Navigating the Complexities and Potential of IPOR in DeFi’s Evolving Landscape
Introduction — the IPOR Index Rate vs LIBOR
IPOR Protocol, an innovative project made by IPOR Labs, marks a significant endeavour in decentralized finance (DeFi) on the Ethereum Mainnet for interest rate pricing. It introduces a novel IPOR Index, serving as a decentralized and transparent benchmark interest rate in DeFi, akin to traditional benchmarks such as LIBOR, SOFR and BSBY but leveraging blockchain’s transparency and fairness. Along with its launch is the integration of interest rate derivatives, primarily the interest rate swaps (IRS), aiming to fill the gap of the long absent but vast interest rate derivative (IRD) market in DeFi.
The purpose of this article is to conduct a critical examination of the current status of the Inter Protocol Over-block Rate (IPOR), to identify and scrutinize the challenges it faces within the DeFi ecosystem, and to thoughtfully consider its future prospects and potential trajectory.
IPOR Index Rate — DeFi Interest Rate Benchmarking
The IPOR Index calculation algorithm uses real-time onchain interest rate data from major DeFi lending market protocols (AAVE & Compound). IPOR is calculated as a weighted average, designed to be modular and updateable, reflecting changes in the market, including new protocols or adjustments in market dominance to ensure that the index remains an accurate and dynamic representation of the current state of DeFi credit markets.
The official IPOR Index calculation methodology from its latest whitepaper is:
The pricing of IPOR is designed using a weighted average formula that takes into account the real-time interest rates from different lending protocols within the DeFi space. Here’s a concrete illustration of how IPOR Index rate is calculated now:
- Target represents the real-time onchain interest rate for the Target stablecoin (USDT, USDC, DAI, etc) on the AAVE / Compound lending protocol (the midpoint rate between the lending and borrowing rates).
- The 2 W are the weights of the AAVE and Compound interest rates in the IPOR calculation, respectively.
- The frequency of the IPOR quote updates is consistent with the block generation rate of the blockchain it operates on, meaning the rate is updated with every new block created.
- Currently (as up to 2024.1.30) IPOR uses a 80%-20% weight assignment for Waave, Wcompound respectively, decided by the IPOR DAO governance.
The IPOR Interest Rate Swap (IPOR IRS) — What & How
A swap contract represents an agreement between two parties to reciprocally exchange two sets of payments at predetermined intervals. Interest rate swap contracts involves the exchange of two interest rates, typically one being a fixed rate and the other a floating rate, such as the IPOR rate in our context. In practical terms, only the net value is transferred to one of the parties.
As for the design of IPOR’s interest rate derivatives (IRD), notably the cancellable interest rate swaps (IRS). These swaps facilitate the exchange of cash flows based on fluctuating interest rates. Featuring customizable elements like early termination options, they provide strategic flexibility for managing interest rate exposure.
Vanilla Swap Contract Coupons based on IPOR rates
For a (non-cancellable) swap, the contract locks the buyer/holder into exchanging floating IPOR rate rt for a fixed rate rfix for a specified time T. Given rates fixed at periods ti, the coupon of the contract on each period can be expressed as:
It is evident that the coupon values, denoted as Cti, may assume either positive or negative figures contingent upon the path taken. Wherein, positive coupon values signify a beneficial outcome for the swap holder, conversely, negative values represent a disadvantageous scenario.
Non-vanilla Contract Payoffs based on IPOR rates
And for a cancellable interest rate swap, each payoff is given by the following formula:
where:
- r stands for the reference rate associated with the leg where rpay for pay fix leg and rreceive relates to the “receive fix” leg
- Pleg represents the payoff for the specific leg, which can be either the “pay” or “receive” leg
- N denotes the notional amount specified in the contract.
- Δt signifies the number of seconds per time period within the contract
- Tyear represents the total number of seconds in one year
The payoff for a swap paying fix rate can be calculated as:
On the other direction, it’s important to note that for a swap that receives a fixed rate, the payoff is Preceive— Ppay.
Calculation of the Spread — Pricing an Interest Rate Swap:
The IPOR IRS utilizes a sophisticated and advanced pricing model for IPOR’s cancellable interest rate swaps. This model uses the Hull-White jump-diffusion model for rate simulation and Longstaff-Schwartz method for pricing. Its key steps include:
- Building an interest rate curve (Hull-White jump-diffusion for rate calculation)
- Dynamic programming for fair value pricing (Longstaff-Schwartz for pricing)
- Fitting a linear function for the spread
- and finally, an Automated Market Maker (AMM) strategy is used for on-chain implementation, balancing computational efficiency and accuracy
1. Building an interest rate curve
IPOR swaps employ a reference value for IPOR — Refleg, t — rather than relying solely on IPOR index value itself to mitigate the risk associated with abrupt fluctuations in the IPOR value, especially when these IPOR index values have not yet been established or validated by the market. If not, quotes provided by the Automated Market Maker (AMM), which is directly linked to IPOR index, were to swiftly align with IPOR jumps, it could expose the AMM to trading activity at levels that may not be sustainable in the long term, potentially resulting in unwarranted losses.
Here is the formal definition:
We can see that in the case of the “pay-fix” leg, the reference value for IPOR is the current IPOR value when it exceeds the moving average of IPOR. Conversely, for the “pay-float” leg, the reference value for IPOR is the IPOR value when it falls below the moving average of IPOR.
Values of EMA do smoothe the abrupt changes spikes in the curve of IPOR values.
2. Dynamic programming for fair value pricing
IPOR determines the pricing of 28-day cancellable swaps (payer and receiver) using an offchain Longstaff-Schwartz Monte Carlo pricing engine. This engine iteratively assesses the swap’s continuation value and allows cancellation if it proves unfavorable. These calculations are part of a root-finding algorithm that solves for the Longstaff-Schwartz Spread,SL-S, ensuring the swap’s costless entry valuation.
In which, r at right represents the rate of a simple non-cancellable swap contract. The Monte Carlo pricing model generates simulated paths for IPOR, and during valuation, IPOR use a polynomial function to estimate the value of each path. The final contract value is determined by discounting the average path values back to the present. Unlike traditional Longstaff-Schwartz applications with constant discounting rates, IPOR Lab’s approach adjusts the discount rate for each path to maintain consistency with its historical rt values.
3. Fitting a linear function for the spread
While the Longstaff-Schwartz method is a robust approach, it’s impractical for blockchain deployment due to its computational demands. Therefore, IPOR Labs devised a simplified spread model approximation Sapprox for SL-S:
These constants are obtained by optimizing over a least squares fix to the observed values of SL-S as a function of explanatory variables rt, EMAt and EMVart.
In the end, a step-wise linear function (fleg(σ², rt- θ)) fit to the output of step 2, i.e., SL-S ≈ fL-S, using IPOR rate (rt) distance to the historical mean (θ), the mean reversion and σ², the volitility.
4. Automated Market Maker (AMM) Quote
Then the quote of swap rate from the IPOR AMM is then computed as:
IPOR’s design intricacies manifest in its interest rate swap mechanisms. These mechanisms allow for dynamic hedging strategies against interest rate fluctuations, a concept well-known in traditional finance but relatively nascent in DeFi. The inclusion of cancellable swaps provides participants with the flexibility to opt-out before maturity, while the LP-AMM framework facilitates liquidity in a market where it can often be fragmented.
Despite its sophistication, IPOR’s quantitative approach to model and price the interest rate fluctuations faces both adaptation and adoption challenges. The whole DeFi ecosystem, characterized by its high volatility and rapid innovation cycles, presents a stark contrast to the more stable and mature TradFi’s.
IPOR’s Market Adoption Hurdles — Complexity vs. Practicality
IPOR’s theoretical foundation seems robust on the first glance, yet its market acceptance and community activity tells a totally different story. The intricate and complex product designs, such as Longstaff-Schwartz Modeling and parametric approximations, comes with a steep learning curve that can deter widespread user adoptions.
