Bitcoin is known as digital gold. It is treasured as an investment asset. Much like the famous yellow metal, bitcoin (“BTC”) does not offer income through dividends or interest. This poses a challenge for investors seeking regular cashflows and income.
One strategy that skilled investors use to turn BTC into an income generating asset is the cash and carry trade (“carry trade”).
This paper describes mechanics of carry trade and the attendant risks. It also highlights that the introduction of spot ETFs has created a secure infrastructure for harvesting carry yields using a regulated platforms such as the CME.
INTRODUCTION TO THE CARRY TRADE
The carry trade is an arbitrage strategy that benefits from the differences in futures and spot price of an asset. It is a delta neutral strategy. In other words, the returns are not price dependent once the carry trade is profitably set up.
To illustrate, consider the forward curve of CME Bitcoin futures which shows futures prices at different expiries.
Bitcoin futures with later expiries trade at a premium to near term ones and this type of market structure is referred to as contango.
In a trade that involves simultaneous acquisition of BTC and selling a BTC futures contract expiring later, investors can lock in the price difference as profits. Once established, this trade’s profit is unaffected by price moves enabling investors to harvest carry yield at the futures expiry.
The pay-off from this trade is driven by convergence of futures and spot prices. Convergence is the movement of a futures price closer to spot price at expiry. Once futures and spot price are sufficiently close, the trade can be unwound by simultaneously exiting both positions.
For CME Bitcoin and Micro Bitcoin futures, convergence occurs because the futures contracts settle to a robust price benchmark known as the CF Bitcoin Reference Rate (“BRR”) which includes price quotes from major crypto exchanges.
BTC FUTURES CONTANGO TERM STRUCTURE AND PREVALANCE OF CARRY TRADE
Carry trades can be executed in both contango and backwardation term structures. While the carry trade can technically be executed in backwardation (where later expiries are cheaper), doing so involves high borrowing costs for the short spot leg. Hence, BTC’s contango term structure is beneficial for extracting arbitrage yields from carry trade.
Factors driving BTC contango term structure are multi-faceted. Simply put, during bull runs, investors anticipate higher prices for contracts maturing later. Furthermore, high demand for spot BTC and limited availability on the sell-side can exacerbate forward premiums.
Additional factors resulting in contango include cost of funds, insurance premiums, and custodial charges that are higher for later expiries, and a convenience yield of holding BTC. Convenience yield represents returns from holding BTC through activities such as lending.
BTC futures term structure has shown both contango and backwardation during different periods. Current term structure indicates bullish sentiment fuelled by spot BTC approval in January and the next halving event expected in April.
Term structure shifts can result in outsized returns at times. Notably, the switch from contango to backwardation can offer outsized returns on the carry trade, exceeding the difference between futures and spot price as observed at trade inception.
The carry trade has been a popular strategy, especially during periods of significant volatility and during bull markets when BTC contango structure widens. Even sell-offs provide compelling trading opportunities as the carry trade is directionally neutral. Carry trades have lower risk relative to an outright long position.
For reference, during 2021, LedgerPrime’s quant fund was able to beat BTC returns using, among others, the carry trade during a large selloff.
RISKS OF THE CARRY TRADE
The carry trade neutralises market risk but is still subject to counterparty risks and liquidity risks when spreads diverge and tear.
Largest risk factors associated with the carry trade is the counterparty risk . While CME futures are regulated by the CFTC, spot crypto exchanges are not subject to similar regulations. This poses significant risk for investors if they opt to hold their BTC on such unregulated exchanges.
Such risks arising from trading on unregulated platforms is most exemplified by the collapse of FTX. FTX was a popular exchange for executing carry trades as it offered dated futures, perps, and spot BTC on its platform. The dramatic collapse of FTX highlighted counterparty risk as a major concern.
Self-custody of spot BTC has its own risks including transfer costs and cybersecurity risks.
Another risk factor is early liquidation. As the futures leg of the trade is a short position, where prices rally sharply, the short position may be at risk of liquidation despite a proportional gain on the long leg of the carry trade.
SPOT BTC ETF HELPS REDUCE COUNTERPARTY RISKS
The rollout of spot BTC ETFs reduces counterparty risk. Unlike unregulated crypto exchanges, spot ETFs are regulated by the SEC, listed on regulated exchanges with investor protection.
With both the futures and spot leg now available through regulated platforms, investors have access to secure infrastructure for executing the carry trade.
