Following the announcement of Vortex, our upcoming basis trading product, this post will shed some light on what basis trading is and how Vortex applies it in DeFi.
Tl;DR — Vortex efficiently manages strategy positions to collect and compound the Funding Rate from Perpetual Contracts while remaining market-neutral. Low maintenance, low(er) risk and high(er) reward — with Vortex you’re GMI.
You can try it out on testnet now and register your interest for early mainnet access.
What is Basis Trading?
Basis trading — also commonly referred to as ‘cash and carry’ — is a market-neutral arbitrage strategy which takes advantage of the difference between the spot and future price of a commodity (the ‘basis’).
The TradFi and DeFi approaches to basis trading are different due to the available infrastructure and liquidity, but both utilize similar market mechanisms to achieve their returns.
Basis Trading in TradFi
In the TradFi world, basis trading works in the way outlined above — taking advantage of the difference between the spot and future price of a commodity — on centralized futures markets. This was a favored strategy of the “arbitrage trader at heart”, Arthur Hayes.
Imagine ETH is trading $3500 at spot and the December 31 futures contract is trading at $4000. This is known as being in ‘contango’, with a price differential of $500 (the basis).
- In this scenario, a trader would:
- Buy 1 ‘physical’ ETH at the spot price of $3500
- Sell 1 ETH worth of the futures contracts at $4000
The trader has paid $7500 in total for these positions.
- Jumping forward to December 31st — where ETH is now trading at $4500 — the trader has:
- Made $1000 on their physical ETH
- Lost $500 on their futures contract
Resulting in a gross profit of $500, which is the basis.
- What if ETH is trading below $3500 on December 31st? Let’s say ETH is trading at $3000. In that case, the trader has:
- Lost $500 on their physical ETH
- Made $1000 on their futures contract
Again resulting in a gross profit of the basis: $500.
There are not yet any on-chain futures markets on Ethereum to take advantage of this traditional basis trading model. As a fully on-chain strategy, Vortex utilizes a similar structure but brings in DeFi innovation.
Vortex — Basis Trading in DeFi
Instead of a centralized futures market, Vortex works through decentralized derivative exchanges that offer ‘Perpetual Contracts’ to generate yield.
What are Perpetual Contracts?
Perpetual Contracts are similar to traditional futures, but, as their name suggests, have no expiration or settlement date. They continue perpetually until the position is closed.
This indefinite-until-closed nature means that Perpetuals trade much closer to the current spot price than futures, but, being derivatives, they do still diverge. This price divergence from spot generally reflects the sentiment of traders on the exchange.
It is crucial that this divergence is controlled and the price of Perpetuals are frequently brought back to closely match spot prices.
The mechanism to achieve this control and incentivize spot/Perpetual price stability is known as the ‘Funding Rate’.
What is the Funding Rate?
The Funding Rate is a fee periodically paid from the ‘more popular’ side of the market to the opposing ‘less popular’ side to incentivize contract purchases.
If the Perpetuals price is above the spot price, the Funding Rate will be positive and traders with open long contracts will pay the rate to traders with open short contracts.
Conversely, if the Perpetuals price is below the spot price, the Funding Rate will be negative and open shorts will pay open longs.
How Vortex applies Basis Trading
The crypto markets have historically been weighted towards longs as the majority of participants speculate that prices will go up.
This trend has continued on decentralized derivatives exchanges that offer Perpetual Contracts, which means that Funding Rates have historically, on average, been positive. As a result, from a Funding Rate perspective, it has been profitable to open short positions — but then you may lose a lot more than your Funding Rate returns if prices suddenly moon.
Vortex fixes this by removing the directional price risk from the short position while maintaining the Funding Rate advantage, enabling users to generate market-neutral yields.
Here’s a high-level example of how Vortex works in favorable conditions:
- User deposits 7000 USDC into Vortex, receiving a proportionate share of the vault as Vortex vault tokens.
Assuming 1 ETH = 3500 USDC, Vortex’s underlying strategy will then:
- Send 3500 USDC to a DEX to buy 1 ‘physical’ ETH;
- Send 3500 USDC to a derivatives DEX and use it as collateral to short 1 ETH worth of perpetual contracts.
- Vortex will automatically collect the funding rate and periodically compound and rebalance into both positions, increasing the value of the vault tokens.
Why use Vortex?
To summarize, you should use Vortex because it’s:
- Market-Neutral — Vortex generates sustainable yield without being exposed to cryptocurrency vs fiat price risk.
- Lower Risk, Higher Reward — Vortex is an effective alternative to lending or farming with stablecoins that is proven to be profitable across all market conditions.
- Low Maintenance — Vortex is a passive ‘set and forget’ strategy for users and returns are periodically compounded to further enhance yields.
All while providing the liquidity that is crucial for Perpetual Contracts to function. Using Vortex means WAGMI.
Vortex v1 will launch on mainnet in Q4 21. The testnet version is available to try right now, and we are also looking for a select group of users to be granted early beta access to the mainnet release. If you’re interested, please: