Cryptocurrency Investment Strategy | Building an Antifragile "Leverage Strategy" Using FTX's Fixed Income

Due to the low interest rates and quantitative easing in the financial environment, the cryptocurrency market has entered a frenzy of bullish cycles. However, as the economy recovers, monetary policy tightening has become inevitable, meaning that the bull market may have reached the middle to late stage, and market risks are increasing. At this point, if investors still adopt a "full position spot/futures" strategy, vulnerable positions will make investors give back profits or even incur losses once the market triggers a black swan event. This article aims to inform readers on how to use the "barbell strategy" to enhance the asset's anti-fragile characteristics.

Anti-fragile is a concept first proposed by Nassim Taleb, the author of "The Black Swan," which means that even in the worst circumstances, one will not be (significantly) harmed. One of the methods he proposed is the "barbell strategy."

Extremely Conservative + Extremely Adventurous Leveraged Strategy

Taleb borrowed the concept of a leveraged strategy with heavy weighting on both ends, adopting an "extremely conservative" and "extremely adventurous" approach on either side, avoiding the middle ground. This strategy aims to combat black swan risks with a conservative and robust approach while seeking profits with the adventurous allocation.

As an example of traditional financial investment allocation, if an investor holds 90% of cash assets and uses the remaining 10% to purchase high-risk securities, regardless of market fluctuations, losses would be limited to below 10%. The 10% allocated to high-risk securities also has the potential to generate returns. Conversely, if an investor allocates 90% of funds to "medium-risk" assets, encountering a black swan event could lead to catastrophic losses.

Interestingly, the leveraged strategy is quite suitable for the crypto market. It is widely known that the crypto market is polarized, with spot, futures/options contracts, and crypto derivatives being high-risk investments, while the other end offers nearly zero-risk "fixed income" options like lending and funding rate arbitrage.

Limited Losses, Unlimited Gains with Positive Convexity Effects

In the leveraged strategy, investors have both a sword and a shield.

When facing market risks, the extremely conservative strategy of the leveraged approach provides a "shield effect," strengthening the anti-fragile effect. On the other hand, the extremely adventurous strategy forms a positive asymmetry, which Taleb refers to as "Positive Convexity Effects."

For example, during the black swan event on March 12th last year, if an investor allocated 5% to go long on Bitcoin, whether in spot or low-leverage contracts, today the returns would be 1,400%. If the investor used a 2x leverage contract, the returns would be 2,800%. This illustrates the "sword effect."

Combining the sword and shield creates a positive convexity effect where losses are limited, but gains are unlimited.

Introduction to FTX's Fixed Income Products

Traditional financial market investors are aware that U.S. Treasury bond yields are typically considered the market's risk-free rate, the safest fixed income product. Similarly, in the crypto market, there are near-zero-risk fixed income products such as lending and funding rate arbitrage.

Most exchanges that offer perpetual contracts and quarterly contracts also provide options arbitrage and funding rate arbitrage. However, only FTX and Bitfinex offer lending services. Therefore, the following two tools will be exemplified using products from the FTX exchange.

Fixed Income Tool 1: FTX Lending

Lending is a unique product in the crypto market. As we all know, cryptocurrencies exhibit high price volatility, so during major market movements, many are willing to borrow short-term funds at a "high interest rate," even if it's for a few days only.

If the borrower profits, repayment is assured. In case of losses, the exchange's margin mechanism ensures that the lender can recover the principal and interest. Therefore, lending is also considered the risk-free rate in the crypto market.

Lending rates are mainly determined by market demand for funds. For example, stablecoin USDT has historically had an annual yield of 5% to 10%, but during bull markets, lending rates can occasionally soar to 50% or higher.

FTX lending is easy to operate, requiring only two steps: click on "Lending Rate" and choose the quantity of cryptocurrency to lend. Leave the minimum hourly rate and minimum annualized rate blank, and FTX's system will automatically match the market rate. If an investor enters a rate that is too high, the transaction will not be completed.

Fixed Income Tool 2: Funding Rate Arbitrage: Spot Hedging

Perpetual Swap is a unique product in the crypto market with no expiration date. The funding rate serves as a mechanism to balance long and short positions.

When the perpetual contract price is higher than the spot price, the funding rate is positive, and long position holders must pay fees to short position holders hourly. This arbitrage mechanism encourages long position closure or attracts arbitrageurs. Arbitrageurs can buy spot positions in the market, then short with 1x leverage. Balancing long and short positions allows arbitrageurs to receive funding rates hourly. (For detailed arbitrage methods, refer to the "FTX Hedging Trading Tutorial Series" written by Benson Sun, FTX Taiwan Partner).

FTX enthusiast Xiaolong compiled a Google Sheet of FTX's historical funding rates for users to review annual returns. We recommend focusing on competitive coins with high annual returns, smaller market capitalization, and higher volatility. Therefore, it is advisable to trade larger cryptocurrencies like ETH (APY: 44.8%) and BTC (APY: 37.4%) to earn funding rates.

It is important to note that if the perpetual contract price is lower than the spot price, the funding rate will turn negative. In such cases, short position holders will need to pay fees, representing the greatest risk in this arbitrage. Other exchanges pay funding rates every eight hours, while FTX pays hourly, mitigating the risk of sudden negative funding rate changes before payment, making it more reasonable.

