Please describe your proposed solution.

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 use the deliverables from this proposal to advance the discussions.

<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.

We aim to revolutionize the trading and settlement of Interest Rate Derivatives by leveraging the capabilities of the Cardano Blockchain. Our initiative is designed to democratize access to this multi-trillion dollar daily market, traditionally dominated by large financial institutions, corporations, and asset managers. By introducing a streamlined solution named BlockMargin, we intend to empower thousands of small companies and individuals to participate in the Interest Rate Derivatives market efficiently.

Challenges Faced by Small Entities:

Interest Rate Derivatives serve as crucial risk management tools for corporations and asset managers, enabling them to hedge interest rate risks associated with loans, bond issuance, and other liabilities. However, small corporates and private individuals often find themselves excluded from this market due to the intricate back-office processes involved, particularly the daily margining requirements. Without the resources to handle daily margining, these entities face inflated fees imposed by financial institutions, leading to elevated credit and operational risks.

The BlockMargin Solution:

BlockMargin, our innovative product, addresses these challenges by seamlessly integrating daily margining onto the blockchain. This transformation simplifies what was once a complex back-office operation into a user-friendly experience, reducing the barriers to entry for small businesses and individuals. Through a user-friendly dashboard, BlockMargin provides 24/7 visibility into positions, market values, and margin requirements. Users can effortlessly manage their positions, manually or automatically post and redeem margin from their crypto wallet.

Key Features of BlockMargin:

• Automated Monitoring: BlockMargin constantly monitors daily market prices, contract conditions, margin requirements, and settlement processes, mitigating risks and simplifying the trading experience.
• Empowering Small Entities: By bringing the power of daily margining to the fingertips of small businesses and individuals, BlockMargin facilitates a win-win situation, eliminating the need for excessive fees and minimizing credit and operational risks.

Significance of Margin Posting:

Understanding why margin matters is pivotal to appreciating the BlockMargin solution. Interest rate derivatives involve dynamic contract values that can turn positive or negative at any point. Margin posting becomes essential to prevent defaults and provide compensation if one party decides to exit the contract prematurely. Additionally, margin posting aids in avoiding litigation, as both parties can walk away, leaving margin with the counterparty to cover any adverse market moves.

Practical Example:

For instance, when a user buys an interest rate future as a hedge against a potential interest rate rise on a 500k mortgage, BlockMargin ensures smooth margin posting during the contract period. This example illustrates the convenience and risk mitigation benefits of our solution.

In summary, BlockMargin is poised to transform the Interest Rate Derivatives market by simplifying daily margining through blockchain technology, making it accessible to a broader audience and significantly reducing operational complexities for small entities.

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>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 6 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

<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. We have been accepted into the Midnight Dev Net

<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 Marlowe's capabilities to support different financial contracts. Marlowe is also blockchain agnostic; therefore, it can be ported to run on Midnight once it 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.

Please define the positive impact your project will have on the wider Cardano community.

The proposal will validate the possibility of trading interest rate derivatives (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.

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

What is your capability to deliver your project with high levels of trust and accountability? How do you intend to validate if your approach is feasible?

100% success rate in delivering on previously funded Catalyst proposal

The team has successfully delivered 3 out of 3 of their previously funded Catalyst projects

The project's technical details were discussed on the Cardano forum back in 2021 <https://forum.cardano.org/t/oracle-for-energy-prices/53588/3>

The key team members, Dmitry and Sergio, have decades of experience with trading and settling these types of Interest Rate derivative contracts and have worked together at a large financial institution in the Netherlands

Dmitry spent over a decade in Risk Management and Trading, managing multi-million dollar positions for the bank and the bank’s clients. Sergio is a banking professional with hands-on expertise in Regulation and bank-to-corporate interactions. They both have deep connections in the industry necessary to convince large financial institutions to do a pilot.

The team is in direct talks with 2 banks in the Netherlands and will raise the level of discussion to proposal level for the prototype if funding is approved and include 3 other banks.

We are in contact with the Marlowe team, who have been very responsive to the community and provided detailed explanations of the edge cases we need to cover in our build.

We have been accepted into the Midnight Dev Net where we will explore the possibility to run our test cases

What are the key milestones you need to achieve in order to complete your project successfully?

Set up dev environment and tooling

Activities:

The first month will be to set-up the Cardano infrastructure and the necessary chain indexes for the back-end and the front-end to read the state of the blockchain

Additional Web2 services will also be set-up for the back end

At the end of the month, it is expected that the team has the necessary tooling and APIs to build the rest of the deliverables.

