Diamond’s New Cash & Carry Vault Beta Launch!
Trading in financial markets usually involves taking a directional risk to pursue excess returns. In TradFi terms, this is called having a positive delta (if you are net longing) or a negative delta (if you are net shorting). Most of the time, the success of your trades depends on the direction in which the market moves.
So what is delta exactly? Delta is the relationship between your portfolio and the underlying asset that is correlated to it. If the delta of your portfolio is positive, when the underlying asset price goes up, your portfolio value should also increase. On the other hand, if the delta is negative, you profit when the price goes down.
It is tough to trade directionally in the current market conditions, as many altcoins have dropped more than 90% from their previous ATHs, and many people are losing money because they are trying to “buy the dip.” You may short the market if you are bearish; however, you can get cold feet when looking at the chart and ask, “how close are we to the bottom?”
Like we said, trading with direction (delta) can be challenging. But, we see another possibility: what if the delta is zero?
Delta Neutral Strategy
A strategy (portfolio) with a zero delta is called “delta neutral,” and it means that wherever the price of the underlying asset is going, your portfolio will have the same outcome. If we play it smart, the outcome will be making a profit.
There are a lot of strategies that can achieve a delta-neutral state. Most involve trading with arbitrage opportunities between different exchanges or using fancy techniques like MEV and flash loans. As you might have imagined, delta neutral doesn’t come free of charge, and it usually takes a lot of capital and a solid technical background to achieve.
However, our latest Cash and Carry strategy is a simple arbitrage strategy that requires the least capital. This delta-neutral strategy targets 20–30% APY at low risk. So how do we achieve this in the bear market?
Let’s dive in!
The Definition of Cash and Carry Strategy
Derivatives are financial products designed to track the prices of the underlying assets. Theoretically, the price of a derivative should match its underlying asset, but in reality, its price can deviate due to temporary market sentiment and higher capital efficiency.
In TradFi, futures contracts have expiration dates, which means when the expiration date arrives, the futures contract will be settled in the spot price. Therefore the contract price will converge with the spot price.
In the crypto world, perpetual futures is a kind of derivative that also tracks the price of its underlying asset without expiration dates. To maintain the peg between perpetual futures and spot assets, a mechanism called “funding rates” was invented.
Funding Rates
Funding rates are periodic payments to long or short traders based on the difference between perpetual contract markets and spot prices. In other words, traders will either pay or receive funding when trading perpetual contracts.
In general, when the funding rate is positive, the price of the perpetual contract is higher than the spot price. Thus, traders who are long pay for short positions. Conversely, a negative funding rate indicates that perpetual prices are below the spot price, meaning that short traders should pay for long positions.
Many factors can affect funding rates, the most important two being market sentiment and arbitrage efficiency.
Market Sentiment
When people are bullish on the market, they tend to leverage their positions to make larger profits. Therefore, the demand for leverage grows to move the perpetual price above the spot price, thus making the funding rate positive. On the contrary, if people turn bearish, the leveraged short positions tend to move the perpetual price below the spot price, therefore making the funding rate negative.
Arbitrage Efficiency
Crypto markets never sleep, so there will be arbitrage opportunities 24/7. Some markets tend to move slower than others, making a difference in funding rates within different exchanges.
Mechanism of Cash and Carry
Now that we are familiar with funding rates, we can go straight to the core of cash & carry. In short, cash & carry is a strategy that takes advantage of funding rates by constructing a portfolio of:
- Longing a certain amount of spot asset
- Shorting the same amount of perpetual contracts
In this portfolio, since we hold the same amount of spot assets and shorted perpetual contracts, the strategy is delta neutral. The strategy will be profitable if the funding rate is positive.
Diamond’s Cash and Carry Vault
Our cash and carry vault is deployed on Optimism, a fast and cost-efficient layer 2 on Ethereum. The strategy is designed to interact with our partners Perpetual Protocol V2 and Uniswap V3.
Perpetual Protocol
Perpetual Protocol is the largest on-chain perpetual futures DEX on Optimism. Users can trade perpetual contracts permissionless on Perpetual Protocol with up to 10x leverage.
User Flow of Vault
Open Position
When you deposit USDC into the vault, the vault contract will mint an LP token representing the shares you hold in our strategy. The USDC will be split into two parts: 50% for buying ETH spot on Uniswap and 50% for shorting ETH perpetual contracts of the same size on Perpetual Protocol.
Rebalance
As the underlying asset’s price fluctuates, there will be an imbalance between our spot position and perpetual position. This becomes a problem when the price almost doubles since we will face liquidation risk on our shorting side. In light of this, we have designed a role “keeper” to monitor the balance in both our spot and perpetual positions. It will automatically rebalance the position if the price movement has been significantly large.
Close Position
When you withdraw your USDC from the vault, the vault will close the positions that match your shares, return the USDC that represents (your principal + strategy PnL) to you and burn the LP token. Users can withdraw their funds at any time.
Why Invest In Our Cash and Carry Vault?
Delta Neutrality
The market has been tumbling recently, and the most important thing right now is to stay in the market and earn yields without taking a directional risk. In this regard, investing in our cash & carry strategy becomes a no-brainer.
High Potential Return
The funding rates are generally high on Perpetual Protocol. We can approximately convert the funding rates to the Cash and Carry strategy performance by dividing the funding rates by 2 (since we are only earning funding payments in the perpetual contract position).
To get a more accurate approximation of the expected return, we ran a backtest starting from 2021/11/28 to 2022/06/14, based on the historical funding rates on Perpetual Protocol. See the results below:
Backtest Result — Past 30 Days
Backtest Result — Past 60 Days
Backtest Result — Past 197 Days (since the inception of Perp V2)
The strategy has performed well since the inception of Perpetual V2. Based on the backtesting results, the cash and carry strategy targets 20–30% APY.
Risk Disclosure
Although there are many advantages to our cash and carry strategy, investors should still be aware of the following risks:
Negative Funding Rates
The cash and carry strategy is profitable only when the funding rates on Perpetual Protocol are favorable, which we believe will last due to the nature of Perpetual Protocol. However, the strategy can incur losses if the funding rates turn negative.
Liquidation
In our Cash and Carry strategy, even though the vault opens the short position with a 100% collateral ratio, we might still face liquidation risk if the price soars almost 100%. To cope with this, a key role called keeper in our cash & carry vault will monitor the price on both the spot and the perpetual sides. If the price has moved more than our safety threshold (33%), the keeper will automatically rebalance the positions to avoid liquidation.
Smart Contract
The smart contract has gone through thorough tests and examinations by our team, and the security firm Quantstamp also audited it in May 2022. However, even though we have done the best we can to ensure the quality of our code, there might still be unknown issues or bugs. Therefore, users should invest with caution and DYOR.
Other Risks
Blockchain and its applications are emerging technologies, which may include other risks not listed above.
Release Timeline
The Cash and Carry vault has completed the alpha testing and will go into the beta phase on 6/18. Initially, we will set the deposit cap at 200,000 USDC and will raise the cap once the strategy goes live, so stay tuned!
Useful Links
🌐 Official Website: https://dmo.finance/
✍ Blog: https://medium.com/@diamondprotocol
🐦 Twitter: https://twitter.com/DiamondProtocol
👾 Discord: https://discord.com/invite/PcC8