The system operates on assumptions that may or may not hold in this highly speculative and fast-changing DeFi market, such as stable and predictable interest rates. The lack of a mature rate formation mechanism rather than mere AAVE/Compound’s pivot-point-interest rate modeling further contributes to IPOR’s tepid reception. Compounded by the absence of a market-involved pricing mechanism, IPOR cannot engage more active participation and efficient swap rate pricing.
IPOR’s Statistics for Market Integration and Acceptance
IPOR currently faces a significant challenge with its low market adoption and this nascent platform has not yet seen widespread integration across the burgeoning DeFi landscape, where the myriad of lending protocols and financial instruments continue to operate largely independent of the IPOR framework.
The DeFi ecosystem, characterized by its preference for intuitive and straightforward mechanisms, appears hesitant to fully embrace IPOR’s sophisticated and theoretically driven system. As a result, IPOR’s presence in the market remains limited, with its potential yet to be realized by a broader audience within the DeFi community.
Critical Evaluations of IPOR Interest Rate Swaps
The reasons behind this tepid reception are multifaceted, but they primarily stem from the model designs and complexities inherent in its model, which may be daunting for potential users and integrators.
The critical issues of IPOR’s product design include:
- The spread calculation, pivotal to the swap pricing, often results in prohibitively high costs, diminishing the attractiveness of swaps as either hedging instruments or speculative bets. After a careful analysis, this is due to an over-reliance on market assumptions that do not adequately reflect the inherent unpredictability of DeFi interest rates.
- The swap tenor options are notably short, given the longest one 90-DAY, offering limited protection against the longer-term interest rate trends.
- The complexity of the product design further alienates potential users who favor simplicity and ease of use.
Why a Simple Market-Transaction-Driven Spread Pricing is in Dire Need for IPOR
In the worlds of finance, both TradFi and DeFi, the effectiveness of any pricing mechanism is fundamentally related to its ability and responsiveness to reflect the real sentiments of the market. Always, a market-transaction-driven model for pricing is crucial because it ensures that the price of an asset, or in the case of IPOR, the price of an interest rate swap, is determined by the actual supply and demand forces rather than mere theoretical regression models.
- LIBOR, SOFR and Other TradFi’s
In traditional finance, the price of interest rate swaps and options is continuously shaped by transactions that occur in the market. For instance, the LIBOR, which served as a benchmark interest rate for swaps, was determined by the average interest rates at which major global banks lend to one another. This benchmark was transaction-based, making it an accurate reflection of the market conditions.
- Uniswap’s Pricing Mechanism
Uniswap epitomizes the DeFi innovation with its AMM model that sets prices algorithmically based on asset ratios in liquidity pools. This design assures that prices are fluid and responsive, adjusting with each trade to reflect the market’s immediate supply and demand balance. It is a self-regulating system where market transactions dictate the asset pricing, ensuring there is no central price-setting authority and maintaining the integrity and trust in the DeFi space.
- How to mitigate the risks faced by the Liquidity Pool of IPOR
The existing limitation in the IPOR AMM quoting formula lies in its omission of the Liquidity Pool’s exposure, as it primarily relies on volatility (σ²) and mean reversion (rt — θ) components. The next step would be in refining the quoting mechanism to incorporate demand-related factors for interest rates and to evaluate the overall exposure of the pool.
Effective risk management when quoting IPOR SWAPS necessitates the on-chain computation of overall exposure and unrealized PnL. To achieve this, the IPOR smart contract should keeps track of two critical quantities for each leg: the Sum of all Payoffs (SOAP) and the volume-weighted average rate (vWAR).
Conclusion
In conclusion, while IPOR’s ambition to provide a structured and stable rate mechanism in the DeFi space is commendable, it faces significant challenges in practice. The platform’s complexity, reliance on ambitious market assumptions, and limited swap tenors hinder its effectiveness and market penetration. For IPOR’s products to realize full potential, it must evolve to offer a more intuitive user experience, align more closely with the realities of DeFi market dynamics, and perhaps most importantly, simplify its offerings to cater to a broader audience. Only through such iterative improvements can IPOR hope to cement its place in the ever-changing DeFi ecosystem.
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