A suite of interest rates
Bitcoin’s Lightning Network (LN) derived interest rates are a fascinating breakthrough from a financial theory perspective. The smart contracts within LN allow its participants to establish a market for routing fees, and routers can earn a bitcoin-denominated return without ever relinquishing complete control of the underlying capital. In comparison, returns are never earned without sending capital to a counterparty in traditional markets. The excitement around LN and counterparty-free income is undeniable, but nominal returns are currently minimal. While financial theory nerds like myself can speculate on the long-term implications of LN routing and a potential Lightning Network Reference Rate (LNRR), large capital mostly doesn’t care yet because it cannot find both a home and a return using Lightning Network.
Thankfully, LN is not the only source of bitcoin-denominated income. Coin mixing offers a new source of return and time value for bitcoin; capital providers can dedicate bitcoin to improve privacy for those participating in a coin mix. Exchange lending is another; investors with a long position can lend bitcoin to short sellers on an exchange and earn a healthy return. Interest rates can be derived from all of these activities that involve counterparty risk. But then again, essentially every income opportunity in every asset class carries counterparty risk. How can a corporation, for example, return income to investors without initially taking outside capital into its own custody? Impossible.
Perpetual funding rates
In a recent interview with on-chain analyst Will Clemente, I was asked about my thoughts on a bitcoin interest rate. It’s something I’ve been thinking a lot about, but my attempt at articulating a response was quite poor (I watched it back on YouTube, sorry Will!). In an attempt at redemption, I hope this post is a clearer explanation of how I envision bitcoin interest rates and how perpetual (perp) funding rates fit in.
Bitcoin investors that read this publication are most likely purchasing bitcoin outright—some are keeping it on an exchange, while others have self-custody mechanisms like smartphone wallets, hardware wallets, and multisignature solutions. In the trading world, however, gaining bitcoin exposure is a little different than it is for you and me.
Bitcoin exchange BitMEX invented the perp bitcoin swap contract in 2016. The perp swap is a derivatives contract that gives exposure to the bitcoin price by using only a fraction of the capital as collateral, similar to how futures contracts work for other assets on exchanges around the world. The difference between perpetual bitcoin swaps and most other futures contracts is the term—expiration is only eight hours away. This brings a metric into the bitcoin market that provides a strong signal to traders and can often make short-term price action follow a pattern: the perp swap’s funding rate. This is the interest rate that links the spot price to the futures price over an eight-hour timeframe. If you’re interested in a deep dive, click here. Allow me to take a slight detour through my former world of US Treasuries to offer some context for bitcoin’s perp funding rates.
Treasury repo: a pawn shop for bonds
I’ll never forget the first in-person conversation I had with a Wall Street repo trader. He told me that the repo desk is the heart of a bank. When he said the word “heart,” he held his fist over his chest and mimicked pumping of the cardiac muscle. The trader proceeded to explain this analogy, but at the time it went completely over my head. Yet I was convinced that I must understand what he meant. It sent me down the repo rabbit hole.
Repo, in this context, is short for repurchase agreement. In a US Treasury repo agreement, the owner of Treasury collateral agrees to sell the security today and repurchase it tomorrow and tack on a little interest. It can also be thought of as pawning your Treasury security—using it as collateral to borrow cash against; I believe the pawn analogy is more intuitive than a repurchase agreement (I use it to teach my students about Treasury repo at USC Marshall School of Business). And because Treasuries are considered the safest possible collateral amongst all dollar-denominated assets, Treasury owners can borrow up to 98% of the face value of their collateral. This type of leverage offers the Treasury market a unique signal to form: Treasury repo interest rates. Why then is repo the heart of a bank? Because banks that make markets in US Treasuries depend on repo to finance their positions. Here’s an example:
A university client has a portfolio of $500 million. The portfolio is held in highly liquid fixed-income securities because within the client’s billions under management with various investment houses, this $500 million sleeve is reserved specifically for construction projects. At any moment, the client might need up to 20% of the funds to pay large bills to the construction company that is building a new athletic facility for the university. The client calls me and says it needs $100 million tomorrow. I immediately survey the portfolio and decide to raise funds by selling Treasuries. I call the Treasury desk at Citi and ask for a bid on $100 million 5-year Treasuries. Citi makes me an offer which is exactly the same price as I see on my Bloomberg screen, and I hit the bid. Now, did Citi have $100 million just lying around? Or did it only bid because of its ability to finance the position in the repo market? It’s the latter.
