Where's The Yield (Curve) - Pt 2

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June 28, 2022

An article by Richard Excell at the University of Illinois @ExcellRichard

Richard Excell is a Clinical Assistant Professor of Finance at the University of Illinois, Gies College of Business. He retired as a Senior Portfolio Manager at Wolverine Asset Management in Chicago where he ran a global equity long/short hedge fund portfolio. Before joining WAM, he was the CIO and a partner at Satori Investment Partners. He spent the majority of his career with UBS O’Connor, where his last role was Managing Director, Senior Portfolio Manager, and Co-Head of the Fundamental Equity Market Neutral Fund. Earlier in his career, he built and managed foreign exchange, precious metals, and emerging market cash and derivatives trading businesses around the world while with O’Connor, First Chicago, BZW (Barclays Capital), and Crédit Agricole Indosuez and has lived in Japan, Hong Kong, Singapore, Switzerland, and the UK.

Paul Tudor Jones

"The whole world is nothing more than a flow chart for capital.”

This month I want to continue the discussion of how the DeFi and TradFi worlds have come together and how that will eventually affect and disrupt both markets in some ways. Last month we spoke about how asset allocation occurs and what DeFi traders and investors needed to understand about how this could impact the flow of capital. This month, we want to continue to speak about that flow of capital but take a different look. This month, I want to discuss futures spreads. 

Before I discuss the spreading of futures, I want to cover some basics. For most of you, I understand this is redundant. However, in my years of teaching, I have always found that covering the basics is a useful starting point.

Dojima Rice Exchange - World’s First Futures Exchange

In the Edo period (1603-1867), most of the rice collected by feudal domains as tax was transported to major cities, such as Osaka. Feudal domains sold tax rice stored at warehouses and residences around Nakanoshima to rice brokers through auctions and issued rice bills (notes promising to exchange for rice) to successful bidders. The rice bills, including those to exchange for rice to be delivered to Osaka, were actively traded.

In 1730, the Tokugawa shogunate authorized a spot market to trade rice bills and a futures market to trade representative brands of rice on a book in Dojima. This marked the inception of an official market known as Dojima Rice Exchange, which was equipped with a membership system and clearing function similar to exchanges in the modern era and is widely known as the forerunner to organized futures exchanges in the world. Ironically, prior to this authorization, many of the elites (including the samurai whose income was tied to rice prices) thought the merchants who wanted to trade the rice futures just wanted to gamble (sound familiar?). It wasn’t until the price of rice went lower in the 1720s that the samurai saw the need to hedge themselves. Funny, how people’s fundamental views can change in a bull market vs. a bear market.

The rice price formed at Dojima Rice Exchange was disseminated by couriers or flag signals across hundreds of kilometers, reaching the capital and other major cities. Many of the trading rules and practices developed in Dojima were carried over to commodity, equity, and financial futures exchanges afterwards. In fact, the Japanese candlestick technical charting, that many use across a range of assets today, began with the trading of rice futures.

Commodity futures moved to England, where the London Metal Exchange was formally created in 1877. One of the oldest commodity exchanges happens to be in North America, though. That's the Chicago Board of Trade (CBOT), which was founded in 1848. The common thread on all of these exchanges is that there is a vested interest of the end-users of the product and those who take the risk as intermediaries to have a transparent price at which business can be conducted. This facilitates more liquidity, more volume, and more smoothly functioning markets. Of course, there are speed bumps along the way, in fact the London Metals Exchange had an ugly one in the nickel market this year. However, that doesn’t preclude the need to price discovery.

What is a future?

A future, also called a futures contract, is a financial contract between two parties—a buyer and seller. The buyer agrees to purchase a specific amount of product from the seller such as currencies, commodities, or other financial assets—whatever the futures contract is for—at a specified price at a predetermined date in the future. All the information is known at the onset of the contract. The buyer must purchase the product at the agreed upon price regardless of what the market price may be.

