In today’s piece we wanted to do another deep dive into what drives the interest rates for both bitcoin and USDC Savings Accounts. 

Changing market conditions for bitcoin and digital assets have resulted in compressing interest rates for both Bitcoin and USDC Savings Accounts in recent months.

As always, we like to be transparent and upfront with our clients and readers about the market forces that are driving these changes. 

Let’s start with Bitcoin. We’ll cover two main use-cases or trades that institutions use borrowed bitcoin or USDC for (outside of Decentralized Finance schemes).

• Market-neutral trades

The main trade opportunity in this camp is the futures basis trade. This trade works when the price for bitcoin contracts for future delivery trade at a higher price than the spot price.

For example, let’s assume that you can buy bitcoin today at $35,000 and sell a contract to deliver that bitcoin in 3 months for $35,250. Implicitly, this means that you can make $250 ($35,250 - $35,000) by buying and holding the bitcoin until future delivery. This means that the implied yield on that trade is $250/$35,000 = 0.7%. That’s 0.7% for a 3-month period. To annualize this yield, we must multiply it by 4, since an investor could perform the trade 4 times in a calendar year. And so, the implied annual yield on this hypothetical opportunity would be 2.8%.

For a more concrete example, let’s look at the implied annual yield on the futures basis trade for 1-month out, and 3-month out contracts on the Chicago Mercantile Exchange (the safest of all futures venues).

As you can see from the chart above, the implied yield on the 1-month contract has compressed dramatically during the month of April. It went from about 6% at the start of the month to a low of -15%. An implied yield can be negative, this means that the “future” price of bitcoin is trading below the spot price. The implied yield on the 1-month contract is currently around 0%. 

The implied yield on the 3-month contract paints a similar picture. From a high of about 5% at the start of the month to the current 1.66%.

In simple terms, the return on high-quality market opportunities at scale has compressed. This, in turn, forces the institutions participating in these market opportunities to lower their cost of borrowing. Which results in lenders, like Ledn, having to lower the rates they can charge institutional borrowers, and therefore having to lower the Savings rates we pay to savings clients. 

• Market-Making (Price arbitrage)

Another common type of market opportunity for which institutions borrow bitcoin is to “make markets” across different exchanges. Because bitcoin has no “central price”, the price at which you can buy and sell bitcoin can vary - sometimes greatly, across different exchanges. 

To take advantage of these small differences, institutions borrow large amounts of dollars and bitcoin to fund accounts across different exchanges and wait for the right opportunity. 

A hypothetical trade would be to buy 1 bitcoin at $30,000 on Coinbase and immediately sell 1 bitcoin on Kraken for $30,050 - pocketing the $50. 

As more market makers enter exchanges, the gap between the “bid” and the “ask” prices across exchanges should compress. 

The chart above shows the average spread on a $1 million dollar buy order for bitcoin on Coinbase and FTX. As you can see, the average spreads have essentially halved over the last 3 months. From around 0.16% in February to the current 0.08%. 

Additionally, the traded volume has also dropped - meaning that the market is getting much more competitive. 

Again, in simple terms - this means that market makers are also seeing their average returns get compressed. Which forces them to have to lower their borrowing costs. Lenders, like Ledn, then have to reduce the rates that they charge to their institutional clients, translating into lower rates that can be paid to clients looking to earn interest. 

Looking into the week ahead, investors seem to be expecting havoc and pricing a 99% probability of a 50 basis point hike. Equity markets have broken the lows from earlier in March and look to continue under pressure. 

Interestingly, bitcoin has been performing quite resiliently in this environment - as we covered last week. The futures markets continue to flash signs of health. 

Futures curves remain mostly in contango (prices increase as the future date is farther away) - and the funding rates for perpetual futures are positive (meaning that more leveraged investors are long than short). 

Short interest for bitcoin on Bitfinex remains well below the highs of the year. Considering the kind of week we are heading into - this is a pretty healthy sign.

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The first trading day for the month was an eventful one for market participants as indexes bounced back from the April lows, one of the worst performing months for the S&P 500 since the crisis brought by COVID. 

U.S. crude prices declined and are hovering $104 per barrel, while the 10-year U.S. Treasury hit 3.00%, the highest level since December 2018. May looks to be another month filled with worries for investors. In April, the S&P 500 decreased 8.8%. Technology equities were hit harder with the NASDAQ losing 13.3% for the month of April. This week, Fed Chair President Jerome Powell will have a conference to discuss market conditions and dictate the central bank’s tone going forward. Economists’ estimate the Fed will increase rates by 50bps, to the already 25bps increase implemented by the Fed during their last meeting. Additionally, the Fed will begin monetary tightening and decrease the $9T balance sheet it currently holds. With the GDP growth turning negative in 1Q22,  since mid-2020 and heightened recession risks, the Fed might have little room to maneuver. Inflation has been rising to levels not seen since the 1970’s and the annualized total equity returns adjusted for inflation are now as bad as the mid 1970’s under president Nixon. As equities have seen major volatility and coupled with ramping inflation, investors have in net-real terms lost a considerable amount of capital if inflation adjusted metrics are implemented. If returns

Global sanctions against Russia may have some unintended consequences. Since the invasion of Ukraine by the Kremlin, the United States dollar has been used as a weapon to add pressure on Russia. There have been several financial sanctions imposed on Russia to deter it from continuing the war in Ukraine, some of these sanctions include: i) freezing over $600 billion worth of foreign exchange reserves ii)banning Russian financial institutions from being part of the SWIFT network  and iii)the Russian central bank restarting to purchase gold from local companies and local financial institutions.