From the other side, Citi sees my sale come across its desk. The Treasuries traders at Citi have a constant dialogue with their repo desk and are aware of how much “sheet” they are allowed to use. Available sheet, short for balance sheet, is something that the Treasuries desk always needs to know so it can make markets without breaking the bank’s cash position. And the repo traders, as the heart of the bank, decide which desks get how much sheet. Think of repo lines to each desk within the bank as arteries carrying blood to the rest of the body. Without funding, individual desks within the bank would not be able to make markets; they would be able to buy securities from clients looking to sell only with cash available on hand. This would severely limit the amount of business Citi could do. An outsider might not think about a bank’s ability to finance activity through the repo market, but every trader inside the bank is acutely aware of the heart’s position. Banks rely on repo funding to generate trading profits.
Mortgages and rental income
I’ll use one more funding example before returning to bitcoin: the mortgage market. A homeowner decides that she wants to invest in a second home and turn it into a rental property (she should have bought bitcoin, but whatever). She doesn’t have the cash available to buy the second home without a mortgage. She finds a mortgage broker willing to lend her 95% of the home’s purchase price, leaving her with very little out-of-pocket cost. Her mortgage payment every month is $3,000, and her rental income is scheduled to be about $4,000. She generates positive cashflow every month, something that would be impossible without a funding source for the underlying asset. We can see with these examples how real estate and US Treasuries are two types of collateral that are powerhouses—they can always be financed.
A powerhouse collateral
Back to perp swaps and perp funding rates for bitcoin. I believe that the aggregate perp funding rate (assembled by calculating a weighted average of funding rates across exchanges) is currently bitcoin’s most informative interest rate. It is highly volatile: when bitcoin’s price is pumping, traders seek to leverage long positions, and the market responds with increased funding rates for such positions. When funding rates reach high levels that are unsustainable (for example annualized rates that approach 50%), leveraged longs run out of firepower and prices return to gravity. Part, but not all, of bitcoin’s short-term volatility is driven by leveraged traders. And this is a key distinction—the long-term price of bitcoin is still driven by supply and demand and not by leverage at the margin. But this is the same for US Treasuries and real estate. Funding rates, like repo and mortgage rates, can significantly affect short-term prices. This is why real estate investors watch mortgage rates closely and use it as a near-term price predicting metric. It’s also why Treasury traders watch repo rates closely to determine if imbalances exist in the market.
Bitcoin perp funding rates have proven to have excellent short-term predictive power, but my belief that these rates are bitcoin’s most important measurement of time value stretches beyond market signals. I believe the vibrant perp funding market is evidence that bitcoin is serving a monetary function on par with two of the world’s most important asset classes: US Treasuries and real estate. Additionally, arbitrageurs are capitalizing on opportunities within the bitcoin asset class based on funding rates across different exchanges. Funding rates often coalesce because the arbitrage trade is becoming highly efficient. Bitcoin is a dynamic collateral type as its commodity qualities shine brighter than ever before.
The bitcoin yield curve
When zooming out to observe how bitcoin’s yield curve is evolving, I don’t think it’s necessary to specifically quantify bitcoin’s exact interest rate. In fact, since bitcoin trading is decentralized, and exchange platforms across jurisdictions contribute to price discovery, a disjointed yield curve and risk spectrum are sure to continue. As we observe interest rates from bitcoin capital market activity, whether it be futures funding, exchange lending, deposits, or LN routing, a robust yield curve is developing. Precisely which interest rates matter the most, which rates lead other rates up and down, or even the nominal amount of interest do not matter as much as the fact they all exist. We might not see a bitcoin interest rate and yield curve dashboard in Bloomberg any time in soon, but we’ll see entire investment strategies that revolve around the diversified bitcoin rates complex. Bitcoin is an asset class, and this type of collateral prowess elevates it to an elite level and separates it from 99% of cryptocurrencies. Can you imagine traders arbitraging Dogecoin funding rates? I didn’t think so.
Thanks to Dylan LeClair for the trade school as I was writing this post. Make sure to follow Dylan for his constant and informative bitcoin analysis!
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