The table below provides details of approved spot ETFs including AUM, expense ratio, and the benchmark index.
Carry trade using spot ETFs with CME CF Bitcoin Reference Rate (CME BRR) enables greater precision in extracting arbitrage yields. Seven of the eleven approved spot BTC ETFs use the CME BRR.
Still, there are downside to using spot ETFs for long BTC exposure in carry trades. For one, ETFs are only tradeable during market hours (9:30AM to 4:00PM US Eastern Time not including extended trading hours) whereas cryptocurrency exchanges and even CME futures trade for longer hours.
Moreover, expense ratios and premium/discount to NAV for ETFs will erode already thin profits. Spot BTC ETFs are currently offering discounts on expense ratio for a fixed period.
CARRY TRADE ILLUSTRATION
To illustrate a hypothetical carry trade, consider the following setup comprising long BITB ETF and short CME Bitcoin futures (BTCH2024).
BITB references the same CME CF Bitcoin Reference Rate as CME futures and its premium/discount of -0.07% (as of 09/Feb) offers a beneficial entry point for this trade. Moreover, the premium/discount on the ETF has been tight.
The premium for MBTH2024 over spot reference rate as of close on 9/Feb was 2.83%. Taking seven basis point discount to NAV, this results in total return of 2.90% over 48 days resulting in an annualized arbitrage return of 22%.
As the trade is required to be directionally neutral, notional value on both legs needs to be balanced. CME Micro Bitcoin futures (“MBT”) offers exposure to 0.1 BTC.
As of close 09/Feb,
The trade requires margin of USD 980 on the short futures leg and notional of USD 4,775 on the long leg for a total capital requirement of USD 5,755 (as of Feb 2023) which translates into ROI of 2.4%.
Still, as mentioned, liquidation risk remains a concern. Hence, it is prudent to maintain higher margin on the short futures leg which would lower the ROI.
Note that timing this trade better can improve the odds and in case Bitcoin’s term structure switches from contango to backwardation, payoff would be higher.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
One strategy that skilled investors use to turn BTC into an income generating asset is the cash and carry trade (“carry trade”).
This paper describes mechanics of carry trade and the attendant risks. It also highlights that the introduction of spot ETFs has created a secure infrastructure for harvesting carry yields using a regulated platforms such as the CME.
INTRODUCTION TO THE CARRY TRADE
The carry trade is an arbitrage strategy that benefits from the differences in futures and spot price of an asset. It is a delta neutral strategy. In other words, the returns are not price dependent once the carry trade is profitably set up.
To illustrate, consider the forward curve of CME Bitcoin futures which shows futures prices at different expiries.
Bitcoin futures with later expiries trade at a premium to near term ones and this type of market structure is referred to as contango.
In a trade that involves simultaneous acquisition of BTC and selling a BTC futures contract expiring later, investors can lock in the price difference as profits. Once established, this trade’s profit is unaffected by price moves enabling investors to harvest carry yield at the futures expiry.
The pay-off from this trade is driven by convergence of futures and spot prices. Convergence is the movement of a futures price closer to spot price at expiry. Once futures and spot price are sufficiently close, the trade can be unwound by simultaneously exiting both positions.
For CME Bitcoin and Micro Bitcoin futures, convergence occurs because the futures contracts settle to a robust price benchmark known as the CF Bitcoin Reference Rate (“BRR”) which includes price quotes from major crypto exchanges.
BTC FUTURES CONTANGO TERM STRUCTURE AND PREVALANCE OF CARRY TRADE
Carry trades can be executed in both contango and backwardation term structures. While the carry trade can technically be executed in backwardation (where later expiries are cheaper), doing so involves high borrowing costs for the short spot leg. Hence, BTC’s contango term structure is beneficial for extracting arbitrage yields from carry trade.
Factors driving BTC contango term structure are multi-faceted. Simply put, during bull runs, investors anticipate higher prices for contracts maturing later. Furthermore, high demand for spot BTC and limited availability on the sell-side can exacerbate forward premiums.
Additional factors resulting in contango include cost of funds, insurance premiums, and custodial charges that are higher for later expiries, and a convenience yield of holding BTC. Convenience yield represents returns from holding BTC through activities such as lending.
BTC futures term structure has shown both contango and backwardation during different periods. Current term structure indicates bullish sentiment fuelled by spot BTC approval in January and the next halving event expected in April.