While this is the institutional application, most traders never take physical delivery of the asset whether they're barrels of oil, Japanese yen, or bushels of wheat. Rather, traders make and lose money based on the price fluctuations of the contract, with most traders opting to close their position before the contract expires.

Traders prefer futures markets because they can be extremely liquid, with very low trading costs. The big reason traders prefer futures is because the leverage that can be obtained in trading futures of any type of asset. A trader needs only to put up initial margin, or collateral, at the time of trade. Then after the price change each day, the trader puts up, or receives, maintenance margin which is the loss (if you must increase your margin) or gain from the day’s trading. It depends on the type of account and the portfolio margining used, but often the amount put up is about 10% of the value of the trade meaning a trader can get 10x leverage in trading futures.

Basis

How are futures prices calculated? Futures are calculated by adding (or subtracting) to the cash price another number which takes into account the cost of carry. This basis is the difference between the local cash price of a commodity and the price of a specific futures contract of the same commodity at any given point in time. Said another way, basis = cash – futures. Cash can be replaced with spot index price as well. I will use them interchangeably.

What goes into the basis cost? To fully understand the basis, it is necessary to understand the cost of carry. There are a number of costs associated with having an investment position. Factors may include financial costs, such as interest, and economic costs, such as opportunity costs.

Futures are not an asset, they don’t convey any rights of ownership, such as receiving dividend payments in the case of equities, or interest in the case of fixed income. However, the financial value, or opportunity cost, of those dividends is accounted for in the price of the Equity Index futures contract. When short-term interest rates (represented by finance charges) are lower than the dividend yields on the spot index, the cost of carry is said to be positive. When these finance costs move higher, as they are now, it is possible for this basis to change materially over time. Basis can switch from positive to negative. The shape of the futures curve can change. Let me show you some examples.

I mentioned above the basis for equity futures includes dividends and interest charges. As the interest rates over time are expected to go higher, this carry cost of holding cash is greater than the dividends the cash holder would receive. Therefore, it is more capital efficient to hold futures and thus the futures curve is now upward sloping. This is a market with negative basis. An upward-sloping futures market is called contango. The opposite would be backwardation. The e-mini S&P futures market has negative basis and is in contango.

Also see contango in Bitcoin futures, which can be traded on a variety of exchanges. Here I show the Bitcoin futures curve for the products traded on the CME. As there is no dividend, the basis comes down to the cost of carry alone and therefore the futures price = spot price * (1+risk-free rate).

Before I get into futures spreading, I want to quickly show you how the basis across a range of instruments can be very different. Both of the examples above show you that the basis is negative and we get an upward-sloping futures market. However, this is quite different in other markets. In the oil market, for instance, we also have to include the cost of storage and transportation costs. However, we also want to take into account the supply and demand for the commodity, which will change over time as a function of price among other things. Thus, the basis can change quite considerably. In this chart, you can see the current oil futures curve (triangles). You see the same futures curve a year ago in green and two years ago in blue. Basis has gone from negative to pretty flat to sharply positive over a couple of years. Markets can and do move from contango to backwardation and back.

Another interesting market to consider is the Eurodollar market. Eurodollars are the lending market of the world, or at least will be until the end of the year. All sorts of loan products – from bank loans to corporate credit to convertible bonds to stock loan to mortgages – are hedged via the Eurodollar market. We can see that currently, the market sees the Fed needing to move rates to over 4% in early 2023 (Rate = 100 – Price). However, rates are then expected to move lower from 2023 to 2025 before stabilizing. As trillions of dollars exchange hands via this market, it becomes a very good proxy of what all market players expect will happen with US interest rates. It is currently the gold standard for market pricing and a market the DeFi world will try to emulate as it further develops and disrupts.

