All eyes are on DeFi these days as brand-new tokens are posting triple-digit performances, but we will start this update looking at the good old BTC market. Carry traders have had quite a run lately, enjoying a 10%+ annualized contango. But where is this contango coming from? In other words, what keeps futures prices above spot?
Here is one simplistic answer to this question: the market is hot, so traders are buying BTC in bulk from liquidity providers. To hedge that flow, liquidity providers are tapping into the most liquid and cash-efficient hedges and buying delta-1 derivatives such as perpetual swaps and futures. Case in point, perp swap funding rates tend to explode higher when the market rallies. However, those funding rates quickly retrace when the realized vol comes off, whereas the contango does not deflate in a similar fashion.
There must be a different dynamic at play with respect to futures. The trail starts with the BTC hashrate. Let me explain:
- Hashrate has gone up nearly 30% YTD.
- This means miners are investing more and more in their operations by deploying new rigs.
- Just like all of us, miners do not have an infinite balance sheet. To buy new hardware, they need to borrow USD. Their collateral of choice is naturally BTC.
- To get those, miners don’t go to their local bank: they go to OTC desks.
This is where the magic happens. Leveraging futures, OTC desks convert a BTC collateral into USD without using a single dollar of their own balance sheet, and get paid for the service. This is how it works:
- Miner wants to borrow 100 USD against $150 worth of BTC
- OTC desk takes the $150 and sells $100 spot, generating $100 of fiat. This cash is lent to the miner.
- With the remaining $50 of BTC, OTC desk hedges its $100 short BTC delta buy buying $100 worth of exposure via futures. Ignoring margin requirements, this means they are buying futures with 2x leverage.
- OTC desk is now delta neutral, and the miner has received its loan.
- If the loan expires on a futures expiry date (ideal case), the futures position settles into a long BTC position that flattens the short spot BTC.
- If the futures curve is in contango, then there is a cost to entering that position: the difference between [spot price sold] and [futures price bought].
- That is fine! Remember, OTC desk charges an interest rate on the USD loan: the 0 PnL interest rate is the annualized futures basis. OTC desk charges a couple of points on top of that and voila, delta-neutral PnL generated without using a single dollar off of the OTC desk’s balance sheet.
There is, of course, a sizable risk to that position: the liquidation risk. The lower the collateral posted by the miner, the higher the leverage OTC desk needs to hedge the short spot with long futures position, and the lower the cost of trading. As competition heats up among OTC desks to win market share in the miner lending business, collateral ratios go down and liquidation risk goes up. This is exactly what we saw in March this year: a sudden drop in the BTC price generated a wave of long futures liquidation, sending the contango into a steep backwardation in a matter of hours on the largest derivatives exchanges.
Switching gears, let’s have a look at what has been going on in the DeFi world, focusing on Curve.fi, a.k.a. Curve. At its core, Curve is 7 different liquidity pools: 5 stablecoin pools and 2 Wrapped BTC pools:
The basic concept is that anyone can deposit their assets in such pools and earn a pro-rata portion of the fees the pool charges. For example, this is the current composition of the y pool:
That’s $634M of stablecoins deposited. That’s big. To give you a sense of how big that is, you could swap $100M of USDT for USDC for 6bps and USDC for USDT for 14bps (there is more USDC than USDT in the pool, so the pricing incentivises the former). Compare that to the order book on Kraken on USDC/USDT:
Of course, like all things DeFi, the main incentive for participating in such pools is that you get a token. In that case, CRV. Just like COMP, the higher the token price, the higher the annualized APY looks and the more enticing the opportunity. Unlike Compound, the mania around Curve has created something of great value for crypto traders: a seemingly bottomless stablecoin swapping facility that is incredibly cheap.
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