In a bull or neutral market, users are generally happy to be exposed to volatile (to put it shortly: non-USD-pegged) tokens. However, in a bear market it has been observed that TVL in non-stable pools drops as rewards are not incentivizing enough to compensate for token depreciation, and DeFi users, looking for a shelter during the storm, naturally shift their positions to stable pools. A consequence of this behaviour is that DeFi becomes more illiquid during bear markets.

Here is proposed a simple mitigation strategy (targeted to stable / fiat capital but it could also serve as a protection to yield farmers) which attempts to be delta-neutral, i.e. with the principal not exposed to some underlying asset price. This "hedged farming" or "hedged staking" strategy can be tested on an individual basis or deployed as a service for customers.

It goes as follows. Initial funds (in fiat currency or stable coins so USD / EUR / CHF / USDT / USDC / DAI / RAI / LUSD) are splitted into two allocations[1].

  1. The "Yield": this allocation is dedicated to generate the profits.
  2. The "Hedge": this allocation is used to insure the initial capital of "the Yield" against market depreciation.

The Yield

The funds dedicated to generate profits are converted to some token and deposited in a rewarding pool.

Here we won't consider dual-asset cases (such as providing dual-side liquidity on DEX pools) as it is difficult to hedge against impermanent loss and associated calculations are much more complex (and oversimplified calculations can turn out to be wrong).

Implementation in CeFi

Staking on Binance or Kraken

Lending on Bitfinex or FTX

Inplementation in DeFi

Lending on Aave (can be leveraged with InstaDapp) or Compound

Providing liquidity to Curve (can be leveraged with Convex or Yearn)

Providing Single-Asset liquidity on Bancor

Providing Single-Asset liquidity to Syrup pools on PancakeSwap[2] (can be auto-compounded with Beefy or Autofarm)

The Hedge

An approach to hedge against market depreciation of the Yield's capital is for a position to have inverse exposure to the underlying asset which can be achieved by selling a perpetual future contract of the same notional amount that has been initially injected into the Yield allocation.

The question is: how much does it cost to hold such a short position? The answer relies in the notion of funding payments.

Funding Payments

Funding payments are the core of perpetual futures mechanism.

According to the decentralized trading platform dydx[3]

Perpetual contracts are inspired by traditional futures contracts, but differ in that there is no expiry date and therefore no final settlement or delivery. Funding payments are therefore used to incentivize the price of the perpetual to trade at the price of the underlying.

Funding is calculated algorithmically based on the Index Price and sampled Mid-Market Prices for the perpetual. When the rate is positive (perpetual trades at a premium relative to index), traders who are long will make payments to traders who are short. When the rate is negative (perpetual trades at a discount relative to index), this is reversed and shorts will pay longs. Traders make or receive payments in proportion to the size of their market position. These payments are exchanged solely between traders, and are neither paid nor received by the exchange.

The purpose of the funding rate is to keep the price of each perpetual market trading close to its Index Price. When the price is too high, longs pay shorts, incentivizing more traders to sell / go short, and driving the price down. When the price is too low, shorts pay longs, incentivizing more traders to buy / go long, driving the price up.

Arbitrageurs make the perpetual price converge to the spot price by operating a "cash and carry" strategy, which is also market-neutral, as described in the second section of this article.

To summarize, in a situation of positive rate (also called contango), shorting a perpetual not only allows to hedge the Yield, but it also rewards the position with regular funding payments.

In the reverse situation of negative funding rate (also called backwardation), holding the short position has a periodic cost (the funding payments to arbitrageurs) and some calculations are needed to figure out if the global strategy is bankable.

Implementation in CeFi

Selling Perpetual Contracts can be achieved on FTX futures market.

FTX: What are Futures

FTX: Futures Specs

Selling Perpetual Contracts can also be achieved on Deribit.

