Author: Tao Huang
Time is valuable, and interest rates are the most basic manifestation of time value. Through the exploration and research of interest rates, we can gain a deeper understanding of the nature of finance, and use this to develop transaction models that are widely applicable to various scenarios and capture long-term stable business value.
1. Causes of interest rates
Interest rate is one of the most important variables in today’s economic models. Almost all financial assets and financial phenomena are more or less related to interest rates. Interest rate policy has become the main method used by central banks to regulate currency supply and demand and economic growth. But its production is nothing more than the following five main reasons:
Delayed consumption: When a lender lends funds, it is equivalent to delaying consumption. According to the principle of time preference (Time Preference), consumers will be more inclined to obtain current commodities than future commodities, thus generating interest rates.
Expected inflation: Most economies will experience inflation. This means that the same amount of funds can be purchased in the future less than the current goods, so the borrower needs to compensate the lender for this part of the loss.
Opportunity cost: The lender’s loan of funds is equivalent to giving up the possible return of other investments, so the borrower needs to compete with other investments for this fund.
Investment risk: The borrower has the risk of not being able to repay, and the lender needs to charge additional fees to compensate for the risk it bears.
Liquidity preference: People tend to prefer the state where funds or resources can be withdrawn at any time, rather than requiring time to retrieve them, so they need to compensate for the liquidity sacrificed by people.
In principle, the lender needs to compensate the borrower for the above five preferences or risks. Among them, delayed consumption, opportunity cost, and liquidity preference constitute the base interest rate, and expected inflation is only related to the nominal interest rate. Therefore, only investment risk directly affects the real interest rate. Logically, the actual interest rate is basically positively correlated with investment risk.
2. Pricing of interest rates
Since the birth of economics, the interest rate determination system has undergone the development and evolution of many different theories. It mainly includes classical interest rate theory, Keynesian interest rate theory, loanable funds interest rate theory, IS-LM interest rate analysis model. The classical interest rate model is too primitive, and the loanable funds interest rate theory and IS-LM interest rate analysis model involve macroeconomic data and are beyond the scope of this article. In order to facilitate understanding, this article takes the most clear and intuitive Keynesian interest rate theory as an example. Keynesian interest rate theory is also known as Interest Rate Parity Theory. The core point of this theory is that the spot exchange rate and forward exchange rate spreads of different currencies are determined by the spread between the two currencies. Specifically, currencies with high interest rates must be discounted in the forward market, and currencies with low interest rates must be premium in the forward market. Take the uncovered interest rate parity model that does not involve interest rate futures (Uncovered Interest Rate Parity) as an example. Its definition is that investors’ arbitrage behavior makes the international financial market denominated in different currencies under the condition that capital has sufficient international liquidity. The returns of similar assets tend to be consistent. In other words, the transnational liquidity of arbitrage capital ensures that the “law of one price” is applicable to the international financial market, and the formula is as follows: Simply put, the faster the depreciation of the currency, the higher the interest rate, in order to compensate for the loss of its depreciation. In theory, when parity fails, international hot money will earn profits through arbitrage and return the parity formula accordingly, so as to maintain the long-term stability of the interest rate parity model.
3. Cargo trading
From a mathematical point of view, the interest rate parity model is beautiful and logically self-consistent. But the reality is very cruel. In most cases, the interest rate parity model does not hold. The main reasons are as follows:
Transaction costs: Arbitrageurs need to bear the costs of handling fees, bid-ask spreads, and transaction slippage.
Market barriers: especially in emerging markets, the international flow of funds is restricted due to foreign exchange controls and other reasons.
Opportunity cost: The use of arbitrage funds needs to cover the opportunity cost, and other investment methods with higher returns will continue to attract capital outflows.
To sum up, due to various reasons, it is difficult for international hot money to accurately capture the theoretical arbitrage opportunities caused by the deviation of the parity formula, which leads to the long-term deviation of the parity formula, which leads to a new trading model, which we generally call carry trade ( Carry Trade). Its core concept is to make interest margins by shorting low-interest-rate currencies and long high-interest-rate currencies. The transaction model has a huge carrying capacity and is widely used in various large hedge funds. According to estimates from the School of Economics of Nanjing University, the overall scale of global carry trades reached US$500 billion in 2002. Since then, due to the rise in interest rates in many countries, the scale of arbitrage transactions rose rapidly, reaching a peak of US$135.9 billion in 2007. It only cooled down due to the outbreak of the financial crisis, but the scale remained above US$800 billion before 2011.
4. USD interest rate
As the new crown epidemic that swept the world at the beginning of this year has caused a major blow to the global economy, major central banks around the world led by the Federal Reserve implemented an unprecedented large-scale release policy to stimulate the economy. The US dollar interest rate fell sharply and the yield of US Treasury bonds approached 0% . In this context, global capital urgently needs to find assets that can provide higher yields. On the one hand, this has led to a substantial appreciation in the global asset market, and on the other hand, it has brought major opportunities for high interest rates including the crypto world.
