kasper vandeloock Follow Mar 17
· 9 min read Back in the good old days of 2015–2016, if you were an ambitious trader & had experience with arbitrage, you could easily make a couple of percent profit by simply arbing out the spread between 2 cryptocurrencies on different exchanges.
Today, however, it is significantly harder to be profitable by using a simple arbitrage strategy.The industry has matured a lot since then.First of all, crypto’s total market cap grew from 10 billion in early 2016 to almost 3 trillion in late 2021 and secondly, exchanges improved drastically.This of course attracted a lot of quantitative traders from the traditional finance scene to take advantage of this opportunity (Alameda research, Wintermute, MNGR etc).
Source: coinmarketcap.com However, even with all these big firms joining the scene, there are still many inefficiencies that smaller firms/individuals can take advantage of.
Let’s take a look at a few examples of some delta-neutral strategies that take advantage of these market inefficiencies, specifically collecting funding (from perpetual futures).
What Is Delta-neutral & what market neutral is the difference?
Delta neutral is a type of strategy where the total exposure to a specific asset is 0.For example, let’s say you spot a price difference between Binance and FTX.
| | ETHUSDT | Balance |
| | | |
| Binance | 3100 | -1 |
| FTX | 3000 | 1 |
| | Total exposure | 0 |
A way you could make money out of this is to lend 1ETH on Binance and sell it.Buy 1ETH on FTX and send it over to Binance to repay your loan.This way you have no exposure but can still make a profit.
Market neutral however is a bit different.
It simply means your total exposure to the market is 0.Most of the time you pick a combination of assets that are in the same category, in this example, we are using layer 1’s Ethereum and Cardano.
| | current price USDT | quantity | total value |
| | | | |
| Ethereum | 3100 | 50 | 155000 |
| Cardano | 0.8126 | -190745.7544 | -155000 |
| | | Total exposure | 0 |
Collecting funding payments
So, what exactly are funding rates? The funding rate is a mechanism to ensure that the perpetual futures contract price stays near the index or price of the underlying.If the perpetual is trading at a premium to the underlying index, long positions pay funding to the short positions.If the perpetual is trading at a discount to the underlying index, short positions pay funding to long positions.
The funding rate to be paid/received is determined by the following formula:
position size * TWAP of ((future — index) / index) / 24
This is an example from FTX , but the formula differs from exchange to exchange depending on their funding rate interval.
How can we profit from this mechanism?
In the following example, we have a stable funding rate of 0.0198%/hour for the Bitcoin (BTC) perpetual future (i.e.BTC-PERP).This means that the longs will pay the shorts.To collect this funding rate all we have to do is short the BTC-PERP to get paid an hourly fee for our position.
But of course, this will create an exposure to the BTC price, which we don’t want.
So we buy 1 BTC on the spot market to hedge our initial short position.Since we now own 1 BTC & are short 1 BTC-PERP, the price change of BTC will have no impact on our capital.
In the span of these 24 hours, we will get paid a total of 309.09$ while having no exposure to BTC at all.
But how can we get more profit out of this type of strategy?
Cross exchange funding arbitrage Alternative coins Using leverage Optimising EV plays Cross exchange funding arbitrage
There is and will always be a small difference between perpetual contracts between exchanges.Not because a specific market has more buyers than sellers but because they:
use different weights for their index (see the example of how to calculate funding prices); Pay funding rates at different intervals (e.g.Once per hour at FTX and once per eight hours at Binance) Traders do not have access to the trading platform creating a price difference Now because of this, you can find opportunities where 1 exchange has a positive funding rate while the other has a negative one.Most of the time these opportunities start showing up after a big price fluctuation and traders had to close/liquidate their positions.
source: FTX.com Source: huobi.com An example of today is Algorand (ALGO), which had a price surge of 20% and caused a couple of large short liquidations.This sudden surge was driven by the listing of the coin on the Korean exchange “Upbit”.These opportunities get arbed out most of the time fairly quickly but the reward you get is of course enormous.
In the first example, we hedged our perpetual short position by buying spot on the same exchange, while here we can long the ALGO-PERP on Huobi and get paid 1.5%/hour and we can short the same ALGO-PERP amount on FTX and get paid 0.0015%/hour (due to the positive funding rate).
Keep in mind that you will have to rebalance your collateral on the exchanges to avoid liquidations.
Alternative coins
Altcoin perpetual contracts often have a larger spread in their index vs contract price than the top coins such as BTC or ETH, especially after big a price movement.This is good for us because there is a higher return but there are a few risks to this strategy.
First of all, you need enough liquidity, if you cannot enter a position easily without a low market impact you should not take the trade.
