As the popularity and trading volumes of BitMEX grow, I repeatedly receive questions from traders about how to execute interest rate trades using BitMEX products. As I discussed in my previous article, a Eurodollar is a USD deposit held outside of America. The interest rate or basis trades I will describe below all take advantage of higher Eurodollar interest rates in Bitcoin.
A spot Bitcoin exchange essentially is a pseudo-bank that offers USD deposits (aka Eurodollars). The interest rate on these Eurodollars is high mainly because of counterparty risk. There is no deposit insurance, and exchanges routinely get hacked or steal customers’ money.
Traders on derivative exchanges would like to own more Bitcoin than they have cash to purchase. Market makers and arbitrageurs who are usually short Bitcoin, hedge themselves by purchasing it with USD held on the underlying exchanges.
These traders supply USD to speculators for a positive rate of return. This interest or basis compensates them for counterparty risk and the opportunity cost of capital. The three basic basis strategies I will describe below allow traders to capture this basis as profit.
First, it is necessary to have an elementary understanding of the futures and swap contracts that BitMEX offers.
Futures Contract: The buyer or seller is entitled to the difference between the entry and settlement price at maturity. Buyers and sellers pay and receive fixed interest rates depending on whether the basis is positive or negative respectively at entry. Basis is the difference between the futures and spot price.
For the following examples I will use the BitMEX Bitcoin / USD 100x Leveraged 31 March 2017 Futures Contract, XBTH17. Each contract is worth $1 of Bitcoin.
Swap Contract: This derivative is similar to a futures contract, but there is no settlement date. Traders are free to hold their position for as long as their capital allows. To anchor the swap price to the underlying spot price, interest rate payments are exchanged between longs and shorts depending on whether the swap is trading at a premium or discount. A swap contract is an exchange of floating interest rate payments for price performance.
For the following examples I will use the BitMEX Bitcoin / USD 100x Leveraged Swap Contract, XBTUSD. Each contract is worth $1 of Bitcoin.
Both XBTUSD and XBTH17 use the same underlying index. Therefore, trading one against the other in the same quantity eliminates any Bitcoin / USD price risk.
This is the simplest basis trade. This strategy is commonly called cash and carry. Basis can be positive or negative, but usually futures trade more expensive than spot. This is because speculators who are short Bitcoin can only make 100%, but infinity is the maximum return for longs.
- Buy $1,000 worth of Bitcoin.
- Sell 1,000 contracts of XBTH17.
- At expiry, sell the remaining physical Bitcoin.
You must deposit at least 1% of the Bitcoin value of the XBTH17 position with BitMEX. The remaining Bitcoin you should store yourself in a properly secured Bitcoin wallet. If the XBTH17 price rises, your position is at risk of being liquidated.
If you are completely comfortable with BitMEX counterparty risk, then deposit the full Bitcoin value. By using 1x leverage, you cannot be liquidated. Otherwise you will have to monitor your liquidation price and occasionally top up your BitMEX account.
The basis captured is your profit. You must hold the trade until XBTH17 expires to realise the full amount.
If you do not fully margin the XBTH17 position, you risk getting liquidated if the price rises before you can deposit additional margin on BitMEX.
This has become a very popular trade due to the historically positive funding rate. A positive funding rate means that longs pay shorts every eight hours. Since May 2016, XBTUSD shorts have been paid a total of 37.60% of interest (47.16% annualised).
- Buy $1,000 worth of Bitcoin.
- Sell 1,000 contracts of XBTUSD.
- Unwind the trade when you believe funding will turn negative for an extended period of time.
The margin considerations are the same as with the previous trading strategy.
It is impossible to know the exact amount of profit before entering the trade. This is because the funding rate changes every eight hours. This is the definition of being long a floating rate instrument.
As mentioned earlier, over the past nine months, this strategy yielded a positive 35.58% outright profit.
The funding rate can and does go negative. When the funding rate goes negative, you lose money. Depending on when you enter the trade, you could experience long periods where you pay funding every eight hours.