Another market that may interest you is the VIX futures market. The cash VIX is not a tradable product, it is simply a calculation based on a constant 1-month S&P 500 futures option prices. The futures then become an estimate of where this cash price will be in the months ahead. Implied volatility, like in the VIX, has serial correlation and mean reversion properties. It is much like the weather. This means on any given day, a trader’s expectation of where implied volatility will be tomorrow is tied to where it is today – maybe a little hotter or a little cooler but anchored on today’s price. However, over time, we know there is mean-reversion and seasonality so very low prices today will be expected to rise in the future and very high prices will be expected to come lower. Right now, with the VIX above 34 or an expected 2% move per day in the SPX for the next 1 month, it is certainly elevated and expected to come lower over time.

This isn’t always the case, as 6 months ago the futures curve for the VIX was in contango (green).

As I mentioned above, institutional futures traders typically do not take delivery. However, this does not mean these traders will move out of futures and into cash as expiration approaches. Instead, traders will roll their futures position – from June to July etc. If we are in contango, a trader rolling their position is paying more to buy the further out future. This is what is referred to as a negative roll yield. In backwardation, it is a positive roll yield because as you roll your futures, you are paying a lower price. One way we can see the effects of this negative roll yield is by looking at various ETF products that track the futures market.

USO is an ETF that tracks the Oil futures market. The ETF will hold some combination of 1st and 2nd month futures, rolling a little each day. Recall two years ago the market was in contango. This means the ETF was slowly losing money each day regardless of whether the spot price moved higher or lower. We can see in the performance of USO vs. the constant maturity front month contract in Oil, when the market is in backwardation, the ETF can outperform; however, when it moves to contango it can lag meaningfully.

Lately, the ETF is doing a very good job of tracking the front month.

This roll yield is probably most pronounced in the VIX futures and ETF market. The VXX or VIX futures ETF consistently must pay a negative roll yield as the VIX futures market is often in contango with only brief periods in backwardation. You can see over the last year, the VXX is actually down even with the front month contract generally moving higher over this period. The futures basis and negative roll can be a massive drag on performance.

Futures spreading

There are a couple more topics to speak about. The first is futures spreading. There are typically three types of futures spreads. I will describe them all here, but really only two types are relevant for our purposes.

The first type of futures spread is the commodity product spread. For example, think soybean, soybean oil and soybean meal are three different futures that are traded. However, two are a byproduct of one. So there is a soybean crush futures spread that is quoted. This is the equivalent of buying soybeans, crushing them and turning them into soybean oil and soybean meal. The prices should be linked and are via the soybean crush futures spread. However, this is not really something that is that relevant for DeFi, though one might suggest that algorithmic stablecoins might have some component of that.

The second type of futures spread is the intermarket futures spread. This is where traders will trade the relative value or mean reversion of two highly correlated products against each other. Think Bitcoin vs. Ether, or S&P 500 vs. Nasdaq or Silver vs. Gold. There is a price relationship that can ebb and flow over time but where it is expected to stay within some range, at least over the life of the futures contract. Traders can then go long the futures on one product and short on the other. For example, in the current market malaise, a trader may think that Bitcoin will return to is dominance vs. Ether and look to buy BTC futures and go short ETH futures. With a 79% correlation over the last two years, there is a tightly held relationship between the two products. However, we can also see from the graph below, the products can also trend into and out of favor. This creates the opportunity for a second type of futures spreading called intermarket spreads.

The final type of futures spreading is called intramarket (within) futures spreads. These types of spreads are where a trader buys a future of one month and sells a future of another month. The trader is expressing a view on the changing basis in the futures market. Right now, that could largely be a function of the changing cost of capital. However, it could also be a function of the changing view on the opportunity cost as we have seen some major risk flares in the cryptocurrency market over the last month.

When I traded on the CME floor back in the day, I noticed that the savviest and crustiest traders stood in the back corner of the futures pits and all they traded all day was futures basis using intramarket spreads. As a young and naïve trader, I never understood why they wouldn’t be attracted to the allure of the delta 1 futures trading – buy or sell, go big or go home. As an options trader, I didn’t understand why they wouldn’t prefer options where you can make (or lose) money regardless of market direction. Now, however, I can see that they were able to take massive positions on the changing nature of basis, from interest expense, to dividends to supply & demand. It took people with a view on the economy, on central banks, on storage costs and on other traders positioning or supply/demand, thus the savviest and most experienced of traders. Small changes in these spreads could lead to massive gains and losses given the magnitude of the positions. We have seen above what a negative roll yield can do to a portfolio. Imagine what shocks to the basis can do as well.

