Sanat Rao, founder of crypto hedge fund Gamma Point Capital, summarized how to efficiently use various tools for neutral strategy trading in the crypto world.
Original title: “How do high-end players make stable profits in a volatile bull market? 》
Written by: Sanat Rao, founder of crypto hedge fund Gamma Point Capital Compilation: Block Rhythm
In a bull market, traders will inevitably lose their way. Yesterday, people in the whole village might still be shouting: “Come on!” You might see a crowd of people crowding the rooftops today.
Yes, it is difficult for you to predict the market, or in other words, it is difficult for you to target everything.
Besides being a friend of time, what other strategies are there to avoid systemic risks brought about by market volatility?
The answer may be a market-neutral strategy.
In traditional financial markets, quantitative institutions have used market-neutral strategies to perfection. Of course, experienced traders have also brought this strategy into the crypto world. However, the empowerment of DeFi can make the imagination of encrypted assets not capped, and the gameplay in the encrypted world may be more than you think.
As a crypto hedge fund, Gamma Point Capital is deeply involved in secondary investment in the crypto market, high-frequency market making and arbitrage, and liquidity mining. In this article, Sanat Rao, the founder of Gamma Point Capital, summarized how to efficiently use various tools for neutral strategy transactions in the crypto world.
Rhythm BlockBeats translated the original text for crypto traders to learn from:
2020 is a turbulent year. Due to the threat of the new crown epidemic, the economies of various countries have suffered severe setbacks. The Federal Reserve lowered interest rates to nearly zero to help accelerate economic recovery. The interest rates of savings banks all over the world have reached their lowest levels in history.
According to Bankrate’s data, the highest annualized interest rate offered by banks in April 2021 is only 0.5%
On the contrary, the cryptocurrency market is rapidly institutionalizing through its strong derivatives market and lending market. Decentralized finance (DeFI) has quickly become a “killer application” in the crypto market, and will change the structure of financial services in the future-DeFi uses smart contracts on the chain to completely bypass traditional centralized financial intermediaries and become more effective. Rebuild its primitives (banks, exchanges, asset management managers, etc.) in a more transparent way.
These developments have brought amazing fixed income opportunities to the crypto world.
Market neutral strategy
A market-neutral strategy means that the return on a strategic position has nothing to do with the direction of the market. It is an ideal choice for investors who want high-risk-adjusted returns measured by a high Sharpe ratio. The ideal market-neutral strategy is to generate returns without taking risks in the direction of the market, so it can be regarded as a fixed-income strategy.
This article describes how to use market neutral strategies to obtain fixed income in the encryption and DeFi markets.
Precautions:
This article does not list all market-neutral strategies. For example, we do not involve the use of option strategies to obtain income, etc.
For the sake of simplicity, we have sorted out the recommended strategies from low complexity to high complexity, starting from the basic encrypted savings deposits and ending with the hedging liquidity mining model.
CeFi and DeFi lending
Range of annualized rate of return: 6-12%
Complexity: low
Centralized lending platform (CeFi)
The first lending platforms launched in the crypto ecosystem are large professional crypto lending platforms such as Blockfi, Celcius and Vauld. Investors can open accounts (similar to bank savings accounts) in these companies, deposit their encrypted assets and earn interest.
At the time of writing, this is the lender’s income of some top crypto assets such as USDC, BTC and ETH:
Investors should note that these platforms are not underwritten by the FDIC and bear all traditional counterparty risks (these lending platforms lend your deposited assets to borrowers who may default) and broader “systematic” encryption risks. This is a good entry point for investors looking for relatively low risk.
DeFi loan agreement
The traditional lending industry relies on underwriting and legally binding contracts to determine the risk of default and improve creditworthiness. For example, when you apply for a loan from a bank, you need to provide salary statements, credit records, etc., and then the bank will determine whether you are approved for the loan. Once approved, you need to sign a legal contract that can be enforced by the court.
In decentralized finance, there are no intermediaries, and users can make loans anonymously. Instead of intermediaries, smart contracts and excess mortgage settlement mechanisms are used. The total value of the collateral provided by the borrower is greater than the value of the loan, and the lender can liquidate the collateral through the open market. These mechanisms are enforced by the software and are the same for everyone and have nothing to do with the creditworthiness of the borrower.
Compound, Aave and MakerDAO were early decentralized lending platforms and are still today’s market leaders. The following table shows an example of how Compound works:
Image source: Compound Finance
In return for taking on high encryption risks and the large demand for stablecoins in DeFi, lenders use “loan to smart contracts” to obtain much higher returns than traditional CeFi platforms. The chart below shows the loan interest rates of USDC on 3 top platforms. These interest rates are always higher than those of centralized lending institutions.
