Extracting Arbitrage Yields In Bitcoin Carry TradeBitcoin is known as digital gold. It is treasured as an investment asset. Much like the famous yellow metal, bitcoin (“BTC”) does not offer income through dividends or interest. This poses a challenge for investors seeking regular cashflows and income.
One strategy that skilled investors use to turn BTC into an income generating asset is the cash and carry trade (“carry trade”).
This paper describes mechanics of carry trade and the attendant risks. It also highlights that the introduction of spot ETFs has created a secure infrastructure for harvesting carry yields using a regulated platforms such as the CME.
INTRODUCTION TO THE CARRY TRADE
The carry trade is an arbitrage strategy that benefits from the differences in futures and spot price of an asset. It is a delta neutral strategy. In other words, the returns are not price dependent once the carry trade is profitably set up.
To illustrate, consider the forward curve of CME Bitcoin futures which shows futures prices at different expiries.
Bitcoin futures with later expiries trade at a premium to near term ones and this type of market structure is referred to as contango.
In a trade that involves simultaneous acquisition of BTC and selling a BTC futures contract expiring later, investors can lock in the price difference as profits. Once established, this trade’s profit is unaffected by price moves enabling investors to harvest carry yield at the futures expiry.
The pay-off from this trade is driven by convergence of futures and spot prices. Convergence is the movement of a futures price closer to spot price at expiry. Once futures and spot price are sufficiently close, the trade can be unwound by simultaneously exiting both positions.
For CME Bitcoin and Micro Bitcoin futures, convergence occurs because the futures contracts settle to a robust price benchmark known as the CF Bitcoin Reference Rate (“BRR”) which includes price quotes from major crypto exchanges.
BTC FUTURES CONTANGO TERM STRUCTURE AND PREVALANCE OF CARRY TRADE
Carry trades can be executed in both contango and backwardation term structures. While the carry trade can technically be executed in backwardation (where later expiries are cheaper), doing so involves high borrowing costs for the short spot leg. Hence, BTC’s contango term structure is beneficial for extracting arbitrage yields from carry trade.
Factors driving BTC contango term structure are multi-faceted. Simply put, during bull runs, investors anticipate higher prices for contracts maturing later. Furthermore, high demand for spot BTC and limited availability on the sell-side can exacerbate forward premiums.
Additional factors resulting in contango include cost of funds, insurance premiums, and custodial charges that are higher for later expiries, and a convenience yield of holding BTC. Convenience yield represents returns from holding BTC through activities such as lending.
BTC futures term structure has shown both contango and backwardation during different periods. Current term structure indicates bullish sentiment fuelled by spot BTC approval in January and the next halving event expected in April.
Term structure shifts can result in outsized returns at times. Notably, the switch from contango to backwardation can offer outsized returns on the carry trade, exceeding the difference between futures and spot price as observed at trade inception.
The carry trade has been a popular strategy, especially during periods of significant volatility and during bull markets when BTC contango structure widens. Even sell-offs provide compelling trading opportunities as the carry trade is directionally neutral. Carry trades have lower risk relative to an outright long position.
For reference , during 2021, LedgerPrime’s quant fund was able to beat BTC returns using, among others, the carry trade during a large selloff.
RISKS OF THE CARRY TRADE
The carry trade neutralises market risk but is still subject to counterparty risks and liquidity risks when spreads diverge and tear.
Largest risk factors associated with the carry trade is the counterparty risk . While CME futures are regulated by the CFTC, spot crypto exchanges are not subject to similar regulations. This poses significant risk for investors if they opt to hold their BTC on such unregulated exchanges.
Such risks arising from trading on unregulated platforms is most exemplified by the collapse of FTX. FTX was a popular exchange for executing carry trades as it offered dated futures, perps, and spot BTC on its platform. The dramatic collapse of FTX highlighted counterparty risk as a major concern.
Self-custody of spot BTC has its own risks including transfer costs and cybersecurity risks.
Another risk factor is early liquidation. As the futures leg of the trade is a short position, where prices rally sharply, the short position may be at risk of liquidation despite a proportional gain on the long leg of the carry trade.
