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Cash and Carry Arbitrage in Crypto a Risk-Free Strategy to Generate High Yields

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Cash and Carry Arbitrage in Crypto a Risk-Free Strategy to Generate High Yields 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 SW Capital may own the tokens represented in this report, and as such this should be seen as a disclosure of any potential conflict of interest. Anyone can access SW Capital’s full token disclosures onhttps://sw.capital/ traded-assets. This report belongs to SW Capital and represents the opinions of our team of analysts. SW Capital is not a FINRA registered broker-dealer or investment adviser and does not provide investment banking services. This report is not investment advice, it is strictly informational. Do not trade or invest in any tokens, companies or entities based solely upon this information. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on topics discussed in this document and develop a standalone judgment of the relevant markets prior to making any investment decision. SW Capital does not receive compensation from the companies, entities, or protocols they write about. The only fees SW Capital earns is through paying subscribers. Compensation is not received on any basis contingent upon communicating a positive opinion in this report. The authors were not hired by the covered entity to prepare this report. SW Capital did not receive compensation from the entities covered in this report for non-report services, such as presenting at author sponsored investor conferences, distributing press releases or other ancillary services. The entities covered in this report have not previously paid the author in cash or in stock for any research reports or other services. The covered entities in this report are not required to engage with SW Capital. SW Capital has obtained all information herein from sources they believe to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind – whether expressed or implied. All market prices, data and other information are not warranted as to completeness or accuracy, are based upon selected public market data, reflect prevailing conditions, and SW Capital’s views as of this date, all of which are accordingly subject to change without notice. SW Capital has no obligation to continue offering reports regarding this topic. Reports are prepared as of the date(s) indicated and may become unreliable because of subsequent market or economic circumstances. The graphs, charts and other visual aids are provided for informational purposes only. None of these graphs, charts or visual aids can and of themselves be used to make investment decisions. No representation is made that these will assist any person in making investment decisions and no graph, chart or other visual aid can capture all factors and variables required in making such decisions. The information contained in this document may include, or incorporate by reference, forward-looking statements, which would include any statements that are not statements of historical fact. No representations or warranties are made as to the accuracy of such forward-looking statements. Any projections, forecasts and estimates contained in this document are necessarily speculative in nature and are based upon certain assumptions. These forward-looking statements may turn out to be wrong and can be affected by inaccurate assumptions or by known or unknown risks, uncertainties and other factors, most of which are beyond control. It can be expected that some or all of such forward-looking assumptions will not materialize or will vary significantly from actual results. Nothing in this report can be repurposed or shared without the expressed consent of SW Capital. 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 contango, 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 contract. 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 option, 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 margin on two exchange, a derivatives exchanges and a spot exchange. 2. Applying Leverage 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 expiration 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.
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