Title: Launch a Basis Trading Product Suite
Author(s): @afromac & Set Labs
Created: 01 March 2022
We’re very excited to propose a new product category that enables the Index Coop community and broader investor ecosystem to generate yield opportunities without asset price risk.
For the last couple months, Set Labs has been developing an integration with Perpetual Protocol to enable not only the use of perpetuals within Set Protocol but the following basis trading methodology, which has been provided by Set to Index Coop to deploy and manage.
The following IIP is the first result from renewed collaboration agreements between Set Labs and Index Coop to launch more successful products and grow IC’s product suite, and has been achieved thanks to a close working relationship between the product and engineering teams from both organizations.
The Product Pod proposes to create a suite of products on Optimism that provide token holders with yield opportunities that are not at risk of price volatility. Users can earn an expected APY of 10-20% denominated in USDC as their short position will benefit from earning a funding rate that helps to correct for any price discrepancy that emerges between long and short perpetual prices. This is achieved through the use of hedging - taking a position that is 50/50 long/short on a crypto asset; and perpetual futures contracts - crypto derivative that enables traders to attain leverage.
The integration of Perpetual Protocol to Set Protocol provides the opportunity to create a suite of products that execute a basis trading strategy on perp.fi. Basis Trading (also known as a cash and carry trade) is a consistent yield generation strategy which is commonly employed in traditional financial markets to earn low risk returns for traders who wish to hedge their risk and profit from arbitrage opportunities and market inefficiencies.
This is a strategy deployed by professional traders that Index Coop (in partnership with Set Labs) is positioned to automate, tokenize and make exchange-tradeable. This creates a novel product category with limited competition that provides new income opportunities to DeFi customers. The Product Pod proposes to create a suite of single collateral basis trading products with a USDC denominated yield of 10-20%.
Customers consistently look for low risk products that provide high yield. Protocols such as Yearn, Notional, Gro and more have had great success by offering these kind of products to their customers. By launching a suite of basis trading products, Index Coop is positioned to capture a share of this market while also providing new opportunities for yield to our current customers. With this suite of products, we can offer this opportunity to customers by disrupting a yield market that has traditionally been exclusive to professional traders and sophisticated actors.
Basis trading is a common strategy in traditional futures markets. When the derivative price of an asset is higher or lower than the spot price, it creates a market inefficiency that can be exploited by traders to earn a yield. This suite of products will tokenize a strategy that earns a yield from those inefficiencies in various crypto markets. By creating this product and making it exchange tradeable, we enable access to anyone to participate in this strategy, while also accumulating capital to provide a useful service - arbitraging derivative market prices back to spot. This is an innovation in DeFi similar to how AMMs created opportunities for liquidity providers to earn fees while trustlessly facilitating trades, disrupting the traditional role of market makers and order books.
In traditional finance, futures market derivatives outnumber options contracts by number of contracts executed each year. It is an enormous market. Many successful firms and traders exploit price inefficiencies in these markets to earn the cash-and-carry/basis trading strategy mentioned above. This is a particularly popular strategy with hedge funds. By taking a delta neutral position (hedging against volatility by taking both sides of a trade) funds are able to mitigate risk and earn an income. Variations on this strategy make up to 25% of total capital managed by hedge funds.
Crypto futures are an increasingly important market. In June of last year, futures trading volume eclipsed spot trading volume for the first time, with the majority of the futures trading happening on Binance.
Ethereum Futures alone has a market size of over $10B daily volume.
Perpetual Futures Contracts are a novel innovation in cryptocurrency space. They differ from traditional futures contracts in that they have no expiry date and roll over indefinitely. Similar to the growth of centralised futures contracts, protocols such as Perpetual Protocols and dYdX are showing extremely high growth of on-chain decentralised perpetual futures contracts. As these markets grow and mature, Index Coop is well-positioned to create a suite of products that will provide yield opportunities that emerge from any price inefficiencies that emerge in these markets.
Currently, 100% of Index Coop products are price action based. During current market conditions this creates challenges for our customers who seek to diversify out of risk assets and to protect their earnings. A recent poll (204 respondents) indicates that 67.3% of our current customers have a preference for USD denominated assets that can generate a steady return, as opposed to creating opportunities for trading or diversification. By providing a range of these kind of products, Index Coop takes steps towards being the asset manager who can protect our customers in all market conditions.
While upcoming PAY, PINT and FIXED products will improve our offerings in this category, a basis trading product can generate higher returns than all of the above mentioned products, while also reducing smart contract risk by relying on only 1 new protocol integration - perpetual protocol. We anticipate this will be an appealing product suite to retail/DeFi customers who seek either high USDC denominated returns, or who wish to diversify their stable income streams to multiple products. In the same poll 68.4% of our customer base told us that they have no strong preference for the underlying mechanism that generates the yield and are more interested in seeking the best available return.
Perpetual Protocol is a market for perpetual futures contracts. A perpetual futures contract is a derivative that enables the holder to speculate on the price of the asset without actually holding the asset. In a perpetual futures market, traders use leverage to take long and short positions on the future price movement of the asset. Because these positions do not actually hold the underlying asset, there is a tendency for the price of the derivative to diverge from the spot price of the asset. The funding rate exists as a mechanism to close this divergence between the mark and index prices - by incentivizing traders to take the less popular side of the trade.