SPOT BTC ETF HELPS REDUCE COUNTERPARTY RISKS
The rollout of spot BTC ETFs reduces counterparty risk. Unlike unregulated crypto exchanges, spot ETFs are regulated by the SEC, listed on regulated exchanges with investor protection.
With both the futures and spot leg now available through regulated platforms, investors have access to secure infrastructure for executing the carry trade.
The table below provides details of approved spot ETFs including AUM, expense ratio, and the benchmark index.
Carry trade using spot ETFs with CME CF Bitcoin Reference Rate (CME BRR) enables greater precision in extracting arbitrage yields. Seven of the eleven approved spot BTC ETFs use the CME BRR.
Still, there are downside to using spot ETFs for long BTC exposure in carry trades. For one, ETFs are only tradeable during market hours (9:30AM to 4:00PM US Eastern Time not including extended trading hours) whereas cryptocurrency exchanges and even CME futures trade for longer hours.
Moreover, expense ratios and premium/discount to NAV for ETFs will erode already thin profits. Spot BTC ETFs are currently offering discounts on expense ratio for a fixed period.
CARRY TRADE ILLUSTRATION
To illustrate a hypothetical carry trade, consider the following setup comprising long BITB ETF and short CME Bitcoin futures (BTCH2024).
BITB references the same CME CF Bitcoin Reference Rate as CME futures and its premium/discount of -0.07% (as of 09/Feb) offers a beneficial entry point for this trade. Moreover, the premium/discount on the ETF has been tight.
Source: Bitwise
The premium for MBTH2024 over spot reference rate as of close on 9/Feb was 2.83%. Taking seven basis point discount to NAV, this results in total return of 2.90% over 48 days resulting in an annualized arbitrage return of 22%.
As the trade is required to be directionally neutral, notional value on both legs needs to be balanced. CME Micro Bitcoin futures (“MBT”) offers exposure to 0.1 BTC.
Notional on short BTCH2024 futures leg: 0.1 BTC
As of close 09/Feb,
BITB market price: USD 25.95
CME CF Benchmark BTC price: USD 47,614
Each share of BITB offers exposure to 0.000545 BTC
184 shares of BITB provide exposure to 0.000545 x 184 = 0.100280 BTC
The payoff from the trade consisting of 184 x long BITB and 1 x short MBTH2024 would be 2.9% of notional value = 2.9% x (0.1 x 47,614 USD/BTC) = USD 138.
The trade requires margin of USD 980 on the short futures leg and notional of USD 4,775 on the long leg for a total capital requirement of USD 5,755 (as of Feb 2023) which translates into ROI of 2.4%.
Still, as mentioned, liquidation risk remains a concern. Hence, it is prudent to maintain higher margin on the short futures leg which would lower the ROI.
Note that timing this trade better can improve the odds and in case Bitcoin’s term structure switches from contango to backwardation, payoff would be higher.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Cashandcarry
Bitcoin futures premium 6% profitThis is a followup to my video about the Bitcoin Cash and Carry arbitrage trade. When I made the video the premium on December futures was over 21%. It took a dive on the last down move of Bitcoin and has now settled around 15%. If people were paying attention they could have locked in the value of FTX:BTCUSD at $57,000 PLUS captured that additional 6% difference!
Bitcoin Cash and Carry 2021For years I have been talking about using futures products to LOCK IN the fiat value of Bitcoin and give investors the added bonus of collecting a return based on the arbitrage. We are once again in a big bullish cycle which is driving up the futures premiums to all time highs creating OPPORTUNITY . In the FTX:BTC1231 for instance as of writing there is a 20% arbitrage. In this video I revisit this concept for 2021 and explain how it works.
See my written idea posts below for this has played out in bull cycles past.
How much profit did the Bitmex arbitrage make?For at least three years now I have been advocating for the Bitmex futures "Cash and Carry" trade which is an arbitrage of the quarterly futures contracts versus the spot price of Bitcoin. With this recent selloff and hedge opportunity I wanted to demonstrate once again how this trade played out and its benefits. I've been telling people to do this not only in period of high volatility but also as a general hedging strategy to "lock in" the VALUE of Bitcoin at any given time that there is an opportunity. I seriously do not think anyone but myself utilizes this strategy because when I explain it to your typical crypto trader they get confused and invariably ask "but how Lambo?" This won't yield sick gainz brah but it will protect your capital !
