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CherrySwap v2, an automated market maker for interest rate swaps, is an early insight into how DeFi can absorb traditional finance by recreating similar mechanisms in a permissionless manner.

Hedging Positions and Swapping Money

Bitcoin was the direct result of technologists and cryptographers experimenting in the world of finance. More than 11 years on, and alternative cryptocurrencies are birthing a new wave of experimentation. That’s why it’s also critical to establish a solid understanding of basic financial operations.

Consider CherrySwap, a crypto-native money market maker protocol, working to improve interest rate swaps.

Interest rate swaps are a fairly straightforward way of hedging interest rate risk or simply capitalizing on a position. There are two sides to the trade: one side pays a fixed interest rate and receives payment based on a floating interest rate, while the other side receives the fixed interest rate and pays the other party based on the prevailing floating rate.

These instruments are generally traded against a benchmark such as the London Inter-Bank Offered Rate, or LIBOR. This rate is an average calculated by the top banks in the British capital. It is used as a global standard in the world of finance.

For example, if a person thinks the LIBOR rates are in for an imminent decline, they can short on an interest rate swap by receiving payments on a fixed interest rate, and paying the floating LIBOR rate. If LIBOR rates decline, the investor pockets a profit made from paying at a lower rate of interest and receiving interest at a higher rate.

CherrySwap introduces a similar mechanism for doing so — except now, investors can be a part of the liquidity pool and earn profits or enter a position without needing a large sum of capital.

To become a liquidity provider, one would need to deposit DAI into the CherrySwap contract to mint an equal amount of CherryDAI. This CherryDAI is then lent out on Compound. The liquidity provider earns profits through pool rewards for putting money into the pool and via the lending yield on Compound.

Traders take positions against the liquidity pools, so the pool takes long and short positions. If more traders are taking positions on one particular side, the cost of doing so surges. This feature not only improves pool profitability if traders pay the increased cost, but it also serves as a rebalancing mechanism for liquidity pool utilization.

Usage has a direct effect on liquidity. If utilization hits 100%, that means there is money in the contract to be withdrawn. As a result, to give liquidity providers the ability to inject and withdraw capital from the smart contract, internal mechanics lean towards discouraging very high use.

It should also be noted that the protocol is currently just a collection of smart contracts. There isn’t a clear interface similar to Dharma, dYdX, or other crypto products. Users should exercise caution in interacting with the contract as it hasn’t been audited by a third party.

Based on their use of Compound, CherrySwap contracts are likely for DAI interest rates on Compound. These contracts are not for LIBOR or any treasury bond index that make up the $500 trillion swap market.

While the scope of CherrySwap is currently limited to crypto, the concept has major implications for permissionless swaps and the ways in which DeFi is staking its claim as an irrepressible trend.