5. Encrypted World
If we regard interest rates as the time law of the financial world, the nascent crypto world time law is still in chaos. This chaotic state is not only reflected in the huge interest rate gap between the traditional financial world and the crypto world, but also in the prevailing interest rate differential and risk inversion in the crypto world. Unlike the traditional world that has globally recognized interest rate indicators such as LIBOR, interest rates in the crypto world are more fragmented and chaotic. And because of the difference in business models, the interest rates in the crypto world are more unique. We briefly describe some of the most important interest rate data.
6. Deposit and loan interest rates
Readers are certainly no strangers to deposit and loan interest rates, but they may not be sensitive. Let’s briefly list the deposit and loan interest rates of a trading platform as follows: It can be seen that there is a huge gap between the deposit and loan interest rates of different assets on the platform. USDT’s lending rate is almost 10 times that of DOT, and the deposit rate is more than 20 times that of DOT. This is the intuitive embodiment of the time value of different assets. Therefore, readers must understand that simply holding assets will continue to lose time value, and the time value of different assets varies widely, and the hidden losses that may be caused are immeasurable. In addition, interest rates in the crypto world are much higher than in the traditional world. Taking the US dollar interest rate analogy, the current LIBOR has been as low as 0.08288%, while the USDT deposit interest rate on the aforementioned platforms is still as high as 6.59%. This on the one hand reflects the systemic risks of the encryption world itself, on the other hand, it also originates from the special business model of the encryption world. In the traditional world, the lender cannot access the use of loan collateral without the counterparty’s credit default. Due to the unique properties of encrypted assets, encrypted asset lending usually requires the borrower to transfer the right to use the mortgaged asset to the lender. In accordance with industry practice, the lender has the right to use mortgage assets in part or in whole for income enhancement. This leads to the borrower being able to bear higher borrowing interest rates, which actually corresponds to a higher default risk.
7. Perpetual funding rate
Perpetual contracts are one of the most successful financial products that have crossed from the traditional world to the crypto world. With this product, Bitmex has established its position as an industry giant in one fell swoop. Perpetual contracts are never settled, and they rely entirely on regular funding rates to anchor the spot price. Funding rate and interest rate are directly linked, and the formula is as follows. To put it simply, there are two parameters in the calculation of the funding rate of the perpetual contract, one is the spread, or the premium index, and the other is the interest rate. Spreads are formed by market dynamics, while interest rates are preset by the trading platform. Therefore, the fund rate of the perpetual contract is the realization of the deviation between the market interest rate and the preset interest rate of the trading platform.
8. Current spread
The delivery contract is the financial derivative with the largest trading volume and open interest in the crypto world. The current spread (the difference between the futures contract and the spot price of the underlying asset) is another manifestation of interest rates. The option pricing model is as follows. Simply put, the relationship between futures prices and spot prices depends on two parameters, interest rate differential and expiry time. For each calculation, the expiration time is a fixed value. Therefore, the current spread can be regarded as the realization of the interest rate difference.
9. DeFi mining yield
The concept of decentralized finance (DeFi) has swept the crypto world this year. I believe that readers have more or less participated in or heard about the miracle of rich wealth in DeFi mining. There are many types of DeFi mining. Pledge model, risk model and return model are all different, which brings more and more complicated interest rate models. Since it is not the focus of this article, here is only the return rate of some DeFi mining products: Data source: CoinGecko
As can be seen from the above table, the yield of DeFi products seems to be unreasonably high, just like the unusually cheap price of early Bitcoin. If we look back after many years, such a high rate of return not only corresponds to high risks, but also comes from the early dividends of the industry.
10. The use of arbitrage trading in the crypto world
Arbitrage trading can not only profit by connecting the traditional world and the crypto world, but also profit from the interest rate difference within the crypto world. Readers can make their own combinations according to the various forms of interest listed in this article. This article briefly explains its principle by taking the simplest futures arbitrage as an example. First, return to the following futures pricing formula. Obviously, when the left term of the equation is greater than the right term, the futures price is overvalued. We can make a profit by holding the spot and shorting the corresponding futures. When the left term of the equation is less than the right term, the futures price is underestimated. We can make profit by longing the futures and shorting the spot with leverage.
11. The significance of the interest rate game
Cargo trading is one of the common trading models in the traditional financial world. This model is particularly effective in the chaotic crypto world. We believe that such industry dividends will not disappear in the short term, but we also realize that such industry dividends will eventually disappear. With this sense of urgency, we can efficiently explore more effective trading opportunities. Cargo trading is also of great significance to the sustainable development of the market. On the one hand, arbitrage trading provides investors with hedging opportunities, helping to bring the distorted market prices back to normal levels; on the other hand, huge arbitrage space will promote the continuous influx of capital, which will increase asset prices. At the same time, it provides sufficient liquidity for the market.