Image source: Compare High Interest Accounts
All in all, the lender converts its U.S. dollars into USDC (stable currency) and stores these assets in Compound to get 14.31% interest! Of course, interest rates will change regularly, and lenders need to bear all DeFi risks (smart contract risks, blanket risks, etc.).
Basis trading
Range of annualized rate of return: 20%-50%
Complexity: Medium
In the traditional commodity and foreign exchange markets, basis trading (also called spot trading) is a well-known arbitrage strategy. Futures contracts for encrypted assets can be found on most large crypto exchanges (Binance, FTX, OKEX, etc.) as well as traditional exchanges (such as CME).
Usually, the trading price of futures contracts is higher than the spot market (this phenomenon is called futures premium in financial terms). The term basis refers to the difference between the futures price f (t) and the spot price S (t) at time t.
In the bull market stage, retail investors have a great demand for using leverage to buy BTC and ETH futures contracts. At this time t = α, F (α) >> S (α), the basis is very high. Basis traders will buy spot (i.e. long bitcoin) and sell futures contracts (i.e. short futures), thus completely hedging their positions.
At maturity (t = ε), the futures price and the spot price will converge. That is, F (ε) = S (ε), the trader can close the position (buy back the futures contract and sell the stock). By holding a basis position before the expiry date, the trader obtains a net profit of Basis (α). Since this profit has no price directional risk, we can treat it as a fixed income return!
In essence, basis traders provide leverage to retail investors at time t = α, and earn Basis (α) from it!
Give a simple example:
On April 10, 2021 (t = α), the BTC spot transaction price was 60,264 USD, and the BTC June 25 futures contract price was 66,264 USD.
That is, F (α) = $60,264 and S (α) = $66,264
A trader buys 1 Bitcoin and uses it as collateral to sell about 663 BTC0625 contracts (each contract value = 100 USD) on Binance. Since the 1 BTC long position is hedged by the short futures contract position, the trader’s risk has been completely hedged.
When the expiry date comes on June 25, the prices of these two instruments will definitely converge (unless there is a systemic risk).
By holding this basis position before June 25, the trader makes a stable profit = basis (α)
Within 3 months (approximately 77 days) 9.94% of income was obtained, which is equivalent to an annualized return of 47.19%!
As long as the exchange (in this case Binance) does not go bankrupt during this period, this is a risk-free return. This is because once the spot and futures prices are locked, their prices will converge, so the price difference between them minus transaction costs is the gain.
This graph shows the rolling basis of BTC over the past few months. In the bull market stage, the basis has been much higher than 30%.
Image source: skew.-Enter Cryptocurrency Markets
As always, the complexity of this transaction lies in the timing of opening a position (when the overall sentiment of the underlying asset is bullish) and the optimization of slippage during transaction execution.
Perpetual contract rate
Range of annualized rate of return: 10%-160%
Complexity: high
Perpetual contracts, also known as perp, are derivatives unique to the crypto market. Perpetual contracts are similar to futures contracts, but there are two differences:
- The perpetual contract has no expiry date, and;
- The price of the perpetual contract closely tracks the spot price of the underlying asset.
Perpetual contracts allow traders to speculate on asset prices without having to hold actual assets. For example, if the user predicts that the price of the underlying asset (BTC) will rise, he can establish a leveraged long position by purchasing the BTC-PERP contract; if the user predicts the price of BTC will fall, he can establish a short position.
Perpetual contract funding rate is a mechanism to keep the contract price consistent with the spot price of the underlying asset. The payment of capital rate is a series of continuous payment behaviors between long and short in perpetual contracts, but it can also be a method of generating income.
Funding rate premium
In a given time interval (usually every eight hours), the exchange will calculate the time-weighted average price (TWAP) of the perpetual contract and the spot TWAP price. The formula for calculating the capital rate premium is:
If the premium is> 0, the market is bullish, and the longs need to pay the funding rate to the shorts, thereby encouraging those shorts who stand on the opposite side of the market to push the mark price to the index side.
If the premium is less than 0, the market is bearish. This causes the shorts to pay the longs, which incentivizes the longs who stand on the opposite side of the market to bring the marked price closer to the index price.
Funding rate interest (1)
If you look at the funding rate from the perspective of interest, the interest rate is the difference between the quote currency of the perpetual contract and the base currency borrowing rate. Therefore, interest rates can be viewed as the cost of holding a perpetual contract position. Most trading platforms use a fixed amount of interest rate (for example, Binance interest rate every 8 hours = 0.01%)
Funding rate and rate payment
The funding rate formula is relatively complicated. Binance uses the following formula:
Traders can use perpetual contracts to earn funding rates, as shown below:
Make sure that the fund rate of a certain contract is always greater than 0 for a period of time (for example, 3 days or 1 week, etc.)
Buy x quantity of spot (for example, BTC) and use it as margin to sell x number of perpetual contracts (for example, BTC-PERP). Traders are now hedged against the risk of price fluctuations in BTC positions.
