Interest Rate Swap Layer: How does DeFi use "spread trading" to solve the fixed interest rate problem?

Author: Nico Pei

Translation: AididiaoJ, Foresight News

Original Title: Fixed-Rate Lending: The Key to Scaling DeFi Success or Failure

The demand for fixed rates mainly comes from institutional borrowers and cyclical strategy users. In the future, on-chain lending volume will expand, but at this stage, most on-chain participants highly value the flexibility to “withdraw funds at any time.” Therefore, instead of requiring lenders to accept “fixed terms,” a better approach is to build a rate swap layer on top of existing money markets (such as Aave) to meet the needs of fixed-rate lending.

Lessons from Traditional Finance: Fixed-Rate Markets Begin with Borrower Demand

In the private debt market, fixed rates are mainstream because borrowers need certainty, not because lenders prefer them.

• Borrower perspective (corporations, private equity funds, real estate developers, etc.): Their main concern is cash flow predictability. Fixed rates can hedge against rising benchmark interest rates, simplify budgeting, and reduce refinancing risk. This is especially important for highly leveraged or long-term projects, where interest rate fluctuations could threaten their survival.
• Lender perspective: They generally prefer floating rates. Loan pricing is typically “benchmark rate + credit risk premium.” A floating structure can protect profit margins when rates rise, reduce “duration risk,” and earn additional yields when benchmark rates increase. Lenders will only offer fixed rates if they can hedge interest rate risk or charge sufficient premiums.

Thus, fixed-rate products are a response to borrower demand, not the market default. An important lesson for DeFi is: without clear and sustained demand from borrowers for “interest rate certainty,” fixed-rate lending will struggle to gain liquidity, scale, or sustain growth.

Who Are the Borrowers on Aave / Morpho & Euler? Why Do They Borrow?

A common misconception is: “Traders borrow from the money market to leverage or short.”

In reality, directional leverage is almost entirely executed via perpetual contracts because of higher capital efficiency. The money market requires over-collateralization and is not suitable for speculative leverage.

However, Aave alone has about $8 billion in stablecoin loans. Who are these borrowers?

They can be broadly divided into two categories:

1. Long-term holders / whales / project treasuries: They collateralize their crypto assets (like ETH) to borrow stablecoins for liquidity, avoiding selling assets (thus preserving upside potential and avoiding taxable events).
2. Yield cycle participants: They borrow to recursively leverage yield-bearing assets (such as staked tokens like LST/LRT, e.g., stETH; or interest-bearing stablecoins like sUSDe). Their goal is to achieve higher net yields, not to speculate on price movements.

So, does on-chain have a real need for fixed rates?

Yes. The demand mainly comes from two user groups: institutional-level crypto collateralized loans and cyclical strategies.

1. Institutional Crypto Collateralized Loans Require Fixed Rates

Take Maple Finance as an example. It provides over-collateralized loans to institutions, lending stablecoins collateralized mainly by blue-chip assets like BTC and ETH. Borrowers include high-net-worth individuals, family offices, hedge funds, etc., seeking cost-predictable fixed-rate funding.

• Rate comparison: Borrowing USDC on Aave costs about 3.5% annualized, while Maple’s fixed-rate loans with similar collateral yield liquidation returns between 5.3% and 8%. This means that switching from floating to fixed rates requires borrowers to pay a premium of approximately 180-450 basis points.
• Market size: Maple’s Syrup pool alone manages about $2.67 billion, comparable to Aave’s approximately $3.75 billion in outstanding loans on Ethereum mainnet.

(Compared to Aave’s ~3.5%, Maple’s ~8% fixed rate, fixed-rate crypto loans pay a premium of about 180-400 basis points.)

It’s worth noting that some borrowers choose Maple to avoid (early DeFi) smart contract risks. But as protocols like Aave prove their security, transparency, and liquidation mechanisms, this perceived risk diminishes. If reliable fixed-rate options emerge on-chain, the premium for fixed-rate loans off-chain could be compressed.

2. Cyclical Strategies Need Fixed Rates

Despite generating billions in demand, cyclical strategies often find these strategies unprofitable due to volatile borrowing rates.

A stablecoin cyclical borrower said: “As a cyclical borrower, I can’t predict borrowing rates, and rate volatility can wipe out months of accumulated gains, leading to position losses.”

Historical data shows that borrowing rates on Aave and Morpho are highly unstable, with annual volatility exceeding 20%.

For cyclical participants, they earn fixed yields (e.g., via Pendle’s PT), but borrowing at floating rates to maintain cycles introduces “interest rate risk.” If borrowing rates spike, they can wipe out all profits. If both borrowing rates and investment returns are fixed, capital risk is eliminated. Strategies become easier to evaluate, positions can be held with confidence, and capital can be deployed more efficiently.

