If you’re reading this on StakingRewards.com, then it’s very likely that you already know the concept of staking, however, let’s go over the main point between staking and the new guy in town – Cash and Carry Trade.
Simply put, staking is the act of locking up your cryptocurrencies, in return for some kind of reward. This can be to support a Proof of Stake network and support its security and operation, or simply a network wants to reduce speculation and increase long-term holding and reward those that lock up their tokens for some period.
Whilst this is great for all of us who are bullish crypto, what about those who have only just started dipping their toes in the shallow end.
In order to stake, you need to own a crypto currency. Thus you have exposure to the price fluctuations of these assets, and the volatility in the markets is anything but calm. With the overall crypto market cap going from $350mill this time last year, to $2.5bill, back down to $1.25bill and once again up to slightly above $2bill, I have seen my personal net worth more than double, plummet 70% only to recover just in time before my next heart attack.
I like crypto, I’ll always be long crypto, but sometimes I wish there was a way to get great returns, whilst having some kind of safety, knowing that if I need emergency funds, I am not at the liberty of the markets.
In this case, what do you do?
One option would be to lend out stable coins, but even those carry some risk. USDT touched a low of 0.99 USD and a high of 1.04 USD in the last year alone, with a few years back reaching 0.92 USD. Rewards are also great, when compared to your measly 0.5% interest rate your local bank gives you. However, these are likely to change, and 16% today, might only be 5% next month, depending on supply and demand; thanks Adam Smith.
So what if you would like to guarantee the exact implied interest rate, with low risk, and small chance of an extra return.
Meet the Cash and Carry Arbitrage Trade
One of the most popular trades in TradFi, this simple buy spot, sell future strategy has evolved into high-speed chases between teams of PhDs whose sole purpose it is to find mispricing in other teams’ models.
Arbitrage is a trade that involves buying and selling of the same or related assets at different prices knowing that the price difference will diverge to 0 over time. An example of this would be buying BTC on Binance for $40,000 and selling BTC on Kraken for $45,000. The profit here would be instant, as BTC on Binance and Kraken are fungible, whereas in a Cash and Carry trade you trade 2 assets that are not fungible. Countless firms are in the arbitrage speed game, competing for 0.1% opportunities between exchanges, with information passing between exchanges in microseconds.
How does it work and how much can I make?
A cash and carry trade, is a market neutral strategy combining the purchase of a spot asset (e.g. BNB tokens) and selling a futures contract on that same underlying asset (e.g. BNBUSD expiring 31/12/2021 on Binance). By doing a buy and a sell, you are market neutral, so if the market pumps or dumps, you are indifferent.
The returns on this strategy come from the difference in price between these 2 products. Currently, and often in the past, the future has been priced higher than the spot, for many reasons, some of which I will go into detail later.
At the time of this writing, BNB is trading 477.8, whilst the BNB future expiring in 126 days is trading 4% higher at 496.7. This gives us a compounded interest rate of roughly 12% annually. Note, that on average, it will take you until the expiry date to capture the full interest.
But that’s not all, the future expiring on the 24th of September, is currently trading 481.1, only 28 days away. The compounded interest rate for this expiry is approximately 9.4%. Lower, but quicker returns. These returns are lower than what can currently be gained from staking BNB, check most up to date information here, however, you do not carry any price risk in this strategy.
But surely, I would not write this article if all we can get is a mildly respectable 9.4% return, right?
What if I told you, you could buy BNB spot, sell the December future, and then also stake your BNB on Binance, in essence double dipping. You see, your BNB tokens act as collateral for your future sell, but you are not required to keep 100% of the collateral. If, for example, you use a 5x leverage on your future sell, you only need to keep 20% of your BNB as collateral, and with the remaining 80% you’re free to do what you like with it – for example, stake it and get an extra 6%+ return.
You might be wondering what I’m doing talking about leverage here? Isn’t leverage basically signing a deal with the devil? Everyone always talks about staying far away from leverage – this is true in most cases; when you are for example trying to chase the market, time the highs and lows, and in general, do things that aren’t very smart.
