Stacking Yields
Earlier this week the Federal Reserve cut the federal funds rate by half a percent lowering the interest rate target between 1–1.25%. The effective fed funds rate (the volume weighted median of the inter-bank lending rates) now stands at 1.58%, a steep 82bp cut from this time last year. (Remember the Fed has generally been tightening — increasing the fed funds rate — since December 2015). Lowering the fed funds rate affects inter-bank lending rates and the impact trickles down to the consumer through lower yields on money market accounts and lower interest on savings. Will the US economy find itself in the same “lower for longer” narrative that dominated the eight years following the 2008 global financial crisis? Indeed, long-term interest rate forecasts (projecting the value of government bonds maturing in 10 years) suggest that the trend of low rates will continue. With this context, it comes as no surprise that investors — institutional and retail — are in a desperate search for yield.
2019 saw the equivalent of $17 trillion investment-grade European bonds turn negative yielding [1]. In the US, there was broad market rotation into bonds with over half of net ETF inflows going into high-yielding fixed-income and international fixed-income investments [2]. Morningstar Inc. reports that taxable-bond mutual funds and ETFs took in a record $414 billion while similar U.S equity instruments saw $72 billion in outflows. As of month-end January 2020, the total inflow to bond ETFs was a striking $850 billion, exceeding more than 2% of total assets [3]. There are many reasons — economic and social — behind the flow of assets into bonds. One factor is uncertainty. 2020 has had a dramatic start to say the least. We’ve seen nothing short of jarring geopolitical flare-ups, a US presidential impeachment trial turned acquittal, and a black swan global health pandemic causing economic rippling effects across nations. Against this backdrop of heightened uncertainty, investors are seeking asset allocation strategies that can offer improved yield and portfolio diversification. Although a market recession has not yet materialised, it is characteristic for asset managers and investors to reassess portfolio construction during times like this. One possible outcome is that asset managers turn to cash. Sure it may be unrealistic to expect this excess cash to be redeployed into crypto, but we may see some yield-seeking investors diversify into “crypto” via stablecoins on the back of demand for alternative income-generating opportunities.
Investing in any asset class is a constant search for yield pickup and crypto is no different. Ultimately, yields are a function of market supply and demand. Through central bank interest rate targeting, the traditional market relies on changes in the yield curve to understand broad market sentiment for both the short and long term. There is no central bank nor defined yield curve in the crypto markets (as of yet), but we can look to crypto futures and lending for an indication of market rates.
Some ways to achieve yield in crypto
- Simple carry trade
- Lockup incentives
- Centralised lending
- Lending through futures markets
Simple carry trade
A popular strategy for investors venturing into crypto is the carry trade: borrow low-interest-yielding assets and invest in higher-yielding assets. While cash deposits in US banks are yielding sub 2%p.a. in interest, dollar-backed stablecoins such as USD Coin (USDC) are currently yielding sub-10% p.a. on major centralised crypto lending platforms. Futures basis — the difference in futures and spot price — is currently 15%p.a. at the time of writing (March 4, 2020). You can see how yields offered in crypto appear relatively attractive to those being offered on your bank cash deposits.
Lockup incentives
A major driver of activity in crypto so far are fiat-backed stablecoins. They serve as the crypto on-ramp for many people who wish to trade on spot and derivatives exchanges, as well as for those looking to convert to platform tokens and generate additional yield. Staking (or “staking”) is one such lockup incentive. I point out staking in air quotes because although staking is technically a Proof of Stake token functionality, some platforms have generalised the term to simply mean giving up the right to liquidity in exchange for yield — regardless if POS or another blockchain like SLP. Some platforms like exchanges just require holders to leave/stake the token in a designated wallet in order for the holder to earn a yield. A simple source of passive income.
Here are some ways to “stake”:
Coinbase will give you a yield simply by holding USDC in your trading account
On ramp process: USD → Fiat-backed Stablecoin (USDC) → Earn a nominal APR% on your USDC
CoinFLEX, a physically-delivered crypto futures exchange, are offering % annualised yields on staked FLEX as a limited time promotion.
On ramp process: USD → Use fiat-backed Stablecoin (e.g. USDT) to purchase FLEX tokens→ Stake FLEX→ Earn a APR%
OKex are offering 20% annualised yields on staked DAI as a limited time promotion.