As long as the fund rate> 0, the trader will earn a fund every 8 hours according to the above formula!
Undoubtedly, this is a complex trading position that requires constant monitoring, but if executed properly, the rewards will be very generous. For example, in the past 3 months, the Delta Exchange SUSHI-PERP contract has an average funding rate of 0.15% every 8 hours. This would be 13.5% == 162% APY monthly income.
Image source: Delta trading platform
DeFi hedge mining
Annualized income range: 10%-300%
Complexity: high
What is liquidity mining
Liquidity mining refers to the use of encrypted assets to provide liquidity for different DeFi protocols to generate income. Roughly speaking, there are 3 types of income in the DeFi world:
Transaction fees: “Farmers” (also known as liquidity providers) provide liquidity funds to the DeFi fund pool and earn a certain percentage of transaction fees. For example, Uniswap charges a 0.3% fee for each token transaction and transfers the fee to the liquidity provider in proportion.
Governance token incentives: Liquidity providers can also obtain the governance tokens of the agreement as incentives. For example, the leveraged mining protocol Alpha Homora currently distributes 237,500 ALPHA tokens to liquidity providers who have established leveraged mining positions in the two weeks from March 31 to April 14.
Pledge Fees: Certain agreements provide additional incentives for users who lock their positions (also known as “stakes”) to govern tokens. For example, users who pledge SUSHI tokens can get a 0.05% transaction fee.
Liquidity mining is a high-risk activity, which has extremely high risks for all participants, including smart contract risks and blanket risks. Liquidity providers need to consider three types of financial risks:
Price risk: The liquidity provider deposits tokens A and B in a pool to earn fees. Obviously the liquidity provider will be affected by changes in the price of these tokens (because the liquidity provider holds long positions in A and B) Positions).
Gratuitous loss: This is the loss suffered by the liquidity provider because the price between the token pair is different from the price when it enters the pool. This is a simple description of gratuitous losses.
Gas price: Gas in blockchain networks (such as Ethereum) is a fee paid to miners to execute instructions in smart contracts. During periods of strong demand, Gas prices may soar and swallow the proceeds of DeFi liquidity mining.
Therefore, the net profit of liquid mining can be calculated as:
As we can see, the net rate of return is severely affected by the price changes of A and B. But we can use futures contracts to hedge this risk.
Example of hedge mining
The following outlines the process of obtaining predictable returns through liquidity mining:
Image source: CoinGecko
In the above picture, a liquidity provider noticed that the Onsen SUSHI/WETH pool on Sushiswap currently has an amazing 154.2% APY.
The user’s capital is USD 250,000. He bought $100,000 of SUSHI (token A) and $100,000 of WETH (token B) on a DEX or DEX aggregator (such as 1inch).
Then, this user sells USD 25,000 of SUSHI-PERP (4 times leverage) and USD 25,000 of WETH-PERP (4 times leverage) contract positions on a centralized trading platform (such as FTX). This ensures that the risk of price changes from the positions of A and B is hedged. [But if the price of A or B rises sharply, 4 times leverage will indeed expose it to liquidation risk]
The user puts A and B into the Sushiswap pool.
The user withdraws the X SUSHI reward tokens he has received at regular intervals, and pledges SUSHI again.
After 4 months, the user withdrew funds from the pool (obtained transaction fees and tokens), closed the futures position, and sold A and B tokens in exchange for legal tender. The user also sold his pledged X SUSHI tokens on the market at the current price P.
The net income of this user is:
Needless to say, the difficulty of the hedging mining process is relatively high. In return, the liquidity provider’s position is not affected by currency price fluctuations and can earn market-neutral returns.
to sum up
Today’s crypto ecosystem, under the blessing of decentralized finance, provides people with opportunities to obtain substantial benefits.
But it is important to first pay attention to the reasons for the existence of these revenue opportunities:
Demand for leverage: Retail investors in the cryptocurrency market have a very high demand for leverage during the bull market, thereby increasing returns. Traders who provide them with this leveraged liquidity have the opportunity to earn profits.
DeFi incentive mechanism: The new DeFi pool will complete a “liquidity cold start” by providing its governance tokens to early liquidity providers.
Low threshold for use: Borrowers, lenders, liquidity providers and traders in DeFi can trade freely with each other without any regulations or national restrictions. With the influx of more and more participants, the agreements will receive more transaction fees and distribute them as revenue to liquidity providers.
As more and larger institutions enter the market and a large amount of capital enters, these revenue opportunities may decrease over time. I think we are still in the early stages of the neutral phase of the crypto market, and these opportunities will continue to exist in the next few years.
Those investors seeking high “risk-adjusted returns” can obtain better returns by adding neutral strategies to their portfolios.