During prolonged periods of negative funding, many traders unwind the position rather than continue to bleed. Bitcoin has been in a bull market since this product was launched, it will be interesting to observe the funding rates during a prolonged sideways or bear market.
This is the most advanced strategy I will present today. This is a fixed vs. floating interest rate trade. Unlike the previous two strategies, the performance can be amplified using leverage on both legs of the trade.
This is referred to as a curve flattener. If the futures basis decline is greater than the interest you pay being long swap, either due to time decay or an outright movement in the implied interest rate, you make money.
- Sell 1,000 XBTH17 contracts.
- Buy 1,000 XBTUSD contracts.
If you place the trade when XBTH17’s basis is positive, wait until expiry, and then sell the XBTUSD contracts.
If you plan to trade around the XBTH17 basis, wait for the XBTH17 basis to fall sufficiently, then buy back XBTH17 and sell XBTUSD to unwind the trade at a profit. You will employ this strategy when the XBTH17 basis is already negative but you expect it to decline even further.
Selling XBTH17 at a negative basis means you bleed money each day until expiry (aka negative carry or negative theta). I tend to avoid any situation where my fixed interest leg is entered into at negative carry. It makes turning an eventual profit more difficult.
This type of trade is also a bearish trade with respect to Bitcoin spot movements. During a quick and sharp drop, traders will short futures and swaps. The futures’ basis will decline and turn negative, and the swap funding rate will go negative as well. In this situation, profits due to movements in interest rates will accrue on both legs.
This is referred to as a curve steepener. If the futures basis rise is greater than the interest paid being short swap, either due to time decay or an outright movement in the implied interest rate, you make money.
- Buy 1,000 XBTH17 contracts.
- Sell 1,000 XBTUSD contracts.
If you place the trade when XBTH17’s basis is negative, wait until expiry, and then buy back the XBTUSD contracts.
If you plan to trade around the XBTH17 basis, wait for the XBTH17 basis to rise sufficiently, then sell XBTH17 and buy back XBTUSD to unwind the trade at a profit. You will employ this strategy when the XBTH17 basis is already positive but you expect it to rise even further. Buying XBTH17 at a positive basis means you bleed money each day until expiry.
This type of trade is also a bullish trade with respect to Bitcoin spot movements. During a bull market, traders will buy futures and swaps. The futures’ basis will rise and turn positive, and the swap funding rate will go positive as well. In this situation, profits due to movements in interest rates will accrue on both legs.
The interest rate differences captured are small. In order to earn a respectable return on equity, leverage must be employed. If the interest rate differential received is 1% unlevered, your return on capital is only 0.5%. Each leg must be margined separately.
Using the same example but with 10x leverage, your return on equity increases to 5%. The one benefit to curve trades is that you do not need to hold until expiry of the futures contracts. You can go one way, then reverse quickly as conditions change. In this way, you become an interest rate day trader.
Speculating on curvature is more difficult, but there are less people employing such strategies. Those who understand the mechanics will be presented with many no-brainer profit opportunities.
For a curve flattener, you are long swap. If the total net swap funding payments (i.e. the funding rate is positive) exceed the basis income from selling the futures contract, you lose money.
For a curve steepener, you are short swap. If the total net swap funding payments (i.e. the funding rate is negative) exceed the basis income from buying the futures contract you lose money.
In general, when the futures basis is positive, longs pay and shorts receive swap funding. When the futures basis is negative, longs receive and shorts pay swap funding. This is because traders will arbitrage the two products to keep the interest rate differentials in line. Profiting from this strategy requires excellent foresight into how the interest rate curve will move.
The most important part of the three strategies that I outlined is that none of them take any Bitcoin price risk. Bitcoin to basis traders is just another asset with an interest rate curve that can be arbitraged. This curve becomes distorted during highly leveraged speculator induced spot price moves. This allows savvy traders to earn excellent volatility adjusted returns.