Please describe your proposed solution.
<u>Summary</u>
We aim to bring Traditional Financial institutions - Banks, Financial Institutions, Funds and Retail that use financial products onto the Cardano blockchain.
Our mission is to Democratize the Interest Rate Derivative Market by making these products affordable for Small Corporates and Retail Customers through:
- Low-Cost Daily Margining
- Secure & PrivateTrading
- Automated Smart Contracts
We are in talks with two banks and aim to do a pilot with one of them at the end of the project.
<u>Background</u>
Recent interest rate hikes highlighted the risk of relying on cheap financing for too long and what can happen when interest rates increase rapidly. Sharp increases in interest rates can cause an unplanned increase in mortgage payments and much higher refinancing rates on every type of credit.
Consumers' current lack of access to the interest rates markets also limits their options for protecting against further rate increases, leaving them in a difficult position - exposed and without options.
We plan to bring interest rates markets onto the blockchain, so consumers and small corporates can access the same instruments as the large banks and large corporations.
The first step in the journey is to bring the markets onto the blockchain by offering existing banks a system that lets them manage the daily payments on these products (the settlement). The second step is to bring liquidity from the main financial players.
The target state is to lower costs by up to 100x for consumers and banks.
<u>Detail</u>
We plan to bring trading and settlement of Interest Rate Derivatives onto the Cardano Blockchain and make this market accessible to thousands of small companies and individuals.
Interest Rate Derivatives are a multi-trillion dollar daily market, with most trading between large financial institutions, corporations, and asset managers. Corporations use them to hedge their interest rate risk on loans, bond issuance, and other liabilities. Asset managers use them to express views on the direction of interest rates.
Small corporates and private individuals are often priced out of the Interest Rate Derivative market because they don’t have the back-office staff required to perform daily margining on these trades. Not doing daily margining comes at a significant cost. On trades without daily margining, financial institutions with whom corporates trade demand extra fees to cover additional risk and the additional capital costs imposed by banking regulators on such trades. Those small Corporates who can afford the high fees and the financial institutions servicing them are in a painful situation. Both face higher credit risk, higher operational risk and higher costs. Given a choice, both sides would prefer to have all trades margined daily. A win-win that is being held back by the operational burden of managing daily margin effectively.
BlockMargin - the code name for our product, solves this by bringing daily margining on the blockchain, turning a complex and large back office operation into a few clicks of a button. BlockMargin delivers the power of a large Corporation to the fingertips of any small business or individual. Monitoring the market value of their positions and corresponding margin requirements in a dashboard, users have full visibility of their positions 24/7 with the option to manually or automatically post and redeem margin from their crypto wallet.
BlockMargin automatically monitors daily market prices, contract conditions, margin requirements and settlement, removing risk and simplifying trading.
<u>Why Margin Matters?</u>
Interest rate derivatives are financial contracts between two parties whose value can change throughout their life. Their value can become positive or negative at any time. And to avoid defaults and the other party simply walking away when the contract is not going in their favour, there is a need to post margin to ensure that even if one of the parties walks away, the other receives compensation for this.
Margin posting also avoids litigation, as each party can walk away from the contract and leave their margin with the other counterparty. This left margin covers any adverse market move for the next day and gives the remaining party enough time to find an alternative hedge.
The margin posting also tends to be a small fraction of the total contract size, which is convenient for risk hedging and avoids putting up the full amount as collateral. This is standard practice in traditional financial markets.
The example below shows the margin posting during the first 15 days of a contract when a user buys an interest rate future at 3% on a 500k notional to protect themselves against further interest rate rises. This could be a hedge against the interest rate rising on their 500k mortgage.
Highlighting a few of the cashflows in the example:
- Day 0: rate is at 3% and the user posts an Initial Margin of $581, just over 0.1% of the notional amount.
- Day 1: rate dropped to 2.9% and the user needs to post an additional $104 as margin.
- Day 7, rate increases to 3.4% and the user can withdraw $320 margin from the contract.
- Day 15: rate has increased to 4.0%, the user closes the contract and gets paid $1,242 in addition to receiving their Initial Margin back
So, the user gets a positive cash flow at the end of the contract as the interest rate ended above 3%. If, at any time in between, the counterparty was to walk away, the user would keep the margin equivalent to the value of the contract.
As you can see, there is a lot of back and forth of margin posting throughout, and in traditional finance, this is done with bank transfers, which are expensive and need a dedicated team to perform. Whilst doing this on a blockchain is a transaction using a web wallet, and even that can be automated
<u>Traction with Financial Institutions</u>
The BlockMargin idea has gained traction in conversations with financial institutions. We aim to make our first trade between a Financial Institution and a Corporate at the end of the proposal.
<u>Building Blocks</u>
BlockMargin has 6 main components that we call the “building blocks”. The team at Dynamic Strategies will build these over the course of 9 months.
- The Front-end through which the user will interact with the smart contracts and the back-end services
- The Back-end will run the cardano node, cardano-db-sync, cardano-grapql and others services that exposes the up-to-date state of the blockchain to the user
- Smart contracts and the smart contract factory. The smart contract will codify the terms of the interest derivative transaction and will include conditions on when it can withdraw the funds locked inside. A smart contract factory will generate a new smart contract for each trade as each transaction will have slightly different characteristics (amount, start time, end time and withdrawal conditions). To the extent possible, we will use the Marlowe smart contract language, its runtime and the knowledge of the Marlowe team
- The Risk Engine will determine how much margin counterparties need to post for the transactions and revalue daily how much extra margin needs to be posted or if the counterparty can withdraw margin.
