Source: Lite Finance

Introduction

As decentralized finance (DeFi) continues to gain popularity, it copies numerous traditional trading concepts. One remarkable concept adopted is “carry trades,” a trading strategy in which investors borrow assets at a very low interest rate and invest them in high-interest-yielding ones. Investors profit from the differences in interest rates between the borrowed and invested assets.

This strategy was fundamentally used in the foreign exchange (Forex), fixed-income, and commodity markets controlled and regulated by central authorities. In DeFi, investors borrow low-interest assets from Web3 protocols and invest them in crypto assets that yield higher interest to make profits.

Although traders can make profits while engaging in carry trades, they are to make a detailed analysis of the crypto assets that would be involved in the trades to avoid losses.

What are Carry Trades?

Source: ALT21

Carry trade is an investment strategy that occurs when investors borrow a currency with a low interest rate and invest it in another currency yielding a high interest rate to make profits through the differences in the interest rates. For example, an investor can borrow a currency, such as the Japanese Yen (JPY), at an interest rate of 2% and invest it in another currency, like the Great British Pound (GBP), which yields a 10% interest rate return on investment.

In the cryptocurrency space, carry trades involve borrowing cryptocurrencies with low interest rates, such as USDT, and investing them in cryptocurrencies that yield a high interest rate, such as BTC or ETH. These investors then make a profit from the interest rate differentials of the cryptocurrency trades. This trading process involves taking advantage of the differences in the interest rates of the monetary assets.

Key Concepts of Carry Trades

Source: WallStreetMojo

The fundamental principles guiding carry trades remain consistent in the financial market. These principles include:

Funding Asset

These are assets borrowed during the start of the carry trading process and they have low interest rates. Investors typically select funding assets with historically low interest rates, such as the Japanese Yen (JPY) or Tether (USDT) to minimize borrowing costs. The idea is to secure funds at the lowest possible rate to maximize potential reinvestment profits.

Investment Asset

An investment asset refers to the asset in which borrowed funds are allocated, selected from a diversified portfolio based on its potential to generate a high return on investment.

Investors usually opt for assets with higher interest rates, such as the Australian Dollar (AUD) or the Brazilian Real (BRL). The primary objective is to achieve returns exceeding the borrowing costs, profiting from the interest rate differential.

Interest Rate Differential

To know the outcome of the trade, there should be an assessment of the interest rates on the funding asset and the investing asset. If the interest rate on the investment asset exceeds that of the funding asset, the trader earns a positive carry, resulting in a profit. On the other hand, if the funding asset’s interest rate rises above that of the investment asset, the trader incurs a negative carry, leading to a loss.

How Does Carry Trades Work?

Source: TradingView

Research

The first step to engaging in a carry trade is to research and draw up a plan for the whole investment process. This includes finding the assets that would be borrowed, the protocol used, and the conditions of the loan to be acquired.

Also, in-depth research on the high interest-yielding asset worth investing in and the protocol to achieve that should be done to profit from the trade.

Borrow

Crypto investors borrow a crypto asset that bears low interest. This can be obtained from a Web3 protocol that supports it, such as Gate.io cryptocurrency exchange. To borrow cryptocurrency from the platform, follow these steps:

a) Register on Gate.io

Source: Gate.io

b) Visit the ‘Earn’ section on Gate.io’s dashboard and click Crypto Loan.

c) After clicking on this, you can access cryptocurrency portfolios showing their respective borrowable amount, the hourly rate, and the APR (Annual Percentage Rate). Choose the desired cryptocurrency you wish to borrow.

d) Enter your borrowing amount in tandem with the value of your collateral and click ‘Confirm.’

Source: Gate.io

Convert

The borrowed crypto asset is converted into the asset that would be invested in if it is not in the same denomination.

Invest

The next step is to choose the best way to invest the borrowed crypto asset to make the most profit. The following are the ways crypto traders can profit from high-interest-yielding cryptocurrency activities:

Crypto Lending

Traders can lend their assets to the platforms—decentralized and centralized exchanges—allowing users to lend idle assets at a reasonable interest rate. Gate.io is an example of a centralized exchange that supports users willing to lend assets using the trading platform.