To recap; a Cash and Carry trade is where one trades a futures contract against its underlying where there is a spread between the two prices. This is an arbitrage trade. Ideally the futures contract will move towards the spot price as time reaches the settlement date. In modern normie markets the spread between futures and spot are too small due to their high liquidity, margin interest requirements, and plenty of other arbitrage traders capturing the minuscule profit potential. This trade still remains though on the Bitmex platform. Bitmex has quarterly futures contracts which can be held without paying the fees of the continuous contract. These will often trade at premiums or discounts to the spot price of BTC. The spread of premium or discount will be largely dependent on market sentiment at that time. When Bitcoin is bullish traders are betting the price to be higher at settlement and the quarterly futures will trade at a premium. The inverse is true in bearish conditions. You can visualize this spread by pasting in "(XBTH20-XBTUSD)/XBTUSD*100" without " " to Tradingview symbol; you can also substitute for other contracts by changing the first symbol.
So what happened in this recent selloff? The important thing here is that we are just trying to lock our BTC value at 0 delta to protect the value against such crashes. We do that by selling the futures contracts equivalent to our account value. Let's assume that when BTC was at around 10k a trader decided that it was time to lock in the USD value of their Bitcoin. Let's say they had 1 BTC in their account to keep it simple. On Februrary 9th the Daily bar closed at 10172 on XBTUSD. The March 27th quarterly futures contract (XBTH20) was trading at 10460. This meant that the quarterly futures were trading at a 2.8% premium to spot.
So the trader Sells -10172 contracts of XBTH20 @ 10460. We want to set the contract size to BTC spot price rather than the futures price to mitigate risk in the event of further premium expansion.
In the weeks that followed the market sells off. By March 12 the premium had inverted to a discount of -4%. We close the trade. At the end our BTC is worth over 57% less than it was at the start but we now own 2.4656 instead of 1. If we then calculate our account value in USD we have $10691. Though BTC is DOWN over half our total holdings value is UP by 5.1% !
Are we going to buy that Lambo this year with 5.1%? Probably not... but we have protected our assets and profited from this rare opportunity! A trader only ever uses 1x leverage to hold the position which means there is plenty of leverage available to trade other contracts while this one position is protecting account value.
A final note about arbitrage opportunities: they always go away . As I've written before about December 2017 bubble the opportunity was around 18%! More recently when BTC dropped from 6500 the premium captured was 8%. This time it was only 5-6%. Slowly this inefficiency is indeed going away. Still, at any given time the futures contracts are trading at a premium this is a virtually riskless trade . Even if one doesn't like taking this trade just watching the spread is still a very useful analysis tool to gauge market sentiment.
Bitcoin Cash and Carry Q1 2018A lot of traders are coming to Bitcoin in recent months hoping for 1000% returns to grace them as if the run is sure to continue. Having seen multiple bubble and bust cycles in my time trading Bitcoin since 2013 I've opted for a different approach. Starting last year I began employing a futures cash-and-carry strategy using the Bitmex Exchange. Usually and especially during bullish times the quarterly futures contracts open and remain at a premium to spot market price. Over the duration of the contract as it approaches expiration the premium decays. As a bonus when the spot price experiences volatile swings to the downside the premium can turn into a discount. What I do at the beginning of the cycle is sell the equivalent capital value in futures at the premium and hold onto them to expiration or to an inversion of premium to discount. This Quarter's arbitrage began at 11% so in theory I am able to lock in the "value" of Bitcoin at around $18,000/BTC and capture a 5.5% return. It's not sexy but it's consistent and filters through the volatility.
Bitcoin Cash and Carry Trade - Full CircleBack on December 20th, before the wild run, I put out a video on how to hedge existing Bitcoin positions and potentially bank some bonus profit on the premium between the spot price of Bitcoin and OKCoin 3 Month futures contracts. Now the trade has come full circle from drawdown at the top of the bubble, to mean reverted expectations, to bonus profit on the trade. Check the video for the explanation:
youtu.be - Full Circle
youtu.be - Original Video