DeFi (Decentralized Finance) has been growing significantly since mid-2018, with Ethereum being one of the most prominent blockchains for platforms and developers1. This report describes trading strategies, namely arbitrage and “carry trade”, within the DeFi space and between DeFi and CeFi2 platforms. Besides, this report aims to discuss potential price inefficiencies along with risks and constraints that must be considered when building these advanced positions.
In the financial industry, arbitrage has relied on market price inefficiencies. Namely, greater opportunities tend to exist in less mature markets. As a result, the crypto-industry exhibited many price efficiencies in its early days3.
Arbitrage is defined by Binance Academy as:
“Arbitrage is the practice of buying and selling assets over two or more markets as a way to take advantage of different prices. [...] Arbitrage exists as a result of inefficiencies in the markets. ”
In the DeFi space, arbitrage opportunities occur when there are differences in interest rates among platforms. In general, interest rate arbitrage links to situations where the lending rate is below the borrowing rate on another platform. We can define “pure interest arbitrage” in the DeFi space as:
“DeFi interest rate arbitrage refers to taking advantage of interest rate differences across decentralized platforms.“
The most straightforward case is when the borrowing rate on one platform is lower than the lending rate on another platform.
However, arbitrage opportunities may also occur with custodial platforms (e.g., custodial crypto-lending services, like BlockFi and Nexo, and non-crypto financial services providers).
Opportunities also exist with non-blockchain financial providers like commercial banks or lending companies.
“DeFi-CeFi interest rate arbitrage refers to taking advantage of interest rate differences between decentralized and centralized platforms.“
Furthermore, carry trade strategies are also discussed in this report. According to Investopedia, they are defined, such as:
“A carry trade is a trading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. A carry trade is typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency, with proceeds placed on deposit in the second currency if it offers a higher rate of interest.”
However, in this report, carry trades are referenced such as benefiting from interest rate differentials between stablecoins, supposedly pegged to the same fiat currency (i.e., the US dollar).
The next two sections discuss both carry trade and arbitrage opportunities4 that have occurred between platforms through the analysis of case studies, both from an existing and an empirical perspective.
Company | Minimum borrowing rates (APR) | Possible maturities |
---|---|---|
Wells Fargo | 5.49% | 12-60 months |
Lightstream | 5.99% | 24-60 months |
Best | 5.99% | 36-60 months |
Freedom Plus | 5.99% | 24-60 months |
CeFi borrowing rates on USD typically do not require users to post any initial collateral. However, short-term maturities are typically expensive.
As a result, a simple strategy could potentially be coordinated around DeFi and CeFi platforms.
For this strategy, Compound is used as a representative example for DeFi as this protocol has the most significant amount of USDC borrowed/supplied6 (more than 30 million as of September 20th 2019) while offering immediate compounding of interest rates.
Step | Platform | Description |
---|---|---|
1 | CeFi platform | Borrow uncollateralized, without any initial requirement |
2 | Circle | Convert borrowed US dollars to USDC stablecoin |
3 | Compound | Deposit USDC in Compound/dYdX |
This strategy would generate a positive annual interest rate as long as:
However, a more realistic version would be to move some USD from a savings account to Compound/dYdX to maximize expected returns.
Then, it would be worth moving USD to Compound from a saving account as long as:
In the previously described strategy, several key elements need to be considered along with potential existing risks that may hinder the expected returns of this particular strategy. Some of these relate to how interest rates on Compound are defined and evolve. Specifically, borrowing and lending interest rates are modeled based on a linear function, with both a floor and a cap for each asset, which respond to real-time demand and supply in the protocol.
On the other hand, CeFi platforms often have variable interest rates, which fluctuate over time based on the macro-economic environment along with specific terms of agreements that often vary from one platform to another.
Hence, different considerations must be considered when building a CeFi-DeFi arbitrage position:
Eventually, other risks are related to Compound (or the DeFi protocol)7:
BlockFi is a custodial crypto-platform that allows users to borrow and lend large market-cap cryptoassets such as XRP, Bitcoin (BTC) or Ethereum (ETH).
As the lending interest rate on BlockFi is higher than the borrowing rate on dYdX, it appears that these interest rate differences may be arbitrage-able.
The table below describes the two-step process required to create an arbitrage position between dYdX and BlockFi for large DAI holders.
Step | Platform | Description |
---|---|---|
1 | dYdX | Borrow ETH with (at an initial rate of 0.99%) with DAI/USDC as collateral |
2 | BlockFi | Lend ETH at 3.3% |
In a similar fashion to other positions, several risks need to be considered, such as:
Specifically, the loan would not be profitable if:
matchingTime: the time it takes for a loan to be matched on BlockFi.
expectedTimeOpportunity: expected time length for the trading opportunity to remain valid.
Binance Lending allows users to hold funds in subscribed Binance Lending products, with fixed maturities, and to grow holdings by accruing interests.
Step | Platform | Description |
---|---|---|
1 | dYdX | Borrow ETH with (at an initial rate of 0.99%) with DAI/USDC as collateral |
2 | Binance Lending | Lend ETH at 6.0%13 |
As the Binance’s ETH lending interest rate is higher than dYdX’s borrowing rate, this trade would return a positive profit.
