How Interest Rate Swaps Work

TL;DR: Interest Rate Swaps exchange one type of yield for another. XCCY uses a Virtual AMM to match parties wanting Fixed Yield with those wanting Variable Yield, settling the difference at maturity.

The Basic Concept

An Interest Rate Swap (IRS) is a contract where two parties exchange yield obligations:

┌──────────────────────────────────────────────────────────────┐
│                    INTEREST RATE SWAP                        │
├──────────────────────────────────────────────────────────────┤
│                                                              │
│   Party A                              Party B               │
│   ───────                              ───────               │
│                                                              │
│   Has: Variable Yield exposure         Has: Fixed Yield      │
│   Wants: Fixed Yield certainty         Wants: VY upside     │
│                                                              │
│                       ┌───────┐                              │
│   Pays VY ───────────►│ SWAP  │◄─────────── Pays FY          │ 
│   Receives FY ◄───────│       │───────────► Receives VY      │
│                       └───────┘                              │
│                                                              │
│   Result: Locked yield          Result: Variable exposure    │
│                                                              │
└──────────────────────────────────────────────────────────────┘

Important: No principal is exchanged — only the yield difference is settled.

The XCCY Approach

Traditional IRS requires finding a counterparty with opposite needs. XCCY solves this with a Virtual AMM (VAMM):

                    ┌─────────────────────────┐
                    │         VAMM            │
                    │   (Virtual AMM Pool)    │
                    │                         │
    FY Seekers ────►│   Price Discovery       │◄──── VY Seekers
                    │   Liquidity Provision   │
                    │   Instant Matching      │
                    │                         │
                    └─────────────────────────┘

How the VAMM Works

1. Liquidity Providers deposit liquidity at specific FY ranges

2. Traders swap between FY and VY at market rates

3. Price Discovery happens automatically via supply/demand

4. No Counterparty Search — the pool is always available

Step-by-Step: Opening a Position

Step 1: Choose Your Pool

Each XCCY pool has specific parameters:

Parameter	Example
Underlying Asset	USDC
Yield Source	Aave aUSDC
Term Start	Jan 1, 2025
Term End (Maturity)	Apr 1, 2025 (90 days)
Current FY Rate	6.2% APY

Step 2: Deposit Margin

You deposit collateral to secure your position:

┌─────────────────────────────────────────┐
│           Margin Deposit                │
├─────────────────────────────────────────┤
│                                         │
│   Notional:    100,000 USDC             │
│   Leverage:    20x                      │
│   Margin:      5,000 USDC               │
│                                         │
│   Your margin covers potential losses   │
│   up to 5% of notional                  │
│                                         │
└─────────────────────────────────────────┘

Step 3: Execute the Swap

For FY Position (Lock Fixed Yield):

You swap VY exposure → FY locked at 6.2%
Transaction: swap() with negative amountSpecified

For VY Position (Trade Variable Yield):

You swap FY obligation → VY exposure
Transaction: swap() with positive amountSpecified

Step 4: Position is Active

Your position is now active until maturity:

Position Summary
━━━━━━━━━━━━━━━━━━━━━━━━━━━
Type:      FY Position
Notional:  100,000 USDC
FY Rate:   6.2% APY
Margin:    5,000 USDC
Maturity:  Apr 1, 2025
━━━━━━━━━━━━━━━━━━━━━━━━━━━

During the Term

What's Happening

While your position is active:

1. Variable Yield accrues — The oracle tracks actual VY from Aave

2. Your FY is locked — Doesn't change regardless of market

3. PnL updates — Unrealized profit/loss based on current VY vs FY

4. Margin monitored — Protocol ensures you have sufficient collateral

Example: Tracking Your Position

Day 1:   VY = 7.1% | FY = 6.2% | Unrealized PnL: -$24
Day 15:  VY = 5.8% | FY = 6.2% | Unrealized PnL: +$16
Day 30:  VY = 4.2% | FY = 6.2% | Unrealized PnL: +$54
Day 45:  VY = 3.9% | FY = 6.2% | Unrealized PnL: +$95
...

