Not even 10 minutes after I clicked ‘Publish’ on my latest post about crypto, I landed on this post from Finumus and I was like oh s**t, there is so much I forgot to cover!
So here we are with a quick update.
Coming from ‘TradFi’, one of the first ways I tried to approach the crypto world was through those lenses. Understanding protocols, especially from a technical point of view, was a big hurdle for me but there were some concepts that translated well from the old world to the new.
Let’s take the cash and carry trade example (did I already write about it? I am not 100% sure): you buy Bitcoin and then use your long position as collateral to sell a future or, even better, a perpetual contract. I will go fast on the basics so if you are not familiar with the terminology, Google it. If the future trades at a higher price than spot (the BTC you just bought), when the future matures you cash in the difference between the two, wherever the price of BTC is at that point.
So in this particular trade you do not care, and do not need to have an opinion, if BTC is overvalued or undervalued, which is a huge plus. Why the future should trade at a higher price? In short, because futures offer embedded leverage: for example you can buy contracts for 10 BTC when you have funds only for 1. So if you think that the price of BTC is going up 30% in the next 3 months, you do not care to buy futures at a 10% premium over spot because you are ‘set’ to gain more than the difference in price between spot and future.
If you want to know more about it, here is a video. Here are some examples of premiums you get on FTX:
As you can see premiums are pretty volatile…and can also go negative. A quick rule of thumb: when prices are going up, premiums are positive and vice-versa. Premiums on perpetuals typically reset every 8 hours.
In short, what in my mind started as a simple way to earn 10%/year turned out to be a big mess.
I use to build FX quant models and trade them when I was younger. The idea of a ‘passive’ way of making money disappears quite fast when you have to deal with markets that trade 24/7. At least with FX you are free during weekends, the market is officially open but banks to settle trades are not so in practice it is closed; with crypto, the amusement park is REALLY open 24/7. You need the model AND a way to place your trades when you sleep. I still miss the latter and do not have time now to find a solution for that.
This trade is not 100% risk-free either because for the future/perpetual side of the trade you still face counterparty risk, i.e. the platform where you trade goes bye-bye. All of these to then maybe make 10% net of all trading costs? Not great…
Especially if you compare it to the alternative of going long a coin: you do one trade, maybe you move your stuff to a cold wallet so you lower the hacking risk, and then wait some years to do 10x (you wish, uh?). Here are three elements that Finumus post made me think of and I should have covered in my previous post. These three elements are highly interrelated, each one by itself does not represent a game-killer but when considered together they are (at least, for me).
Research
DeFi lending requires at least the same amount of research than directly trading coins. Just read Finumus post. The difference is that in this case your gains are capped (Finumus put the ‘low risk trades’ at 10-30% gains) while if you go long the potential gain is infinite. Both have the same nuclear risk of your investment going to zero, albeit that risk source is different and, if your research is deep enough, lower for DeFi lending. In simple terms, is like investing in stocks or bonds…but in the wild wild west, i.e. a place where the rule of law is non-existent. Not sure if you ever had the pleasure of reading a bond prospectus and the Programme under which an issuer is allowed to issue a bond: the Lord of the Rings-length of the documents shows the amount of work a lot of people did so that investors can sleep well. Smart contracts are not yet that smart (nor vetted, nor have by design the mental flexibility required to act in some circumstances).
Finumus correctly identify that yields will fall. Coincidentally, more than two years ago I explained the same point for p2p lending in this post. At best this is an opportunity with a due date, is still worth your time? Maybe, but you should ask yourself the question.
Taxes
Finumus explains well the reason why taxes are a pain in the a**. The pain obviously depends on where you live but, generally speaking, in Europe income is not treated that well. In UK, the free tax allowance on income is laughable compared to the capital gain one. So ceteris paribus, if you have two investment opportunities with the same gross risk/return profile but one generates income and the other capital gains, the capital gain one has a huge tax advantage. The difference between the two can be as high as 40%…
Since you have to keep your own accounting for tax purposes, I find trading coins with a longish time horizon (i.e. I do not day-trade so the volume of transactions I have to record is not that much) the most efficient way to have exposure to this asset class.
Fees
This is the part I have very little first-hand experience with. So far I just bought a few coins on Revolut and then a bit more on Kraken; while trading fees on both platforms are not small, they cannot be remotely compared with ETH gas fees…if you are not a ‘semi-whale’. When I looked to buy the ENS domain, out of the $75 cost, 99% of it were gas fees.
I got bored/disinterested before I even reached this point in my analysis on DeFi lending but do not expect to do it if you have a small capital to invest. Fees on Solana are way smaller than on Ethereum, so if you find an opportunity there my point could be invalid; it is just that as of today, Ethereum is the most used layer 1 protocol, so a lot of stuff is built there. Not sure if you are crazy enough to have read about the Wormhole hack this week but the risk of using Solana right now is that is less tested than Ethereum. In way, you get what you pay for.
There is a final point to be made about the required investment size. Let’s say you find a great and secure DeFi lending strategy that yields 15%. In order to have a meaningful absolute return you need to invest put at risk a meaningful amount of capital; if you think BTC is going to double in a year (or less), you need to risk way less to achieve a meaningful return (if it happens, obv). In other words, you need to price the rug pull risk way lower to make DeFi lending a superior choice over a direct investment in a coin. Ok, is not that simple because in the DeFi case you have a binary distribution while coins have a bell one with huge tails….but still, you live or die on your ability to understand the rug pull risk.
15% as a one-year-only opportunity is good, it is fantastic if you manage to compound it over many years. Look what I found on Bloomberg the other day:
These are funds that cost MORE than 2-and-20 and sometimes have lock-ups of 5 years. Basically, your strategy to get 15%/year EVERY year would put you in the same league as the very very best HF managers. Legit DeFi lending strategy will disappear (arb-ed away) faster than political dissidents in North Korea.
What I am reading now:
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