How to hedge against USD risk on Bitfinex
Lendary currently focuses on the most liquid and attractive lending market: US Dollars. Though the USD continues to be the dominant currency in the financial world, political circumstances, complicated macroeconomic developments, and fiscal policy can cause significant price fluctuations of the USD in comparison to other currencies. In 2020 alone, the USD weakened compared to the EUR by ~8.7% (as of December 17th, 2020). This volatility is referred to as the FX (=foreign exchange) risk, which plays an important role for evaluating portfolio performance and risk.
For EUR-based investors (people who evaluate their investment performance on a EUR basis), this means that for 2020 any USD-based investment effectively yields ~8.7% less return — quite a significant impact! To put this into perspective, Lendary is well on track to yield ~14% for the year 2020 for its users. However, any EUR-based investor will have effectively made a yearly return of about ~5.5% from Lendary (which is still attractive considering the high liquidity and no-downside volatility).
It is important to note that this can also have the opposite effect of increasing the returns if, in this example, the EUR weakens against the USD. However, it is important to think about the actual investment thesis underlying any investment. If the currency is not part of the original investment thesis, it may be wise to consider strategies to protect oneself against this “unwanted” volatility. Since it is extremely complicated to accurately assess future development of foreign exchange rates, it is a common practice to hedge positions in a portfolio that are based in a different currency.
With recent innovations on crypto currency exchanges, we now have instruments at hand that let us do just that — take the FX risk out of the equation! To achieve this, we can use futures that are based on the FX-rate we are exposed to. In this example, we will continue to use EURUSD.
Consider a Lendary user from the EU (hence he evaluates his investment returns on a EUR basis), who has 1.000 USD in his Bitfinex account taking advantage of the Lendary automation service to generate some passive income. To eliminate FX risk, this Lendary user can now build up a future position on Bitfinex that will exactly offset any gains/losses his 1.000 USD generate due to FX effects (i.e. movements of the EUR-USD price). To do so, execute the following steps:
- Take 5–10% (dependent on how actively you want to manage your hedge) of your invested USD and convert them into USDt (the largest “stablecoin”, which is pegged against the USD). This step is necessary, since the future contracts on Bitfinex require USDt as the collateral. In our example, this would be 100 USD (10%).
- Transfer 100 USDt into the “derivatives” wallet on Bitfinex.
- Select the FX EUR perpetual futures contract from the list of available future instruments
- To compute the amount of contracts you need to acquire to accurately hedge your investment, take the remaining USD (= 900) and divide them by the current EUR-USD price (~1.22). This results in ~738 contracts required to build up a futures position worth 900 USD. You can think of one contract as “one Euro”.
- Set the leverage setting to 10 (since we used 10% of our capital as collateral — if you chose 5%, the appropriate leverage would be 20 and so forth).
- Next, build up a long position of 738 EUR perpetual contracts.
We have also made a video demonstrating this process and explaining everything in more detail. You can watch it here.
This is basically it. You now have created a situation where any gain/loss of the 900 USD due to FX effects will be perfectly offset by the futures position. This is because as the EUR-USD price increases, the 900 USD loose value in terms of EUR. At the same time, the future position gains value of the same amount. Congratulations, you have effectively taken out the FX risk out of your Lendary investment!
We have tried to explain this process as simple as possible. The topic of hedging and dealing with futures can be very complicated so please reach out to us if you have any questions! It’s also important to note that this does not constitute any investment advice, but solely describes a method of how to control FX risk using instruments on Bitfinex.
There are a couple of important additions to this process:
- When building up the future position, be aware of the spread resulting from any given order book situation. If you plan to build up a significant position (e.g. larger than 25.000 USD equivalent), you may want to consider building up the position over time, rather than just executing one single large order.
- Using leverage can cause the position to be auto liquidated. To avoid this risk, take note of the liquidation price of your futures position. When the actual price approaches the liquidation price, consider transferring more USDt to your derivatives wallet and edit (increase) the collateral of your position. This will change the liquidation price in a way that the liquidation event becomes less likely.
- This method is extremely cost effective in total, but some transaction costs occur in the process of building up (and at a later stage closing) the hedge position.