Settlement at Maturity

The Settlement Process

At maturity, positions are settled:

┌─────────────────────────────────────────────────────────────┐
│                    SETTLEMENT                                │
├─────────────────────────────────────────────────────────────┤
│                                                             │
│   1. Oracle reports final Variable Factor                   │
│      (Total VY accrued over the term)                       │
│                                                             │
│   2. Protocol calculates settlement cashflow                │
│      Cashflow = (FY - VY) × Notional × Time                │
│                                                             │
│   3. Winners receive, losers pay                            │
│      (From margin deposits)                                 │
│                                                             │
│   4. Remaining margin returned to traders                   │
│                                                             │
└─────────────────────────────────────────────────────────────┘

Settlement Math

Settlement Cashflow Formula:

cashflow = fixedTokenBalance × fixedFactor 
         + variableTokenBalance × variableFactor

Where:
- fixedFactor = (termEnd - termStart) / SECONDS_IN_YEAR / 100
- variableFactor = Accumulated VY from oracle

Example Settlement

Parameter	Value
Notional	100,000 USDC
Term	90 days (0.247 years)
FY locked	6.2%
VY actual (average)	4.8%

For FY Position:
PnL = (FY - VY) × Notional × Time
PnL = (6.2% - 4.8%) × 100,000 × 0.247
PnL = 1.4% × 100,000 × 0.247
PnL = +$346 profit

You receive: 5,000 (margin) + 346 (profit) = 5,346 USDC

The Role of Liquidity Providers

LPs make the market work by providing liquidity:

┌─────────────────────────────────────────────────────────────┐
│              LIQUIDITY PROVIDER ROLE                        │
├─────────────────────────────────────────────────────────────┤
│                                                             │
│   LPs deposit liquidity at specific FY ranges               │
│                                                             │
│   Example LP Position:                                      │
│   ┌─────────────────────────────────────┐                   │
│   │  FY Range: 5% ─────────── 8%        │                   │
│   │  Liquidity: 500,000 USDC            │                   │
│   │  Earns: Trading fees on all swaps   │                   │
│   └─────────────────────────────────────┘                   │
│                                                             │
│   Benefits:                                                 │
│   - Earn fees from every trade in range                     │
│   - Concentrated liquidity = capital efficient              │
│                                                             │
│   Risks:                                                    │
│   - Impermanent loss if FY moves outside range              │
│   - Directional exposure based on where price ends          │
│                                                             │
└─────────────────────────────────────────────────────────────┘

Complete Flow Diagram

┌──────────────────────────────────────────────────────────────────┐
│                     XCCY IRS LIFECYCLE                           │
└──────────────────────────────────────────────────────────────────┘

    ┌─────────┐       ┌─────────┐       ┌─────────┐
    │  OPEN   │──────►│ ACTIVE  │──────►│ SETTLE  │
    └─────────┘       └─────────┘       └─────────┘
         │                 │                 │
         ▼                 ▼                 ▼
    
    • Deposit       • Position        • Calculate
      margin          tracked           final VY
                                        
    • Execute       • VY accrues      • Compute
      swap            via oracle        PnL
                                        
    • FY locked     • Unrealized      • Transfer
      at market       PnL updates       funds
      rate
                    • Margin          • Return
                      monitored         remaining
                                        margin

Key Takeaways

1. IRS exchanges yield types — FY ↔ VY with no principal transfer

2. VAMM enables instant trading — No counterparty search needed

3. Settlement is automatic — Oracle reports VY, protocol settles

4. Margin protects the system — Both sides have skin in the game

5. LPs make it work — They provide liquidity and earn fees

Next Steps

• Locking Fixed Yield — Detailed walkthrough

• Risk Management — Understanding the risks

• Architecture Overview — Technical deep dive