On ramp process: USD → Use fiat-backed Stablecoin (e.g. USDC) to purchase the Decentralised stablecoin (DAI) → Stake DAI on OKEx to receive 20% APR
Centralised lending
In their most recent Q4 2019 summary, Genesis Capital reports that their lending desk has seen steady quarter-over-quarter growth in cash loans. Notably, cash demand is a function of forward (yield) curve steepening and desire for higher leverage among hedge funds and miners who want to take advantage of various arbitrage (primarily in the derivatives market) and lending opportunities [4]. (Side note: the crypto futures market is currently in contango, with futures prices higher than spot prices. This means that people are willing to sell futures and buy spot. Widening spreads between futures and spot means steeper contango)
The challenge around optimising arbitrage opportunities in the derivatives market is that they are highly dependent on funding rates. The interesting thing about trading derivatives is the difference in funding rates across exchange contracts. Bitmex perpetual swaps, for example, calculates interest rate payments every 8 hours (24 hours/8 hours = 3 funding payments/day; x 30 days = 90 funding payments/month). The frequency of interest payment calculations means that your funding costs are variable. Meanwhile, in the crypto futures market, you are able to lock in one funding rate. Say for example you put on a short 1-month futures position, your basis is calculated upon expiry in one month. Amber Group explains that while positive carry trade opportunities may exist, you have to look at funding rates to assess the viability of arbitrage opportunities. They give the example where a delta hedged trade — long swap position hedged with short March futures — may look like an easy arbitrage (and thus realise positive carry), but only if the perpetual swap funding payment is lower than basis — the effective funding rate in the futures market [5].
Now certainly there are unforeseen risks that come with crypto trading. Let’s think through a possible scenario where the crypto market finds itself in a correction but funding rates remain positive. Now theoretically the market would go into backwardation, causing basis to go negative (futures would be lower than spot). But if prices don’t invert and the futures market continues to be in steep contango, markets would still be bid for cash. As mentioned earlier, major lending platforms are seeing most of their lending activity in crypto-backed cash loans. In fact, Dollar demand is so high (in contango, traders are willing to borrow to margin trade) that there is now dollar scarcity in the market (it was recently reported that Binance had a temporary shortage of USDT (Tether) and were unable to fund margin long trades). The problem in a market correction is that theoretically some borrowers would be liquidated out of their positions and be forced to default on their loans. The question for lenders would be how they can protect against this kind of market risk so that we don’t see a form of the housing market credit crisis appear in a crypto market recession. (A deeper dive for another time)
Lending through futures markets
As we have been discussing,the growth of the crypto futures market is providing unique income-generating opportunities. Binance Futures, for example, recently announced adding a BUSD cross collateral function.
Users will now be able to borrow USDT at 0% interest, using BUSD in their Exchange wallet as collateral, and without having to transfer BUSD to their Futures wallet.
Just as Binance successfully engineered BNB, their native exchange token, they are similarly turbocharging the use case for BUSD, their dollar-backed stablecoin. As I mentioned in an earlier post, the value creation lies not in the token model itself, but in the benefits/value derived from using the token. Given that BTC-backed cash loans are in high demand (especially by exchange operators), this presents a uniquely advantageous funding opportunity for borrowers. Traders effectively stake their existing BUSD for access to liquidity to trade futures without ever needing to move their collateral from their Binance wallet. Margin funding for BUSD is hovering around two-thirds (~9 p.a.%) of USDT funding, albeit capped at 120,000 BUSD.
This is just one example. Other platforms may also be working on similar margin trading/lending incentives, but as you know, rates in crypto are ever changing and the opportunities here today may be gone tomorrow. I hope this write up highlighted a few helpful insights on yield capture opportunities in the crypto markets.
Stack sats and stack yields. While supplies last!
*This article is for information only and must not be considered financial advice. Unless cited, views are my own and not that of Amber Group.
Sources:
[1] Ainger, John (2019). Bond World Is Backing Away From
All That Negativity as 2019 Ends. https://www.bloomberg.com/graphics/negative-yield-bonds/
[2] Gurdus, Lizzy (2019).Over half of this year’s net ETF inflows have gone into this one part of the market. https://www.cnbc.com/2019/12/05/51-percent-of-2019-net-etf-inflows-have-gone-into-fixed-income.html
[3] Zweig, Jason (2020). Bond funds are hotter than Tesla. https://www.wsj.com/articles/bond-funds-are-hotter-than-tesla-11581091201
[4] Ballensweig, Matt; Patel, Roshun; Marshall, Leon (2020). Genesis Capital Digital Asset Lending Snapshot 2019 | Q4 Insights http://genesiscap.co/insights/q4-insights-2019/
[5] Kullander, Tiantian (2020). Dollar Scarcity and Contango in Crypto. https://globalcoinresearch.com/2020/02/10/dollar-scarcity-and-contango-in-crypto/