A positive factor about using this strategy on altcoins that most do not consider is that a lot of the time the spread between the index & perp is not the only profitable factor.Altcoins often have a price difference between different exchanges, this is because a lot of these coins carry a higher risk than the majors & thus have a lower priority to arbitrage out…
Some of these higher risks are:
Slow networks A high requirement of transaction verifications Deposits get disabled by a certain exchange Low liquidity However, for us, this is a good thing since these price differences get arbed out over time & it also makes it cheaper for us to hedge using spot.
You might find things such as the high requirements of transaction verifications odd but coins such as Ethereum Classic (ETC) require a LOT of verifications since the network is “cheap” to hack.
What do I mean by this? In the past hackers have used 3rd party mining services to rent out a lot of GPU’s to mine on ETC until they take over at least 51% of the network to execute a 51% attack.In other words, they have 51%+ of the hashing power of that network, therefore they can falsely verify transactions on the blockchain & make transactions from wallets that they do not own, for a more detailed explanation I would recommend this article .
Alternative platforms
With alternative platforms, I mean decentralized exchanges (DEX’s).Platforms such as
Mango markets (Solana) Perpetual Protocol dYdX Most of these platforms do not have a lot of liquidity & give some interesting opportunities.There is, of course, a catch, most of these platforms are built on top of Ethereum which currently has incredibly high fees.
Besides that you need to have capital on the platform to be able to execute the trade or the opportunity might be gone once your capital arrives.
Besides all of that, most of these platforms require you to deposit money into the smart contract so you are also exposed to the risk that if the platform gets hacked you would lose your collateral.
Most would argue that this could also happen on centralized exchange platforms however these have improved a lot compared to a few years ago.They use a combination of hot/cold wallets, they have a large insurance fund, stable coins such as USDT & USDC can get frozen and the amount of times a CEX has been hacked has dramatically decreased over the years even though more & more capital gets deposited on them.
Levering it up.
The most obvious one would for example be simply using a certain amount of leverage on the perpetual and using margin to borrow enough USD/coin to hedge.
This would require a lot of rebalancing.The biggest problem with this is that it’s not capital-efficient.
You see most platforms only accept stable coins such as USDC/tether/BUSD to be used for trading futures.So let’s say you want to short 3 BTC at the value of 50 000$/BTC you need enough capital to buy 3 BTC & short 3 BTC which is around 300K, not the optimal play.
Platforms such as FTX have a fun feature where you can use coins as collateral for your futures account.
This makes it easier to be capital efficient.Non-USD collateral
Let’s say you want to execute the same trade of shorting 3 BTC on FTX & buying 3 BTC spot and we have a capital of 150K.
BTC currently has a weight of 0.975 meaning that if we have 150 000$ worth of BTC we can use (150 000 * 0.975) = 146 250$ worth of collateral to trade futures contracts.
So you are automatically forced to use leverage.Now because we are using Non-USD as collateral there is a trade-off we need to make.
FTX automatically start liquidating your coins once your balance breaks the threshold of -30 000$.To ensure you have enough collateral to maintain your account.
In this case, it will not be a problem if the price of BTC goes down.However, if the price of BTC would go up by 9750$ you would have a problem.So be sure that before you reach that level you already have rebalanced your positions to keep your delta at 0 at all times.
You can find the calculation of collateral on FTX here but don’t forget to take into account the IMF factor to avoid liquidation when using non-USD collateral
Optimising the plays by EV
The good part about funding collecting is that it’s easy to maximize EV (Expected Value), you know exactly when you get paid & you can calculate with high certainty what the funding rate will be (see calc of funding rate example at beginning of the article).
Create a dataframe where you put in all the potential trades you could take, which could be a simple funding collector or cross-exchange funding arbitrage.Calculate how much it would pay hourly, calculate the costs it would bring such as trading fees, withdrawal fees & multiply that by the probability based on previous trades.
Take it a step further, take into account that you could earn a profit on maker fees, don’t wait till a trade is done, check if it’s more profitable to rotate into another.
The risks of this type of strategy.This type of strategy is profitable because it is able to execute many trades profitable trades with the occasional small loss & there are a lot of ways these trades can go wrong.
Bad inventory management Failure of order placement or bad execution Trading gets disabled of a market Connection issues Disabling or slow deposits/withdrawals CEX/DEX goes down Risk of liquidation when using leverage False data Exchange failures => Examples All of these topics deserve their own article which I will not do in this post, however, if you decide to try and execute one of these strategies be sure to take these risks into account & think about how you can avoid them.
Ending:
There are lots of opportunities out there in the crypto markets by taking advantage of small inefficiencies, sadly it’s not as easy as a few years ago when a simple arbitrage was all you needed to bring in a good chunk of profits but it’s a sign that the space is evolving.
Large profits by taking advantage of these inefficiencies are still there to take advantage of, you just have to think a bit more outside the box than in the past :).