The weaponization of the dollar has brought on new economic surprises. As of last week, Russian oil company Gazprom has halted exports of oil to Bulgaria and Poland until payments for exports are paid in rubles. The rubble is now backed by gold purchases made by the Russian central bank. In contrast, the U.S. dollar has not been backed by gold since 1974. The EU immediately stepped in and mentioned that it violates commercial contracts. In March of 2022, the Russian energy committee mentioned that it could consider taking Bitcoin as payment for its oil and gas exports as it looks to be more “payment friendly”. Other international oil exporters considering to take alternative currencies to U.S. dollars include Saudi Arabia taking yuan for exports to China. 

Other unintended consequences have made the U.S. dollar a stronger currency and has seen inflow as a safe-haven asset but on the other hand, it could encourage other countries to diversify from the U.S. dollar standard - this could be beneficial for gold and Bitcoin as they could be considered as alternative payment methods across the world. Will more countries adopting Bitcoin as a legal tender accelerate this matter ….?

During 1Q20, the total value locked (“TVL”) of DeFi was ~$1B, within a year the TVL had surpassed $20B, representing a 20x growth in less than 12 months. Three quarters later and the TVL reached $200B, an impressive 100x growth in just nine months. Several factors have contributed to the massive adoption of DeFi. 

1. i) farming protocol tokens were implemented: the first player to introduce this concept was $COMP, where it would not only pay interest to market participants who provided liquidity to the protocol, but it would also pay $COMP tokens additionally to create incentives mechanisms. 
   
   
2. ii) capital efficiencies for creating a market were introduced: $CURV paved the way for stable assets to be farmed which provided new concentrated trading pairs with lower slippages costs. This mechanism made trading more capital efficient for market makers and liquidity providers. Additionally, $CRV introduced vote-escrow which required liquidity providers to lock their assets for longer periods of time to create trading pairs with reliable liquidity and decrease slippage costs for participants. 

iii) By far, one of the most important attributes that allowed DeFi to grow so fast was the application of bridges to create multi-chain interoperability. Fragmented liquidity across chains has been an ongoing challenge in crypto, but now with networks able to communicate and bridge assets, the fragmented liquidity can now be unlocked and bring investors into chains and projects that generate the highest yields to incentivize their participation. 

1. iv) The latest contribution to the growth of DeFi has been institutional demand. As more and more institutional investors warm up to blockchain and crypto, the more they continue to participate in the digital economy, especially with some focus on DeFi. With more demand from institutional investors, several crypto platforms have launched products geared towards these investors. MetaMask has launched an institutional wallet, Aave has created a KYCed and permissioned pool for digital assets, and more products are in the pipeline. Institutional capital inflows can be the next catalyst to bring DeFi closer to $1T in TVL. 

Bitcoin, the most resilient blockchain against cybersecurity attacks, has once again reassured its position with the mining difficulty reaching a new all-time-high (“ATH”) of 29.794T. The higher the mining difficulty becomes, the higher computational power that is required to mine a block on the Bitcoin network. A higher computational power helps keep the network safe by preventing malicious actors from taking over the network and manipulating transactions, as costs to hack the Bitcoin network become too expensive. Over the past seven days, Foundry U.S. has mined 224 (20.76%) of all global supply and have had a global hashrate of 46.80 EH/s, followed by F2Pool with 151 blocks (13.99%) mined with a global hashrate of 31.55 EH/s. At current ATH, the Bitcoin network stands to be at the safest time of its lifetime. 

This will be an important week for investors as jobless claims will be released and the Fed Chair Jerome Powell will have a conference. Investors will look to pair last week’s corporate earnings with the market indicators that will be released, in addition to Powell’s remarks on the economy.  

In terms of price levels to watch, if bitcoin (and most markets) continue to be under pressure, a key level to watch will be Microstrategy’s average purchase price - $30,700. Institutions will likely look to defend this level by adding to their portfolios at “Saylor” prices. 

We hope you enjoyed reading and as always, we wrap up with a summary of the upcoming economic data and earnings reports for the week:

Wednesday:

8:15 AM EST - ADP employment report 

8:30 AM EST - International trade balance 

9:45 AM EST - S&P Global U.S. services PMI (final)

10:00 AM EST - ISM services index

2:00 PM EST - FOMC statement 

2:30 PM EST - Fed Chair Jereme Powell conference 

Thursday:

8:30 AM EST - Initial jobless claims, continuing jobless claims, productivity (SAAR) and unit labor costs (SAAR) 

Friday:

8.30 AM EST - Nonfarm payrolls, unemployment rates, average hourly earnings and labor force participation 25-54

3:00 PM EST - Consumer credit 

It's a big week coming up, and as always, we'll keep you posted on any relevant news throughout the week right here and from our Twitter account.