DEFI BLOG SERIES
Intro to ‘Yield Curve Play’ for Cryptocurrency
Unlock Innovation for Institutional-grade Decentralized Finance
Cryptocurrency is not cash equity; it is the currency that comes with banking-level businesses, using loans and swaps to enable various trading and hedging strategies. In decentralized finance, the yield curve is the final piece completing full-range financial markets. This article presents three strategies to reveal the yield curve’s power, and introduces the way to elevate your trading and risk management. This is the fourth article of the DeFi blog series presented by Secured Finance.
Disclaimer: This is not financial advice. All information, assumptions, and scenarios provided here are created and simplified for educational purposes.
Simple Long (Carry and Roll-down) Strategy
This is a popular way to generate profits in the asset management field. It is economically the same as purchasing a bond. You can receive a coupon for a few years, but you don’t need to hold it until maturity. You can sell anytime. Let’s look at an example using the Bitcoin yield curve.
If you are a Bitcoin Hodler, you may invest in a 3y loan with 7% annual interest rates. Then one year later, you’ll receive 7% carry in Bitcoin. If the curve remains the same, a 2y loan yield is 5%, while your loan is a 2y loan with 7%. You may unwind your loan to fix the yield spread by 2% (7% minus 5%). This profit is called roll-down, and you realize 4% (2% for 2y) profit. This strategy allows Bitcoin investors to aim for not only capital gain but also income gain.
Carry Trade Strategy
This is a common investment strategy among hedge funds and wealth management products available through private banks. There is always a chance to make profits from the yield spread between two different currencies. As long as you can take currency risk, this would be an interesting idea. Here’s an example using the BTC yield and the USDC yield.
In previous simple long strategy, you just invest in a 3y loan to receive a 7% yield. In the carry trade strategy, you also borrow low-interest USDC for 3y and pay 3%. So, you can aim for a 4% yield spread. The point here is that you don’t need to prepare BTC in the beginning; you borrow USDC and convert to BTC and lend out. You will probably need to provide collateral, but the collateral amount should be smaller because you are both the borrower and the lender. Therefore, you can leverage on this, say, three times, and you can aim for 12% (4% spread times 3), but it comes with the BTC/USDC currency risk.
Currency Risk Hedge by FX Forward
The yield spread can be used for currency risk hedges. FX Forward is used to fix the future exchange rate; therefore, it’s a very popular product for import/export corporate businesses and asset management businesses. Having two yield curves enables calculating forward FX rates using the arbitrage-free theory, and you can use it for advanced trading and hedging strategy.
For example, if a one-year yield spread between BTC and USDC is 2%, the 1y forward BTC/USDC rate is roughly 2% lower than the current spot rate. This is useful if you expect BTC income one year later, but you want to fix the USDC amount using the current level. If the current spot is $61,200, then the 1y forward exchange rate is roughly $60,000 per BTC, and you can fix the future USDC amount now. Isn’t it cool?
Cost Reduction Strategy
The yield curve is useful to reduce interest rate costs if you borrow money. You may reduce the borrowing cost by using the yield spread from different currencies, but it comes with a currency risk. Alternatively, you can use the term structure of the yield curve, so you don’t need to entail a currency risk. Sometimes, the yield curve is inverted by strong demands in short-term lending. Let’s have a look at the Filecoin yield curve and see how to reduce costs.
Filecoin is a decentralized storage protocol, and there is a strong borrowing demand from Filecoin miners. They need to pledge FIL to start storage mining, and therefore the short-term borrowing rate becomes high. In contrast, as the long-term borrowing demand is not so strong, the interest rate is lower.
A cost reduction is possible if you already borrow FIL and paying high interest rate, and also you can assume the yield curve shape remains the same. You can borrow Filecoin for 5y with 5%; then, you can lend the Filecoin for 1y with 15%. In this way, you can offset the interest rate you pay (15%) and receive (15%), and you only need to pay 5% for 5 years. In two years, your loan will become a 3y loan with a 5% payment, while a 3y loan is 8% in the market. If you don’t need Filecoin, you can lend out or unwind to realize 9% (3% spread for 3y) profit.
Interest Rate Swap Trading
You can aim for profit from the term structure of the yield curve. For example, you can borrow FIL for 5y and lend it for 1y and aim for a 10% yield spread annually. This is called an Interest Rate Swap. As explained in the carry trade strategy, you don’t need to prepare for the initial amount. However, you may need to provide collateral, but the amount should be much smaller because, essentially, it is just an interest rates exchange. Because notional currency and amount are identical, the notional can be virtual; therefore, you don’t even need borrowing/lending operations. Interest Rate Swap is a capital-efficient, over-the-counter, and off-balance transaction; therefore, it is a powerful tool for risk control to underpin the entire financial system. Now, you learned the power of the interest rate swap and why this has become the largest market ($500 trillion) in the world (Source). Secured Finance sees this is a huge potential, and is building this market for cryptocurrency.
The yield curve is the biggest and most important piece enabling full-scale finance in cryptocurrency. Three strategies have been discussed. The simple long strategy provides income gain, the carry trade strategy allows advanced trading and hedging, and the interest rate swap enables cost reduction and more flexible trading opportunities. Secured Finance enables all digital asset traders and financial institutions to access full-scale capability and aims to unlock innovation in finance.
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