Interest Rate Arbitrage on Ethereum
There are increasingly more Ethereum projects building Decentralized Finance (DeFi) applications. Whilst liquidity across platforms remains scarce compared to centralized counterparts, we foresee interesting trading opportunities arising in the space from both existing and new platforms.
MakerDAO Collateralized Debt Position (CDP)
The Maker (MKR)credit system acts similar to a decentralized lender, allowing users to lock up collateral in smart contracts and borrow DAI. A user that wishes to transact in DAI would send a specific amount of ETH to a contract which creates a Collateralized Debt Position (CDP). To hedge against a decline in the price of collateral users must over-collateralize these contracts.
dYdX Margin Tokens
A dYdX margin token is a freely tradable ownership interest in a dYdX margin position. The protocol allows users to tokenize leveraged long (LETH) and short positions (sETH) on ETH. To create more ETH for minting LETH, users borrow DAI (currently @ 8% APR). To mint sETH, users borrow ETH (currently @ 10% APR) and collateralize with DAI.
MKR Funding Arbitrage
Pledging ETH creates a MKR CDP, which collateralizes the ETH and mints a DAI loan/liability. The DAI loan has a CDP stability fee (interest rate) which currently stands at 2.5% (APR).
Market participants can use DAI minted from MKR CDPs to lend on other DeFi platforms, in order to earn the interest rate spread.
We can lend out the DAI from the CDP via dYdX protocol at 8%, funding leveraged long contracts for users minting LETH positions. This earns you 5.5% APR net interest on DAI. However, if the ETH collateral value falls below 150% of the dollar value of the DAI borrowed, the CDP could be liquidated. This starts the auction process in which the ETH collateral of the CDP are sold in order to pay off the outstanding DAI loan balance, stability fees, and liquidation penalty (13% of CDP collateral). Adjusting for a collateralization ratio of 200%, this trade nets you only 2.75% APR, flat to 3m LIBOR.
This funding arbitrage exhibits negative convexity. An increase in value of the collateral earns us extra dollar-P&L from our ETH on top of our net interest, but a sharp fall in prices causes pressure on both legs of the trade. As the underlying declines in value, market participants will either have to acquire more ETH to top up collateral, or DAI borrowing demand would spike as underfunded CDPs scramble to pay down principal + stability fees.
Currently, 1.64mm+ ETH is pledged as collateral in MKR CDP’s (~1.6% of supply). Levels preceding steep curvature points across the aggregate liquidation table gives indication to levels of ETH that may correspond to increases DAI interest rates, based on the same mechanism described above.
Interest rate arbitrage becomes more attractive following funding squeezes. Recently, Compound borrowing rates for DAI spiked >20% APR. This was likely driven by demand to either top up collateral or pay down existing CDPs following the recent slide in ETH/USD.
Borrowing DAI from MKR CDPs at 2.5% and lending at 20% now yields an annualized rate of 17.5%. Earn extra yield when DAI trades +ve to USD (premium has gone to +5% previously). The DAI interest + USD premium can be used to buy ETH in order to re-collateralize the CDP, and earn the interest rate spread whenever Compound lending rate> MKR CDP stability fee.
- Lend DAI and borrow ETH (Compound/dYdX/Dharma)
- Use borrowed ETH to create a Maker CDP; mint more DAI
- Lend the newly minted DAI and borrow more ETH
- Repeat and earn the interest rate spread whenever DAI lending rate> [ETH funding %+ MKR CDP stability %]
For reference, the USD lending rate on Bitfinex is currently below 3% APR whilst the annualized rate for ETH has averaged ~10% with current daily funding at 3bp net of fees.
On December 17, MakerDAO will have an executive vote to decrease the stability fee for DAI from 2.5% to 0.5%.
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