16th April 2021

How institutions are searching for crypto yields

Institutions entering the crypto ecosystem usually have one of the following two objectives: building an allocation to bitcoin (asset managers, treasuries) or exploiting the inefficiencies of this young market through spread trades and other strategies (hedge funds).

As a result, for a number of traditional finance institutions, entering crypto markets doesn’t mean taking a directional view on the assets but rather implementing delta neutral and risk management strategies, ultimately contributing to making this asset class more mature and efficient.

An interesting aspect of this young market is the very steep contango of the bitcoin futures curve, reflecting a structural shortage of US Dollars in crypto capital markets (historically crypto rich & cash poor).

CME is a natural place for institutions to start looking at crypto as most funds are already trading its derivatives products across other asset classes, making the operational onboarding and internal approval process more straightforward.

Alongside the rest of the industry, CME bitcoin futures have experienced very strong growth over the last two quarters with open interest and volumes up approximately 500%.

Looking at the weekly Commitment of Traders report published by the CFTC, short positioning from the hedge fund community has been on aggregate gradually increasing over time both in bitcoin and $ terms, highlighting the growing popularity of the so called basis trade (long spot bitcoin short futures).

After months of trading in tandem, it is unsurprising to see this quarter a clear decoupling between the CME basis futures and other “offshore” crypto derivatives exchanges - highlighting the more institutional nature of trading on CME and resulting in an increased focus on capturing the basis.

What will be the drivers that can make the CME basis come off further?

The most straightforward would be the ability to post margin in bitcoins, which is not possible today. Hedge funds need access to physical bitcoins or equivalent such as the Grayscale Bitcoin Trust (“GBTC”) or in the future ETFs, and then to work with prime brokers to borrow US dollars by putting crypto as collateral - US dollars that are used as margin to trade the CME contracts.

This contributes to the main flow in the crypto lending market with US Dollars typically being borrowed at 10% annualised using bitcoin as collateral.

The future ability of increasingly well capitalized prime brokers (including banks) to accept bitcoin and equivalents (ETF, GBTC) as collateral to provide US dollar financing will contribute greatly to making crypto capital markets more efficient.

Historically, an instrument of choice for institutions to implement the basis trade has been GBTC - allowing exposure to bitcoin spot in a fund format with the opportunity to capture an extra premium by investing in the primary issuance of the fund. This was so popular that the trust crossed $30bln of AuM this year, one of the most successful investment products of all time.

With the fund now starting to trade at a discount to NAV in the secondary market and no redemption mechanism available, we are now seeing this trade underperforming - a function of new competitions in particular from ETFs as well crowded positioning related to the search for yield.

For institutions trading physical bitcoins, another important feature for implementing large spread trading books is the ability to manage the expiry very accurately. As the CME Bitcoin futures are cash settled, this means being able to very precisely replicate the expiry using execution algorithms across the constituent venues (around 60% of the CME CF BRR index is Coinbase, other venues are Bitstamp, Gemini, Kraken and Itbit).

Interestingly, volumes on the index venues and CME futures are tracking very closely.

As the futures basis inevitably compresses, we should see actors looking at other opportunities for yield enhancement, for instance leveraging options. As an example, a popular structured product for high volatility underlyings are accumulators which net supply optionality to the market.

The cost in % premium to hedge for a 50% decline in bitcoin over the next three months has already corrected this quarter to almost its one year low, around 60 basis points, despite the all-time-high in spot.

Today’s crypto markets might seem very inefficient for new entrants but they have already come a long way since 2017 - where price discovery was much more challenging as for instance the ability to short did not exist.

The development of liquid futures and options markets, as well as dedicated infrastructure for institutions, such as custody and prime brokers, have most likely contributed to decreasing volatility relative to the previous cycle.

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Disclaimer: Past performance is not indicative of future results. All charts and graphs current as of 24 March 2021.
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