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Main points:
Main points:
Interest rate arbitrage in the decentralized finance (DeFi) space refers to exploiting interest rate differences between decentralized finance platforms. There is also an arbitrage between DeFi-CeFi (decentralized financial platform-centralized financial platform), which usually occurs when there is a difference in interest rates between the two platforms.
Investors can also use the carry trade strategy in reverse, meaning they can borrow assets with lower interest rates and invest in assets with higher returns.
However, all existing decentralized finance platforms impose overcollateralization requirements on borrowers, which limits potential arbitrage opportunities.
There may be several potential market inefficiencies within decentralized finance and with centralized financing platforms for the following reasons:
Decentralized finance is still a new thing, and it can be seen from the borrowable amount and daily transaction volume that its liquidity is low (compared with centralized financial platforms).
Specific risks involved in each platform: interest rate fluctuations, potential smart contract issues, loan matching uncertainty, redemption risk, etc.
Different platform and protocol characteristics: All protocols and platforms, whether decentralized or centralized, have different expected characteristics, collateral requirements, and terms of agreement.
Ultimately, as the decentralized finance space continues to mature, new arbitrage opportunities are expected to become more scarce. As long as the assets and platforms have similar risk characteristics, interest rates between platforms will also converge. New platforms and protocols such as interest rate swaps may bring more trading opportunities.
The decentralized finance industry has been growing significantly since mid-2018, and Ethereum is one of the most well-known blockchains for platforms and developers. The report describes trading strategies within the DeFi space and between DeFi and CeFi platforms, known as arbitrage or carry trades. Additionally, this report aims to discuss potential price inefficiencies as well as risks and constraints that must be considered when building a dominant position.
1. General definitions
Define arbitrage as:
Arbitrage is the act of buying and selling assets in two or more markets to profit from the difference in their prices. […] Arbitrage exists as a result of market inefficiencies.
In the world of decentralized finance, arbitrage opportunities arise when there are differences in interest rates between platforms. Generally speaking, when interest rate arbitrage occurs, the borrowing rate on one platform is higher than the lending rate on another platform.
We can define pure interest rate arbitrage in the field of decentralized finance as:
Interest rate arbitrage in decentralized finance refers to the use of interest rate differences between different decentralized platforms.
However, arbitrage opportunities can also occur on centrally hosted platforms (such as BlockFi and Nexo, as well as non-cryptocurrency financial service providers, for example). There are also opportunities for non-blockchain financial providers such as commercial banks or lending companies.
DeFi-CeFis interest rate arbitrage refers to the use of interest rate differences between decentralized platforms and centralized platforms.Investopedia,Additionally, this report discusses carry trade strategies. according to
They are defined as follows:
A carry trade is a trading strategy in which you borrow money at low interest rates and invest in assets with higher returns. Carry trades in traditional financial markets are usually borrowed in a currency with a low interest rate and converted into another currency deposit with a higher interest rate.
Carry trades, as referenced in this report, refer to transactions such as those that benefit from interest rate differentials between stablecoins, assuming these stablecoins are pegged to the same fiat currency (i.e., the U.S. dollar).
The next two sections discuss the carry trade and arbitrage opportunities that exist between platforms through the analysis of case studies from a current perspective and experience.
2. DeFi-CeFi Case Study
2.1. Retail platforms and DeFi protocols
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Table 1 - Comparison of retail platform interest rates assuming FICO score > 720
The US dollar borrowing rate of the centralized financing platform usually does not require users to make an initial collateral. However, short-term borrowing is often expensive. Therefore, a simple strategy can be implemented around decentralized finance and centralized financing platforms.
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Table 2 - Sequence of steps to be taken
This strategy will generate a positive APR as long as the following conditions are met:
USDC Deposit Yield (%) on Compound > Unsecured USD Borrowing Rate (%)
However, a more realistic approach would be to transfer some of the USD you already have from a savings account to Compound/dYdX to maximize the expected return.
Transferring USD from a savings account to a Compound account is worthwhile as long as the following conditions are met:
USDC deposit rate on Compound (%) > USD bank deposit rate (%)
2.1.2. Risks and considerations
In the strategies described above, there are some key factors to consider in addition to potential existing risks that may hinder the expected returns of that particular strategy. Some of these are related to the determination and changes of Compound interest rates. Specifically, the borrowing rate and lending rate are modeled based on linear functions, and each asset has a lower limit and upper limit, which will be adjusted according to the real-time supply and demand in the agreement.
