Paradigm Insights | Where's The Yield (Curve) - Pt 1

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June 20, 2022

Perpetual futures contracts, AKA perpetual swaps or perps, were a massive success when they began trading back in 2016 and still are today. Economist Robert Shiller first wrote of such a product back in 1992, but it took the innovative cryptocurrency market to take that concept to market.

Perps have some characteristics that opened crypto to a large pool of new traders.

• Leverage can be set incredibly high. Exchanges allowed leverage as high as 100x, and relatively low levels of margin accompanied leverage.
• Perps never expire and don’t need to be “rolled,” whereby tradfi traders must close a futures position in an expiring contract and open a new position in another expiration month.
• Perps are often established as “inverse” futures, whereby a cryptocurrency is the payout currency not fiat. The payout in crypto allows traders to move their trading collateral in and out of the exchange more easily as they’re moving crypto via the blockchain and not USD or another fiat via cumbersome bank transfers.
• You can short perps. Not an easy thing to do in the spot crypto market given that ‘borrowing to short’ was still not liquid.

The ability to short is shared with dated futures as is leverage on a smaller scale. Beyond the fact that they never expire, one other glaring difference between perps and dated futures is the funding method used to keep perps aligned with the underlying spot market.

Two types of futures contracts in crypto:

• Dated - kept in line with an underlying’s price by settling near expiration price
• Perps - kept in line with an underlying’s price by Funding Rate payments

Dated futures prices are connected to their underlying product because when the dated futures contract expires and settles, its price should match or be very close to the price of the underlying asset. Traditionally, expiring futures in tradfi could be delivered vs. the underlying spot market thus, the prices should converge at expiry. Some contracts are not physically delivered, and upon expiration, they settle on a cash-settled basis in fiat (normally USD). Those short the contract at expiration must deliver either the underlying physical asset or its cash equivalent, depending upon the contract specifications. Traders who are long at expiration would take delivery. This settlement process is a natural driver of bringing dated futures contracts toward their spot equivalent, especially as you approach expiry. It’s worth noting that delivery of futures contracts is a rare event as positions are generally closed before expiration.

Perps don’t have this same draw to the spot priceas they don’t expire. Perps are kept in line by applying what’s known as a Funding Rate. Funding Rate calculations and practices vary a bit among exchanges, but from a high level, Funding Rate payments keep perps tied to their underlying crypto instrument by transferring funds from winning trades to traders on the wrong side of the trade when perps move outside of a deviation band connected to the underlying. In a nutshell, when perps rally faster than the underlying index, long traders will compensate short traders for their losses. This transfer of funds is intended to encourage those on the right side of the trade to close their positions which would pressure perps back toward their spot price.

Yield Curves

TradFi futures are going through a monumental shift at this time. This is related to the massive undertaking of replacing LIBOR with SOFR.

LIBOR is the London Interbank Offered Rate, the interest rate banks pay when they borrow from other banks. LIBOR rates have traded in the futures market through Eurodollar futures, AKA euros. Eurodollar futures reflect what the market expects U.S. 3-month interest rate levels will be in the future. The replacement, SOFR, is the secured overnight financing rate and pretty much the same thing. Banks live and breath LIBOR and, more specifically, the LIBOR curve.

Banks borrow short-term and lend long-term. Essentially this means banks borrow money for themselves using short-dated instruments. They’ll borrow money from other banks overnight or for a few days/weeks/months. They’ll lend that money out to individuals and businesses on longer terms, perhaps a five-year auto loan or 30-year mortgage. When short-term rates are lower than long-term rates, bankers are making the spread. Looking at today’s rates, banks could borrow for three months at a rate of 1.16 and sell a five construction loan at 2.92. They’re effectively “earning” the spread here, buying at 1.16 and selling at 2.92. There’s a bit more to it than that obviously which is that the bank is running duration mismatch risk. But they can hedge that five-year loan in the futures market using a number of instruments like Eurodollars/SOFR or 5-yr Treasury Note futures. That’s their lifeboat which allows them to hedge the mismatch. The existence of these futures contracts are essential to the growth of the fixed rate loan market.

This connection to the lending market drove massive volume in Eurodollars futures, and for many years, Eurodollars were the most active futures contracts in the world. Banks relied on Eurodollars for hedging purposes, and proprietary traders loved trading Eurodollars because of the ability to speculate on changes in the yield curve.

Ah, yes. The curve. Loans come in all shapes, sizes, and durations. Lenders need the curve. The curve indicates when to lean in on issuing more loans and when to dial back. The curve also gives them numerous outlets for hedging. There are multiple futures contracts along the curve so banks can find an instrument that closely matches the period of their loan exposure. They needn’t fit a round peg in a square hole.

