Drixx Academy/Cryptocurrency yields, interest rates and savings – what you need to know/

Cryptocurrency yields, interest rates and savings – what you need to know

Lawrence Zhou
Drixx Quant
January 26, 2021

Introduction

When we talk about the yield of a cryptocurrency, we are generally talking about interest rates. While the terms are not synonymous, they are very close over the short term, which is what we will examine here. So, when we refer to 10% interest rates (or APY -- annual percentage yield), it means that a $100 investment will return an extra $10 in 1 year.

As of 2021, central banks around the world are engaging in quantitative easing in a bid to stave off recession, which has pushed interest rates on traditional currencies to near zero or negative. In some countries, you might even end up paying a fee to keep money in a bank! To put things into perspective, let us look at the interest rates and yields on some traditional instruments. A FDIC-insured savings account at a U.S. bank might pay interest of 0.01%. Ten-year U.S. Treasury bonds are yielding around 1.1%. (https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield) Even moving up the risk curve does not change rates much. An index of short-term high-yield bonds (or junk bonds) might yield only 4-5%. (https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY)

In cryptocurrencies and decentralized finance (DeFi), the numbers are completely different.

Because of the novelty of the crypto ecosystem and the operational / risk hurdles in collecting cryptocurrency interest, interest rates average around 20-30%, and can be as much as 400% for the riskiest opportunities. Interest rates on cryptocurrencies can be highly volatile but are largely disconnected from broader non-crypto financial markets. We are going to learn about common sources of cryptocurrency yield on both centralized and decentralized platforms, while discussing their inherent risks and operational challenges. Finally, we will learn how the Drixx Yield Aggregation service makes these interest-earning strategies more accessible for investors by reducing risk and simplifying operational issues.

What are the Most Common Ways to Earn Interest in Crypto?

The four most common sources of crypto yield are lending, hedged roll yield, perpetual funding, and liquidity mining. We'll go on to explain what each of these terms mean, but first let's look at their APYs. Crypto lending on a DeFi platform like Aave or Compound might return up to 20% APY (depending on the asset). A hedged roll yield strategy on a centralized exchange might yield around 20% a year. A perpetual funding strategy could earn up to 40-50% APY. Finally, liquidity mining / DeFi yield farming can return up to 400% APY or even more, although the opportunities for this are generally temporary. The latter two opportunities can be highly volatile. For example, Ethereum perpetual funding rates may be 1% per day, or 3700% a year if compounded and sustained! However, these high-interest periods are rarely sustainable.

Crypto Lending

Lending in the cryptocurrency world is generally a form of securitized lending. This means that when you lend the borrower an asset, it is secured by their collateral. The borrower, or counterparty, is almost always overcollateralized - meaning that the value of their collateral is worth more than the value of the loan. If the collateral's value drops, the collateral is liquidated in exchange for the loaned asset - meaning the collateral is sold off in order to buy back the loaned asset - and thus the loan is repaid. Of course, the loan is not free: The borrower pays the prevailing interest rate.

Let us look at a simple example of this type of loan. Say someone borrows $100 USDC, a stablecoin currency pegged to the U.S. dollar, and puts up $150 worth of Bitcoin (BTC) to facilitate the loan. If the value of the BTC does not drop below a certain threshold set by the lending marketplace, nothing happens. However, if the value of the BTC drops close to $100, the BTC is sold in order to buy back USDC on the market. This USDC is then used to pay back the loan. Note that there is risk for the lender. If there is a huge dropwick down in the price of BTC - meaning the price drops suddenly before recovering - there might not be enough collateral to pay back the loan in full. Different lending / borrowing marketplaces have different mechanisms to mitigate some of this risk. The interest rate is set partially based on this risk.

Why would someone take out this kind of loan? The two most common reasons to borrow a stablecoin are leverage and taxes. In the first case, an investor might use collateral to borrow a stablecoin in order to buy more of the collateral asset, for example, using BTC as collateral to borrow USDC, and then using that USDC to buy more BTC or another risky asset. In the second case, selling BTC with a low-cost basis will cause a tax event - or in other words, an investor who made a large profit on a BTC investment may need to pay taxes when he or she sells. Therefore, the borrower might borrow some USDC against their in-profit BTC to pay for real-life expenses instead of selling the BTC. Another common reason to borrow a crypto asset like BTC is to short it. For example, if an investor expects that the price of BTC will decrease, he or she can borrow $100 of BTC against $150 USDC. The investor can then take that BTC and sell it, and if it does actually become cheaper, later repurchase the BTC at a lower price to return it to the lender, and pocket the difference.

While centralized exchanges like Binance might offer lending-style products, to support spot margin trading on their platform, most lending opportunities are on decentralized services like Aave, Compound, or Maker. For example, let us look at some of the lending opportunities on Aave.

yield-platforms-drixx.png

Credit: https://aave.com/

In this case, we see that the variable deposit rates for stablecoins vary, going as high as 35% for sUSD. These rates fluctuate over time depending on market supply and demand.

