# Paradigm Insights | Basis Basics - Pt 3

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September 8, 2022

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In this final edition of our basis trading series, we discuss interest rate arbitrages between futures premiums and DeFi interest-bearing instruments.

### Overview

In previous parts of this blog series, we introduced basis trades and the relationship between bases and crypto asset interest rates[1][2]. Here, we focus our attention on a class of basis-like trading strategies which utilize yield generation from smart-contract based financial applications, i.e. “DeFi applications”[3]. We give a survey of current on-chain yield generation strategies, and we give actionable guidance for the implementation of delta-neutral basis+DeFi trades.

This post has three components. First, we review the relationship between the basis and crypto interest rates. Next, we give a survey of alternative yield-generating opportunities. Then we give a demonstration of how these yield-generating strategies can be paired with futures in a basis-like arbitrage. Finally, we conclude with some historical evidence for the existence of these trades.

### Review of futures interest rate arbitrages

In part 1 of the series, we defined a spot-futures basis $$b$$ as the difference between a futures price $$p_f$$ and a spot price $$p_s$$. We also defined the basis percentage, $$b_\%$$.
\begin{align*}
b & = p_f - p_s \\
b_\% & = \frac{p_f - p_s}{p_s}.
\end{align*}

We showed that when the basis is positive, traders can receive a fixed interest rate by shorting futures and buying spot asset, i.e. shorting the basis.

In part 2 of this series, we showed that traders can also achieve higher overall interest by holding only a minimal amount of the spot asset as collateral and lending the rest. If the spot asset A purchased can be lended at a rate of $$r_A$$, and the trader lends proportion mm of their A holdings, then their rate of return is

\begin{align*}
r_\% = b_\% + mr_A
\end{align*}

Some centralized exchanges allow account leverage of as much as 100x, therefore mm can be close to 11. Thus, if $$r_A$$ is significant, then $$r_\%$$ can increase well past the baseline basis return $$b_\%$$; in fact, it is possible that even when $$b_\%$$ is negative, $$r_A$$ is large enough to make the short basis trade profitable.

Here, we generalize this short basis trade to include any interest-bearing opportunities for asset A. We survey examples across various smart contract blockchains where traders can tender asset A to earn interest.

### Defi money markets

Smart contract blockchains, such as Ethereum and Solana, enable replicated computation across a decentralized set of nodes. While simple ledger blockchains like Bitcoin are limited in their applications’ expressivity, smart contract blockchains allow any application that can be run by a regular computer to be run in a publicly verifiable manner.

In the same way that Bitcoin enables users to hold balances without trusting a single entity to maintain a valid ledger, smart contract blockchains enable users to perform computation without trusting the entities running that computation. Smart contract blockchains are particularly well-suited to host financial applications, such as money markets and simple exchanges, due to these limited trust requirements. The ecosystem of financial applications on smart contract blockchains have become known as Decentralized Finance, typically abbreviated as DeFi.

Here, we give an overview of some key DeFi applications that give traders the opportunity to earn interest on idle assets permissionlessly.

### Staking on proof-of-stake blockchains

One of the most predominant consensus mechanisms in crypto today is called Proof of Stake (PoS). On a proof of stake blockchain, there are blockchain validators who “stake” assets into a smart contract, and if they act adversarially to the protocol, there is a way for other validators to “slash” that validator’s stake[4]. Typically these blockchains give a reward to the validator for participating honestly.

Since proof-of-stake blockchains require validators to escrow assets in order to participate in consensus and get yields, there are staking markets which have arisen to bridge the gap between capital and validating capabilities. In these markets, stakers provide capital to validators, and validators and stakers share the profits accrued by staking. Stakers can achieve a mostly passive yield on their assets through this, and assuming they stake to a legitimate validator, this investment has limited principal risk.

If a volatile-price asset A can be staked for a high interest rate, then traders can simultaneously buy A and short its perpetual, then stake some of the A spot to validators. This achieves a higher rate of return than simply shorting A’s basis, however users must accept risks associated with the validator application. Chiefly among these risks is the possibility that the validator gets slashed, thus losing all of the principal invested to that validator.

### Lending on DeFi applications

Motivated by the appealing security properties of blockchains, some companies have started lending companies whose logic is codified into smart contracts [5][6][7]. These projects closely resemble margin lending that is available on centralized exchanges: borrowers can collateralize asset A to take out a loan of asset B. This makes it possible for traders to short an asset or get leveraged exposure of an asset.

In order for users to borrow, there must exist a pool of asset from which those loans can be drawn. The demand for loans and the supply of loans reaches equilibrium at an interest rate greater than zero. Lenders can provide their assets and passively earn interest.

If a volatile-price asset A has a high interest rate, then traders can simultaneously buy A and short its perpetual, then lend some of the A spot. This achieves a higher rate of return than simply shorting A’s basis, however users must accept risks associated with the lending application.

### Yield aggregation vaults

As the number of DeFi applications increases, maximizing the interest rate earned on supplied assets becomes more challenging. To make this easier, some DeFi applications have created automated yield aggregators that supply assets to the most profitable lending applications[8][9]. The user interface on these applications is similar to that of lending applications: lenders supply assets and passively earn yields.

If a volatile-price asset A has a high interest rate in a vault, then traders can simultaneously buy A and short its perpetual, then deposit some of the A spot into the vault. This achieves a higher rate of return than simply shorting A’s basis, however users must accept risks associated with the yield aggregation application.

### Voter escrow

There are a number of DeFi applications that are not only hosted on decentralized blockchains, but also maintained via a decentralized set of individuals. To make decisions on these projects, such as updating interest rate parameters or listing assets, there is typically a token that confers voting rights to its owners.

In an effort to filter governance participants by their conviction to the project, some projects require users to lock their token in escrow for a pre-defined time in order to receive voting rights[10][11]. To incentivize users to lock their assets and participate in governing the project, projects typically pay the lock-up value back with interest. This gives a smart-contract enforced rate of return, denoted in the lock-up asset.

If a volatile-price asset A can be locked up for a high interest rate, then traders can simultaneously buy A and short its perpetual, then lock some of the A spot. This achieves a higher rate of return than simply shorting A’s basis, however users must accept lock-up smart contract risks. Users must also accept basis risk, as it is possible that the basis interest rate, b%b%, increases during the lock-up period. This trade can only be perfectly hedged with futures expiring the same date as the termination of the lock-up period.

### Wrapping up

As we have seen, there are many smart-contract based venues for passively generating interest on crypto assets. Some of these opportunities can be performed without hedging by depositing a stable asset, however the richer subset of these opportunities involves depositing a volatile asset and simultaneously shorting that asset. This multi-leg trade resembles a short basis trade, but with added returns generated by the spot asset.

1. https://www.paradigm.co/blog/basis-basics-pt-1
2. https://www.paradigm.co/blog/basis-basics-pt-2
3. Decentralized finance is based on new technology. Nothing in this post should be considered as financial advice, and statements made here do not represent the opinions of Paradigm nor Xenophon Labs.
4. https://tendermint.com/static/docs/tendermint.pdf
5. https://compound.finance/documents/Compound.Whitepaper.pdf
6. https://github.com/aave/aave-protocol/blob/master/docs/Aave_Protocol_Whitepaper_v1_0.pdf
7. https://whitepaper.dydx.exchange/
8. https://docs.yearn.finance/
9. https://www.sommelier.finance/
10. https://resources.curve.fi/governance/voting#how-to-participate-in-governance
11. https://docs.balancer.fi/ecosystem/vebal-and-gauges/vebal/how-vebal-works
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