In this case however, you are not shorting more than you are long elsewhere. If you for example own 10 BNB, you could take 8 BNB and stake them, and use the other 2 BNB you have as collateral to short the 10 Futures with 5x leverage. In this case you are not long BNB, you are not short BNB, and if you ever for some reason get close to your liquidation level, you can always move some BNB from staking to the Futures account. This strategy is not riskless, so you cannot just walk away and forget about it; you should ensure to have some sort of monitoring every now and again. This is why I would advise, going for a slightly lower return, and trading the closer expiry Futures.
The higher you set your leverage, the more staking rewards you will get, but the more risk your trade will carry as well.
But what if you don’t have BNB? The list of Futures on Binance and FTX is ever expanding, with Binance currently offering BTC, ETH, LINK, BNB, DOT, ADA, LTC and XRP. At the time of this writing, DOT seemed to offer the best returns, with the Cash and Carry trade opportunity for spot vs December Future being 9.5% Annualized. Add to that an average of 13.2% you can make from delegating your DOT, you can find up to date rates here, and you can make up to 22.7% returns on this trade with a high leverage. However, being a bit more risk averse; setting your Binance leverage to 5x means you can stake 80% of your token at 13.2%. This would give us a total annualized return of 20%. Setting your leverage to 2x only, would give us a 16.1% return (9.5% + 0.5 * 13.2%).
Unfortunately, here is where I will start talking more technically, going into how to calculate the rates correctly, what a future actually is and some of the reasons behind the premium (or sometimes discounts).
But before I do that, I wanted to discuss the main risk
The gap between spot and future will always be 0 at expiry. However, between now and then, the gap can become smaller or larger; meaning you can capture the rewards faster than you expected or take a momentary loss on your position. However, if you do experience a loss, please remember that the gap will always close at expiry, and you will make your guaranteed reward, as long as you keep enough margin on your position.
If this gap widens too much, you run a risk of liquidation, this liquidation level depends on your margin and your leverage setting, but if done correctly, this risk can be minimized to a point where I personally do not look at this as a risk for my own portfolio.
Let me try to illustrate this in the graphs below:
Assume you bought BTCUSDT on Binance on the 1st of April 2021. The price was 58,795.74. You could have sold the 25/06 expiry BTCUSD Future on Binance for 63,576. This gives us an annualized rate of 33.5%.
Here you can see the gap between the future and the spot diverging from the 1st of April until the 25th of June, at which point the future will expire close to the price of the spot.
Let’s look at the PnL over time:
As you can see, the PnL graph for this cash and carry trade is quite volatile. This volatility can be traded by professional trading firms, who would buy and sell numerous times; however you can clearly see that the general trend of this line is upwards. Also, remember that May 2021 was one of the most volatile times in crypto, and therefore the PnL would be more jumpy. Also note, that the Profit you make from this trade is always guaranteed, as long as you stay liquid and do not get liquidated.
What is a futures contract?
According to Investopedia:
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange. The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
So, what does this mean for us; if we now sell a Futures Contract for BNB expiring on the 31st of December 2021 for 496.7, it means that on the 31st of December we have the obligation to honor this price.
Futures contracts in crypto are cash settled, which means that at the end of the contract, you only settle the difference between spot and the pre-agreed upon price with the other party.
In TradFi, there are also Physical futures, which means that if you sell a futures contract, you are obliged to deliver the physical product to the buyer. This can lead to a some interesting scenarios:
End of March, beginning of April 2020, Oil futures saw a historic, first of its kind, dip below 0. This meant that you could buy Oil and receive money at the same time… awesome, right?
Well, not so great. Due to the Covid lockdowns, with global travel and industrial activity dying down, the global use of oil plummeted.
So, what do you do with all this oil that was not used… you have to store it, and obviously storage is not free, nor infinite.
Everyone who held any significant amount of oil, rushed in to rent oil tankers, storage containers, you name it. Prices for storage skyrocketed, meaning that anyone who still had oil left over, was willing to pay others to take it off their hands. Fortunately, law forbids anyone to just discard of the oil in a harmful way, preventing organizations to buy oil for negative prices, and then discard the oil in the oceans or rivers.
The Mathematics behind Futures
It’s difficult to continue, without at least trying to understand the mathematics behind how futures work, and how their fair levels are calculated.
