Optimizing synthetic leverage in delta-neutral trades

TL;DR

There are multiple ways to employ delta-neutral strategies. Most obvious way is to go with CEXes, but adding a little bit (or even more!) of DeFi flavour can result in higher yields. In this article, we explore how tapping into Tier-1 DEXes and lending protocols helps to moderately leverage a strategy and achieve 50+% APY on a synthetic ETH-based delta-neutral trade.

INTRODUCTION

There are a lot of fresh ideas in crypto that enable new money market instruments. At Resolv Labs, for example, we are building a stablecoin backed by delta-neutral ETH strategy. But the potential landscape is much wider than that. A broad range of instruments can be created due to abundance of tokens and trading venues and ability to leverage liquid positions to magnify yields.

One example of such liquid market-neutral trade is a composition of synthetic long and short futures positions. Let us dive deeper and analyze performance of such strategy.

LEVERAGED DELTA-NEUTRAL STRATEGY WITH PERPETUALS

Leveraged delta-neutral strategies generally involve taking long and short positions in synthetic format, taking advantage of leverage effect. For example, starting with $1,000, a trader can allocate $500 as collateral to each of two different exchanges; then open ETH/USDC perpetual futures positions of $2,500, each in opposite directions. This turns the initial $1,000 into a $2,500 delta-neutral position, creating 2.5x leverage effect.

Typically such strategy makes sense in situations when there is a significant spread between rates on various venues.

In our use case of a model strategy, we have looked at funding rates of ETHUSDT & ETHUSDC perpetual futures across different exchanges. This time, in addition to centralized venues, we have included dYdX v3 into the scope of analysis. We have focused on performance of future funding rates over last 6 months as it reasonably reflects current state of money market in crypto.

Funding rates for stablecoin-margined ETH perpetual futures, last 6 month APY (26/01/24)

The table above ranks venues by funding rates of ETHUSDC and ETHUSDT futures. dYdX had the largest skew in funding rates which makes it very profitable for short positions.

This is the historical performance of long-short strategies that utilized dYdX as the venue for a short position. Long Binance and short dYdX historically, on average, showed the best result. As of the date of the article, its average performance over the past 6 months was 11.52% p.a., and latest 30d APY was 30%.

We will use it as our benchmark for future analysis.

Performance (30d APY) of synthetic delta-neutral strategies based on combinations of perpetual futures

Depending on the tokens used as underlying asset, as well as funding rates on different venues for perpetuals on such tokens, it makes sense to monitor a range of exchanges to identify optimal performance. However, in the next section we dive into the alternative to exchanges.

LEVERAGED LONG WITH ON-CHAIN LENDING PROTOCOLS

It is easy to see that monetization of leveraged short positions would benefit from relatively cheap, and less correlated, source of long leverage.

For this, on-chain lending protocols, such as Aave or Compound, can be used to execute leveraged long positions. For example, a position equivalent to leveraged long perps is achieved by a position of $2,500 Ether built up using $500 own funds and $2,000 borrowing in USDC. It is relatively common to use smart contract tools like Defi Saver for execution of such strategies in one go without having to loop funds in a number of deposit-borrow circles.

It is worth noting that on-chain lending products are generally more restrictive in terms of possible leverage vs exchanges. With Aave, for example, the maximum leverage potential is slightly above 5x.

DO LENDING PROTOCOLS OFFER LOWER COSTS?

Now let us find out how exchange funding rates compare to borrow rates on Aave/Compound.

We analyzed ETH supply and USDC borrow rates from Aave v3 and Compound v3 on Ethereum Mainnet, and compared it with data on funding rates from derivative exchanges we have covered earlier.

We define net cost of long position on a relevant lending protocol as USDC borrow rate minus ETH supply rate.

The chart below compares 30-day moving averages of the long position cost for each venue.

Cost (30d APY) of leveraged long exposure on ETH via perpetual futures vs lending protocols

The chart indicates that, on average, lending protocols offered lower borrowing costs than most exchanges. However, from September to November 2023, they were comparable or slightly higher than the overall average. In the last two months, lending protocols have shown significantly more attractive rates compared to all exchanges. Another key observation is that the net borrow APY is less volatile and less correlated with funding rates. This is noteworthy because funding rates exhibit strong correlations which can negatively impact the strategy yield.

Now, let’s compare the performance of our new strategy, which is based on the long exposure obtained using Aave, with the benchmark we established earlier. The chart below clearly indicates that the new strategy consistently yields higher average APY suggesting that the new approach is more cost efficient. 6-month average returns are 25% p.a., and 30d APY exceeds 50%!

Performance (30d APY) of synthetic delta-neutral strategies based on combination of dYdX perpetual futures with different sources of long ETH exposure

Overall, utilizing lending protocols enhanced returns by reducing the costs of the long exposure. This effect is more pronounced in the periods of relatively high funding rates on exchanges, when the basis spread between different types of money market rates widens.

KEY TAKEAWAYS

When looking at leveraged positions of your strategies, make sure to identify the sources of costs and yields — the goal is to optimize either or both. To achieve that, it is useful to explore both CeFi and DeFi opportunities.

In our example, dYdX offered much more attractive funding rate for short positions. Now, you just have to find a cheap way to get long exposure. Simple approach is to choose another DEX or CEX.

However, being more creative pays off — you can identify alternative primitives such as Aave that get you what you need at a better price. As in many other fields, being open to new opportunities is the key to achieving higher yields in crypto.