Futures trading is increasing along with the increase in spot trading in cryptocurrencies. As more institutional investors enter the market, either as end-users, hedgers or speculators, there will be a need for sophisticated futures markets and futures curves to develop. We can see the volumes of just BTC and ETH futures below. This will surely go up over time.

Perpetual futures

The last topic I want to discuss, even if briefly, are perpetual futures or perps. This idea never really took off in the TradFi world. That market has preferred the dated futures that have defined expirations. It has worked well as volumes continue to increase each year. However, there is a big drawback to these products in the roll yield. If one is long a future, in a market in contango, there is a drag on your performance as you have to pay to roll it to the next month every 30 days or so. Of course, not every product has a negative roll yield and even those that do see this roll yield ebb and flow over time. What if you never had to roll your futures? What if the futures were perpetual instead?

The first benefit we can see is the logistics of not needing to remember when to roll your futures. If you miss your chance to roll your future, or you wait too long, bad things can happen. Remember when oil futures prices went negative? This only affected the traders who held the futures until the day of expiration. Most of the savvy futures traders had rolled out of the front month to the next month a week prior, before liquidity dried up, and went largely unaffected. With perpetual future, you don’t need to roll and so this could never happen.

However, there are still costs involved. Instead of using daily settlements, perpetual futures contracts use a different mechanism to maintain a direct relationship with the underlying asset — funding. Said another way, perpetual futures are tied to basis squarely via the funding rate. The execution of this occurs frequently as long and short traders exchange a funding cost periodically (say every 8 hours) to reflect the price expectations during each funding interval (i.e. the spread between the perpetual contract price and spot price) and the cost of funding.

Another feature of perpetual futures is that a trader can be ‘penalized’ for being on the right side of the market.

Per Coindesk:

"Because these types of trading contracts have no expiration date, they require a special mechanism to ensure the contract price tracks the spot price (current market price) as close as it can. This system is known as a “perpetual swap funding rate” and essentially involves long (buyers) or short (sellers) traders paying the opposite party a periodic fee, depending on whether the contract’s price is above or below the market price.”

Per Coinglass.com, these are the perpetual swap funding rates for a few coins across a variety of exchanges.

Coinglass.com:

"If the market price is lower than the perp futures price, long traders will be required to pay a fee to short traders to discourage more traders going long. Conversely, if the market price is higher than the perps futures price, short traders will pay a fee to long traders. Perp funding rates can often be a useful metric for gauging market sentiment around a particular asset.”

Paradigm’s angle

How can Paradigm help traders today? The market is sophisticated and getting more and more so each day. There are a variety of products on a variety of exchanges. There are a myriad of inter and intramarket spreads a trader can consider. How do you keep it straight and ensure the best price? The image below exemplifies how Paradigm beats the street as Paradigm’s market makers have provided a superior price and quantity for both the bid and ask on this simple intramarket spread at Deribit. This is what they do. Provide liquidity. Better prices, more quantity.

DeFi markets continue to evolve, adapt and disrupt. Cryptocurrency futures markets are really in their infancy. Recall, TradFi futures markets started over 300 years ago and we still find problems with them. It will take time. However, we know the development of futures markets, of futures spread and of the understanding of the drivers of basis, will attract more investors and more traders to create deeper, more liquid and more transparent markets that will allow for the development of more and more products to fit the needs of every investor. Most importantly, these futures markets allow for everyone to manage risk to the best of their ability and navigate volatile and panicked markets.

Paul Tudor Jones

"At the end of the day, the most important thing is how good you are at risk control.”
Article by
Richard Excell
Clinical Assistant Professor of Finance at the University of Illinois
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