT Futures contracts on USD. They are traded on the CME exchange with daily settlements. To bring the settlement and margining of Synthetic Futures onto a blockchain, we will build the following:

  • An Oracle to deliver end-of-day settlement prices into the blockchain
  • A Smart Contract that accepts the term sheet of each future maturity
  • A risk engine that determines how much margin requirement is needed for each Future
  • A transaction builder that will post and retrieve margin from the smart contract at end-of-day settlement
  • Resolve the smart contact if the required margin is not posted

Forward Rate Agreements (FRAs) and FX Forwards

FRAs and Futures are very similar in settlement and collateral exchange. The main difference is that Futures have a standardized maturity schedule (Mar, Jun, Sep, Dec of each year ), whereas FRAs do not have a standardized maturity.

There are subtle differences in how the yield is calculated, but besides these, a FRA on a SOFR rate is very similar to a Synthetic Future on a SOFR rate.

Therefore to extend Synthetic Futures to FRAs, we will need to build additionally:

  • A curve-building method from Future Oracle prices to FRA prices
  • Pricer for FRAs

To add FX Forwards, we will need the following:

  • An oracle with FX forward rates at different maturities
  • Pricer for FX Forwards

On the G10 currencies, the FX forward rates are close to the FX spot rates at shorter maturities. Therefore, we will use the spot rates where the prices for the forward rates are not available.

Interest Rate Swaps (IRS)

Interest Rate Swaps are constructed from FRAs. Therefore trading Swaps is equivalent to trading a series of FRAs. Settling, managing cashflows, and markings on Swaps becomes a problem of managing these on FRAs, which are covered in the previous step

To extend the functionality of the platform to swaps:

  • A master Smart Contract linking FRA Smart Contracts

The rest of the infrastructure will rely on individual FRA contracts to manage the settlement and margin.

Proof-of-Concept

We are looking for a partner to test the platform with their client(s). This is an excellent opportunity for a financial institution to test drive the possibility of delivering a classic financial product to its clients using blockchain technology. And be first in line to capture the benefits of DeFi in Interest Rate Derivatives

The platform will be deemed a success if:

  • A Synthetic Future is settled within the legal entity, between two desks, or between legal entities of the same group
  • A FRA is settled with a client and managed on the blockchain to maturity
  • An FX Forward is settled with a client and managed on the blockchain to maturity
  • An Interest Rate Swap is traded with a client and managed on the blockchain to the maturity of the first two FRA contracts.

Further Work

Futures, FRAs, Fx Forwards, and Interest Rate Swaps are the building blocks. The platform expansion will then advance across two routes:

  • Expand the suite of products on the platform to include Basis Swaps, Xccy Swaps and other reference rates
  • Build an Exchange where counterparties can trade with a liquidity pool. This will match passive market makers and active traders and automate some of the work currently done by financial institutions when providing liquidity.

Our Credentials

Dynamic Strategies' management has trading and risk-managing experience in Interest Rate Derivatives acquired at large investment banks over more than a decade. We actively provide liquidity to Decentralized Exchanges (DEXs) and run validator nodes on Layer 1 and Layer 2 blockchains (Ethereum, Binance Smart Chain, Fantom, Avalanche, Polygon), and we develop innovative applications on the blockchain and push the boundaries of what is possible with smart contracts. Our latest achievement has been to extend the functionality of smart contracts to include GPS coordinates. On top of which, we built a Cardano Beam platform and run an annual cycling race using this technology.

Read more