Market Opportunities and Pricing
Historically the markets for interest rate swaps have been intermediated by large banks and swap dealers with AAA credit ratings. Following the credit crisis regulators have mandated the use of central counterparty execution and clearing facilities to address the risk of default of a single major institution. These markets, though large and relatively liquid, have only been available for larger institutional players. The collateral requirements and large ticket sizes (in the millions of dollars in notional for most standardized swaps) and significant fees from the banks making markets in these instruments have been barriers to entry for smaller institutions and investors seeking the benefits of hedging or speculating in rates markets.
With the advent of smart-contract-based digital securities, the unit cost of issuing a rate optimizing security has dropped to minimal levels. The ability to generate a new contract in near real time at ticket sizes as small as a few dollars opens up the access to rate strategies to a much wider range of investors and speculators, while providing hedging tools and funding optimization to thousands who previously could not practically engage in any of these strategies.
How the instruments are priced In traditional financial markets, a swap is priced based on the fluctuation in value of a given variable interest rate or rates. On the day both parties enter into a swap contract, the value of the notional principal and interest payments on both sides should be equal. A swap is then priced based on the difference between the fixed and floating rates of the underlying assets. A swap’s value shifts over time in correlation with the difference in realized value between the underlying cash flows from the two legs of the swap, and the projected difference in the rates for remaining periods.