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Yield, Interest Rates and Savings in Crypto

Yield, Interest Rates and Savings in Crypto

How to start earning in crypto and minimize risks

Lawrence Zhou
DRIXX Quant
February 13, 2021
Yield, Interest Rates and Savings in Crypto

Intro

When we talk “yield”, we are basically talking interest rates. For the purposes of this piece and to simplify the discussion, we will be using them synonymously (though technically, these terms are different in fixed-income math). In general, the two are very close for very short-term opportunities (like the ones we will be looking at). So, when we say 10% interest rates (or APY – annual percentage yield), it means that a $100 dollar investment will return $10 in 1 year.

Currently in 2021, central bank easing across the globe has dropped traditional interest rates 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 US bank might be 0.01%. 10-year US treasuries are yielding around 1.1%. Even moving up the risk curve does not change much. An index of short-term high-yield bonds (or junk bonds) might only yield 4-5%. In crypto and DeFi, we see a completely different story.

Because of the novelty of the crypto ecosystem and the operational / risk hurdles in collecting interest in crypto, we can see rates of up to 400% for the riskiest opportunities (though typically averaging around 20-30%). These interest rates can be highly volatile but are largely disconnected from broader non-crypto markets. We are going to explore common sources of “yield” in both centralized and decentralized (smart contract) sources.  In addition, we will also talk about the risks and operational challenges involved in collecting interest from these sources. Finally, we are going to take a brief look at the new Drixx Yield Aggregation service and how it will solve and simplify this process.

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. Each of these opportunities offers differing rates of return. Crypto lending on a DeFi platform like Aave or Compound might return up to 20% APY (depending on asset). A hedged roll yield strategy on a centralized exchange might yield around 20% a year. A perpetual funding strategy (though highly volatile) can sometimes earn up to 40-50% APY (depending on asset). Finally, liquidity mining / defi yield farming can return up to 400% APY (or even more) in temporary opportunities. Because the latter two opportunities can be highly volatile. For example, you can see temporary ETH perpetual funding rates of 1% per day (or 37x a year if compounded and sustained)! However, these high-interest periods are rarely sustainable. To better understand these yield / interest opportunities, we will need to dive deeply into each one.

Crypto Lending

Lending in crypto is generally a form of securitized lending. This means that whatever you lend to the counterparty is “secured” by their collateral. The counterparty is almost always overcollateralized (meaning that the value of their collateral is worth more than the value of the loan). If the value of the collateral drops, the collateral is liquidated for the loaned asset (and the loan is paid back). Of course, the loan is not free. The borrower will have to pay the prevailing interest rate to borrow. Let us look at a simple example of this type of loan. 

Say for example, that someone borrows $100 USDC. To do this, they put up $150 worth of BTC. 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 to buy back USDC on the market. This USDC is then used to pay back the loan. Note, that this type of loan is not riskless. If there is a huge instant wick down in the price of BTC, 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. Part of the interest rate paid reflects this risk.

What prompts someone to take out this kind of loan? The two most common reasons to borrow a stable coin is leverage and taxes. In the first case, someone can borrow a stable coin against collateral to buy more of the collateral asset (ex: borrowing USDC against BTC collateral, then taking that USDC to buy more BTC or some other risky asset). In the second case, selling BTC with a low-cost basis will cause a tax event. The borrower might just borrow some USDC against their in-profit BTC to pay for real-life expenses instead. A common reason to borrow a crypto asset (like BTC) is to short it. For example, someone can borrow $100 of BTC against $150 USDC. They can then take that BTC and sell it, betting on the price decreasing.

While centralized exchanges like Binance might offer a lending-style product to support spot margin trading on their platform, most of the lending opportunity is on decentralized services like Aave, Compound, or Maker. Let us look at some of the lending opportunities on Aave.


Credit: https://aave.com/

Here we see that the variable deposit rates for stable coins can vary between 5.66% for USDC to 35% for sUSD. These rates can fluctuate over time depending on the market supply and demand.

