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Paypal Finance: Understanding the crypto market arbitrage strategy application

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Three kinds of Arbitrage schemes are analyzed in detail in this paper.

Original title: "An Understanding of the Application of crypto Market Arbitrage Strategy"

Original source: paypal Club

原文作者：Peter Guo

This article is based on the author's independent research and analysis and judgment. It is for reference only and does not constitute any investment advice. Paypal Financial accepts no liability for the reader's use of this article or for any consequences arising therefrom.

Essentially, Arbitrage, characterized by low risk, quick return and easy operation, is a method to obtain time value or space value by taking advantage of the pricing deviation of the same or highly related objects. Especially in the early stage of development of the cryptocurrency market, due to differences in investor preferences, high volatility of the currency price and derivatives design rules, many investors have flocked to such arbitrage opportunities.

It is also worth noting that as the crypto market evolves, various arbitrage strategies are also evolving with The Times. From the manual tile moving of BTC and USDT in the early stage to the current popular quantitative strategies such as DeFi flash loan arbitrage, Kimchi Premium cross-regional arbitrage, and new currency cross-market arbitrage, it can be said that human high-quality arbitrageurs have captured a lot of profits through elaborate and diverse arbitrage models. At the same time, it also improves the market pricing efficiency and price discovery function.

Based on the existing research and practical results, this paper will make an in-depth discussion on the logic principle and empirical analysis of the three well-known arbitrage schemes, hoping to provide valuable reference for readers in trading decisions, and welcome your criticism and correction.

· Rate arbitrage of perpetuity contract funds

· Arbitrage of current basis regression

· Gray trust premium arbitrage

1. Rate arbitrage of perpetual contract funds

1. Capital rate carry principle

In the cryptocurrency market, in order to adjust the price of perpetual contracts and spot prices to be basically consistent, trading platforms have introduced a Funding Rate mechanism.

According to the set rules, if the price is bullish in a period of time, the market is dominant, will lead to the price of the perpetual contract is higher than the spot, at this time the capital rate is generally positive, that is, the long party on time to pay a certain proportion of interest to the empty party, otherwise the empty direction to pay. The greater the deviation, the higher the capital rate, the better the correction effect, so that the perpetuity contract price is "tamed" close to the spot price.

In theory, the capital charge is deducted from the margin of the position and the income is automatically deposited into the contract account. Although the income and expenditure of capital expenses will not affect the original position value, but strong price and maintain margin rate will track adjustment.

Most trading platforms carry out mutual exchange of funds and fees every 8 hours, respectively at 0, 8, 16 o 'clock Beijing time. Of course, there are surprises, the FTX trading platform is executed every hour on the hour.

As the bitcoin market has been long and short, the premium has been positive most of the time. Further, if an investor shorted a perpetuation contract and hedged the same spot position, it could theoretically achieve a positive rate of return over the long term.

Figure 1 source: BiTMEX, Babel Finance

2. Capital rate carry step

The operation steps of taking capital costs are relatively simple, because the strategy is long-term position to obtain long-term net costs, its income is open, manual operation can be.

Buy spot Bitcoin and transfer it into a contract account.

Open an open perpetual contract for the same position. Perpetuity contract is divided into U standard and currency standard. Investors can choose the corresponding contract type according to the requirements of arbitrage.

According to the profit target, choose the time to buy the perpetual contract, sell the spot, make a profit.

Although this operation is relatively simple, two important points need to be noted.

1) The design of mixed margin rules varies from trading platform to trading platform. Investors should pay attention to whether the trading platform can realize the function of profit and loss of coins.

Generally speaking, there is no problem for investors to short the currency based perpetuities directly because they have bought spot contracts. However, there may be a rule of operation barrier for shorting the U-based perpetuities. Generally, the head trading platform will provide a unified margin (OKEx) model or a joint margin (Binance) model. In this mode, the currency holding assets can be converted into USDT valuation, supporting cross-margin asset trading, so as to achieve profit and loss balance and improve the utilization rate of funds.

2) Investors should play by the rules of low or even zero leverage.

Admittedly, although the risk-free basis of capital rate arbitrage lies in the price consistency between the perpetual contract and spot, it is still necessary to guard against the abnormal fluctuation of various pins.

