Boosting Yields of Crypto Barbell Portfolios
By using DeFi protocols
Introduction
In our previous report, we introduced how a simple VIX risk-parity barbell strategy using only cryptocurrency tokens can be achieved with a pairing of a stablecoin like Tether (USDT) with tokens such as Ether (ETH) or Bitcoin (BTC). But what if there was a way to increase our portfolio’s return even further by earning interest on our assets? In a traditional finance barbell portfolio, we often see this only at the low-risk end of the barbell in the form of owning interest-yielding treasury bills or bonds. However, in a pure cryptocurrency barbell portfolio, we can own interest-yielding assets at both the low-risk and the high-risk end of our portfolio. In traditional finance, we can margin trade to further boost returns. In the cryptocurrency DeFi world, we can do the same as well through leveraged staking. In this research report, we will introduce the sDAI-stETH as an interest-yielding crypto barbell portfolio, explain how leveraged staking in DeFi works, and discuss the key risks of implementing such strategies.
Interest-yielding cryptocurrency at the low-risk end of the barbell — sDAI
Very broadly, one can earn interest on stablecoins in the DeFi ecosystem by:
· depositing stablecoins to liquidity market protocols (e.g. Aave, Compound) to be lent out to others in the market
· depositing stablecoins to liquidity pools and automatic market maker platforms (e.g. Uniswap, Curve) to provide liquidity for seamless swapping of one token for another
Let’s use the stablecoin DAI in this example. DAI is another stablecoin like USDT, also pegged to the U.S. dollar (USD). How DAI is different from USDT is that instead of being backed by 1:1 reserves of USD held in a bank, DAI is backed by ETH and other tokens accepted as collateral by their governing decentralised autonomous organization (DAO) called MakerDAO. The interesting thing about DAI is that you can deposit it back into the Maker Protocol via the Dai Savings Rate (DSR) Contract to then earn a yield for providing DAI for others on a lending protocol by MakerDAO called Spark Protocol to borrow.
For every DAI you deposit in the DSR Contract, you will receive a 1:1 liquid, representative liquid token called savings DAI (sDAI). Whenever you want to swap your sDAI back to DAI, you will receive back the same amount of DAI you deposited, plus a small percentage as interest, as determined by the Dai Savings Rate (DSR).
For example: If the DSR is 5%, a user who deposits 100 Dai into DSR mode, and keeps it in the contract for a full year, would earn 5 additional Dai which will automatically be added to their wallet when the Dai is swapped back from sDAI.
Interest-yielding cryptocurrency at the high-risk end of the barbell — stETH
On the high-risk end of the barbell, let’s use ETH as an example. The most common way to earn interest on ETH is by staking it. Broadly speaking, staking ETH means depositing your ETH into a contract on the Ethereum network and qualifying yourself to participate in validating transactions on the Ethereum blockchain. As a reward for using your computational power to solve complex puzzles to validate transactions on the blockchain, you are rewarded with additional ETH.
Staking on the liquid staking protocol Lido DAO is a great way to earn interest on ETH while still holding on to a liquid representative token of staked ETH. Traditionally, staking in proof-of-stake protocols such as Ethereum has been about locking one’s tokens in the project for a long period of time and expecting a fixed, predetermined staking reward in return. But through what is termed as liquid staking these days, you can receive a liquid representative token of the staked token and use it for other investing or trading purposes, potentially generating even more returns.
The way it works on Lido is that once you deposit ETH into a Lido staking contract, you will receive an equivalent amount of staked ETH token (stETH) in return. Staking rewards are given in the form of more stETH daily, and is broadly governed by the following formula where Lido simply takes 10% of the Protocol annual percentage rate (APR):
Lido Staking APR = Protocol APR * (1 - Lido’s staking fee)
Lido Staking APR is the ETH staking yield for Lido staking participants
Lido’s staking fee = 10%
Combining the two, we have the sDAI-stETH barbell strategy portfolio
Strategy
In this portfolio, just like the USDT-BTC and USDT-ETH portfolios, we periodically rebalance stETH and sDAI to maintain VIX-parity. The ideal weight of stETH in the portfolio can be determined by the following formula:
VIX / DVOL of ETH = Weight of stETH
The remaining weight is then allocated to sDAI following this formula:
1 — Weight of stETH = Weight of sDAI
Backtesting Results
Preliminary backtesting shows that a $1,000 investment in the sDAI-stETH portfolio on Aug 22, 2022, would have grown to $1,110 on Aug 23, 2023. This return slightly outperforms the S&P 500, which would have grown a $1,000 investment to $1,072 over the same period.