• Set-up a Linux server
• Set-up Cardano-Node, Cardano DBSync and Cardano Graphql
• Set-up a self-hosted Marlowe deployment with Docker
• Run supporting services via Docker: NodeJs, SSL, MongoDB
• Sign up with 3rd party providers for backup: blockfrost, maestro
• Set-up dev environment for Web2, Haskell and Aiken

Expected time to completion: 1 month

Resources:

• One Senior developer 40h per week for 4 weeks

Deliverables: A working Cardano stack and Dev environment for Haskell and Marlowe

Outputs:

• Set-up a Linux server;
• Set-up Cardano-Node, Cardano DBSync and Cardano Graphql;
• Set-up a self-hosted Marlowe deployment with Docker;
• Run supporting services via docker: NodeJs, SSL, MongoDB;
• Sign up with 3rd party providers for backup: blockfrost, maestro;
• Set-up dev environment for Web2, Haskell and Aiken.

Intended Outcomes:

The team has a sever and a dev environment to build the rest of the project

>Building blocks to trade a Synthetic Future on SOFR rate

Activities:

The building blocks for settling Synthetic futures on the 3-month SOFR rates will be built. Most of this work will focus on the backend, sourcing and recording price information onto the Cardano blockchain

3-month SOFR futures contracts are traded on the CME <https://www.cmegroup.com/markets/interest-rates/stirs/three-month-sofr.html>

We will build a daemon that reads their settlement prices once a day, after the market closes, and records them onto the blockchain. A proof of concept of this has already been built and a trial ran where these prices were recorded as metadata back in 2021 using <https://nut.link/> and <https://github.com/functionally/mantis-oracle>

We will investigate the possibility of using Marlowe oracles, which already comes with a SOFR rate as explained in this article: <https://github.com/input-output-hk/marlowe-cardano/blob/main/marlowe-apps/Oracle.md#custom-external-feeds>

This will result in settlement prices on the 3-month futures contract being posted on-chain to test and run a pilot with a financial institution.

Our Regulatory Expert will investigate the need for licencing of the futures prices and the associated cost. This will be put forward for discussions with the banking partner during the pilot phase. If the cost of the futures feeds are prohibitive, then a beta of the SOFR spot price will be used as a proxy - which is published by the FED free of charge <https://www.newyorkfed.org/markets/reference-rates/sofr>

The other deliverable is the Risk Engine and the Pricer. 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.

Interest Rate Derivatives are margined trades, where each counterparty needs to put up a margin at the start of the trade, which is typically just a tiny fraction of the notional amount. For example, on a 3-month Forward Rate Agreement with 10mn notional, the initial margin might be less than 5%

This margin will vary during the life of the trade, and a risk engine is needed to decide how much initial margin needs to be deposited into the smart contract by each of the counterparties and how much this margin will change over time.

The Pricer calculates the instrument's price for a given set of inputs and is a necessary component of the Risk Engine.

These will be deployed as backend services with an API

A smart contract factor will generate new smart contracts (its CBORHex and address) for each new transaction.

Smart contracts will codify the terms of Synthetic Futures. In addition, they will determine the tenor, term, notional, rate, and other elements of the term sheet.

Execution of the smart contracts is guaranteed; once a trade is registered, there is no ambiguity on the dates and margin conditions. Margin is revalued daily, and if the counterparty does not post additional margin, then the contract is resolved, and the remaining margin is returned to each counterparty.

A front-end will be developed around this functionality to show the user the value of the positions, the value of the collateral they need to post, or can withdraw depending on how the market has evolved over the last days and options to post or redeem collateral into their wallet.

Users will be able to connect to the app with their web wallets using the wallet connector developed and open-sourced by Dynamic Strategies <https://github.com/dynamicstrategies/cardano-wallet-connector>

Expected time to completion: 2 months

Resources:

• One Senior developer 40h per week for 8 weeks
• One Regulatory Expert 20h per week for 8 weeks
• One Quant Modeler 20h per week for 8 weeks

Deliverables:

Web2 full stack and smart contract that represent 3 months SOFR Synthetic Futures.

We will trial the Marlowe smart contract language for specifying this product and if successful, will use Marlowe for the rest of the project

Smart contract code will be open-sourced

Outputs:

• A daemon to fetch market prices once a day at the close;
• Publish market data on-chain as a daily metadata transaction;
• Deploy a Risk engine to forecast 2-day forward range of rates;
• Deploy a Pricer to give back up-to-date value of future cash flows;
• Wallet connector implemented to main web wallets (Nami, Eternl, Flint, Lace …);
• Dashboard showing live trades and required actions;
• Initiate trade on the testnet;
• Post collateral / redeem collateral.

Intended Outcomes:

A working prototype ready to settle test trades on the Cardano preview testnet

>Execute test trades on the testnet and fix bugs

Activities:

A test trade will be done on the testnet to validate functionality and identify bugs. It will be run over five days to check the initial trade and daily collateral management functionalities. At the end, the trade will be closed out and cashflows exchanged

Any bugs will be logged and addressed.

Expected time to completion: 1 month

Resources:

• One Senior developer 40h per week for 4 weeks
• One Regulatory Expert 20h per week for 4 weeks
• One Quant Modeler 20h per week for 4 weeks

Deliverables:

Execute a trade on the testnet and run the following tasks

• Initiate a trade on testnet;
• Manage cashflows for 5 days;
• Closeout trade.