There are many factors to consider when lending on a DeFi platform. First, you need to look for the best yield opportunities across the various lending platforms, including centralized platforms. The best opportunities might not be the highest yielding ones, because each platform has a different risk profile due to differing policies toward smart-contract risk, how much collateral is required, how liquidations are handled and what price oracle is used, among other factors. Second, you need to manage your lendable assets (and potentially swap between stablecoins) while minimizing transaction fees, known as gas costs. Finally, you need to make sure that your wallets are managed properly, to minimize the risk of hacks or lost keys. Furthermore, stablecoins themselves might have risks. For example, while DAI aims to keep its value pegged to $1, it is not USD-backed and can deviate from $1 during times of high market stress.

Hedged Roll Yield

Collecting hedged roll yield is a classic strategy in traditional finance. To understand how it works in the cryptocurrency context, we need to first have a general understanding of futures contracts. In a futures contract, an investor commits to buy or sell an asset for a specific price on the contract's expiration date, regardless of the asset's market price that day. For example, let us consider BTC futures. Let us assume that you purchase the March 26, 2021 expiring BTC future at a price of $35,000 on Feb. 1, 2021. If on March 26 BTC costs $40,000, then you have made around 14.3% (or $5,000 on $35,000). Generally, the crypto markets trade in contango: This means the price of the future is higher than the current market price, known as the spot price. (If the spot price is above the future price, this is called "backwardation"). The higher futures price reflects the borrowing cost to hold a leveraged long position in BTC. To see how it works, we look at a snapshot of futures and spot prices on the Binance trading platform.

hedge-roll-drixx.png

We see that the spot price on Feb. 1, 2021 was $33,695.70. The future expiring March 26, 2021 was trading at $34,594.20 as of Feb. 1. The future expiring on June 25, 2021 was trading at $35,642.20. How do we take advantage of this upward sloping curve to get yield? We can long the underlying BTC and short the future - meaning buy BTC now, and sell a futures contract to another investor. At the future's expiration, because we are short, we will be receiving the future price and paying out that day's spot price of BTC. However, because we already own the underlying BTC, we will effectively receive the premium we calculated in advance (future price minus the Feb 1. spot price). Let us see how an execution of this strategy could work out:

Using the current curve above:

  • We buy BTC at $33,695.70 on Feb. 1
  • That day, we sell the March 26 future at $34,594.20
  • At expiration on March 26, we receive $34,594.20 but pay out that day's spot price of BTC. Because we bought BTC earlier, we can always sell that BTC at expiration to cover the settlement cash flow.

So how much yield can we get from the curve above? Looking on Feb. 1, we see that roughly two months later, the future price is $34,594. This means that over the period of two months, this strategy would pay around $34,594 / $33,695 -- 1 = around 2.6%. If we compound this, we can have an APY of (1 + 0.026)^(6) = 17% (not including fees).

Note that the annual yield is calculated as the two-month yield to the power of 6, because if we can generate 2.6% in two months, over a year the interest would be compounded for six consecutive two-month periods, for a total of 12 months = 1 year.

This brings us to the rolling aspect of this yield strategy, which refers to how it is executed over time. As opposed to profiting from a one-time opportunity, an investor executing a rolling strategy makes repeated, similar hedges in order to generate ongoing returns.

Like DeFi lending, there are many considerations when executing this strategy. First, every exchange will have different futures curves throughout the day. Second, these futures could be different across assets (for example ETH futures versus BTC futures). Third, there are fees for both selling the future and buying the matching spot crypto, as well as the cost of the bid-ask spread. Fourth, anyone taking advantage of this yield method needs to monitor their margins on the centralized exchanges and watch the futures-over-spot premium as they roll forward their position. Even though the price of the future will always converge to the spot price as it approaches expiry, short-term spikes can happen. Finally, even though most exchanges are safe, hacks are known to happen. Therefore minimizing your margin and collateral is crucial.

Perpetual Funding

Perpetuals are another type of derivative you'll find on crypto derivative exchanges. Perpetuals are similar to futures contracts in that investors can take a long position if they forecast the price of the underlying asset will increase, or a short position if they forecast it will decrease. However, unlike a traditional futures contract, perpetuals never expire - you can hold them as long as you want, which may suit an investor who believes that he or she knows in which direction a currency's price will change but doesn't know how long it will take. Instead of paying a fixed price as in classic futures, they pay a form of interest called funding. Whenever the price of the perpetual deviates too high above the spot price of the underlying cryptocurrency, positive funding is accrued - a form of interest paid periodically by investors with long positions to those with short positions. Whenever the price of the perpetual trades below the price of the spot, negative funding is accrued, which is paid in the opposite direction. This funding serves as a mechanism to keep the perpetual contract's price in line with the cryptocurrency's spot price.

