July 21, 2022
Death of the Degen
Until this point in our brief history, the average crypto user didn’t need to think about taking a rational trade. It’s been “numbers go up” season for a while, so why would anyone use a conservative spread when they could be exposed to pure unadulterated alpha? Why would you take 5-10% when you could get 800% in food-themed Ponzi farms? But the question everyone should have been asking themselves is, where does the yield come from? In most cases, it was inflationary Cantillon mechanisms, meaning the yield was really only for a few and a façade for many. If the last year has taught us anything it’s that we should maybe be a bit more cautious when things seem too good to be true. Maybe we should try a few strategies that have stood the test of time, like a future spread.
Futures vs Perps
If you are reading this I am sure you are aware of what a future is, but just in case, let me refresh your memory.
Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date. – Investopedia
In other words, a future is a contract that’s settled between a buyer and a seller on a certain date in the “future”. In the crypto world, futures are generally cash-settled, meaning when the contract expires the buyer and the seller exchange cash, not the actual underlying (BTC.) Because things are settled later in time, a future doesn’t necessarily trade at par with the underlying. If traders believe that Bitcoin is going to increase in value over the next couple of months, it's normal, and logical for the future to be trading at a premium. So even if Bitcoin is worth 20k today, the BTC 30DEC22 future might be trading at 22.5k, as time passes and we get closer to the expiration date, the price of the contract will draw near to and eventually settle at the index price because the time premia has now expired.
During the life of the contract, the price of the future can fluctuate a great deal. The delta between the spot price of Bitcoin and the future price is called the basis. For example, let's say Bitcoin is trading at 20k, but the December future is trading at 22k. This implies that traders believe Bitcoin will be worth at least 22k in December, second, the future is trading at 2k over spot, which means its trading at a 10% premium (2k/20k *100 = 10%).
Current Futures Chart for BTC across Exchanges
A perp (perpetual future) is similar to a Future but has no expiration date. As the name implies, it goes on perpetually. The perp’s job is to stay in line with the underlying, it does this through a mechanism known as the Funding Rate, which is essentially an interest rate. If the perp price goes over the index price, traders who are long pay an interest rate to traders who are short. This incentivises longs to sell and bring the perp back in line with spot prices. Inversely, if the perp falls below the spot price, shorts pay longs an interest rate, ideally incentivising shorts to close out and drive the perp price back towards the index.
When trading on FTX, funding is paid every hour. So let’s assume Bitcoin is trading at 20k, and you are long 5 BTC Perp contracts, let's further assume funding is .0001. If this were to be the case you must pay $10 every hour to traders who are short - 20k*5 =100k * .0001 = $10.
Funding fluctuates wildly throughout the day, and can even go negative, which (as stated above) means shorts now pay longs. This is what’s known as funding risk and it’s hard to predict because of the volatile nature of crypto markets.
Below is the current funding rates for the top 5 tokens on FTX. Generally, we look at the 3d rate to filter out the noise and get a more accurate view of what's being paid.
Cash and Carry and Futures Spreads
Now that we have a firm grasp on how these derivatives work, let’s talk about how to use both to lower our risk. If you just buy spot, you obviously have directional risk, so one common avenue that people go down is to buy the spot and then sell a perpetual or future against it. Generally, this is done when futures trade at a premium to spot and allows investors to lock in a favourable yield without directional risk. This is particularly favoured by investors new to crypto, since they don’t have to look into the dynamics of each coin and can get a pure market neutral yield. This is colloquially known as the ‘cash and carry’ trade - why? Because you need ‘cash’ to buy the underlying spot and then you are entering into a market neutral ‘carry’ trade.
But first, to fully understand this trade, we must understand delta. Delta is the rate of change of a derivative with regards to a change in the underlying. The spot and these perpetual/future derivatives are tied to the price of Bitcoin, and both have a delta of 1, meaning if BTC moves $1 both the Perp and the Future should move the same amount. Therefore, using opposing positions of the exact same size puts us in a delta-neutral position. If Bitcoin increases by 2% our short will go negative 2% but our long will go positive 2%, thereby offsetting any loss or gain we might have received. When structuring a portfolio in this manner you need to be wary of the execution risk, meaning if the legs execute at different times and different prices you won’t be Delta neutral and will be exposed to outsized market risk in the interim. This risk of the market moving away from your original target price is often referred to as ‘leg risk’.
