The cryptocurrency market is booming. How are professional investors making stable profits?

Original Title: "How High-End Players Stabilize Profits in a Volatile Bull Market?" Author: Sanat Rao, Founder of the Crypto Hedge Fund Gamma Point Capital, Translated by: BlockBeats

In a bull market, traders can easily lose their direction. Yesterday, everyone in the village might have been shouting, "Charge!" Today, you might see a crowd packed on the rooftop.

Yes, it's hard to predict the market, or rather, it's hard to hit the nail on the head every time.

So besides being friends with time, what other strategies can avoid the systemic risks brought by market fluctuations?

The answer may lie in market-neutral strategies.

In traditional financial markets, quantitative institutions have mastered market-neutral strategies. Of course, seasoned traders have also brought this strategy into the crypto world. However, the empowerment of DeFi has allowed for limitless imagination regarding crypto assets, and the ways to play in the crypto world may be more than you think.

As a crypto hedge fund, Gamma Point Capital is deeply involved in secondary investments, high-frequency market making, arbitrage, and liquidity mining in the crypto market. In this article, Gamma Point Capital's founder Sanat Rao summarizes how to efficiently utilize various tools for neutral strategy trading in the crypto world.

BlockBeats has translated the original text for crypto traders to reference and learn from:

2020 was a turbulent year. Due to the threat of the COVID-19 pandemic, economies around the world were severely impacted, and the Federal Reserve lowered interest rates to near zero to help accelerate economic recovery. The savings bank rates worldwide reached historical lows.

According to Bankrate data, the highest annualized interest rate offered by banks in April 2021 was only 0.5%.

In contrast, the cryptocurrency market is rapidly institutionalizing through its robust derivatives and lending markets. Decentralized Finance (DeFi) has quickly become the "killer app" of the crypto market and will change the architecture of financial services in the future—DeFi uses on-chain smart contracts to completely bypass traditional centralized financial intermediaries and rebuild its primitives (banks, exchanges, asset managers, etc.) in a more efficient and transparent manner.

These developments have brought astonishing fixed-income opportunities to the crypto world.

Market-Neutral Strategies

Market-neutral strategies refer to strategies where the returns of positions are independent of market direction, making them an ideal choice for investors looking for high risk-adjusted returns measured by a high Sharpe ratio. An ideal market-neutral strategy generates returns without taking on market direction risk, thus can be viewed as a fixed-income strategy.

This article introduces methods for obtaining fixed income using market-neutral strategies in the crypto and DeFi markets.

Notes:

This article does not list all market-neutral strategies. For example, we do not cover using options strategies to generate income, etc.

For simplicity, we have organized the recommended strategies from low complexity to high complexity, starting with basic crypto savings deposits and ending with hedging liquidity mining models.

CeFi and DeFi Lending

Annualized Yield Range: 6-12%

Complexity: Low

Centralized Lending Platforms (CeFi)

The earliest lending platforms in the crypto ecosystem are large professional crypto lending platforms such as Blockfi, Celsius, and Vauld. Investors can open accounts with these companies (similar to bank savings accounts), deposit their crypto assets, and earn interest.

At the time of writing, here are the lender yields for some leading crypto assets like USDC, BTC, and ETH:

Investors should note that these platforms are not insured by the FDIC and carry all traditional counterparty risks (these lending platforms lend your deposited assets to borrowers who may default) as well as broader "systemic" crypto risks. This is a good entry point for investors seeking relatively low-risk investments.

DeFi Lending Protocols

The traditional lending industry relies on underwriting and legally binding contracts to determine default risk and enhance creditworthiness. For example, when you apply for a loan from a bank, you need to provide pay stubs, credit history, etc., and then the bank determines whether you are approved for the loan. Once approved, you must sign a legally enforceable contract that can be enforced by the courts.

In decentralized finance, there are no intermediaries; users can borrow anonymously, with smart contracts and over-collateralization liquidation mechanisms replacing intermediaries. The total value of collateral provided by borrowers must exceed the value of the loan, and lenders can liquidate collateral through the open market. These mechanisms are enforced by software and apply equally to everyone, regardless of the borrower's creditworthiness.

Compound, Aave, and MakerDAO are early decentralized lending platforms and remain market leaders today. The following table shows an example of how Compound works:

Image Source: Compound Finance

As a reward for taking on high crypto risks and the significant demand for lending stablecoins in DeFi, lenders can earn much higher yields by "lending to smart contracts" than on traditional CeFi platforms. The following chart shows the lending rates for USDC on three leading platforms. These rates are consistently higher than those of centralized lending institutions.

