In the world of traditional finance, market players can swap future interest rate payments with one another. This is often done as a way to hedge against losses, manage credit risk, or speculate on increasing or decreasing interest rates based on future market conditions. These swaps may occur as fixed-to-floating, floating-to-fixed or floating-to-floating swaps, each of which is a type of derivative contract. When a swap occurs, the parties do not take ownership of the counterparty’s debt. Instead, under the derivative contract, the interest rates are swapped while the loan's value (notional principal) remains with the original party.
In what is known as a "vanilla swap", one party gains the risk protection of a fixed rate, while the other gains the possibility of profit from a decreasing floating rate. For example, a smaller institution might want to trade their riskier floating interest rates with a larger institution, which is willing to accept the risk of interest rate fluctuations. In return, the smaller institution would acquire a fixed interest rate, allowing for better financial planning. The size of the OTC derivatives market is colossal - according to the most recent data from the Bank for International Settlements, the notional value of interest rate derivative contracts recently hit $488 trillion.
Unfortunately, the market for interest rate swaps hasn't seen significant change since the 1980s. It has since become plagued with extensive fees charged by banks and high settlement costs, often resulting from monopoly institutions taking greater control over the market. For this reason, decentralized finance (DeFi) is seen as a clear solution to eliminate the middleman with a comprehensive and scalable solution,
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