Cash and Carry Arbitrage in Crypto A risk-free strategy to generate high yields

Report #2

Issued: Updated on: 09 Mar 2020 09 Mar 2020 Disclosures

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2 SW Capital | www.sw.capital Introduction

With yields in traditional markets at all-time lows, investors are starving for yield - there are no real alternatives beside buying low or negative yielding government bonds or taking on risk in the form of corporate bonds or selling volatility in one form or another.

In this short report we want to introduce an easy and proven strategy to generate almost risk-free, two-digit APR producing yields - by doing Cash and Carry arbitrage in the crypto markets.

Cash and Carry arbitrage describes the buying of an underlying and selling the corresponding future of said underlying. This is done when the future is in , which means the future is trading at a higher price than the spot price. Once the futures settles one sells the underlying and earns the spread between spot and future at the time when the trade was opened.

The big advantage of this trade is, that it is dollar neutral: Since we are buying and selling the same asset, our exposure to the asset’s price fluctuations is zero. Thus, this strategy is risk-free, excluding exchange risk such as our exchange getting hacked.

In bigger and more established markets like commodity markets, the concept of Cash and Carry arbitrage does exist, however the profit does not come close to the same strategy applied to crypto. Crypto being a highly inefficient market and due to general long bias of market participants, quarterly futures (not perpetual futures) contracts of Bitcoin often trade 3-4% higher than spot.

Spread between nearest BitMEX XBT Future and BTCUSD (Coinbase)

As it can be seen in the chart above, the spread between spot and nearest-dated future usually fluctuates between +3 and -2% - a phenomenon which we can profit from as we will demonstrate on the following pages.

3 SW Capital | www.sw.capital A Simple Example

Let us assume that the current Bitcoin spot price is $10,000. The quarterly future contract is trading in contango with a premium of 3%, at $10,300. Historically, this has been an average premium. Step 1: Buying Spot & Selling Future

We are going to buy 1 Bitcoin at the spot price of $10,000. Then, we transfer this Bitcoin to a derivatives exchanges like BitMEX, FTX or Kraken Futures. On those exchanges, Bitcoin can be used as collateral. On the derivatives exchange we sell futures contracts worth 1 Bitcoin at a price of $10,300, locking in a profit of $300 or 3%.

Step 2: Wait until Expiry

Once the trade is opened, we have to wait until expiry of the . Futures expire to the index/spot price. When the futures contract expires, we have to transfer our Bitcoin back to a spot exchange and sell it for dollars. Step 3: Calculate Fees

Until now, we have assumed zero fees for our trade. In reality, we would have paid 25 bps on the first spot buy, and 7.5 bps on the futures sell, another 7.5 bps on the future settlement and 25 bps on the spot sell. This amounts to a total of 65 bps in fees, excluding the transfer fees which many exchanges charge. Our total profit would be 2.35%. Assuming we can do this trade for every quarterly futures contract and future premia stay elevated, we can get a risk- free 9.4% on our investment.

The big advantage of this trade is, that our capital is not locked up. Since your Bitcoin is lying on a derivatives exchange in a dollar-neutral fashion and most exchanges offer a cross-collateral , we can still use our Bitcoin as collateral to trade other contracts. This is possible on BitMEX and FTX.

Distribution of hourly Future/Spot Basis

4 SW Capital | www.sw.capital Improving our Strategy

While a risk-free 9.4% APR is certainly impressive, there are effective ways to further improve this strategy and generate higher yields. This however, will require automation and cannot be achieved by manually putting on trades like in the previous example. 1. Long Backwardation

The chart on page 3 shows that future premia are sometimes negative, a state that is called backwardation. When this happens, it would be possible to long the future with a discount and short spot Bitcoin. This is possible on exhanges like Kraken, Bitfinex and Binance. For this trade to work, one has to factor in the borrow cost of Bitcoin which is usually between 0.03% and 0.05% per day, depending on exchange. If the time to expiry is short and the future trades at a big discount, this trade could make sense. Another factor to take into account however, is that we have to post on two exchange, a derivatives exchanges and a spot exchange.

2. Applying

In both the case of backwardation and contango, it is possible to apply leverage - if the discount/premia is bigger than the cost of borrowing. Many spot exchanges offer 5-10x leverage, however keeping margins on two exchanges in sync becomes a critical issue when doing this. An automated system that transfers Bitcoin between exchanges would need to be built to prevent any liquidation from happening in the case of a quick price move.

3. Closing Trades early

Future premia are mean-reverting. Over the course of its life, a future usually trades in contango but occasionally the premium dips to zero or even down to backwardation. We can take advantage of this dynamic by not holding our position until future but close our futures short position when the premium is down to zero and open another position once there is a big enough premium or discount. 4. Optimizing Entry Points

Historically, future contracts have always traded at least with a 3% premium somewhere over their lifespan. In times of high volatility, spot and future prices tend to diverge more and we see higher discounts/premia. We would need to create a model to estimate the future expected premia which would certainly be a difficult endeavor. One could have success by building a model based on implied and realized volatility as well as the funding rate of perpetual future contracts.

5 SW Capital | www.sw.capital