Image Source: Compare High Interest Accounts

In summary, lenders convert their dollars into USDC (stablecoin) and store these assets in Compound to earn 14.31% interest! Of course, interest rates fluctuate regularly, and lenders bear all DeFi risks (smart contract risks, rug pull risks, etc.).

Basis Trading

Annualized Yield Range: 20%-50%

Complexity: Medium

In traditional commodities and forex markets, basis trading (also known as cash-and-carry trading) is a well-known arbitrage strategy. Futures contracts for crypto assets can be found on most major crypto exchanges (Binance, FTX, OKEX, etc.) as well as traditional exchanges (such as CME).

Typically, the trading price of futures contracts is higher than that of the spot market (this phenomenon is referred to as futures premium in financial terms). The term basis refers to the difference between the futures price f(t) at time t and the spot price S(t).

During a bull market phase, retail investors have a high demand for leveraged purchases of BTC and ETH futures contracts. At this point, t = α, F(α) >> S(α), and the basis is very high. Basis traders will buy the spot (i.e., go long on Bitcoin) and sell futures contracts (i.e., go short on futures), thus creating a fully hedged position.

At expiration (t = ε), the futures price and spot price converge. That is, F(ε) = S(ε), and traders can close their positions (buy back futures contracts and sell the spot). By holding the basis position before expiration, traders earn the net profit of Basis(α). Since this profit has no price directional risk, we can consider it as fixed income return!

Essentially, basis traders provide leverage to retail investors at time t = α and earn the yield Basis(α) from it!

Here's a simple example:

On April 10, 2021 (t = α), the spot trading price of BTC was $60,264, and the futures contract price for BTC expiring on June 25 was $66,264.

That is, F(α) = $60,264 and S(α) = $66,264.

The trader buys 1 Bitcoin and uses it as collateral to sell about 663 BTC0625 contracts on Binance (each contract valued at $100). Since the long position in 1 BTC is hedged by the short futures position, the trader's risk is fully hedged.

When the expiration date of June 25 arrives, the prices of these two instruments will converge (unless systemic risk occurs).

By holding this basis position before June 25, the trader stabilizes profits = Basis(α).

Earning a 9.94% return over 3 months (about 77 days) translates to an annualized return of 47.19%!

As long as the exchange (in this case, Binance) does not go bankrupt during this period, this is a risk-free return. This is because once the spot and futures prices are locked in, they will converge, and the difference between them minus transaction fees is the profit.

This chart shows the rolling basis of BTC over the past few months. During the bull market phase, this basis has been well above 30%.

Image Source: skew. - Enter Cryptocurrency Markets

As always, the complexity of this trade lies in timing the entry (when the overall sentiment of the underlying asset is bullish) and optimizing for slippage during trade execution.

Perpetual Contract Funding Rates

Annualized Yield Range: 10%-160%

Complexity: High

Perpetual contracts, also known as perps, are unique derivative instruments in the crypto market. Perpetual contracts are similar to futures contracts but have two differences:

1. Perpetual contracts have no expiration date, and;

2. The price of perpetual contracts closely tracks the spot price of the underlying asset.

Perpetual contracts allow traders to speculate on asset prices without holding the actual asset. For example, if a user predicts that the price of the underlying asset (BTC) will rise, they can establish a leveraged long position by purchasing BTC-PERP contracts; if the user predicts that the price of BTC will fall, they can establish a short position.

The funding rate of perpetual contracts is a mechanism that keeps the contract price aligned with the spot price of the underlying asset. The payment of the funding rate is a series of continuous payments between longs and shorts in perpetual contracts, but it can also be a way to generate income.

Funding Rate Premium

At a given time interval (usually every eight hours), the exchange calculates the time-weighted average price (TWAP) of the perpetual contract and the TWAP price of the spot. The formula for calculating the funding rate premium is:

If the premium > 0, the market is bullish, and longs must pay the funding rate to shorts, incentivizing those on the opposite side of the market to push the marked price toward the index side.

If the premium < 0, the market is bearish. This leads to shorts paying longs, incentivizing those on the opposite side of the market to push the marked price closer to the index price.

Funding Rate Interest (One)

From an interest perspective, the funding rate can be viewed as the difference between the borrowing rates of the perpetual contract quote currency and the underlying currency. Therefore, the interest rate can be seen as the cost of holding a perpetual contract position. Most trading platforms use a fixed amount for the interest rate (for example, Binance's rate every 8 hours = 0.01%).

Funding Rate and Rate Payments

The funding rate formula is relatively complex. Binance uses the following formula:

Traders can use perpetual contracts to earn funding rates as follows:

Determine that the funding rate for a certain contract over a period (e.g., 3 days or 1 week) is consistently greater than 0.