The chart below shows the trend of the BTCUSDT perpetual versus spot premium on Binance trading platform. On July 26, 2021, the premium hit 19%. If an investor uses more than 5x leverage to buy spot or arbitrage, the programmed strategy is likely to explode in the mode of tracking the latest price.

Figure 2 source: Tradingview

For the prudent, no leverage or maintain low leverage, to avoid this kind of long-term inevitable occurrence of small probability events.

3. Capital rate carry income analysis

In order to verify the feasibility of this strategy, we respectively selected the currency standard and THE U-standard perpetuity contract of mainstream currency to conduct historical data backtracking. The results show that the currency standard perpetuity carry strategy is more stable, but from the perspective of the value of legal currency that can be realized, the U-standard perpetuity arbitrage strategy is more suitable for most investors.

1) Currency standard perpetual carry

Taking Binance trading platform as an example, we selected the perpetuity contracts of mainstream currencies such as BTC, ETH, BCH, ETC and LINK. After implementing carry strategies according to the steps described above, we obtained the return results as shown in the following figure.

Figure 3: Babel Finance

As can be seen from the chart, the arbitrage returns of all currencies in the past year are above 10%. In the sample of the top 12 largest market capitalization, the returns of many currencies are much more eye-catching than their market capitalization performance, the best performance is XRP, DOT, LTC, BTC absolute return of 18.85%, the performance is in the middle, not outstanding.

However, this strategy is somewhat misleading, as Ripple Labs, the company that runs XRP, is known to have been sued by the SEC, resulting in the coin being removed from more than 50 trading platforms. Therefore, although XRP arbitrage has the highest yield, for most investors, the currency price itself falls or rises less than other mainstream currencies, and even all kinds of over-the-counter risks, such yield will become a castles in the air.

In contrast, the BNB, despite its bottom yield, has seen price increases far higher than those of other currencies during the retest period and has the highest arbitrage returns.

In addition, the choice of trading platforms with different pricing also has a significant impact on the results of obtaining capital costs of the strategy. We backtested Binance, Huobi, BitMEX and Bybit, and found that Bybit's profit in the sampling period was 35.24%, much higher than Binance's 23.30% and Huobi's 20.15%.

Figure 4 source: Babel Finance

It can be seen from the above that investors can choose mainstream currencies with higher value recognition and head trading platforms with better performance in capital rates by using the currency-based sustainable carry strategy.

2) U standard perpetual carry

U-based perpetuities are relatively easy to understand. By shorting a U-based perpetuities contract, an investor can get a stable currency or fiat currency paid long most of the time.

Taking Binance trading platform as an example, we chose the perpetuity contracts of mainstream currencies such as BTC, ETH, LINK, LTC and BCH to carry out u-based perpetuity arbitrage operations according to the same position value, and obtained the income results as shown in the figure below.

Figure 5 source: Babel Finance

If the return of the currency - based carry is not as straightforward as the profit calculation of the currency, then the U - based arbitrage settled in stable currency is easy to compare. As can be seen from Figure 5, this strategy varies with currencies and does not have a positive relationship with their market value. XRP, LTC and ETH have the best annual returns of 42.28%, 39.50% and 39.12%, respectively, while BTC has a lower performance of only 27.41%.

In the mainstream currency perpetuity contract, BTC's arbitrage yield performance is not outstanding, whether it is the currency standard or the U standard contract, which seems not commensurate with its leading position. From the perspective of capital rate, although bitcoin has a large increase in the sampling period, it is still small compared with ETH, LINK, DOT and other currencies. We speculate that it may be caused by BTC's more balanced long-short forces, or more hedging and arbitrage funds involved.

However, although the backtest result is not ideal, it does not mean that bitcoin has no arbitrage value. On the contrary, the result suggests that we can adopt multi-currency arbitrage operation to improve the overall potential return.

As the leading cryptocurrency, bitcoin has the broadest consensus of value and is increasingly recognized as a medium of exchange and store of value in a decentralized world. It's hard to see a major bearish scenario like XRP. At the same time, it can be seen from the data that the arbitrage return of bitcoin perpetual contract basically represents the average return of mainstream currency, which is a relatively reliable arbitrage choice.