Outputs:

A successfully completed transaction and lessons learned

Intended Outcomes:

The transaction is initiated and completed correctly

Who is in the project team and what are their roles?

Project Lead: Dmitry Shibaev

Dmitry Shibaev is an experienced Project Lead and Senior Developer with a proven track record in both big tech and financial markets. His expertise spans 5 years in delivering large-scale SAP projects for energy companies in southern Europe and 15 years in financial markets, where he successfully led significant projects at a prominent investment bank across London, Singapore, and Amsterdam.

Open-Source Contributions:

Dmitry has actively contributed to the open-source community, showcasing his skills in building tools and fostering collaboration:

• Developed a wallet connector for DApps and Wallets, utilized by the Cardano Beam Web App. The GitHub repository has garnered 100+ stars and has been forked by IOHK.
• GitHub Repo
• App Demo 1
• App Demo 2
• Contributed to the Cardano Developer Portal with a quick start guide on connecting Web Apps to different Cardano web-wallets.
• Created a Public GraphQL endpoint with a web client, enabling users to query the Cardano blockchain conveniently.
• GitHub Repo
• App
• Developed a Staking Reward Calculator synced to the blockchain, providing insights into expected payouts from different pools.
• App
• Contributed Cardano Wallet Functions for integration into React Native apps.
• GitHub Repo

Full Stack Expertise:

Dmitry is proficient in both Web2 and Web3 technologies, showcasing his skills in building the full stack behind Dynamic Strategies (https://dynamicstrategies.io) and Cardano Beam (https://cardanobeam.app).

Plutus Pioneers Cohort:

Dmitry was part of the inaugural cohort of Plutus Pioneers and received recognition for building community tools at Adafolio (<https://adafolio.com/portfolio/8f7da192-0257-11eb-9684-a45e60be653b>).

Stake Pool Operation:

He is an integral part of a team operating the Cardano Stake Pool with the ticker DSIO, registered in 2020. The pool has received multiple delegations from the Cardano Foundation in acknowledgment of outstanding contributions to the community.

• Pool Details

Community Engagement:

Dmitry actively participates in the Cardano forum and Cardano Stack Exchange, contributing to community discussions and sharing knowledge.

• Cardano Forum
• Cardano Stack Exchange

Project Delivery and Recognition:

The team has successfully delivered two out of three previously funded Catalyst projects, with the completion report submitted for the last proposal. Dynamic Strategies was selected for the Midnight Dev Net and has a track record of delivering solutions in risk management and AI for the traditional banking sector (e.g. https://riskview.app).

Regulatory Expert: Sergio Rodrigues

<https://www.linkedin.com/in/sergio-vieira-rodrigues-819bb8/>

Sergio has 20 years of experience in systems implementation in Large International Banks. He is also a Banking Regulatory Expert with experience dealing with financial regulators across Europe

Please provide a cost breakdown of the proposed work and resources.

The budget is estimated based on 40 hours per week and 4 weeks per month.

Milestone 1: Set up dev environment and tooling

• One Senior Developer 20h per week for 4 weeks @ $60/h

Total $4,800

Milestone 2: Building blocks to trade a Synthetic Future on SOFR rate

• One Senior Developer 40h per week for 8 weeks @ $60/h
• One regulatory Expert 10h per week for 4 weeks @ $30/h

Total $20,400

Milestone 3: Execute test trades on the testnet and fix bugs

• One Senior Developer 40h per week for 4 weeks @ $60/h
• One regulatory Expert 10h per week for 4 weeks @ $30/h

Total $10,800

Server costs @ $18/month for 4 months = $72

The total budget is 36,072 USD

At a price of 0.37 ADA per USD

Total in ADA: 97,491

How does the cost of the project represent value for money for the Cardano ecosystem?

The project will test the possibility of bringing trading of Interest Rate Derivatives onto Cardano

Trading in Interest Rate Derivatives is currently a very lucrative business for the banks because the volumes are very large (It is the biggest market in the world in terms of daily volume) and the banks can command relatively wide margins.

Moving this market on-chain will bring a lot of trading volume to Cardano in terms of the number of trades and also in terms of TVL

High-value transactions will justify higher fees on the Cardano tiered fee market when implemented. This will result in higher staking rewards to ADA holders and potentially higher ADA price as it grows in demand to pay for fees.

Discussion on the tiered fee market: <https://iohk.io/en/blog/posts/2021/11/26/network-traffic-and-tiered-pricing/>

Additionally, Financial institutions and corporates will be inclined to move their trading of interest rate derivatives on-chain due to the cost advantages that this presents.

Based on our market estimates, banks currently add a markup of between 0.5% and 1.5% on top of the interest rate they charge to clients to cover their operational costs. We think that can be reduced to between 0.01% and 0.05%, which would represent a 20x to 100x cost saving.

We will trial the newly released Marlowe smart contract language for financial contracts and become one of the first candidate projects for the privacy-oriented Midnight side chain.