Buy x amount of spot (e.g., BTC) and use it as margin to sell x perpetual contracts (e.g., BTC-PERP). The trader's price volatility risk for the BTC position is now hedged.

As long as the funding rate > 0, the trader will earn a funding payment every 8 hours based on the above formula!

Undoubtedly, this is a complex trading position that requires constant monitoring, but if executed properly, the returns can be quite substantial. For example, over the past 3 months, the SUSHI-PERP contract on Delta Exchange had an average funding rate of 0.15% every 8 hours. This would yield a monthly return of 13.5% == 162% APY.

Image Source: Delta Trading Platform

DeFi Hedged Mining

Annualized Yield Range: 10%-300%

Complexity: High

What is Liquidity Mining?

Liquidity mining refers to using crypto assets to provide liquidity to different DeFi protocols to generate returns. Broadly speaking, there are three forms of yield in the DeFi world:

Trading Fees: "Farmers" (also known as liquidity providers) provide liquidity funds to DeFi pools and earn a certain percentage of trading fees. For example, Uniswap charges a 0.3% fee on each token trade and proportionally transfers that fee to liquidity providers.

Governance Token Incentives: Liquidity providers can also receive governance tokens of the protocol as incentives. For example, the leveraged mining protocol Alpha Homora is currently distributing 237,500 ALPHA tokens to liquidity providers who establish leveraged mining positions during the two weeks from March 31 to April 14.

Staking Fees: Some protocols offer additional incentives to users who lock up (also known as "stake") governance tokens. For example, users who stake SUSHI tokens can earn 0.05% of trading fees.

Liquidity mining is a high-risk activity that poses significant risks to all participants, including smart contract risks and rug pull risks. Liquidity providers need to consider three types of financial risks:

Price Risk: Liquidity providers deposit tokens A and B into a pool to earn fees, and they are clearly affected by price fluctuations of these tokens (since liquidity providers hold long positions in A and B).

Impermanent Loss: This is the loss incurred by liquidity providers because the prices between token pairs differ from when they entered the pool. This is a simple explanation of impermanent loss.

Gas Prices: Gas on blockchain networks (such as Ethereum) is the fee paid to miners for executing instructions in smart contracts. During periods of high demand, gas prices can skyrocket and eat into the profits of DeFi liquidity mining.

Therefore, the net profit from liquidity mining can be calculated as:

As we can see, the net yield is severely affected by price fluctuations of A and B. However, we can hedge this risk using futures contracts.

Hedged Mining Example

The following outlines the process of obtaining predictable returns through liquidity mining:

Image Source: CoinGecko

In the above image, a liquidity provider notices that the Onsen SUSHI/WETH pool on Sushiswap currently has an astonishing APY of 154.2%.

This user's capital is $250,000. They purchase $100,000 of SUSHI (Token A) and $100,000 of WETH (Token B) on a DEX or DEX aggregator (like 1inch).

Then, this user sells $25,000 of SUSHI-PERP (4x leverage) and $25,000 of WETH-PERP (4x leverage) contract positions on a centralized exchange (like FTX). This ensures that the price volatility risk from positions A and B is hedged. [However, if the price of A or B rises sharply, the 4x leverage does pose a liquidation risk.]

The user deposits A and B into the Sushiswap pool.

The user regularly withdraws the X SUSHI reward tokens they receive and stakes the SUSHI again.

After 4 months, the user withdraws funds from the pool (earning trading fees and tokens), closes the futures position, and sells A and B tokens for fiat currency. The user sells their staked X SUSHI tokens at the market price P at that time.

The user's net profit is:

Needless to say, the process of hedged mining is relatively complex. In return, the liquidity provider's position is not affected by price fluctuations and can earn market-neutral returns.

Conclusion

Today's crypto ecosystem, bolstered by decentralized finance, offers opportunities for substantial returns.

But it is important to first note the reasons these yield opportunities exist:

Demand for Leverage: Retail investors in the cryptocurrency market have a very high demand for leverage during bull markets, which increases returns. Traders providing this leveraged liquidity have the opportunity to earn profits.

DeFi Incentive Mechanisms: New DeFi pools will complete "liquidity cold starts" by offering governance tokens to early liquidity providers.

Low Barriers to Entry: Borrowers, lenders, liquidity providers, and traders in DeFi can freely transact with each other without regulatory or national restrictions. As more participants flood in, protocols will earn more trading fees and distribute them as returns to liquidity providers.

As more and larger institutions enter the market, and with the influx of significant capital, these yield opportunities may diminish over time. I believe we are still in the early stages of the crypto market's neutral phase, and these opportunities will continue to exist in the coming years.

Investors seeking high "risk-adjusted returns" can achieve better returns by adding neutral strategies to their portfolios.