How to Utilize Fixed Income to Create a Leveraged Strategy?

According to the logic of the leveraged strategy, crypto investors with a low risk tolerance can consider a 90/10 or 80/20 allocation, with the majority of funds allocated to fixed income.

For example, if an investor has $1 million in funds, they can allocate 90% of the funds to the lending strategy ($900,000). At the time of writing, the annual return rate for USDT was 10%, but assuming a more conservative 8%, the annual return on $900,000 would be $72,000.

The remaining funds ($100,000) can be invested in higher-risk assets such as spot or contracts. For example, considering Bitcoin investments in 2018, 2019, and 2020, the returns were -73%, 94%, and 303% respectively.

The table below calculates the returns from 2018 to 2020, investing only in Bitcoin, only in lending, as well as the total returns and ROI using leverage strategies.

It can be seen that investing the entire $1 million in Bitcoin in 2019 yielded the best performance, with a total ROI over three years of an astonishing 781%. As expected, the ROI from lending alone was the most mediocre at only 26% over three years. The ROI from using leveraged strategies like "BTC + Lending" and "2x BTC Long + Lending" were 82.5% and 214% respectively.

Readers may wonder why not simply invest all in Bitcoin, which has the highest ROI.

This is because the uncertainty of Bitcoin's potential decline must be considered. For instance, looking at 2019 and 2020 alone, Bitcoin outperformed other assets. However, if the investment started in 2018, the ROI would have been reduced to 110%, only 30% higher than BTC + Lending, equivalent to an additional 10% per year, but with far greater risks.

In contrast, using leveraged strategies like BTC + Lending and 2xBTC + Lending, during the 2018 decline, the ROI was only -0.1% and -2.8%. In the following year, 2019, funds could be reallocated to 90% lending and 10% BTC, resulting in ROIs of 82.5% and 122% over three years, or even better with 2xBTC + Lending, which outperformed the All-in-BTC strategy since 2018, with significantly lower risk.

Additionally, the continuous rise of Bitcoin is uncertain, and a substantial drop similar to 2017 and 2018 cannot be ruled out. If Bitcoin were to drop by 70% in 2021, how would the scenario change?

In the event of a black swan event in 2021 resulting in a 70% Bitcoin drop, the ROI for investing fully in Bitcoin since 2018 would be -25.7%, representing a total ROI over four years, equivalent to a 6.4% annual loss, worse than a bank deposit.

Even for those who started investing all in Bitcoin in 2019, the ROI would be reduced to 134%. Only 18% higher than 2x BTC + Lending, but with significantly higher exposure.

On the contrary, using a leveraged strategy to diversify risks, the ROI would be approximately 60% and 116%, equivalent to around 15% and 30% annual returns.

Additional Advantages of FTX

For investors looking to manage risks effectively, FTX offers a useful tool: Subaccounts.

The subaccount creation feature allows users to create subaccounts within one account to manage different assets separately.

Funds between subaccounts are independent. With this feature, investors can separate Bitcoin spot (or futures) and fixed income accounts, enabling better asset management, risk control, and clearer returns.

Spot Margin Trading allows users to pledge spot assets and borrow other assets.

Following the previous example, if a user buys Bitcoin spot ($100,000), and expects Bitcoin to not fall by more than 70%, they can pledge Bitcoin to borrow stablecoins, then use the funds for other investments such as DeFi mining to increase profits.

This is the benefit of spot leverage, enhancing the efficiency of fund utilization. However, it's important to note that pledging Bitcoin to borrow assets also incurs interest (borrowing USD incurs interest on borrowed USD), so the returns from other investments must exceed the interest to be profitable.

Moreover, risk management is crucial. While spot trading, DeFi mining, and other investments can yield high profits, they also come with higher risks. If investors do not understand the investment products or have a low risk tolerance, it is not recommended to use spot leverage.

Investing is Like Driving, You Don't Need to Become a Racecar Driver to Reach Your Destination

Everyone has different risk tolerances. The 90/10 conservative fixed income and Bitcoin allocation shown above can be adjusted to 80/20 or further diversified with funding rate arbitrage to increase returns for investors with higher risk tolerance.

At the end of 2017, Bitcoin plummeted from its peak of $19,891 to $6,000 in just eight weeks, a 70% drop. Going back a year, when there was a liquidity crisis in the real economy, Bitcoin dropped over 50% in two days. Can investors stomach the rapid profit erosion in a short period?

Moreover, not everyone has such high risk tolerance. Therefore, strengthening the anti-fragility of the investment portfolio and strategy is crucial for the average person.

The essence of a leveraged strategy is not to seek "maximum returns" but to enhance anti-fragility, reduce losses first, and then create higher yields with limited positions. When applied correctly, a leveraged strategy can create a more stable investment portfolio, maintaining an actively positive convexity effect.

Investing is like driving a car. Not everyone aims to become a racing driver like Michael Schumacher but simply to reach their destination (live a good life). Achieving this goal does not require annual returns exceeding 100%. For the average investor, achieving ideal returns while managing risks is key, and a leveraged strategy is one method. Combined with FTX's fixed income products such as lending and funding rate arbitrage, it can create a robust investment allocation and strategy.