In addition to the spot based carry trades, there are ways to structure carry trades in the futures space, first, Perp vs. Future with a Fixed Maturity, and second Fixed Maturity Future vs. Fixed (Different) Maturity. Today we will be covering the former. Why you might ask? Well fundamentally, the two derivatives might have a different implied carry rate - which of course means you can buy one and sell the other and make a return. And the more astute amongst you may have noticed…. There is no need for cash since both sides are derivatives so the yields can be significantly magnified!
Let’s assume you thought Bitcoin was going to trade sideways for a while, but the consensus was bearish and funding was negative. What could you do? A simple way to express your view would be to:
- Long 100k Perpetual
- Short 100k BTC 0930 Future
Here is a short video explaining how to execute this specific trade on Paradigm.
The goal here is to collect funding. In the scenario we described, most traders are bearish and thus short the perp, meaning funding is negative and short traders are paying an interest rate to longs.
For ease, let’s just assume you had one contract on, meaning you were long one BTC perp contract and short one Future contract. Funding earnings get paid out every hour and might look like the chart below.
In 6 hours you would have earned $279 on one contract. Our portfolio allows us to be delta neutral (not exposed to directional risk) while at the same time collecting a nice interest rate. The risk, of course, is that over the life of the trade funding turns positive and we have to start paying the rate on our position instead of receiving it.
Trades where you are only exposed to trading the basis we broadly classify as delta neutral.
We have focussed a lot on the yield seeking risk taker in this article but also bear in mind that most people who buy one future and sell another future are simply hedgers, who are simply rolling their now expiring hedge into another tenor. Spread trading is a real boon for these guys, since they are able to buy one leg and sell another in one go without first waiting for their existing future to expire.
The entry of Paradigm to the basis trading space has been a game changer. For those of you who don't know Paradigm is an institutional liquidity network that connects you with market makers for pricing on derivatives. It has become very simple to execute any kind of spread on Paradigm since market makers give you a package price on both legs. This means regardless of whether you are doing spot vs. future or perp vs. future or even doing two options at the same time, you always have atomic execution so you never have to worry about the leg risk we described above.
"Outside the fact that you can now do cash and carry or roll futures hedges without leg risk, the pricing benefits of trading as a spread are often overlooked. Since you are not taking leg risk the person who is making you the price also doesn’t have leg risk, and so market makers who price spreads make it a lot tighter than outright futures.”
Sohan Sen, Head of Asia Sales, Paradigm
Finally, because Paradigm has integrated with FTX the cash and carry component of the offering will be a massive draw to non-traditional crypto investors. The Cash and Carry trade is a big flow (especially in alts) and as FTX is one of the most liquid exchanges with some of the highest spot volume, we should be able to get incredibly tight pricing from Market Makers when executing for those yield-seekers. Most importantly for these price sensitive degens is that its 50% off exchange fees - so you are ALWAYS better off trading the cash and carry as a package rather than trying to leg into it on exchange! Can't wait to see what degens get up to when they can get in and out of spot/perp or spot/future so easily!
We have covered a lot of ground above but the core of the ability to deal spreads very tight and with atomic execution is a big step for creating a longer-tenor hedgeable yield market. It will also undoubtedly lead to improved liquidity in the longer tenor derivatives which will allow more term liability hedging. This evolution in crypto to more sophisticated, and more conservative strategies will be good for the entire industry as a whole. Less leverage and less volatility lead to less 50% draw downs, this subsequently leads to less scrutiny and vitriol from unfriendly regulators. It will be interesting to see how some of the more traditional strategies are received and adopted by the “degen” crowd. Strictly speaking for ourselves, we are very excited to have a place to execute our Cash and Carry trades safely and efficiently via Paradigm.
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