Implementation in DeFi

dydx (on Starkware L2): 1INCH, AAVE, ADA, AVAX, BTC, COMP, CRV, DOGE, DOT, ETH, FIL, LINK, LTC, MATIC, MKR, SNX, SOL, SUSHI, UMA, UNI, YFI

PERP Protocol (on Ethereum Mainnet and xDAI network): AAVE, ALPHA, BTC, COMP, CREAM, CRV, DOT, ETH, FTT, GRT, LINK, MKR, PERP, REN, SNX, SUSHI, UNI, YFI.

Worthiness of the overall strategy

Over a year, in first approximation not taking into account deposit fees, exit fees, nor network fees, the whole Yield + Hedge position has a positive expected return if the (opposite of the) annualized funding rate (AFR) is lower than the annualized payment yield (APY). In other words, cost of hedging is lower than profits.

with AFR = <FR_8> * 3 * 365 (where <FR_8> is the average 8-hour funding rate over a year).

30-day history of Funding Payments can be found on Defirate.

Below is the resulting break-even plot:

Break even line of the Hedged Yield Farming Strategy

From this simplified graph can be inferred that in present market conditions, the strategy could work with tokens such as CAKE (FR_8 > -0.06%, APY = 100%), AAVE (FR_8 = 0.004%, APY = 6.5%), 1INCH (FR_8 = 0.005%, APY = 6.8%), XTZ (FR_8 = 0.009%, APY% = 12%). Nevertheless crypto markets are subject to steady changes, so in order to build a set-and-forget strategy some key components would be automating recollateralization of the Hedge (cf "Risks" below) and monitoring funding rates and APYs in order to proactively switch to more profitable new positions (or exit if needed).

In average, the return of this strategy should be half of the APY of the Yield allocation times the overall relative appreciation of the underlying asset.

Risks

Market Risks

Hedge position Liquidation Risk

The main risk of the strategy is for the Hedge to be liquidated if the underlying asset price raises. Hence it's crucial to monitor the short position and bring more collateral before a margin call.

APY / Funding Rate volatility Risk

Due to changes in funding rates other Yield APY, the overall position yield might turn negative. To prevent such a fate, the strategy needs to be able to detect such situations and take the necessary countermeasures such as temporarily exiting fish for a new +EV Yield/Hedge pair and switch to it.

Cefi Risks

Despite the aforementioned centralized exchanges (Binance, Kraken, FTX, Bitfinex) being well established, with CEXes come the NYKNYC motto, and are remanent the following risks: shutdown, cessation of staking service, loss of keys controling the funds, external theft, exit scam.

Defi Risks

(Inspired by Autofarm wiki)

In the space of crypto, especially in the Decentralised Finance (DeFi) space, users have to understand the risks of projects and smart contracts before venturing into DeFi. We call this DYOR (do your own research).

DeFi risks encapsulate a wide range of risks such as impermanent loss to risks of falling for scams such as wallet draining, private key being stolen, et cetera. Hence, DeFi users have to be careful themselves and learn to educate themselves constantly in this space.

Smart contracts are an innovative way for cryptocurrencies to interact with one another and with dApps (decentralised applications). However, due to the complexities that come with smart contracts, certain smart contracts may be prone to bugs or hacks.

Resources

Sanat Rao (Gamma Point Capital), The quest for yield - Market-neutral strategies in crypto

Yuffie (Nansen), Commonly used market metrics when investing in crypto

Perpetual Protocol, Why use perpetual contracts (and how do they work)

Weiting Chen (Perpetual Protocol), How to make bank off the funding

Weiting Chen (Perpetual Protocal), How to use perpetuals from non speculators

Notes

[1] The ratio between the two allocations is assumed to be 50/50 but it can vary. In the latter case it implies that the Hedge position will be leveraged. The larger the share of the Yield the larger the gains, but also the larger the risks.

[2] BSC isn't DeFi, more CeDeFi.

[3] In the words of Perpetual Protocol: By introducing the funding payment, derivative exchanges can incentivize arbitrageurs to come in to correct the contract’s price by taking the less popular side, which creates a better trading environment for all of the participants, and Nansen puts it quite similarly: Another simple way to understand funding rates is to visualize it as payments made to arbitrageurs to ensure that the perp price is tracking the underlying spot price (essentially paying for the difference between the two prices.