Finally, we also conducted carry analysis on the bitcoin U-standard perpetuity contracts of different trading platforms, and found that the carry yield curve was basically synchronous, but different rates resulted in certain differences in absolute yield, and Bybit also performed better than Binance.

Figure 6 source: Babel Finance

Second, current basis regression arbitrage

1. Arbitrage principle of basis difference

The cash (index) price is anchored by the fund rate mechanism of the perpetuity contract, while the cash (index) price is anchored by the regression of the basis when the delivery is near. Therefore, after the fund cost arbitrage of the perpetuity contract is discussed, the basis arbitrage scheme of the delivery contract is discussed.

The operation principle of current basis arbitrage is based on the following two points.

First, there is a natural fluctuation hub of the basis, that is, before the delivery follows the market bulls and bears mood synchronous fluctuations, near the delivery will converge to zero, that is, the zero axis is the essential point of the basis volatility.

According to the delivery rule, the futures settlement price is calculated according to the average or weighted price of the spot (index) price during the last period of the contract, so the two will tend to be flat in the long run.

As shown in Figure 7, in the past more than a year, the quarterly current premium rate of some mainstream currencies has been changing constantly, with the highest rate being 10% and the lowest rate nearly -5%. In short, when the market has a large fluctuation, the premium rate also tends to fluctuate greatly, and these fluctuations will eventually be repaired to zero due to the futures delivery.

Figure 7: QKL123,Babel Finance

In other words, this method of "mean reversion" can achieve a degree of separation beta, that is, the arbitragerdoes not have to pay attention to the market price to get a given expected return.

Second, the design of currency standard and U standard product rules for delivery contracts provides the basis for risk-free operations.

At present each big trading platform for currency trading profit and loss of standard contracts designed to contract value * (1 / price - 1 / positions open price), so do more currency standard should be decided by the rules of maximum profit is less than 100%, but much lower limit is in the currency binary kui light all the money, open or short currency standard theory of maximum profit is less than the contract value, The upper limit of floating loss is not more than 100%.

The product of the U standard contract is actually linear and easy to understand. The calculation of profit and loss is also relatively simple. The profit and loss is equal to the product of the value of the position calculated in U and the rise and fall of the price.

Take the value of the operation position of 1 bitcoin as an example, the approximate profit and loss trend of these two contracts is shown in the figure below, which means that the arbitrage of short contract and long spot is more suitable for the currency standard, while the arbitrage of long contract and short spot is more suitable for the U standard.

Graphic illustration of profit and loss of currency standard and U standard & NBSP; Figure 8 source: Babel Finance

2. Stage basis arbitrage step

Based on the near delivery period, the arbitrage operation steps of basis convergence to zero are as follows:

1. Track the fluctuation trend of the basis premium rate and wait for the trigger of the set threshold. Generally speaking, we are more involved in arbitrage operations during bull markets, because bear markets have a short duration, and there are certain costs (borrowing interest, capital expenses) for both short selling and perpetuating short selling.

2. Establish hedging positions in the opposite direction of buying and selling. When the basis is positive, it is appropriate to use the opposite contract; when the basis is negative, it is appropriate to use the positive contract. If the current premium rate is positive, the currency should be bought and transferred to the currency standard contract account, while establishing the same currency standard contract short position; If the cash premium rate is negative, the stable currency or fiat currency should be transferred to the U standard contract account after short selling, and the same U standard contract long position should be established. It should be added that many head trading platforms provide multi-currency mixed margin models (such as OKEx's cross-currency margin model, Binance's combined margin model, etc.), which can support u-based and currency-based long-short mixed combination, and can automatically offset profits and losses without transferring coins.

3. Wait for the basis premium rate to return to a certain threshold, liquidate the contract and spot position, and obtain profits.

For example, on April 13, 2021, we found that the spot closing price of Bitcoin was 63573.30U, and the closing price of 0625 futures contract in that quarter was 68483.00U. The basis difference between the two was 4909.70U, and the premium rate reached 7.72%. If we had bought one bitcoin at the current price on that day and shorted 684 futures (100U each) for the quarter, we would have theoretically made a profit of about 7.72% by June 25, or about 38.61% annualized.