Herein lies part of the problem in crypto as a financial instrument. As is, crypto lenders use perps for much of their hedging, where the greatest liquidity exists. As perps are tied to the spot market, lenders are effectively hedging with current conditions for an obligation that has a duration of say three months. Their risk is where crypto, we’ll say BTC, is trading in three months, not today. They may then roll their exposure out to a dated futures contract and more closely align their risk, but initially, they’ll use perps. Unfortunately, dated BTC futures do not have much liquidity as you move out their curve.

Back to Eurodollars, contracts are offered with expiration dates spaced out every three months. When you line these contracts up by their interest rate or yield, you have a curve. A beautiful curve that expresses the market’s opinion of interest rates in the future. This is similar to the classic Treasuries yield curve that traders and economists watch as an indicator of the state of the economy. The Treasuries curve is often cited as a leading indicator of changes in the economy. It’s often said that when the yield curve inverts, short-dated Treasuries yield more than long-dated Treasuries, it’s an indication that the economy is headed into recession.

These yield curves are the single most relevant market indicators in trading. These yield curves project lending rates and what you, the consumer, may be paying on your credit card, car loans, and home mortgages. Every other market keys off of interest rates and yield curves. Equities, FX, metals, commodities…they all key off interest rates and share/direction of yield curves. Banks lived and breathed LIBOR.

These yield curves are a glaring hole in crypto offerings. Bitcoin futures at most exchanges only go out a few months and they don’t reflect interest rates. Real interest rates at which loans are transacted. They’re improper hedges.

Dated futures and yield curves also open up the prospect of trading calendar spreads. Calendar spreads are spreads composed of two or more expiration dates within the same product. As noted earlier, dated futures are drawn to their underlying spot price and generally expire near the same price as the spot. Dated futures further out the curve tend to hold a premium and generally will not be priced exactly at the basis level. In fact, the further away the expiration date is of a futures contract, the further away from its spot it may trade. So as a series of futures contracts, we’ll say a contract expiring in June and a contract expiring in September move toward the expiration date for June; it’s likely the June contract will move toward the basis more quickly.

The image below shows BTC futures at Deribit and a simple spread of 24 June ‘22 futures (dark green) - 30 September ‘22 futures (light green). The price differential, AKA spread, is indicated by the white line. The spread hit a low of -1249.5 in January. Since that time, bitcoin has fallen a great deal and you can see the June contract has fallen much more than the September contract. Now, five months later, the spread price has rallied to -251.5. That’s a 5x return while bitcoin fell ~ 33%. Dated futures must move toward their basis and contracts dated near to expiration are likely to move toward their basis more quickly. It’s that simple.

The need for a crypto yield curve is about more than just yield. There are yield products out there. Look at the red-hot DeFi Options Vault (DOV) space as an example. That yield, however, is for income. Crypto needs a space for hedging yield. A highly liquid two-way market where lenders and speculators can experience rich price discovery and easily offset their risk. Interest rate derivatives are the lifeblood for TradFi futures. Open interest (OI) for Interest Rate derivatives at CME Group dominates. This is a massive opportunity for the crypto space.

In the meantime, while we wait for the crypto fixed income market to evolve, we still have BTC, ETH, and other futures. BTC futures at Deribit certainly have a curve, and you can find volume and open interest through the first few dated futures. At the time of this writing. BTC 24 Jun 22 futures and 30 Sep 22 both have open interest of $230+ million, but OI drops sharply from there with 30 Dec 22 showing an OI of$73 million.

The lit market doesn’t always have the robust liquidity required to move in and out of listed crypto futures without impacting the market and suffering slippage. Paradigm has a solution for that. Paradigm’s institutional OTC liquidity network allows traders to execute block trades that are frequently filled at prices and quantities that are better than what you’ll find on the native exchange screens. Our market makers live inside the bid/ask you’ll find on the screen.

The image below exemplifies how Paradigm beats the street as our market makers have provided a superior price and quantity for both the bid and ask on this simple calendar spread at Deribit.

As legacy fintech participants continue to migrate toward crypto, you can bet that they’re going to demand and install many of their legacy tools. Some say that as crypto matures, it will take on many more attributes of the legacy crypto fintech space. Dated futures, and yield curves, are certainly areas to watch for more innovation in crypto. As the TradFi crowd continues to migrate to crypto, expect more and more of the traditional tools and protocols to emerge and prominent components in the crypto ecosystem.

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