With on-chain infrastructure like Pendle’s PT passing over five years of security testing, demand for on-chain fixed-rate loans is growing rapidly.

Since there is demand, why isn’t the market bigger? Let’s look at the supply side issues.

Flexibility Is the “Priceless Treasure” for On-Chain Participants

Here, flexibility refers to the ability to adjust or exit positions at any time without lock-up periods—lenders can withdraw funds anytime, borrowers can repay or redeem collateral anytime, with no penalties.

In contrast, Pendle PT holders sacrifice some flexibility. Even in the largest pools, Pendle’s mechanism cannot allow positions exceeding about $1 million to exit instantly without significant slippage.

So, how much compensation do on-chain lenders forgo by sacrificing flexibility? For Pendle PT, compensation can be as high as over 10% annualized, and during YT token trading frenzy (like on Arbitrum with usdai), it can exceed 30%.

Clearly, genuine borrowers (not speculators) cannot afford a 10% fixed rate. This high rate is essentially a “premium” paid for giving up flexibility, which is unsustainable without speculation on YT tokens.

Although PTs carry higher risk than basic lending protocols like Aave (adding protocol and underlying asset risks), the core conclusion remains: any fixed-rate market requiring lenders to give up flexibility cannot scale if borrowers cannot afford the exorbitant rates.

Term Finance and TermMax are examples: few lenders are willing to give up flexibility for a tiny margin, and borrowers are unwilling to pay 10% when Aave’s rate is 4%.

Solution: Don’t Let Fixed-Rate Borrowers Match Directly with Fixed-Rate Lenders

Instead, fixed-rate borrowers should match with rate traders. Specifically:

Step 1: Protect Lender Experience

Most on-chain capital trusts only the safety of Aave, Morpho, Euler, and prefers the simple passive experience of “deposit and earn” on Aave. They are not “seasoned managers” who evaluate every new protocol for a 50-100 basis point premium.

Therefore, for the fixed-rate market to grow, lenders’ experience must be identical to using Aave today:

• Deposit anytime
• Withdraw anytime
• Almost no additional trust assumptions
• No lock-up periods

Ideally, fixed-rate protocols should be built directly on trusted money markets like Aave, leveraging their safety and liquidity.

Step 2: Trade “Interest Rate Differentials,” Not “Principal”

Borrowers seeking fixed rates do not need another full-term, locked principal loan. They only need a capital position willing to bear the “agreed fixed rate” versus “Aave floating rate” spread risk, while the rest of the principal can still be borrowed from Aave or similar.

In other words, traders are trading the expected difference between fixed and floating rates, not the entire principal.

A rate swap layer can achieve this:

• Hedgers can exchange fixed payments for floating income that perfectly matches Aave’s floating rate.
• Macro traders can express their views on interest rate trends with high capital efficiency.

Capital efficiency example: traders only need to post a small margin to bear interest rate risk, far less than the nominal loan amount. For example, shorting a $10 million, 1-month Aave loan at a fixed rate of 4% annualized might require only about $33,300 margin—implying 300x implied leverage.

Given Aave’s rates typically fluctuate between 3.5% and 6.5%, this implied leverage allows traders to treat interest rates as a highly volatile “token” (e.g., from $3.5 to $6.5), with volatility far exceeding mainstream cryptocurrencies, closely tied to overall market liquidity and prices, while avoiding the risk of liquidation common with explicit leverage (like 40x on BTC).

Long positions profit from “peaks,” short positions profit from “troughs.”

Long-term Outlook: Fixed Rates Are Essential for On-Chain Credit Expansion

I foresee that as on-chain lending grows, demand for fixed-rate loans will also expand. Borrowers will increasingly need predictable financing costs to support larger, longer-term positions and productive capital deployment.

• Institutional credit expansion: Projects like Cap Protocol are promoting on-chain institutional credit. They help re-pledge protocols provide insurance for institutional-grade credit stablecoins. Currently, rates are determined by utilization curves suited for short-term liquidity, but institutional borrowers value rate certainty. In the future, a dedicated rate swap layer will be crucial for supporting “fixed-price” and risk transfer.
• On-chain consumer credit: Projects like 3Jane focus on on-chain consumer lending. This sector is almost entirely fixed-rate because consumers need certainty.

In the future, borrowers may enter different segmented rate markets based on credit grades or collateral types. Unlike traditional finance, on-chain rate markets might allow borrower groups to directly face market-driven interest rates rather than being locked into a single lender’s set rate.