The additional yield from sDAI is estimated as follows:
Average weight of sDAI in portfolio of $1,000 during backtesting period (367 days): 68%
DSR Rate offered by Maker Protocol: 5%
$680 x 5% = $34
The additional yield from stETH is estimated as follows:
Average weight of stETH in portfolio of $1,000 during backtesting period: 32%
Latest lido staking APR: 3.7%
$320 x 3.7% = $12
Total staking yield: $34 + $12 = $46
This means that $1,000 investment in the sDAI-stETH portfolio on Aug 22, 2022, would have grown to $1,110 + $46 = $1,156 on Aug 23, 2023. This translates to a 15.6% return versus 7.2% for the S&P500. This represents an 8.4% alpha over the S&P500 returns over the same period.
Leveraged Staking
Leveraged staking in the DeFi world is a way to increase our staking rewards and exposure to a particular token and thereby amplify our returns. Let’s take leveraged staking with stETH as an example. Here are the steps you would take:
1. First, we need to deposit our stETH on a lending platform like Aave as collateral
2. Next, we would borrow more ETH on Aave against the stETH collateral
3. Finally, we re-stake it into Lido to receive more stETH and hence more staking rewards
We can repeat these steps multiple times to increase our exposure to stETH and increase our staking rewards too.
In the staking pathway above, if you follow the pathway on the bottom branch and focus on the values in blue, you can see that we can get $250K more exposure on an original $500K amount of stETH through the process of collateralizing stETH on Aave, then borrowing ETH on Aave, and finally re-staking that ETH into Lido.
Risks
Investing strategies that interact with DeFi protocols come with a unique set of risks. Here are some of the main ones that we need to consider carefully:
· Smart contract risk — The smart contracts that govern DAI and sDAI, stETH undergo rigorous auditing but there’s still always the risk of undiscovered vulnerabilities or bugs that could be exploited by hackers.
· Impermanent loss — When providing liquidity in certain types of pools, the value of your deposit could decrease if the price of the tokens changes. If the price changes and you withdraw your funds, you could end up with less value.
· Collateral risk — For collateralized stablecoins, there is a risk associated with the collateral backing them. For instance, if the collateral is mismanaged, devalued, or otherwise compromised, the stablecoin could lose its peg.
· Management and governance risk — MakerDAO and Lido are managed and governed by a community of token holders. While this decentralization has advantages, it also means that poor governance decisions could adversely affect the protocol and your staked assets.
· Slashing risk — Lido stakes Ethereum on the Ethereum 2.0 network through validator nodes. If these nodes act maliciously or fail to perform their duties, they can be “slashed” or penalized, leading to a loss of staked ETH. Lido tries to mitigate this through decentralized management and insurance, but the risk cannot be entirely eliminated.
When it comes to leveraged staking, we have a few additional risks, namely:
· Liquidation risk — In leveraged staking, the Loan-to-Value (LTV) Ratio is a key metric to monitor. It’s defined as: LTV = (Loan amount / Collateral value) x 100%. If the LTV is 80%, this means the loan amount is 80% of the collateral’s value. If the value of the collateral falls, the LTV will rise. If price movement in the market causes your asset’s LTV to reach the liquidation threshold that the lending platform puts out, the collateral will be liquidated to repay the loan. There is often a liquidation penalty to pay as well.
· Interest rate risk — Borrowing assets to leverage usually comes with interest. If the staking rewards, which can change over time, dips under the interest rate, you could end up with a negative return.
· Liquidity risk — Some staking protocols have lock-up periods where assets can’t be immediately withdrawn. This might pose a risk if you need liquidity immediately, especially in a market where asset prices are declining rapidly.
Conclusion
In conclusion, having interest-yielding crypto assets at both ends of the barbell like in the sDAI-stETH portfolio is a great way to boost a portfolio’s returns beyond what you can get from the asset’s price movement. With leveraged staking involved, returns can be boosted further, if you know how to manage the risks too. As the preliminary results once again indicate, such a strategy can outperform a traditional benchmark like the S&P500 and should definitely be considered alongside traditional investing strategies the next time you have some capital to deploy.