- The Pricer will determine the fair value of instruments and serve as an input to the Risk Engine
- A Wallet connector through which user will connect their Cardano web wallets and interact with the app
<u>Midnight Platform</u>
We are currently in touch with two banks in the Netherlands who have shown an interest in exploring this idea further. They see the potential for a large cost saving and improved operational efficiency by moving part of their trading onto their blockchain. One of the high priority points on their wishlist is to ensure the privacy of transactions, as they do not want to expose their dealings with clients completely to the public.
Therefore, after delivering this project on Cardano mainnet, we will look to port it to the Midnight sidechain that is planned to launch on Cardano sometime in 2024 <https://midnight.iohk.io/>
Our product will be the prime candidate for Midnight when it launches with an existing client base.
<u>Marlowe Smart Contracts</u>
We met with the Marlowe team at their product launch in Lisbon on 5th Jul 2023 and had a good discussion about the capabilities of Marlowe to support different financial contracts. Marlowe is also blockchain agnostic; therefore, it can be ported to run on Midnight once that goes live. Therefore, we will aim to use Marlowe for our smart contracts and troubleshoot with the Marlowe team the edge cases. More on what Marlowe is here: <https://marlowe.iohk.io/>
Financial Derivative Contracts tend to require a programming language that offers sufficient flexibility to encode their multiple terms - and therefore, a Turing complete programming language such as Haskell is a desired starting point. However, since Marlowe was designed specifically for Financial contracts, we will test its ability to mould to different products. The Marlowe team has so far been forthcoming with explanations and examples of how it can solve certain edge cases. We look forward to leveraging their expertise throughout the project.
<u>Looking further ahead</u>
Looking further ahead, after delivering BlockMargin and doing a pilot trade with a bank, we will expand the products suite to create a decentralized exchange for these derivatives.
The decentralized exchange will let anyone provide liquidity into “interest rate derivative” pools against which users can trade. With this offering a market-making service in interest rate derivatives similar to what trading desks do at large banks:
- Available 24/7
- Prices determined by supply and demand
- No minimum amounts
- Settlement is done using BlockMargin
- Access available to all
Where BlockMarging is the platform that manages a derivative trade after it has been traded (what we call the settlement and daily margining), the initiation of the trades will be done through a decentralized exchange.
How does your proposed solution address the challenge and what benefits will this bring to the Cardano ecosystem?
The proposal directly addresses the challenge’s focus areas of “Creation or improvement of different products that provide value to the Cardano community and wider ecosystem.” by being a completely new product on Cardano and other blockchains and can potentially bring the financial services industry onto Cardano.
This proposal targets the traditional finance sector and aims to bring some of their operations onto the blockchain and create a Decentralized Finance alternative (DeFi)
It will increase the Total Value locked, total number and active daily users. And it will bring the largest market in the world onto a blockchain.
This product is suitable for execution right now and the Cardano ecosystem has the right technical requirements.
- The Marlowe smart contract language was released in 2023. Marlowe is a domain-specific language for the financial sector that we will use in our build;
- A stablecoin (Djed) has been released and;
- A number of DeFi projects are running;
- Cardano lacks adoption by the Financial sector due to the lack of apps for them on Cardano. We propose building one of their essential apps and engaging with a financial institution to trial it.
The Interest Rate Derivative market is the largest market in the world by a big margin, with $250+ Billion daily volume between Small Corporates, Retail and Financial institutions. The overall market that includes large corporates is even bigger at over $5 trillion of volume per day.
Bringing the settlement of these derivatives onto a blockchain has the potential to open up adoption of the large financial sector on a blockchain and, over time, drive a tide of adoption to that blockchain.
The second effect is that settling these trades on the blockchain, reduces their operational cost drastically, making it possible for financial institutions to offer these products to smaller clients they overlooked in the past. This can lead to market growth as new participants enter the market
How do you intend to measure the success of your project?
It will increase the number of innovative products available for the Cardano community and traditional businesses. It will enrich the ecosystem with new use cases and increase the number of integrations with the traditional financial and corporate sectors.
The proposal directly addresses the challenge's success criteria of "increasing number of products and integrations that offer new solutions for people to interact with and benefit from using Cardano." This is a completely new solution that is unique to Cardano and other blockchains.
The Cardano ecosystem has the right tools to permit this type of innovation. With the advent of Midnight later in 2024, the BlockMargin app will be a natural candidate for one of the first products to migrate to Midnight and offer the financial service industry privacy-preserving smart contracts for their financial transactions.
We will consider the project to be a success if we build a platform that permits:
-
An app running on the Cardano Mainnet that does the daily exchange of collateral based on Synthetic SOFR Futures and;
-
A pilot between a financial institution and a corporate client.
This will validate the use case of using blockchain for selling and managing collateral on interest rate derivatives and open up the possibility of building a DEX for trading these instruments in a decentralized manner.
Please describe your plans to share the outputs and results of your project?
We will share progress on our Twitter page https://twitter.com/dynamic_io and on the catalyst website through the monthly Milestone reports.
The app will have a front-end with all its functionalities open to the public. It will run on the testnet during the first 5 months, and community members will be able to connect with their Cardano web-wallets and test its functionalities.
At the end of the project, the app will be released on the Cardano mainnet for everyone to use.
Additionally, we will monitor the following KPIs and report back to the community through the monthly progress reports.
Build KPIs
- Number of weekly commits
- Total lines of code
User engagement KPI
- Number of total wallets created on the test net
- Number of transactions
- Number of contract interactions
- Number of average daily visitors to web app
Stability KPIs
- Average CPU and RAM utilization on server
- Peak CPU and RAM utilization on server
- Total % server downtime