But in fact, the price of the currency fell quickly after the market, and the premium rate even turned negative. By 11:30 on April 18th, the current price of the futures was 56500.00U and 56383.00U respectively, and the premium rate was close to zero. If the empty orders were cleared at this time, the profit would be about 0.2118 BTC, and 68325U could be obtained by selling all BTC at the spot price.

Some currency base arbitrage details & NBSP; Table 1 Source: Babel Finance

综上，在不计手续费和滑点的前提下，盈利约 4752U，5 天的盈利率约 7.47%。

3. Arbitrage income analysis of basis difference

In the in-depth Application of Basis in crypto Asset Investment, we conducted a preliminary fitting test on the returns of Basis arbitrage, and here we conduct further research.

In order to quantitatively analyze the arbitrage returns based on the "mean regression" principle of basis, we conducted a full position rolling back test of the bullish basis arbitrage opportunities of some mainstream currencies such as BTC and ETH in the past three years. The results showed that when the entry and exit values of the basis premium rate in the current quarter were 5%-0%, 4%-1%, 5%-2% and 4%-0%, The market long-term profit effect obtained by the fitting is the best, and the data in the sample can achieve the expected annual return rate of more than 20%.

Bitcoin current quarter current premium rate trend & NBSP; Figure 9 source: FMZ

The table below shows the profit results of the backtest when the basis premium rate is greater than or equal to 4% (long spot, short futures) and when it is equal to or less than 0% (buy flat futures, sell flat spot). Unsurprisingly, the net performance of BTC is also behind, and the arbitrage return of BCH in the past three years is much higher than that of other currencies.

Some currency base arbitrage details & NBSP; Table 2 Source: Babel Finance

Note: Based on FMZ platform, this strategy carries out basis arbitrage back test of Huobi trading platform's contract and spot in the current quarter, the backtest accuracy is 5 minutes, the default counterprice is the transaction price, and the commission is 0.1% for spot and 0.04% for futures. This strategy adopts large capital by default, and controls the minimum profit premium space above 3%, so as to avoid the loss caused by unequal or different double-leg trading.

The deadline for retesting in 2021 is July 12.

We put forward some enhanced in the original fill in the details, including the selection of discount space more currency, build many varieties of multilateral arbitrage, take advantage of the lever balance out has a certain margin of safety margin continued investment profit, price difference of using different trading platform in the main broker platform across trading platform to buy low and sell high. Here, we take advantage of the breakthrough relationship between the K line, which records the fluctuation of the basis premium rate, and the moving average, and use the dynamic entry trade to optimize the results as follows.

Some currency base arbitrage details & NBSP; Table 3 sources: Babel Finance

Note: The deadline for retesting in 2021 is August 8.

Gray trust arbitrage

1. Gray trust arbitrage

Before introducing gray arbitrage, it is necessary to understand the products of gray trust.

GrayScale Trust, a cryptocurrency trust issued by GrayScale Investments,LLC, Currently, it has 13 single-asset trusts (BTC, ETH, BCH, ETC, ZEC, ZEN, LTC, XLM, FIL, LPT, MANA, BAT, ZEC) and two multi-asset funds (Digital Large Cap Fund, DeFi Fund).

Among them, Bitcoin Investment Trust (GBTC) is the earliest and the largest. Investors can buy some GBTC shares from grayscale by spot or physical Bitcoin, and conduct transactions on the OTC MARKET OTCQX.

Because it was one of the few accredited bitcoin offerings available to Accredited investors and had a mover advantage with relatively simple subscription methods, GBTC's mapping of bitcoin prices remained skewed at a high premium for a long time, which became the basis for many arbitrageurs.

Figure 10: GrayScale, Babel Finance

As shown in Figure 9, the premium rate of grayscale trust products shows long-term convergence. Among them, the Bitcoin trust GBTC has a long-term positive premium. In the past five years, the premium rate has reached 130% at the highest, -20% at the lowest, and -7.53% as of August 8, 2021, while the Ethereum Trust ETHE has seen a premium rate of 900% at the highest and -15% at the lowest since its listing. It fell to -4.04% as of August 8, 2021.

2. Gray trust arbitrage steps

At present, there are four popular gray arbitrage methods.

