Dharma Markets Report #6: Trading Strategies in #DeFi
Trading is integral to any well functioning capital market. By taking advantage of supply and demand mispricings, traders help the market with price discovery, and in the act of trading, also serve to bring liquidity to a market. Traders that excel at providing these services are rewarded handsomely.
Crypto markets are no different. In fact, crypto markets need traders more than ever to help bring liquidity and price discovery to an immature and inefficient market. For their crucial role in helping bootstrap a global market, crypto traders have generated massive returns. An argument can even be made that crypto markets to date have been much more lucrative to, and psychologically easier on, traders than they have been to long term investors. While the latter requires relentless patience in the face of massive volatility, traders are able to take advantage of irregular price movements without bearing as much risk.
Just as traders were needed to bootstrap traditional crypto markets, they’re needed more than ever within the decentralized financial system being built on Ethereum. Not only are these markets nascent, but the actual infrastructure that underpins them is still in development. Given such high levels of inefficiency, #DeFi is a breeding ground for traders who are willing to take on risk in exchange for massive returns.
To take advantage of the new opportunities available in the decentralized finance ecosystem, a number of new trading strategies have emerged.
- Token Pair Trading
Summarized well in this article, pair trading is a market neutral strategy in which traders take advantage of mis-pricing between two highly correlated assets. So let’s say that two assets usually have a price ratio of 2:1. If the price ratio moves substantially, say to 2.2:1, then a token pair trader would short the outperforming asset and long the underperforming asset. The expectation will be that the ratio will revert back to 2:1, and the trader will profit from the “normalization” of the prices back to this ratio.
To illustrate a pair trade, let’s use ETH and BTC as an example. We’ll assume their correlation is high, somewhere above 0.75. If the price of ETH appreciates 3x relative to Bitcoin, a pair trader would go short ETH and long BTC, then wait for the prices to converge back to their norm and repay their debt. Remember that for going either long and short, the trader must borrow some other asset.
2. Uniswap Short Straddle
Uniswap is a novel system in which users can earn a return for supplying assets to liquidity pools. Essentially, users act as market makers and are rewarded when there’s a lot of trading activity in the pool they supply assets to. You can think of liquidity pools as ‘order books’ — they represent the liquidity available between two assets. For example, ETH/DAI is its own pool, as is ETH/MKR.
Generating returns on Uniswap is not as simple as it might seem. Summarized well in this article, liquidity providers earn a great return when the liquidity pool they supplied assets to has a lot of volume and when the price ratio between the two assets remains fairly constant.
Given this return profile, many traders have been treating supplying liquidity to Uniswap as a short straddle. In this trade, the trader is betting on low volatility and a lot of trading volume between the two assets that they’re supplying. Since market makers on Uniswap are supplying both sides of a trading pair, they’re basically hoping the price of one of the underlying assets doesn’t shift against them all the while they can collect a premium for the trading volume.
3. Staking Yield Arbitrage
With the emergence of Proof of Stake, cryptocurrency holders can earn a yield for participating in network consensus. For many traders, this represents an arbitrage opportunity if they can get exposure to the staking yield without actually holding the asset. The trader would borrow either the underlying asset or a stablecoin which they can use to buy the underlying. In both scenarios, traders are looking to borrow at a rate below the staking yield.
Take for example Tezos — holders can earn 7.34% APR by staking XTZ. A trader who wants exposure to the annual yield, but doesn’t want to hold XTZ on their balance sheet, can either borrow XTZ or USDC/DAI at a rate below 7.34% APR. They can then stake XTZ for some duration, repay their debt, and pocket the profit. This strategy works much better if the borrower can get a fixed term loan as a variable rate agreement can make the trade unprofitable.
As lending markets within decentralized finance continue to grow, a community of organizers is leading an initiative to introduce DIPOR: the Decentralized Inter-Protocol Offered Rate. DIPOR aims to be similar to the LIBOR index in that creators and consumers of open finance products can use DIPOR as a foundational benchmark to make decisions and price risk. One particular beneficiary would be the MakerDAO risk management team as they could use DIPOR as a tool to better price the stability fee. While DIPOR is a great idea in practice, the market is likely too fractured to support a standardized rate. As the ecosystem develops, we expect DIPOR to play an influential role in helping coordinate decentralized lending markets.
