Carry
Overview of carry strategies
Carry involves borrowing at a lower rate and lending or investing at a higher rate. This may entail price exposure, as the collateral used to borrow might not be correlated to the opportunity used to invest at a higher rate.
In DeFi, a simple trade to conceptualize is borrowing at a Prime rate and lending at a High Yield rate.
The spread between the two rates and the change in price of the underlying collateral combine to produce a carry return. The main risks involved are:
Interest-rate risk: if the spread between the rates compresses, the return of the strategy is meaningfully squeezed
Price risk: The overall profitability of the strategy is dependent on the price of the collateral asset used to borrow
Additionally, depending on the solvency of the collateral used and the liquidity of the investment used to realize the higher interest leg, other risks may present themselves to the borrower.
Levered Carry
On its own, unlevered, most carry rates are not sufficiently attractive relative to much lower risk strategies with the same net rate. The spread can be amplified with leverage, where proceeds of the borrow are first use to lever up the collateral and invest a larger notional amount in a higher yielding trade. Conceptually, if the spread is +2% and the strategy is levered 5x, the total return is 10%.
The level of risk is commensurately higher with leverage as it will also magnify negative spreads if the borrow cost is higher than the earning cost.
Asset-based earning
Carry is one of the main meaningful ways to generate a sustainable asset-based yield. Asset-based yield is the concept of earning a return in assets other than fiat currencies, such as gold, bitcoin or ether.
Gold has various financial and industrial use-cases that justify an active borrowing market. Bitcoin and ether have significantly less borrow demand and without this crucial leg in the repo market, lending rates on these assets is effectively 0.
Ether does have a native 'yield' in the form of staking, a form of token inflation, with a corresponding counterbalance in the form of burned gas fees. Bitcoin has no such mechanism and effectively only inflates through mining activity, making it difficult for non-industrial users of Bitcoin to access any form of bitcoin-based return.
With asset-backed earning, collateral assets can be used to open carry positions with moderate leverage in order to generate a return in another asset before bringing it back to the denomination asset.
Example asset-backed earning strategy
Assumes constant borrow cost, high yield returns and $100,000 bitcoin price for the simplicity
Start, investor equity: 1 BTC (valued $100,000)
Collateral: 1 BTC
Loan: 10% LTV, i.e. $10,000 borrowed at 3%
Invest the proceed in High Yield product: $10,000 invested at 15%
Expressed over the deposits, the borrow cost impact is -0.3% while 10% invested at 15% returns 1.5%
Total level of leverage is 1.1x ($100,000 of the deposited BTC + $10,000 borrowed)
Net return in bitcoin terms is 1.2% (1.5% - 0.3%)
There are multiple risks involved to this strategy:
The net return is a tradeoff between leverage and risk on the higher-yielding leg
Higher levels of leverage allow for the higher-yielding leg to be lower and less risky but takes on more sensitivity to price risk
For the example above:
Example asset-backed earning strategy
High-yield rate required to meet 1.2% net return with a 3% borrow cost at different levels of leverage
10%
15.0%
Low
High
20%
9.0%
30%
7.0%
40%
6.0%
50%
5.4%
60%
5.0%
70%
4.7%
High
Low
An illustrative vault executing this trade could look like the following:
Last updated