But there are plenty of other ways to earn yield that do require a directional market view. These are truly market-neutral strategies. While lending stablecoins and basis trading carry both counterparty and duration risk, these two strategies often carry little, if any, price risk. All of these factors determine the forward-looking rate environment, and managing that duration risk is imperative to generating stable returns. With digital assets these rates are highly volatile and are dependent on outside factors such as how much leverage is in the market, new participants entering and existing, and new tokens with inflationary incentive mechanisms built in as marketing costs to attract customers. As such, investors need to have an opinion on forward-looking rate opportunities regardless of how attractive is the current environment. Whether you are buying a bond, lending an asset, taking out a home mortgage, doing an arbitrage trade with a lockup or trading an options or futures curve, these investments have a shelf life. When hunting for the best rates, understanding this duration and reinvestment risk matters a great deal.Įvery yield instrument has a maturity. While the 20% yield sounds much better, if rates plummet to 1% by the time that instrument matures you are now faced with 11 months of lower returns that could have been avoided had you locked in the lower rate. Would you prefer a 10% fixed return locked in for one year or a 20% fixed return locked in for one month? To properly assess, one must have a view on what rates will be one month from now. Related: A Play-to-Earn Account Beats a Bank Account But not understanding the risk taken can be costly. This same dynamic occurred again in 2011-2012, when brokerages like Knight Capital, MF Global and Jefferies teetered on the brink of insolvency (with MF Global filing).Īll risks can be managed, including counterparty risk, when one properly identifies the risks and conducts proper due diligence. Back in 2008-2009, after the demise of Lehman Brothers and Bear Stearns, investing became less about what you owned and more about who you owned it with. The recent bankruptcy case of Cred Capital is a stark reminder of how great these risks can be. The counterparty can be an exchange, an over-the-counter (OTC) dealer, a technology provider, a DeFi protocol or one of the interest-bearing quasi-banks. Both lending and spot/futures arbitrage introduce counterparty risk. This cash shortage creates demand for dollars, which in turn leads to high lending yields and often higher prices for derivatives that require lower cash collateral. Similarly, market makers require cash to facilitate trading at each of these venues. Unlike traditional markets where there is too much cash in the market and a single prime broker can help one execute across any and all venues, in digital assets there is often not enough cash to navigate a fragmented and dislocated market.įor example, to buy just $1 million of assets, one might need $3 million-$5 million of cash to ensure there is enough buying power spread out across different venues, as the best offer might only appear in one place. These yields, which can range from 5% to 40% annually, largely exist because of an industry-wide working capital deficiency. Two of the most well-known and heavily discussed yield opportunities come from the basis trade (“cash and carry”) and stablecoin lending (e.g., staking USDT with a decentralized finance platform).

Related: US Stablecoin Regulation Could Lead to Geopolitical Competition So why do high yields exist in digital assets, and how are they generated? To answer that, we need to explore the three different types of risk that currently exist in the market.Ĭounterparty risk – the risk that the principal will not be returned due to the health and solvency of the party that holds the assets.ĭuration/reinvestment risk – the risk that yields will be lower at the expiration of an investmentĭirectional risk – the risk that the price of the underlying asset declines Jeff Dorman, a CoinDesk columnist, is chief investment officer at Arca, where he leads the investment committee and is responsible for portfolio sizing and risk management.

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