Someone could use DAIs as collateral to borrow ETH on dYdX and then transfer onto Binance to subscribe to a lending offer for Ethereum. Once again, collaterals parked on dYdX also receive lending interest rates and any Dai, used as collaterals, would receive lending rates too.
Before establishing this position, there are three main potential risks which may impact this position:
Furthermore, there are other additional major components and constraints to consider:
The next section discusses “pure DeFi” strategies. Namely, carry trade strategies and arbitrage strategies are investigated in the next section, through the analysis of several case studies.
One carry trade opportunity exists if it is possible to obtain a lending interest rate higher on one platform than on another platform.
Despite both cryptocurrencies being pegged to the US dollar, DAI and USDC display extremely different lending interest rates, with DAI exhibiting much higher lending rates.
Sources: Binance Research, LoanScan, Compound
Like other carry trade strategies, it displays potential high risks mostly owing to peg deviation with DAI and USDC prices deviating from their respective peg. Interestingly, if the price of DAI was to appreciate against USDC (e.g., August 2019 on the chart below), it could lead to an additional source of profit.
Sources: Binance Research, Coinbase
Here are some of the largest potential reasons which could lead to fluctuations in DAI price:
As this strategy only relates to USDC-holders, the next subsection discusses a more advanced trading strategy, which can be executed by ETH-holders.
Ethereum’s lending interest rates on Compound and dYdX are respectively lower than 0.03% and 0.10% APR, as of September 23rd 2019.
As the borrowing rate on USDC is inferior to the lending rate on DAI (see chart 3), ETH-holders could potentially consider engaging in a carry trade to earn an additional profit.
Sources: Binance Research, LoanScan, Compound.
Sources: Binance Research, LoanScan, Compound.
Spread is the difference between the DAI lending rate minus the USDC borrowing rate.
Step | Platform | Description |
---|---|---|
1 | Compound | Deposit ETH |
2 | Compound | Borrow USDC |
3 | Kyber / Uniswap | Sell USDC to DAI |
4 | Compound | Lend DAI |
However, the most accurate version of the previous inequality includes expectations of the length of this opportunity. Hence, it would be worth engaging in this trade if:
expectedTimeOpportunity: expected time length for the trading opportunity to remain valid. transactionFee: transaction fee (in % of the amount traded) at step 3.17
The Maker/Compound arbitrage opportunity refers to a historical opportunity that occurred in late 201818.
DAI stablecoins are minted in the MakerDAO’s ecosystem, through the creation of CDPs which are backed solely by ethers (ETH). Specifically, the mechanism relies on over-collateralization. DAI are backed by ethers (ETH), parked in CDPs, which are over-collateralized by at least 150% of the equivalent value in USD worth of ethers.
In late 2018, Compound’s lending interest rate on Dai was higher than the respective interest rate in the MakerDao ecosystem (i.e., stability fee). As a result, it was possible to open CDPs collateralized by Ethereum to earn an annualized interest rate higher than the lending interest rate on ETH.
Sources: Binance Research, LoanScan, MakerDAO, Compound.
Step | Platform | Description |
---|---|---|
1 | MakerDAO | Open a CDP |
2 | MakerDAO | Deposit some Ether and mint DAI within the protocol |
3 | Compound | Park DAI to Compound |
This strategy generated a positive profit as long as the following inequality holds:
Unlike Compound and dYdX, it is also worth noting that ether parked in a CDP do not return any interest, thus representing an opportunity cost.
Hence, it would have been worth conducting this trade as long as the following inequality holds:
In the strategy defined in the preceding subsection, there were some key constraints to consider to assess the profitability of the profitability strategy:
Similarly, some risks needed to be considered:
Eventually, this opportunity ended once the stability fee was hiked several times, through a series of votes by MKR token-holders.
Without considering historical gas fees, this trading position would have resulted in a “pre-gas” positive profit for three months, starting on December 1st 2018 and ending on March 9th 2019, and would have yielded a total return of around 0.87% i.e., 3.25% annualized.
With a close price at $119 on December 1st 2019, ETH price reached a low of $83 on December 15th 2019. As a result, the minimum initial collateralization ratio that would have been required to prevent any liquidation, assuming no additional deposit of ether in the CDP, was around 215%.
Part of the DeFi Series, this report discussed several arbitrage strategies along with carry trades in the Ethereum space.
Arbitrage opportunities appear to be longer-lasting between CeFi and DeFi than within DeFi. Potential reasons may explain this such as the lack of maturity of the DeFi space, the importance of over-collateralization in all protocols, and interest rate setting mechanisms that reflect protocol supply/demand factors (rather than global macro-environment dynamics). On the other hand, different risk profiles between DAI and USDC may explain this persisting divergence between their respective interest rates.
Other important aspects are also worth to be noted:
Furthermore, it is worth noting that “second-layer” DeFi protocols and platforms have been built, which introduced new features like:
Furthermore, new aspects must also be considered for future analysis like oracle price arbitrage opportunities or additional decentralized platforms like Uniswap. Ultimately, interest rate swaps25 or markets to hedge against the direction of interest rates26 could further bring a whole new range of trading opportunities.