Exploring Derivatives Strategies in DeFi
Galleon DAO just launched a new structured product that offers exposure to basis trading strategies on DeFi.
⛵ Galleon DAO
Galleon DAO is an ecosystem project derived from Set Protocol. Set Protocol develops asset management tools and infrastructure to manage crypto portfolios. Currently it is used by other popular projects such as Index Coop, Bankless or DeFi Pulse, that provide a way to invest in Crypto Indexes. This technology enables Galleon to create structured products in Crypto, consisting of automated on-chain strategies where any investor can easily participate without having to manage the underlying strategy by themselves.
The first product that Galleon launched was named ‘ETH Max Yield Index’, a leveraged strategy involving Lido’s staked ETH (stETH) and the lending protocol Aave. It allows investors to gain exposure to the price of stETH against ETH with leverage. Although it is widely considered a risky strategy it has been a very popular strategy among DeFi, allowing it to earn almost 15% APY in ETH at some point. Their new product just launched in Optimism is called Basis Yield ETH Index. It empowers the modularity of DeFi by leveraging the derivatives protocol Perpetual to offer exposure to a leverage strategy on perpetual markets known as basis trading.
🧮Basis trading
Basis trading consists of generating yields by arbitraging funding rates. This is considered a legit source of yield that is originated by the diverse positioning of traders in derivatives markets. If our reader is not familiar with how funding rates work, we have written a guide about them and how to interpret them before. Since many investors do not want to have exposure to the market moves of crypto assets, they include a hedge that converts this strategy into delta-neutral which makes it more appealing.
The yield is gained everytime that longs position pays short positions on Perp protocol. So Galleon is always positioned short in perpetual futures, earning yield always that funding rate is positive. Historically a positive funding rate has been the usual for an asset such as Ethereum. As can be seen in the next chart:
As can be seen from the chart above, when the market sentiment remains highly positive, the funding rates remain positive, but in moments such as the one we are experiencing now, the funding rates tend to remain near 0.00% or slightly negative. As it is understood by Galleon‘s documentation, a period of extended negative rates would incur a loss to the vault, so the strategy is not risk free. Although the derivatives markets on BTC and ETH had an imbalanced long positioning, nothing assures that this would remain like this in the future, for example in cases where a bear market would extend over several years like happened in 2018.
👋 BYE token
The implementation of the strategy involves an ERC-20 token, named BYE, that accrues the revenue and autocompounds it. BYE can be minted Set Protocol Issuance by providing a third of USDC (that is used to collateralize the short position that earns the funding rate) and two thirds of WETH, which allow it to remain hedged. BYE trades against USDC on its Uniswap V3 pool which is what allows an investor to gain the yield of the strategy without having to hold ETH. The composition of the BYE token can be seen in the next image:
📈Funding Rates Tendencies
The expected annual returns of the strategy could be close to the annualized funding rate of ETH. Taking 2021 into account In most derivative markets this oscillated between 25% and 35%. Although these figures seem disproportionate compared to the current yields of ETH, the returns diminish substantially if we take into account the first quarter of 2022. Depending on the derivative market that we look into, yields would be ranging from -3% or -2% up to 7%.
Taking the median of the Q1 funding rates of these exchanges and annualizing it we would arrive at 3.5% yearly if the market would continue this pace. This yield would certainly improve if the crypto market sentiment would turn slightly positive again. But at this point that is an uncertainty, and a yearly return of 3.5% is lower than a risk-free strategy (although not highly liquid) as Lido’s stETH.
🌯Wrapping up
We are excited to see the launch of novel structured products in DeFi. They offer an accessible way to be able to use DeFi strategies that are hard to perform by retail investors. In DeFi, simply buying a token and letting it compound is the easiest way to have access to a strategy such as this one. It allows remaining liquid and keeping track of the performance directly. In return, Galleon DAO gets a fair performance fee, which is an industry standard. It is positive that the composability of DeFi is embraced and will be interesting to witness which other on-chain derivatives strategies could come tokenized in the future as long as the volume on these platforms continues growing.