Centralized funding platforms, on the other hand, typically have variable interest rates that fluctuate over time based on macroeconomic conditions as well as specific terms of agreements that often vary from platform to platform. Therefore, when establishing a CeFi-DeFi arbitrage position, the following different factors must be considered:
Volatility of variable interest rates: On most decentralized finance platforms, interest rates fluctuate according to the protocol supply and demand mechanism. As such, it introduces volatility risks associated with lending rates. As the decentralized finance industry remains small, platform-specific supply and demand dynamics may deviate significantly from off-chain equilibrium.
Early repayment penalties for centralized financing loans: Many centralized financing platforms do not allow individuals to repay early, or early repayment may require corresponding penalties. Therefore, if decentralized finance lending rates are about to fall below centralized finance borrowing rates, traders face two main choices:
1. Wait and continue with negative yield strategies.2. Pay the prepayment penalty.
Gas Fees: These fees must be considered and included when evaluating the profitability of a strategy. For practical reasons, this analysis omits miner fees. Since the gas fee is usually fixed (i.e. not related to the amount transferred from one address to another), this omission will only slightly affect the profitability of the strategy in the case of large transaction amounts.
Additionally, there are other risks associated with Compound (or decentralized finance protocols):
Withdrawal risk: Because funds lent on Compound do not have any maturity date; it may be difficult to redeem immediately, depending on the borrow-loan difference.
Centralized management: Compound will determine and update the interest rate model8. It is worth noting, however, that the specifics of the model are fully transparent, but admin keys may be compromised.Nexus MutualSmart contract risks: Like most smart contract-based decentralized financial protocols, Compound may have smart contract risks. However, the development of insurance platforms may be able to mitigate the smart contract risks specific to each platform to some extent. For example, investors can
The above subscribes for a fixed-term and specific amount of insurance for the Compound smart contract.
2.2. BlockFi and dYdX
BlockFi2.2.1. Transaction Description
is a centralized custodial cryptocurrency platform that allows users to borrow and lend large-cap crypto assets such as Ripple (XRP), Bitcoin (BTC) or Ethereum (ETH).dYdXSince BlockFis lending rate is higher than
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Table 3 - Series of steps to be taken (September 23, 2019)
2.2.2. Risks and considerations
Similar to other arbitrage combinations, there are also several major risks to consider, such as:
The interest rate of the centralized financing platform is artificially set by three parties: BlockFi can set the borrowing and lending interest rate by itself (see terms and conditions 10). Historically, previous exchange rate changes have been significant11 with almost immediate effects. Therefore, this may affect the profitability of the strategy.
Price volatility risk: dYdX positions may be liquidated if the price of Ethereum increases. Therefore, the initial collateralization ratio must be considered and traders need to monitor it on an ongoing basis.
Smart contract risks: As with most smart contract-based decentralized financial protocols, there may be risks in terms of the overall behavior of smart contracts. Similar to what was mentioned in Section 2.1.2, investors can insure against smart contract risks unique to the dYdX12 platform on certain insurance platforms.
Binance Research: Carry trades and arbitrage opportunities among DeFi platforms
Matching Time: The time it takes to match a loan on BlockFi.
Expected Time Opportunity: The expectation of how long a trading opportunity will remain valid.
2.3. dYdX and Binance Savings
2.3.1 Transaction Description
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Table 4 - Series of steps to be taken (September 23, 2019)
Since Binances ETH lending rate is higher than dYdXs borrowing rate, the trade will have a positive payoff.
Someone can use DAI as collateral to borrow ETH on dYdX, and then transfer it to the Binance platform to apply for an ETH loan. Likewise, collateral on dYdX can also earn loan interest, as will any Dai used as collateral.
2.3.2. Risks and considerations
Before entering this position, there are three main potential risks that could affect it:
Price volatility risk: dYdX positions may be liquidated if the price of Ethereum increases. Therefore, the initial mortgage rate must be considered, and traders need to continuously monitor the mortgage rate.