· Cash lending arbitrage. Investors buy GBTC shares with cash or bitcoin and sell them in the secondary market after a six-month lock-up period. This scheme is greatly affected by the drop in bitcoin price, and only when the GBTC price is higher than the initial cost can it be profitable.

· Physical lending arbitrage. Institutional investors borrow bitcoin on lending platforms and hand it over to grayscale to replace the primary market share. After the lock-up period of 6 months, choose the time to sell, and buy bitcoin to return to the lending platform. At this time, the premium income sold by GBTC after deducting interest and other expenses is arbitrage profit.

· GBTC share lending arbitrage. Investors directly borrow GBTC shares, in the secondary market at the time to sell. At the same time with cash or bitcoin in gray into GBTC shares, after the lock-up period to repay the borrowed GBTC shares. There are two costs involved here, one is the borrowing cost of GBTC, and the second is 2% custody fee. If the GBTC premium range exceeds the sum of the two fees, it is possible to make a profit.

· Lock in premium arbitrage. Investors convert cash or bitcoin into GBTC in grayscale, and borrow GBTC over the counter when the market value of GBTC is higher than the net asset value and short GBTC. Ultimately whether GBTC up or down, profits are fixed. The final premium minus borrowing costs and custodial fees is earnings.

However, in the author's opinion, the above conventional programs have greater practical operational obstacles.

Cash lending arbitrage and physical lending arbitrage, the profit can only hope to maintain a positive premium before the unlocking period, it is obviously unscientific to ascribe this ordinary naked buying operation to the arbitrage strategy, because it does not lock the profit of the premium effective hedging measures, there is a reserve fill.

The essence of GBTC share lending arbitrage and lock-in premium arbitrage lies in selling by over-the-counter borrowing GBTC. However, according to the gray trust data we observed, in the product share locking period, the loaned share cost is high and the quantity is small, while after the unlocking period, the premium rate tends to drop sharply.

In conclusion, while we have seen some gains made using this approach during the bull market in the second half of 2020, this scheme relies heavily on the persistence of high premiums for lock-in periods and ample access to borrowing and low costs.

We put forward another two operating schemes according to the lock-up period and unlock-up period of the shares.

(1) Lock-up period. If it is detected that there is a high premium in gray trust products, investors can purchase shares in kind and construct Collar Trade for profit hedging. They can buy flat put options that expire on the unlocking date and sell dummy call options at the same time.

Figure 11 source: Babel Finance

(2) Unlocking period. When the lock-up period of gray trust products is over, a large number of products will be put into the secondary market. If there is still a premium space at this time, investors can make profits by hedging trading in the spot market and otc MARKET OTCQX.

But whether it is the threshold requirements for qualified investors to subscribe shares or the investment restrictions for cross-border transactions, it is another obstacle for most cryptocurrency investors.

One possible alternative is for investors to trade on Tokenized Stocks, a crypto trading platform.

Currently, Bittrex Global, FTX, BitPanda, Mirror (DeFi), Synthetix (DeFi) and other trading platforms all support equity token trading. FTX, for example, currently supports the share transaction of GBTC and ETHE, two grayscale trust products. From the perspective of the share of the trading platform and the corresponding actual OTC transaction price, they are basically consistent.

Figure 12: GrayScale, Babel Finance

In this case, when we find GBTC, ETHE, there is operational premium space, the spot and the product can be equivalent long short operation.

3. Gray trust arbitrage income analysis

As mentioned above, grayscale trust products provide an asymmetric opportunity of high profit, but there are many practical obstacles in the actual operation, which are shown as follows:

· High transaction friction costs. If you take into account the administration fees for actual share subscriptions (GBTC of 2%, ETHE of 2.5%), or interest on loaned short positions during lock-up periods, then the actual profit may be significantly reduced.

· Cross-account arbitrage brings high idle cost. Such cross-account operation will occupy a large amount of funds for collared options and equity token transactions to deal with losses. Meanwhile, due to the liquidity limitation of the market, highly matched hedging positions may not be constructed, which will greatly reduce the potential earnings.

· Uncertainty of arbitrage regression. From the past history, the premium regression of grayscale trust is not as clearly time constrained as the basis regression, and the operation process needs to face the uncertain time consumption and the sunk cost brought by the continued expansion of premium.