For example, when the derivative price is above the spot price, the perpetual market is currently overweight on long positions. To drive convergence towards the spot price, long position holders will pay a portion of their position at regular intervals as a funding rate to short position holders. The opposite scenario is also true. When the derivative price is below the spot price, shorts will pay longs the funding rate to incentivize convergence on the spot price.
A basis trading strategy can be executed using perp.fi by taking a 50% position in the spot market of an asset and a 50% -1x short position in the perpetual market. This creates a risk neutral position, and enables the holder of the position to earn a yield over time as the funding rate is paid out every 8 hours.
There are currently only 2 active competitors in DeFi: Lemma (Arbitrum) and UXD (Solana). Lemma currently has $1M TVL and only offers USD denominated 1x long basis. Set Protocol’s implementation of this product will offer a higher yield than Lemma. It will not require the user to stake in order to earn yield, and will be an entirely liquid and exchange tradeable yield-bearing asset. UXD is an algorithmic stablecoin that is backed 100% by a delta neutral position using derivatives. IC has no plans to offer this product on the Solana chain.
These products are differentiated from IC’s current products in that they offer a delta neutral yield opportunity that is not dependent on stable coin farming incentives. They are differentiated from the composite and leveraged products in that their value is independent of price movement.
There are two potential compositions for products in this suite - single collateral and multi collateral. Perp.fi currently uses USDC as the sole collateral asset used for creating positions on the platform. In the near future it will be possible to use other crypto assets as collateral, increasing the flexibility and yield for future products.
In a single collateral composition, 50% of funds are used to purchase spot of the underlying and 50% used to go short with a perp. The collateral used for the short is USDC. In the example below we show a ETH/ETH short composition
In a multi collateral position, 100% of the position is created by using the spot asset as collateral used to create a short perp position. This has the advantage of achieving a delta neutral position while using 100% of the asset to earn yield.
Backtest data [Optional]
Using the ETH perpetual market data, in the 21,528 data points sampled the funding rate flow was negative 72% of the time, or 2.57 times more often than it was positive. Backtesting indicates a potential APY of 15-16% based on data since the launch of this perp market.
Open interest for perpetual futures on centralised exchanges is currently over $20 billion per day. On-chain perps are growing quickly - dYdX and now Perp V2 have over $2B combined daily volume. As these protocols grow it will provide a deep opportunity for yield generation. For comparison, by the end of 2020 the market for global derivatives was valued at $15 trillion. Crypto markets for these kind of assets are extremely early, and have massive potential room to grow.
This product is targeted towards retail investors who seek high but variable returns on their assets, and are not able or willing to execute a basis trading strategy to access those returns. It may also appeal to DAOs who are willing to diversify their treasury into a range of stablecoin income stream, but that will require further market research to establish demand exists. More sophisticated institutions, like crypto-native hedge funds, that actively employ this trading strategy may also be interested in this tokenized alternative.
As a user, I want high returns (10-20%) from a variety of assets and different markets.
As a user, I want to be able to generate revenue from the cash and carry trade strategy, but I am unwilling to manage my own margin positions due to risk and complexity
As a DAO, I want stablecoin returns that are sustainable and not dependent on short-lived stablecoin farms.
As a DAO, I want to diversify my treasury into stablecoin denominated yields from different sources that avoid concentration of risk.
As an institution, I want access to DeFi protocols and products to earn above average interest compared to traditional financial markets
The basis trading products suites enables users to access yield by providing capital to earn the funding rate by shorting the (historically overweight long) perp price on perp.fi.
This example uses ETH as the base asset, but any asset with a perp.fi market can be used as a base asset
The product take a position of 50% spot ETH and 50% ETH perp short
Every x days the positive funding yield that has been collected is distributed into more spot and perp.
If ETH per leverage ratio is less than -1x, the product levers up the set by buying more eth short and eth spot
If ETH rises above a max leverage,the product will delever perp and sell spot to maintain safety and delta neutral
0.5 * $1 / ETH price
Cost to customer
The fee will accrue 100% to Index Coop.
As this product will USD denominated, price action will be stable and seed capital requirements will be minimal. Product Pod recommends the seeding of a 0.05% pool on Uni V3 with $100K of capital positioned. In future, opportunities should be explored to bridge this product to mainnet to make it more accessible for DAOs and to web3 wallets such as Argent to make it more accessible for retail users.
The product was designed through collaboration between Index Coop and Set Protocol
As the success of this product will be heavily determined by the performance of the yield and through direct sales to DAOs, Index Coop is best positioned to lead marketing and distribution.
Amended to better reflect the large contribution made by Set Labs in product design.
Describe any modifications to this proposal since the original post on the forum
Copyright and related rights waived via CC0.
Provide links to the following:
- Initial forum discussions
- IIP for DG1
- Community call thread / recording
- Snapshot for DG1
- Work team report
- Initial Product Requirements Doc