The Liquidity Feedback Loop: Why Liquidity is Returning to the Bitcoin Market

Written by Reflexivity Research

While Bitcoin and alternative digital assets have offered immense returns for capital allocators over the past decade, one facet of the market that we believe has been underemphasized is the tremendous opportunities for funds that seek to maintain delta neutrality in the Bitcoin derivatives market. While there are a multitude of opportunities on-chain through strategies such as yield farming, lending assets through DeFi protocols, etc., the intent of this report is to provide an overview of the opportunity for yield generation in the Bitcoin futures market specifically, which is the most liquid in crypto. Note that the strategies discussed in this report may also be applicable to other crypto assets.

Throughout the past year, heightened counter-party and regulatory risk has triggered a pullback in activity from major market making firms such as Jane Street and Jump. This, general crypto market decline, alongside with the decline of yields throughout the market, has led to a decrease in the state of liquidity in the crypto market overall, which is shown in the (slightly outdated) chart below from Kaiko Data; which illustrates the 2% bid/ask depth for BTC USD/USDT trading pairs (in BTC denominated terms) on a continuous decline after the FTX collapse.

However, the pullback of these firms sparks opportunities for those that remain involved and well capitalized in this market; as there are now fewer large players to capture market inefficiencies which should bring back many of the dislocations we saw in the previous bull run.

Futures Basis Trade

One of the largest opportunities for delta neutral funds looking to profit from the Bitcoin market is the “cash and carry” trade. Well known in traditional finance, this is done by purchasing the underlying spot Bitcoin and shorting a Bitcoin futures contract that is trading higher than the current spot price. By doing so, you are locking in the difference/spread between the current spot price and the futures contract price, and thus the trade can be perceived as relatively “risk free”, however there are a few small risks to be aware of:

• The first is counterparty risk; which shouldn’t be ignored in crypto (especially after FTX) but is minimized during raging bull markets.
• The second is basis risk. While being long spot and short futures maintains delta neutrality, allocators must be sure that they are capitalized enough to add collateral to the short leg of the trade should the futures basis move higher. Conversely to counterparty risk, this risk actually increases during raging bull markets.
• As a long term investor, the third “risk” to consider is opportunity cost. By shorting the futures contract in equivalent size to your underlying spot position, you miss out on any further potential upside in Bitcoin’s spot price; but most entities (and the ones we are speaking to in this report) putting on this trade are non-directional in nature.