Term structure shifts can result in outsized returns at times. Notably, the switch from contango to backwardation can offer outsized returns on the carry trade, exceeding the difference between futures and spot price as observed at trade inception.
The carry trade has been a popular strategy, especially during periods of significant volatility and during bull markets when BTC contango structure widens. Even sell-offs provide compelling trading opportunities as the carry trade is directionally neutral. Carry trades have lower risk relative to an outright long position.
For reference, during 2021, LedgerPrime’s quant fund was able to beat BTC returns using, among others, the carry trade during a large selloff.
RISKS OF THE CARRY TRADE
The carry trade neutralises market risk but is still subject to counterparty risks and liquidity risks when spreads diverge and tear.
Largest risk factors associated with the carry trade is the counterparty risk . While CME futures are regulated by the CFTC, spot crypto exchanges are not subject to similar regulations. This poses significant risk for investors if they opt to hold their BTC on such unregulated exchanges.
Such risks arising from trading on unregulated platforms is most exemplified by the collapse of FTX. FTX was a popular exchange for executing carry trades as it offered dated futures, perps, and spot BTC on its platform. The dramatic collapse of FTX highlighted counterparty risk as a major concern.
Self-custody of spot BTC has its own risks including transfer costs and cybersecurity risks.
Another risk factor is early liquidation. As the futures leg of the trade is a short position, where prices rally sharply, the short position may be at risk of liquidation despite a proportional gain on the long leg of the carry trade.
SPOT BTC ETF HELPS REDUCE COUNTERPARTY RISKS
The rollout of spot BTC ETFs reduces counterparty risk. Unlike unregulated crypto exchanges, spot ETFs are regulated by the SEC, listed on regulated exchanges with investor protection.
With both the futures and spot leg now available through regulated platforms, investors have access to secure infrastructure for executing the carry trade.
The table below provides details of approved spot ETFs including AUM, expense ratio, and the benchmark index.
Carry trade using spot ETFs with CME CF Bitcoin Reference Rate (CME BRR) enables greater precision in extracting arbitrage yields. Seven of the eleven approved spot BTC ETFs use the CME BRR.
Still, there are downside to using spot ETFs for long BTC exposure in carry trades. For one, ETFs are only tradeable during market hours (9:30AM to 4:00PM US Eastern Time not including extended trading hours) whereas cryptocurrency exchanges and even CME futures trade for longer hours.
Moreover, expense ratios and premium/discount to NAV for ETFs will erode already thin profits. Spot BTC ETFs are currently offering discounts on expense ratio for a fixed period.
CARRY TRADE ILLUSTRATION
To illustrate a hypothetical carry trade, consider the following setup comprising long BITB ETF and short CME Bitcoin futures (BTCH2024).
BITB references the same CME CF Bitcoin Reference Rate as CME futures and its premium/discount of -0.07% (as of 09/Feb) offers a beneficial entry point for this trade. Moreover, the premium/discount on the ETF has been tight.
Source: Bitwise
The premium for MBTH2024 over spot reference rate as of close on 9/Feb was 2.83%. Taking seven basis point discount to NAV, this results in total return of 2.90% over 48 days resulting in an annualized arbitrage return of 22%.
As the trade is required to be directionally neutral, notional value on both legs needs to be balanced. CME Micro Bitcoin futures (“MBT”) offers exposure to 0.1 BTC.
- Notional on short BTCH2024 futures leg: 0.1 BTC
As of close 09/Feb,
- BITB market price: USD 25.95
- CME CF Benchmark BTC price: USD 47,614
- Each share of BITB offers exposure to 0.000545 BTC
- 184 shares of BITB provide exposure to 0.000545 x 184 = 0.100280 BTC
- The payoff from the trade consisting of 184 x long BITB and 1 x short MBTH2024 would be 2.9% of notional value = 2.9% x (0.1 x 47,614 USD/BTC) = USD 138.
The trade requires margin of USD 980 on the short futures leg and notional of USD 4,775 on the long leg for a total capital requirement of USD 5,755 (as of Feb 2023) which translates into ROI of 2.4%.
Still, as mentioned, liquidation risk remains a concern. Hence, it is prudent to maintain higher margin on the short futures leg which would lower the ROI.
Note that timing this trade better can improve the odds and in case Bitcoin’s term structure switches from contango to backwardation, payoff would be higher.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com/cme/.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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