Smart contract risks: As with most smart contract-based decentralized financial protocols, there may be risks in terms of the overall behavior of smart contracts.
Volatility in DeFi interest rates: If dYdX’s lending rate is higher than Binance Savings’ lending rate, this situation will lead to negative yields. However, current interest rate differentials are wide enough to prevent this from happening.
Additionally, there are other major components and constraints to consider:
Binance Savings does not allow prepayment: Unlike many platforms, funds in Binance Savings subscription products cannot be redeemed before the maturity date. Accordingly, positions cannot be reduced in the event of an unfavorable situation of any of the risks mentioned above.
Unable to subscribe: Due to the popularity of Binance Savings subscription, users may not be able to participate due to the upper limit of subscription. This upper limit includes both the total subscription size and the corresponding personal limit.
Binance Withdrawal Fee: Like many centralized exchanges, Binance has adopted a policy of charging a fixed fee for asset withdrawals14. However, this will only have a slight impact on profitability due to the very high subscription size cap.
Gas fees: Again, gas fees must be considered and included when evaluating the profitability of a strategy. For practical reasons, this analysis omits miner fees. Since the gas fee is usually fixed (i.e. independent of the amount transferred from one address to another), this omission will only slightly affect the outcome of the strategy.
The next section explores “pure decentralized finance” strategies. That is to say, in the next section, we will study the spread strategy and arbitrage strategy through the analysis of several cases.
3. Arbitrage and carry trade strategies for pure decentralized finance
3.1. The interest rate difference between USDC and DAI
A carry trade opportunity exists when a higher loan rate is available on one platform than another.
3.1.1. Transaction Description
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Table 5 - Series of steps to be taken (September 23, 2019)
3.1.2. Risks and considerations
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Chart 2 - OHLC data of DAI price on Coinbase Pro (denominated in USDC), source: Binance Research, Coinbase
Here are some of the biggest potential reasons for DAI price volatility:
DAI Supply Cap: With a supply cap of 100 million units, the supply of DAI may not be able to increase in response to market demand. Therefore, this strategy could lead to higher price uncertainty if the circulating supply increases and approaches the boundary value of 16.
Downtrend in ETH price: If ETH price falls, CDP (Collateralized Debt Position) holders may experience a demand shock for DAI, as they may prefer to close their existing CDP accounts rather than deposit more ETH. Therefore, there may be a potential short-term price increase due to changes in market demand.
Lack of liquidity to convert DAI to USD (and collateralized stablecoins): Things like low order books or a lack of trusted trading venues can prevent strategies from executing properly.
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Figure 4 - The price difference between DAI lending rate and USDC borrowing rate in Compound v2 version, source: Binance Research, LoanScan, Compound
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Table 6 - Series of steps to be taken (September 23, 2019)
Binance Research: Carry trades and arbitrage opportunities among DeFi platforms
Expected Time Opportunity: The expectation of how long a deal opportunity will remain valid.
Transaction fee (%): transaction fee in step 3 (percentage of transaction amount) 17
3.2. Arbitrage between two Maker-Compound platforms (historical cases)
The Maker/Compound arbitrage opportunity refers to a historical opportunity that occurred in late 2018.
The DAI stablecoin was created within MakerDAOs ecosystem by creating a CDP fully backed by Ethereum (ETH). Specifically, the mechanism relies on overcollateralization. DAI is backed by Ethereum (ETH) locked in CDP accounts that are over-collateralized by at least 150% of the Ethereum equivalent USD.
1. Description
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Table 7 - Sequence of steps to be taken (December 1, 2018)
This strategy yields positive profits as long as the following inequality holds: DAI lending rate on Compound (%) > Stability Rate (%)
Unlike Compound and dYdX, its also worth pointing out that ETH held in a CDP does not generate any interest income, so this creates an opportunity cost. Therefore, this transaction is worthwhile as long as the following inequality holds: DAI loan rate on Compound (%) − stability fee rate (%) > ETH loan rate on Compound (%)
2. Risks and constraints
In the case of the strategies described in the previous subsection, some key constraints need to be considered in order to evaluate the profitability of the strategy:
MakerDAOs overcollateralization requirement: In order to create DAI in the ecosystem, it needs to be collateralized at an initial collateralization rate of 150%. In addition, as long as the mortgage rate is lower than 150%, CDP will be at risk. As a result, the median collateralization ratio in the system is much higher than 150% (368% on September 23, 2019). Since the Ethereum deposited in the CDP account will not be returned with interest, strengthening the protection of collateral prices will reduce the expectation of returns.