For a simple, non-dividend paying asset, the following is the formula most often used when calculating the fair value of the futures contract:
F = price of the future
S = current spot price
e = Euler’s number. Constant approximately equal to 2.71828.
r = the implied interest rate between now and the expiry of the future
t = the time until expiry in years. In TradFi, number of days in a year is equal to business days. As crypto is a 24/7/365 market, we’re using 365 days = 1 year.
So going with our BNB prices from earlier, let’s try to find r.
Now we take the natural log of 1.039556 to find the value of r* (126/365)
ln 496.7477.8 =0.0387939= r* 126365
Solving for r gives us
Therefore, the implied interest rate between now and the 31st of December 2021, for BNB, is 11.2%.
Adding the 6% + you can receive for staking your BNB on Binance, you’re looking at a nice 17.2%+ ROI, with low exposure to the underlying asset.
How can you use this as part of your portfolio?
I am obviously not expecting many people to want to completely reduce their crypto exposure to 0. However, every now and again, we’d like to reduce our overall crypto exposure, if we feel the market is overheated, or whilst we are rethinking our investment strategy. In this case, you have 2 options:
- Either sell part of your crypto, and incur (for most of us) insanely high spot trading fees. Then stake your stablecoins to not lose out to inflation.
- Take part of your holdings that you no longer wish to be exposed to at this point in time, move it to your Futures trading account, and do a short-term cash and carry trade, whilst simultaneously staking your underlying. Fees on future trades are lower than spot, and you can potentially make a higher return on your Cash and Carry + Stake, than you would otherwise have made on your Stable Coin staking only.
Historical Implied Interest Rates:
Just like cryptocurrency prices, Implied Interest rates have also swung a lot in the past year.
The graph above, shows us the implied interest rate for a BTC futures contract expiring in 3 months. As you can see, we are currently sitting around 10%. By doing a simple Spot vs Futures trade, and holding it until expiry, the above is the reward you would have received, ranging from 0 to 40% + depending on your time of entry. These are annualized and compounded, so for a 3-month period, the highest return you could have received was roughly 9% in this case. Certainly not bad for 3 months, when compared to 0.5% annualized interest rate our local banks give us.
But what drives this implied rate you may ask?
How do you know that when you enter the trade now, you’re not missing out on a better opportunity tomorrow?
Well, first and foremost, the implied rate is simply supply and demand. When the market is pumping, people want leverage, and will buy futures instead of spot, increasing the gap between them. Most people will either buy the perp or the first expiry, to maximize gains but those smart PhDs I mentioned earlier; their systems will keep all the implied rates in line, meaning that if we all buy the first expiry, they’ll start buying the expiries after as a hedge.
Secondly, the r in our formula above can be broken up into more pieces; of most interest to us is r = r + y, where r is the interest rate we can get in the market (for example lending out our stable coins) and y is called the convenience yield.
The convenience yield is near impossible to calculate, as it incorporates a whole list of things, but it’s purpose is to quantify how much more people are willing to pay for a future than spot for reasons such as:
- Futures might be safer to trade than spot
- Futures can be leveraged
- Spot trading has higher fees
- Etc, etc, etc.
As you can imagine, each of us will have different reasons as to why we might prefer to buy a future vs spot, and the amount which we’re willing to pay more will differ. And that’s why it’s very difficult to predict the direction the total implied interest rate will go.
Adding the occasional Cash and Carry + Staking trade to your portfolio can help you reduce your market exposure in a way that maximizes your return and lowers your potential trading costs.
Whilst a Cash and Carry trade guarantees you a specific return if held until expiry, your PnL on the trade during the period up until the expiry can be volatile. As you can see from the historic graph of the BTC Implied 3 month rates, the rates can move quite a bit. If rates increase during your holding period; your position will take a momentary loss. However, if the rates go down during the holding period, you will receive your rewards faster than expected and rolling your Futures expiries if they go with you, might be a way to increase your returns even more.
Trading firms will not only buy and sell once per expiry, but try to predict how quickly and in what direction this rate will move. However, discussion on how to trade this rate on a shorter time frame is outside the scope of this article.
If you want to learn more about this, send us a message in our TG Chat, and we will try to answer your questions.