Writing

Our Investment in Swivel Finance

December 10, 2020 | 6 minute read

Today I’m excited to announce that Multicoin Capital has led a $1.15 million seed round in Swivel Finance, a new decentralized protocol that enables fixed-rate lending and interest-rate derivatives.

Electric Capital, CMS Holdings, Divergence Ventures, and DeFiance Capital also participated, as did several angels including Ash Egan, Stani Kulechov of Aave, Alex Pack, Imran Khan, Qiao Wang, and Thomas Klocanas.

Swivel represents an important next step in the natural evolution of DeFi, one that will make crypto more stable, accessible, and financially attractive to millions of users around the world.

Building On The Lending Block

Trading, and borrowing and lending, are the two primitives that dominate DeFi. DeFi lending is 11% of CeFi lending, and DeFi trading is 15% that of CeFi trading.

Money market protocols like Compound, Cream, and Aave are the primary venues for lending and borrowing. These protocols offer simple borrow/lend functions in a permissionless, decentralized manner; however, their biggest shortcoming is precisely what makes them so great: variable rates.

Today if Alice lends her tokens to Compound, the rate she earns varies over time as other users borrow and lend from the protocol. Upon depositing, she may be earning 5% APY, but that could swing to 10% or 1% tomorrow. If her yield drops to 1%, she is likely to pull her tokens from the protocol and seek higher yield elsewhere. This problem has led to the rise of yield aggregators, like Yearn.Finance, Idle.Finance, and APY.Finance, which automatically move and rebalance lenders’ tokens across markets in an attempt to maximize yield.

While yield aggregators are great for market participants seeking to earn the maximum variable-rate yield, they don’t solve for a massive segment of the market that simply wishes to reduce risk and increase certainty—i.e., lock in a fixed rate.

Interest-rate derivatives are the most liquid financial product on the planet: they trade over $6.5 trillion per day. Swivel unlocks this market and brings these concepts to crypto. It enables fixed-rate lending and interest-rate trading (i.e., interest rate swaps), with the ability to long interest rates with 10-100x implied leverage.

While it’s technically possible to earn fixed rates by cobbling together zero-coupon bonds (we’ll get to this below), Swivel streamlines the entire trade, increases capital efficiency, and taps into large and growing liquidity pools. It also introduces the simplest, most gas- and time-efficient process we’ve seen to date and radically reduces smart contract risk by pushing it lower down the stack to trusted and tested primitives.

Swivel Trading

Let’s walk through a trade on the Swivel exchange, which is an orderbook-based exchange built on top of the Swivel protocol. Orders on Swivel are matched on a central limit order book, and only require 100% like-kind collateral (as opposed to requiring >100% collateral, which is commonplace in DeFi).

Suppose Alice has $1000 of USDC in principal and wants to lend her tokens for 1 year and earn a fixed 5% rate. Bob has $50 USDC and wants to go long the Compound USDC interest rate, which is currently 8%.

Both users deposit funds ($1000 from Alice and $50 from Bob) into Swivel, which are then pooled together in the Swivel smart contract until the end of the term. That pool of funds is then deposited into Compound for the duration of the contract.

Assuming the rate remains an average of 8% over the 12 month contract, Bob will receive $84: a 68% return on his $50 investment. Because of Swivel’s unique financial construction, Bob receives levered exposure to interest rates, increasing capital efficiency and liquidity. Relative to the $4 Bob would have earned lending $50 at 8% on Compound, using Swivel Bob earns $34 of profit, representing an 8.5x improvement. Meanwhile, regardless of what happens to the variable rate on Compound, Alice will receive $1050.

It’s important to note three key design features unique to Swivel: 1) it doesn’t rely on an oracle, 2) users cannot be liquidated, and 3) Swivel taps into the liquidity in Compound and Aave.

This entire process, start to finish, only takes 2 steps on both sides.

The Red Ocean of Fixed Rate Protocols

The most common fixed-rate product in DeFi is the zero-coupon bond (ZCB) model. Yield, Notional, UMA, and Mainframe are building various flavors of this model.

In the ZCB construction, borrowers mint synthetic bonds that are redeemable for some par value at a specified date in the future (usually $1), and then sell those bonds at a discount to $1. As such, the lender is the buyer of the bond, and the borrower is the minter and seller of the bond. The collateral and liquidation process is managed by the ZCB protocol. These ZCB protocols rely on external oracles, and borrowers face liquidation risk if the value of their collateral falls.

On the other hand, lenders on Swivel keep their capital and their position directly in a trusted money market protocol of their choice, which eliminates this additional smart contract risk that ZCB protocols introduce.

Additionally, without the need for overcollateralization (which is required on Yield, Notional, UMA, and Mainframe), Swivel speculators can trade rates with a lot more leverage than ZCB designs. While ZCB protocols limit leverage to 0.5 - 0.75x, Swivel can provide 10 - 100x. Given the available leverage on Swivel, we expect that it will be the most liquid venue for interest-rate speculators.

To be clear, we’re excited about this entire space and think Swivel’s model and the zero-coupon bond model will both be successful. While Swivel offers more leverage for interest rate speculators than ZCB protocols, Swivel does not offer fixed-rate borrowing, and so we are interested in the ZCB model as well because Swivel and ZCB protocols will serve different segments: Swivel for interest-rate speculation and fixed-rate lending, and ZCB protocols for fixed-rate borrowing.

The Next DeFi Horizon

Since the ICO craze of 2017, many market participants have left and have not come back. We’ve been thinking about potential catalysts that could bring the next wave of new users in.

With interest rates near historic lows, it’s reasonable to expect that the next wave of crypto users will come from people who simply want to “earn 10% on their USD.” Several crypto consumer apps are building front end services for this (Outlet, Linus, Dharma, BlockFi, Celsius, etc), and they currently source liquidity from (1) centralized liquidity pools, and (2) Compound and Aave. Swivel provides fixed rates using the flexible, global, 24/7, permissionless DeFi rails that users want.

Swivel creates a new opportunity in DeFi. Today, there is not a way to speculate on DeFi interest rates. Swivel solves this problem—and offers speculators a lot of implied leverage. Leverage will help bootstrap this nascent market, and help Swivel catalyze interest-rate derivatives in crypto.

While the Swivel protocol is starting with fixed-floating swaps (the contract example used in the section titled Swivel Lending), we expect them to continue adding new interest-rate derivatives, such as floating-floating swaps, swaptions, floors, and more.

Just as we spent a long time thinking about synthetic asset constructions in DeFi, we’ve been thinking about the fixed-rate DeFi space for almost 12 months. When we met Julian, Swivel’s founder earlier this year, we instantly recognized the elegance of the Swivel construction. We couldn’t be more thrilled to back Swivel and watch as they establish a new market in DeFi for interest-rate derivatives.

p.s. If you want to build the future of interest-rate derivatives for DeFi, Swivel is hiring!

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