For example, if 0.05% of positive funding is accrued, the longs pay the shorts 0.05% of the perpetual position value. If the perpetual position value is 5 BTC, then 0.0025 BTC is paid from longs to shorts.

The derivatives market is an order of magnitude larger than the spot market. As a result, most buys and sells happen on derivative exchanges. During a bull market (like now), buying pressure pushes up the perpetual price relative to the underlying price, driving a positive funding premium. For example, let us look at the ETH funding rate on the Deribit exchange.

perpetual-funding-drixx.png

Credit: https://www.deribit.com/

On this exchange, funding is paid every eight hours. In this case the current eight-hour funding rate is 0.095%. If we compound that rate, it would equal (1 + 0.095/100)^(3 * 365) = 182% APY. Of course, because these funding rates are so volatile, the realized APYs can be very different.

So how can a trader or investor take advantage of these funding rates? As with futures, you could employ a hedging strategy by going long on the underlying and short on the perpetual. However, unlike the future rolls strategy, the perpetual funding rates are short-term and uncertain. This means you need to hold the position for only around 8 hours (depending on the exchange) to realize the funding rates.

This strategy's risks and operational issues are similar to those of the future roll strategy. However, there is a much higher dispersion in short-term funding rates than futures prices across the different exchanges. Some exchanges might be overheated with high premiums (because of retail buying) while other exchanges might not. This dispersion makes monitoring, tracking, and margin management even more important. When the funding rates become too low (or even negative), you will need to close your long underlying / short perpetual position.

Liquidity Mining

Now let's look at liquidity mining and yield farming. Liquidity mining means that you are providing liquidity to an automated market maker (AMM) pool. Unlike the other strategies, liquidity mining involves price risk. Every time you join an AMM pool, you are exposed to impermanent loss risk. Let's look briefly at what this means.

Generally, when you are a liquidity provider (LP), you are putting two assets into an AMM pool. When someone buys from the AMM pool, they are receiving one of the assets and giving up the other. This transaction changes the composition of the AMM pool (as well as the effective price of each asset). As the LP, you will also be receiving a different composition when you withdraw liquidity. Impermanent loss refers to your loss from this change in composition. When the price of one of the assets increases significantly relative to the other, you receive more and more of the asset that appreciated less. Consequently, your total return will always be lower than if you had just held onto the initial 50/50 portfolio.

To compensate liquidity providers for this risk, LPs are paid transaction fees (AMMs normally charge around 0.3% per trade). In addition, liquidity providers might receive additional rewards. For example, a new project might want to bootstrap liquidity by giving additional project tokens to liquidity providers. The standard LP fees along with these bonuses can result in massive APYs. For example, if we look at the pool rewards within the Badger ecosystem, we see APYs of over 400%.

liquidity-mining-drixx.png

Credit: https://app.badger.finance/

Liquidity mining is risky and operationally intensive. First, you are taking price risk. Second, you have smart contract risk. New projects might be unaudited and risk getting hacked (or having funds stolen). Third, the total value of rewards is generally fixed, meaning that the overall APY will drop as more people farm a project. Fourth, you need to monitor the overall APY to make sure that you are getting a reasonable risk / return for providing liquidity. Finally, ETH gas fees could be very high, making swapping between farming projects cost prohibitive.

In general, most "stable" liquidity mining (meaning limited price risk) is done on stablecoin pools. For example, you could have a USDC / USDT pool. In such a pool, the ratios should never deviate too much since both tokens are pegged to the U.S. dollar.

Drixx Yield Aggregation Platform

There are many sources of yield in crypto. However, as we can see, it can be very difficult for an individual investor or trader to properly optimize yield collection. In addition, there are various operational and risk concerns. This is where the Drixx Yield Aggregation platform comes in.

The Drixx platform focuses primarily on enabling investors to take advantage of futures roll, perpetual yield, and lending. When significant temporary opportunities arise, it also engages in liquidity mining opportunities with no price risk. Unlike DeFi vaults, Drixx takes advantage of both DeFi and CeFi opportunities. The Drixx platform manages all the operational and optimization issues inherent in executing these strategies. In addition, it manages risk for these yield opportunities by limiting exposure to any single CeFi or DeFi platform. The amount of margin and collateral kept on any single service is also minimized, and excess collateral is stored in cold storage.

The Drixx platform currently takes USDT and USDC stablecoins to execute its yield aggregation strategies. To learn more about the Drixx yield aggregation platform, head to Drixx Yield.

Disclaimer: The information presented here is for educational purposes only and should not be construed as investment advice. Cryptocurrency trading involves high risk. Drixx will always strive to do it’s best in educating customers and providing high quality products but will not be held responsible for their trading and investment decisions, losses or profits.