Miner’s fee: This strategy also needs to consider factors such as miner’s fee, such as opening a CDP account on Compound, storing Ethereum, creating DAI, depositing DAI, and withdrawing DAI from Compound and closing the CDP account. miner fee.
Again, there are some risks to consider:
Risk of forced liquidation: Although this strategy is profitable, if the price of Ethereum falls further, it will put CDP accounts at risk, requiring users to transfer some DAI to reduce CDP account funds or increase collateral.
Compound redemption risk: Historically, more than 98% of the funds on Compound have been lent, which has resulted in the protocol being unable to process all redemption applications immediately. That could, however, cause interest rates to spike, boosting the expected return on the trading strategy.
Risks specific to each platform: All of these platforms are subject to price oracle errors because MakerDAO and Compound use two different price oracles.
Ultimately, this opportunity ended with several hikes in the stability rate through a series of votes by MKR token holders.
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Figure 6 - OHLC data for Ethereum price (in USD)
4 Conclusion
Part of a series of reports on decentralized finance, this report discusses arbitrage strategies and carry trades in the Ethereum network.
Arbitrage opportunities between centralized funding platforms and decentralized finance platforms appear to be somewhat more persistent than those within decentralized finance platforms. Potential reasons for this could be the immaturity of the decentralized finance space, overcollateralization being required by all protocols, and interest rate setting mechanisms that reflect supply and demand factors within the protocol (rather than global macro environment dynamics). On the other hand, the different risk profiles between DAI and USDC may be the reason for the persistent divergence between their respective interest rates.
Other important aspects are also worth noting:
Long-term asset allocation perspective: Some trades are profitable, depending on which assets one wishes to hold on to over the long term. For example, ETH loan deposits denominated in ETH itself have extremely low returns. Therefore, strategies that attract ETH holders may not necessarily attract other token holders. For example, someone holding DAI/USDC might be reluctant to take a complex position.
Ability to diversify interest rate exposure: Arbitrage positions, such as those between Maker and Compound, allow individuals to gain exposure to new assets.
Additionally, it is worth noting that “layer 2” decentralized finance protocols and platforms have been created and introduced the following new features:
Platform Bridges: Platforms like InstaDapp22 provide an automated way to transfer loans between Maker and Compound.
Agreements and contracts that are automatically allocated to the best platforms such as MetaMoneyMarket23 or RAY (Automatic High Yield Allocation Robot)
In addition, future analysis must also consider new aspects such as oracle spread arbitrage opportunities or opportunities found on other decentralized financial platforms such as Uniswap. Ultimately, interest rate swaps25 or market hedging26 of trends in interest rates could further open up a whole new set of trading opportunities.
References:
References:https://medium.com/amber-group/interest-rate-arbitrage-on-ethereum-621813ae7c0
Amber Group. Ethereum Interest Rate Arbitrage (2018).https://compound.finance/documents/Compound.Whitepaper.pdf
Compound. Compound: A Money Market Protocol (2019).https://blog.dharma.io/dharma-markets-report-6-trading-strategies-in-defi-b7651378bedb
Dharma (Max Bronstein). Dharma Market Report #6 - Trading Strategies for Decentralized Finance (2019)https://whitepaper.dydx.exchange/
dYdX (Antonio Juliano). dYdX: The Standard for Decentralized Spot Leveraged Trading and Derivatives (2017).https://files.kyber.network/Kyber_Protocol_22_April_v0.1.pdf
Kyber Network. Kyber: On-Chain Liquidity Protocol v0.1 (2019).Https://medium.com/@pintail/understanding-uniswap-returns-cc593f3499ef
Pintail. Understanding Uniswap Yield (2019).https://www.placeholder.vc/blog/2019/4/9/defi-liquidity-models
Placeholder (Alex Evans). Decentralized Finance Liquidity Models (2019).https://hackmd.io/@477aQ9OrQTCbVR3fq1Qzxg/HJ9jLsfTz?type=view