Alex Evans at Placeholder wrote an excellent overview of the strategy behind sourcing liquidity in decentralized protocols. Alex notes that today, open finance systems are split into three categories: peer to peer markets, liquidity pools, and smart-contract based counterparties. An interesting observation emerged — protocols in which users interact with a pool or smart contract are much better at sourcing liquidity than peer to peer markets. The main reason being, peer to peer markets always require a counterparty on the other end of the trade. To counteract this difficulty, many protocols are moving up the stack and getting closer to the end user. This is exactly what we did with our recent product launch, and our volume numbers affirm the hypothesis made in this post.
Derek Hsue of Blockchain Capital provides an in-depth analysis of the rise of IEO’s and what they mean for the crypto capital markets. While IEO’s haven’t reached the scale that the ICO craze did in 2017, it feels like the fundraising method was created to give exchange tokens the same monetary premium ETH received during the last bubble. IEO returns to day very well may have contributed to the recent market uptrend as early investors were able to generate a quick return off of risky assets. Luckily, it doesn’t seem like IEO’s will be as pervasive as ICO’s once were.
Token Daily researcher, Mohamed Fouda, made the claim that blockchain data represents the next billion dollar opportunity within the crypto markets. Mohamed defends his claim by highlighting the importance of easily indexable data and who the core customers are. The Dharma team is very much aligned with the thesis laid out in this post. We think whoever can make the global financial system’s data accessible to all, stands to capture a great deal of value.
Last week, Augur unveiled the specifics behind their upcoming v2 protocol upgrade. There are a ton of great improvements, but the ones that stand out include the ability to denominate markets in DAI, protocol inflation to create a decentralized oracle, and immediate dispute rounds. You can find the full spec from Augur here, and an in-depth twitter thread going into the upgrade details here.
Growth Post Launch
It’s been a huge week for us at Dharma! On monday, we officially opened our product to the public and saw a large influx of demand for both DAI and ETH. On the borrow side, we broke $1,000,000 USD in cumulative borrow across both ETH and DAI. DAI borrowing constituted over 90% of total demand as the recent market movements look like the crypto markets could be making a comeback.
Our lend side saw even more growth, with over $1,400,000 USD in cumulative lend volume. Similar to the borrow side, most of our lend volume was concentrated in DAI, which represented over 70% of all lent capital. Given the stability fee was just raised to 11.5%, our assumption is that DAI holders are looking to lock in some savings rate and wait for the stability fee to fall back down.
Dai spent the majority of last week trading between $0.94 — $0.99 as selling pressure continues to come from investors using Dai as a way to get leverage on their ETH. To combat the increased use of leverage, MKR holders just voted to raise the stability fee to 11.5% in the hopes that CDP owners would buy Dai on the open market to pay back their debt. So far, it seems like the market isn’t phased by a 11.5% interest rate. We wrote about this in our last Dharma Markets Report and we feel strongly that Dai must develop use cases outside of speculation if it wants to maintain its peg.
ETH Locked in DeFi
The total value of ETH locked in DeFi just crossed $400,000,000 USD, further proving there is demand for a new class of globally available financial services. Lending makes up for most of that demand as Ethereum, in its current shape, is perfect for in-frequent, high value transactions. In the traditional system, taking out a line of credit can take days, if not weeks, and borrowers interested in buying more cryptocurrencies would have to pay additional fees to move their principal onto exchanges.
Last monday, we opened our doors to the public, allowing anyone to earn interest or take out a line of credit against crypto, from anywhere in the world. We saw a surge in interest on both sides of the market. The most volume came from DAI borrowers as the market is starting to feel better about future growth. You can sign up for the platform here, and you can follow along with all our stats here.
An interesting article out of Galois Capital last week discussed what effect, if any, a eurozone debt crisis would have on the crypto markets. The piece briefly goes over what happened to the prices of the Euro and of Gold, and then extrapolates what could happen if the same amount of capital flees into Bitcoin. Something to keep an eye on cryptocurrencies continue to enter the mainstream.
Binance research put out a great report on how to evaluate crypto market cycles. Spoiler alert: seems like consensus is that we’ve transitioned from a freezing winter, into a slowly thawing spring. The report goes over asset correlations, how investors have behaved throughout previous cycles, and how global regulation is affecting institutional participation.
Early Sunday, MKR holders voted to officially increase the stability fee to 11.5% APR, marking another quick rate hike aimed at getting Dai back to $1.00 USD. As we covered above, Dai is seeing increased use from margin traders, which is adding sell pressure to the asset. It will be interesting to see how the price of Dai reacts to the increased fee.