There are many factors to consider when lending on a DeFi platform. First, you will need to look for the best yielding opportunities across various lending platform (including centralized platforms). The best yielding opportunities might not be the highest yielding ones, because each platform has a different risk profile (smart-contract risk, how much collateral is required, how liquidations are handled, what price oracle used, etc). Second, you will need to manage your lendable assets (and potentially swapping between stable coins) while minimizing gas costs. Finally, you will need to make sure that your wallets are managed properly (to minimize the risk of hacks or lost keys). The stable coins themselves might have risks. For example, DAI 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, we need to first have a general understanding of crypto futures. Unlike the perpetual contract, a crypto future contract has an expiration date. At the expiration date, you will pay your future purchase price and receive the price of the underlying crypto asset. For example, let us consider BTC futures. Let us assume that you purchase the Mar 26, 2021 expiring BTC future at a price of $35,000 on Feb 1, 2021. If, at settlement, the spot price of BTC (the “spot price” refers to the price of the underlying BTC asset) is $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 spot price (if spot price is above the future price, this is called “backwardation”). The higher price of the future reflects the borrowing cost to hold a levered long position in BTC. To see how it works, we look at a snapshot of Binance futures and spot prices.


We see that the spot price on 2/1/2021 is 33,695.70. The future expiring 3/26/2021 is trading at 34,594.20. The future expiring on 6/25/2021 is trading at 35,642.20. How do we take advantage of this upward sloping curve to get yield? We can actual long the underlying BTC and short the future. At expiration, because we are short, we will be receiving the future price and paying out the spot price of BTC. Because we are long the underlying BTC, we will effectively receive the fixed premium (future price minus the current 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
  • We sell the 3/26 future at 34,594.2
  • At expiration, we receive 34,594.2 but pay out the spot price of BTC at expiration. Because we bought BTC earlier, we can always sell that BTC at expiration to match the settlement cashflow.

So how much yield can we get from the curve above. We see that roughly 2 months from 2/2/2021 (the current date), the future price is $34,594. This means that 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).

Like DeFi lending, there are many considerations when executing this strategy. First, every exchange (or even decentralized futures exchanges) will have different futures curves throughout the day. Second, these futures could be different across assets (ex, the ETH futures versus the BTC futures). Third, there are fee considerations, since selling the future to match the spot crypto will cost a fee and the bid-ask spread. Fourth, anyone taking advantage of this yield will need to monitor their margins on the centralized exchanges and watch the (futures – spot) premium. 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 margin and collateral across exchanges is crucial.

Perpetual Funding

Perpetuals are another type of derivative on crypto derivative exchanges. Instead of settling on a fixed date, the perpetuals never expire. Instead, a form of interest called “funding” is paid. Whenever the price of the perpetual deviates too far from the price of the underlying crypto, positive funding is accrued. Whenever the price of the perpetual trades below the price of the spot, negative funding is accrued. Depending on exchange this funding is periodically paid from longs to shorts. 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 size of 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, causing the positive funding premium. For example, let us look at the ETH funding rate on the Deribit exchange.


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

The above 8-hour funding rate is shown as 0.095%. If we are able to compound that rate, it would mean (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? Like the future roll strategy, you would long the underlying and short the perpetual. However, unlike the future rolls strategy, the funding rates are short-term and uncertain. This means you only need to hold the position for around 8 hours (depending on exchange) to realize the funding rates.

The risks and operational issues of this strategy are like that of the roll yield 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 premium (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 future position.

Liquidity Mining

Finally, we look at liquidity mining and yield farming. Liquidity mining basically 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, are you are exposed to “impermanent loss risk.” A full discussion of AMMs and impermanent loss is beyond the scope of this article. However, we will give a short description.

Generally, when you are a liquidity provider (LPs), you are putting in 2 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 action 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 is effectively 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, there might be additional rewards to liquidity providers. 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 for the Badger project, we see APYs of over 400%.


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, rewards are 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 stable coin 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 a 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 will primarily be focused on futures roll, perpetual yield, and lending. However, depending on the size of temporary opportunities, it will engage in liquidity mining with no price risk. Unlike DeFi vaults, Drixx can take advantage of both DeFi and CeFi opportunities. The Drixx platform manages all the operational and optimization issues faced with executing these strategies. In addition, it will risk-manage 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 stable coins to execute its yield aggregation strategies. To read more about the Drixx yield aggregation platform, head to <link here>.