In the emerging crypto trading landscape, there are numerous opportunities for time-tested arbitrage strategies. Here, we walk through a practical illustration of the Cash & Carry strategy using Perpetual Contracts on multiple exchanges.
The crypto landscape is an interesting place to be as a trader, as it is earlier on in its development compared to the traditional finance world. Thus, it should be possible not only to apply traditional strategies seldom seen outside of textbooks, but to apply them in a relatively straightforward manner, without the need for sophisticated algorithms.
In this article, we take the Cash & Carry trade as an example. We’ll briefly recap the details of this strategy first, for those who took their CFA exams some years ago. Next, we’ll share a real-world example of a study we carried out in the second half of 2021. As you’ll see, our pragmatic methodology was able to identify opportunities on Futures Exchanges, without the need for real-time monitoring or algorithmic trading.
Recap: the Cash & Carry Trade
This section contains an explanation of the building blocks of the strategy. Those familiar with the fundamentals of Futures, Perpetuals, and the Cash & Carry Trade can skip to the next section.
Price at which a token is available for purchase now.
Price at which a token is available at a future date (as agreed between two parties in a contract).
Cash & Carry Trade
The two prices (Spot and Future) are typically different from one another.
When demand for futures contracts is high (e.g. when the outlook is extremely uncertain and clients want to put a ceiling on the price at which they must purchase the asset), the futures price will be higher than the spot price.
The technical term for this situation is contango, and the reverse situation – spot price higher than the futures price – is called backwardation. Apparently all the sensible-sounding names were taken.
In a Cash & Carry trade, an investor purchases the asset at the spot price (a “long” position) and sells a futures contract at the higher price (a “short” position). Alternatively put, the investor finds a counterparty who will commit to purchase the asset at a higher price.
The investor will therefore at least pocket the difference between the initial spot and future prices (known as the basis).
If the spot price rises above the futures price, the investor can profit further by selling the asset on the spot market and buying a futures contract (i.e. a long position that cancels out the original short position).
A Perpetual (also known as a “Perpetual Swap”) is a form of futures contract with no expiry date. Instead, the difference between the long and the short side of the contract is continuously settled at periodic intervals. The length of the interval depends on the exchange managing the contract.
The payment is calculated by means of a % of the contract value called the funding rate. When the perpetual contract price is higher than the spot price, the funding rate is positive. In other words, traders who are long the contract pay money to those who are short the contract.
While the above approaches are in theory risk-free, nothing is risk-free in reality. The main challenge to strategies that rely on selling a contract is counterparty risk (i.e. the buyer of the futures contract refuses or is unable to fulfill their side of the bargain).
Failure to pay can arise as a result of the buyer of a contract simply disappearing, or being genuinely financially unable to meet their obligation. It can also in some cases result from the failure of the exchange itself, owing to a temporary glitch in the mechanics of the trade, or (more rarely) the total or partial collapse of the platform owing to an external event or hack.
What we wanted to test
Crypto exchanges that allow users to purchase currencies at both the spot rate and futures rate provide opportunities for Cash & Carry strategies.
Our aim in this study was to develop a workable strategy for the manual execution of profitable cash and carry trades.
To identify potential opportunities, we needed to systematically monitor spreads and funding rates for a selection of perpetuals.
We opted to target coin-collateralized perpetuals (as opposed to USDT-collateralized). Avoiding the need to lock in additional USDT as capital is not only a more efficient strategy, but also more straightforward in terms of execution, and hence more practical for manual implementation.
In particular, we filtered for positions where the asset exhibited the following characteristics relative to its peers:
- High positive basis (i.e. perpetual price above the spot price)
- High positive funding rate
- High spot and future volume (to ensure liquidity).
We began by gathering a historical sample of actual pricing data from three exchanges (Huobi, OKEx, FTX). The time period was from mid-September to mid-October.
As stated above, we wanted to test if the strategy was stable enough to follow a manual approach, rather than devise more complex/high-frequency algorithms.
- The data are ranked by average APR (over 4 weeks), from highest to lowest.
- Color coding of results:
- APR < 0% (negative funding rates) are highlighted in red.
- APRs ≥ 13% highlighted in green. This is deemed to be ‘high’ as it encompasses the top 30% of performers.
- Contracts are filtered to include only securities with spot and future daily volumes greater than 25m. This is to ensure that the market is liquid and that large purchases do not unduly affect the price.
The data above suggested three main conclusions:
- Good performance tends to last for at least two consecutive periods, and often for longer
- The OKEx platform seems to be the most volatile, with funding rates swinging from negative to highly positive in the space of a few weeks
- FTX had many potential high performers from a funding rate perspective but did not sell the underlying asset on the exchange for spot purchase (these are excluded from the data above).
Developing the strategy
The initial findings showed a certain measure of stability, and so implied that a pragmatic approach might be feasible. We built the following strategy:
- Exclude OKEx: operating a manual strategy across multiple exchanges is a high-effort exercise. Since OKEx appears most volatile, we decided to focus on the remaining two.
- Deploy capital across FTX and Huobi.
- Diversify across assets
- Select the top contracts in each exchange, based on stability and Week 4 APR.
Over the course of the period, we would perform the following adjustments:
- Monthly: Allocate and/or rebalance the portfolio in line with the initial target allocations
- Weekly: Close out contracts with a negative average funding rate for the previous 7 days.
When closing a position, we would redeploy the capital to alternative contracts, based on the latest historical data. For practical reasons, we would not move capital between exchanges. This means being willing to relax the initial target allocation by being overweight in one perpetual, or trading the same perpetual on two exchanges simultaneously.
As a side note: our analysis ignores the potential profit an investor could make by timing the opening and closing of the trade when the basis changes in sign. This is complex if done manually, so we assume for simplicity that the basis at the start and end of the trade would be comparable and cancel each other out
Sustained negative rates across the board would of course have a significant impact on the success of the strategy, and represent a material risk to the strategy as a whole.
Backtesting the strategy
To backtest this strategy (i.e. calculate the returns we would have made using actual historical returns) we used data from August to September (i.e. the period before the preliminary analysis) and applied the same logic to identify promising contracts.
These were the results by exchange:
These data imply the following allocation of capital and selection of contracts:
- Deploy across 6 contracts
- FIL, SHIB, ATOM, DOGE, EOS, XRP
- Deploy across 4 contracts
- AXS, FTT, SOL, LINK
Applying the selections to the September-October period, we saw that the strategy would have achieved the following results:
(Note: a strikethrough represents a position that is not active, i.e. has been closed, or not yet opened)
In spite of an outlier (AXS) that generated a negative average APR, the strategy was demonstrated to be successful and superior to a random allocation approach.
The total portfolio APR of the strategy was 9.51%, compared with an average available APR of 3.45% calculated on the basis of all eligible futures (i.e. coin-margined contracts, spot, and future daily volumes greater than 25m). In other words, a performance improvement of 176%.
Examining the performance of individual contracts in the sample, we saw significant volatility from interval to interval. For example, here is the performance of the FILUSD perpetual contract:
This implies that if a manual approach is to be followed, a less granular strategy is likely to be more successful than one that updates more frequently. Not only is a manual strategy more prone to error, but it would also be more time-intensive in a fluctuating market.
All in all, we found that in the current state of the market, it is possible to generate a significant alpha with a manual Cash & Carry approach, provided that prudent measures are taken to account for the volatility of the individual securities. The analysis required to prepare the strategy took around a day’s effort. This is a non-trivial commitment, but within reasonable bounds and justified by the increase in returns.