· There are compression arbitrage opportunities for competing products. The barriers and barriers for investors to participate in the crypto market are gradually coming down, as more and more homogeneous products (such as Purpose Bitcoin ETF, BITH11, etc.) and exchange providers (such as Coinbase, Robinhood, etc.) divert more and more investors. When the monopoly advantage of gray trust gradually collapses, the opportunity and space of premium arbitrage will largely disappear.

Arbitrage opportunities in the final analysis, gray trust is heavily dependent on the specific background the compliance of the product supply and demand imbalance caused by the high premium, not like sustainability, period now carry a long-term profit marginal effect, specific arbitrage scheme execution details and risk control's mad and dangerous, in short, so there is no longer for further quantitative yield.

Therefore, investors should also fully consider the various restrictive elements of the arbitrage approach and make a comprehensive evaluation.

Four,

In our research on crypto market arbitrage, we found that the arbitrage strategy itself can not only serve as an auxiliary scheme to smooth out the volatility of portfolio returns, but also become the main allocation choice of crypto investors through bull and bear.

(1) Different arbitrage strategies adapt to different cycles, and multiple arbitrage strategy combinations can effectively improve the overall return.

It is generally believed that arbitrage strategies perform better when there are large fluctuations in the currency price. However, this may not be the case. We find that during the great bull market of 2020, the perpetuity arbitrage strategy received a higher cost of capital than usual, but at the same time, the basis arbitrage return was much smaller than the performance of the minor bull market of 2019.

Therefore, by magnifying the observation period, the combination of multiple strategies derived from various arbitrage strategies can smooth the overall return and avoid the situation of large amount of idle funds or even arbitrage losses.

Figure 13 source: PwC, Babel Finance

(2) The nominal return of Bitcoin is not leading among various arbitrage strategies, but it does not prevent it from being the preferred target of long-term investment.

We observe that BCH, which has the best performance in cash arbitrage, has a low return on perpetuity carry, while XRP, which has the best performance in perpetuity arbitrage, suffers from delimitation risk due to bad fundamentals, so blind allocation of Altcoin may not be a robust first choice.

It can be seen that although the arbitrage performance of Bitcoin obviously lags behind other targets, it can obtain the average return level of mainstream currency arbitrage because it is the leading cryptocurrency with the highest value consensus and sufficient liquidity.

(3) Investors should be cautious about leverage, or not leverage.

From the limited data samples, it is suggested that the futures leverage of the perpetual carry basis should be controlled within 5x, and the cash arbitrage leverage should be controlled within 4x.

In addition, we should also note that these arbitrage operations also face many limitations, including but not limited to:

· Uncertainty of profitability. The strategy of this report is to expand sample currencies and test cycles as much as possible. However, the crypto derivatives market is in the early stage of development with limited available data, and the performance of the strategy has not been effectively tested in more dimensions. The conclusions drawn have certain one-side and limitations, which may restrict the actual profit results.

· Trader status or amount limits. With the increasingly strict regulation of the crypto market in various countries, many trading platforms implement KYC/AML or even stricter trading restrictions on users in some countries or regions, which greatly restricts cross-platform or cross-regional arbitrage operations.

· The influx of participants may wipe out arbitrage opportunities. As cryptocurrency continues to "go out of the ring", incremental arbitrage funds will inevitably form a long-term game with the liquidity force of price difference deviation, which will narrow the window period of crypto arbitrage to some extent.

· Other non-systemic risks cannot be avoided. The risks of the crypto market itself, such as hacker theft, technical failure of trading platform (server down, abnormal quotation, delayed trading, etc.), otc exchange rate risk, etc., all belong to the category of peripheral risks, which may lead to the failure of risk exposure hedging and unexpected losses.

Table 4 Source: Blofin

总而言之，投资者应意识到在市场微观上并非全息可测的，试图构建一劳永逸的套利方案可能是徒劳的，恰恰相反，投资者需要密切关注市场中套利要素的结构性变化，将获利预期、套利计划、资金成本等纳入综合考量。我们也在最后一如往常地提示投资者要进行适度的风险管理，并欢迎有套利需求或经验的朋友与我们交流更多真知灼见。