We’re extremely excited to announce to the Voltz community the first ever TradFi rate trading venue in DeFi, with the launch of a SOFR rates market on Voltz Protocol on Avalanche.
Now, anywhere where Voltz Protocol is available, DeFi users have access to a permissionless environment within which to hedge, speculate, or build products off the key TradFi benchmark rate. Whether aware of it or not, many investors are impacted by the SOFR given its high correlation to the Fed Funds Rate. This marks the first time TradFi rates established by the Federal Reserve can be hedged by those outside of TradFi — bringing TradFi off-chain rate hedging and speculation to DeFi.
Understanding SOFR: The New Benchmark Interest Rate
The Secured Overnight Financing Rate (SOFR) is a key interest rate that has gained prominence in the TradFi markets. Designed as a replacement for the London Interbank Offered Rate (LIBOR), SOFR is a reference rate that reflects the cost of borrowing cash overnight, backed by U.S. Treasury securities. Unlike LIBOR, which relied on bank estimates, SOFR is based on actual transactions in the robust and diverse repurchase agreement (repo) market. Although SOFR is derived from actual transaction data in the repo market, it exhibits a correlation with the Fed Funds Rate due to the Federal Reserve's influence on overnight funding conditions.
Most people are exposed to the SOFR rate indirectly through everyday financial instruments and transactions, whether they realize it or not. These include things like mortgages and home loans, student loans, business loans, floating-rate bonds and notes, and money market funds. Despite their exposure to the SOFR rate, everyday people often do not have direct access to sophisticated hedging instruments like interest rate swaps or derivatives, limiting their ability to effectively hedge against the risks associated with fluctuations in the SOFR rate.
How and Why to Trade SOFR on Voltz Protocol
Voltz Protocol v1 acts as an automated market maker for interest rate swaps, within which users can convert a variable interest rate linked to SOFR into a fixed interest rate or vice versa. To understand the general concepts of Voltz Protocol v1, read this article that walks through the step by step guide to trading rates. This unlocks several opportunities for market participants anywhere Voltz Protocol is available. Let’s walk through a few key examples:
- An opportunity to hedge: Whether you’re a large institutional borrower in crypto or an individual trader you are exposed to decisions the Fed make. With the launch of SOFR rates on-chain, you can now structure a swap to offset this exposure and ensure it’s aligned with your specific risk profile and financial goals. For example, if you have assets or liabilities tied to the SOFR rate, you can use interest rate swaps to create a hedge that offsets the impact of interest rate fluctuations, minimizing potential losses.
- Credit market construction: The cost of capital arriving into DeFi is inherently linked to the cost of borrowing in TradFi. This can be direct, with crypto institutions borrowing from Traditional Finance, or indirect, with lenders only willing to lend at certain rates given the rate market opportunities that exist outside of DeFi. Given this dynamic, credit markets in DeFi need a permissionless SOFR forward curve to more accurately price and hedge loans relative to the TradFi rate regime. The existence of this curve also provides an open and accessible benchmark for crypto lenders, both protocols and institutions, to start constructing new and innovative products.
- SOFR arbitrage and yield opportunities: Trading interest rate swaps on the SOFR rate can also present opportunities to enhance yield or profit from market inefficiencies. Skilled traders may identify discrepancies or mispricings in swap markets across TradFi venues and DeFi, providing opportunity to capitalize on potential arbitrage opportunities or generate additional income.
- DeFi Rate Arbitrage: TradFi rates exhibit different characteristics relative to DeFi rates, as shown in this research released by Voltz Labs last year. For skilled traders this provides an opportunity to generate yield by trading these different markets against each other. This could exist both as a profitable source of carry trading or through the creation of yield curve strategies for more sophisticated actors.
- Product construction: Finally, the creation of a permissionless forward curve for SOFR rates provides a venue through a range of new products can be created. For example, cross-currency swaps can now be created, providing a mechanism to enhance on-ramp capabilities. Comparably, more sophisticated structure products can be created that incorporate both DeFi and TradFi rates, like exchange-traded notes or more complex non-linear derivatives.