Trading DeFi: What Traders Need to Know

Running successful trading strategies in DeFi can seem daunting. It requires data at four separate levels: protocol, pool/asset, wallet and governance. Overlaid on that are market risks such as being stopped out of pools or being hacked.

But DeFi is developing quickly, and firms are finding alpha. At a recent webinar hosted by CoinDesk and sponsored by Amberdata, four experts gathered to discuss how to take advantage of the opportunities presented by the developments in DeFi. Here we present excerpts of the conversation in two areas: market structure and trading strategies.

One of the key differentiators between Defi and CeFi (and TradFi) is the level of transparency that is available with DeFi. Traders have access to data that is just not available in other arenas. This is a key consideration when developing a trading strategy.

“One of the interesting things in DeFi versus CeFi is that you can know the state and behavior of everyone in the system. You can see what other parties are doing and historically what certain actors have done. And then, based on that, you can come up with reasonably good fidelity models of the behaviors of participants. I spent a lot of time in traditional trading trying to attribute something to a particular individual or particular action or a particular state change. The beauty of DeFi is that you can do that and that can make trading a lot easier.”

Tarun Chitra, CEO and Founder of Gauntlet

At the same time, however, DeFi is still fragmented, with many different protocols and pools and many different chains, although this is consolidating. Moreover, each protocol has its own idiosyncrasies that need to be understood. But where there is fragmentation and price differences, there is trading opportunity.

“We are in an environment where there are about 12 blockchains that are competing for liquidity and this liquidity is very fragmented. It reminds me of 2017, when exchanges were starting up right and left before there was a big consolidation of volumes. We are now at a similar stage of the market: Liquidity tends to aggregate and converge to an oligopoly of liquidity pools. We're at the stage in the DeFi market where there is a lot of fragmentation, and there are a lot of inefficiencies.”

Alex Elkrief, DeFi PM & Head of Ledgerprime Labs at LedgerPrime

Arbitrage is one of the best known and most successful of all trading strategies, and works particularly well in young markets that haven’t had their price differences ironed out. But scale can be an issue when trying to arbitrage in size.

“We produced a technical paper last month that looked at CeFi to DeFi arbitrage. In that, we showed that a simple strategy going between a decentralized exchange and a centralized exchange could generate up to 8% in a month. But you can't get too big. We couldn't get above around $200,000, otherwise we started to have price impact and cause slippage.”

Shawn Douglass, CEO and Co-Founder of Amberdata

DeFi can be seen as a tool that can amplify trading activity already underway. For instance, providing a separate layer of access to assets that are available in CeFi, such as options, allows traders to also act as market makers.

“We don't see DeFi in isolation, because for us scale, and being able to do large size, is important. What we do in DeFi tends to be paired up with something we are doing in CeFi. We do some market making on some of the indexes, but we are probably the most focused on the DeFi options vaults. That is because they act like a distribution layer or an access layer to CeFi options. It allows us to give the entire market access to options that would be otherwise quite difficult to access. This can be defined as an access layer distribution strategy for vanilla options and eventually for more complicated products as well. And it almost becomes an extension of CeFi. And then what we must deal with is how to manage the idiosyncrasies of each DeFi protocol. So market making tends to be the primary strategy for us, straddling the CeFi and DeFi worlds.”

Darius Sit, CIO and Co-Founder of QCP Capital

Trading strategies in DeFi follow the same rules of thumb as trading in TradFi and CeFi: When there is more supply than demand, prices fall. And the greater the risks taken, the greater the potential rewards.

“Returns are a function of what strategy you're using. If you are doing the most risk-free lending, you are going to generate returns that are less than U.S. Treasuries at the moment. DeFi is probably more flush with cash than TradFi, which is why you are getting low rates on the debt. But there are always going to be high alpha strategies in DeFi that come with higher risk as well.”

Darius Sit, CIO and Co-Founder of QCP Capital

For more insights into DeFi trading, and the opportunities and risks in liquidity protocols, please click here to watch the full webinar.