You can follow the steps below to lend your coins:

a) Visit the Earn tab on Gate.io’s dashboard and click on ‘Simple Earn.’

Source: Gate.io

b) On the dashboard, browse the portfolio of assets and decide on the ‘coin’ you wish to lend.

c) Click on the desired ‘coin’ and enter the amount you will lend.

Crypto Staking

Investors can lock up their crypto assets on a proof-of-stake (PoS) blockchain to support the transaction validation process on the protocol and earn rewards. The reward is often an attractive interest rate or Annual Percentage Yield (APY) on the amount of assets staked for a specified period.

Also, investors can stake their cryptocurrencies on decentralized (DEXs) and centralized exchanges (CEXs) that offer staking services. Gate.io provides a crypto staking feature, and investors can access it by following the steps outlined below:

a) Visit the Earn tab on Gate.io’s dashboard and click on ‘Staking.’ You can choose between GT Staking, or ETH 2.0 Staking.

Source: Gate.io

b) On the Staking Dashboard, review the asset portfolio and select the cryptocurrency you wish to stake.

c) Click on the desired ‘coin’ and enter the amount you are willing to stake.

Yield Farming

Yield farming, also called liquidity mining, is a decentralized finance (DeFi) strategy in which users provide cryptocurrency liquidity to a decentralized exchange (DEX) that supports this feature. In return, participants earn rewards such as interest, a share of transaction fees, and governance tokens.

Differences Between Arbitrage and Carry Trade

Arbitrage and carry trade could be mistaken for one another due to their similarities, but they have distinct meanings and practical applications.

Arbitrage involves capitalizing on price discrepancies across markets by purchasing an asset at a lower price and selling it at a higher price. This strategy is typically executed quickly, with relatively low liquidity and minimal risk.

Carry trade, on the other hand, entails borrowing an asset at a low-interest rate and investing it in a higher-yielding asset to profit from the interest rate differential. Unlike arbitrage, carry trades are generally long-term strategies, involving higher liquidity and increased risk exposure.

Differences Between Traditional and Cryptocurrency Carry Trades

Carry trades are typically executed using a standardized approach, regardless of the financial asset involved. However, a few factors distinguish traditional (Web2) carry trades from cryptocurrency (Web3) carry trades.

Impact of Carry Trades on the Cryptocurrency Market

As a trading strategy, carry trade can greatly influence the cryptocurrency market. The main impacts of this strategy are as follows:

Increased Market Liquidity

When carry traders allocate capital to a DeFi protocol to generate returns, they simultaneously enhance the ecosystem by supplying liquidity. This increased liquidity flow strengthens the protocol’s market depth, drives trading volume, minimizes price slippage, and ensures more efficient trade execution.

Enhancing Trading Volumes

When crypto assets exhibit unusually high or low interest rates, they attract crypto-carry traders seeking to capitalize on these opportunities. Traders may borrow assets with lower rates or invest in those with higher rates, driving increased demand. This surge in demand subsequently leads to higher trading volumes for the affected assets.

Challenges of Cryptocurrency Carry Trades

Carry trades in the cryptocurrency market have the potential to generate substantial returns when supported by thorough analysis and strategic execution. However, this approach also carries inherent risks that traders must carefully assess.

Volatility

The volatility of the cryptocurrency market can affect the profit projected on a carry trade, particularly when the value of the borrowed funding asset increases or the investment asset depreciates.

For example, suppose Romeo borrows 100,000 USDT at an annual interest rate of 5% and invests the full amount in ETH, expecting an 8% return. ETH is priced at approximately 3,000 USDT per token at the time of investment. However, before the trade reaches maturity, the price of ETH declines to 2,500 USDT.

As a result, the total value of Romeo’s ETH investment drops to approximately 90,000 USDT. Upon maturity, he must repay 105,000 USDT (including interest), resulting in a net loss of 15,000 USDT on the carry trade.

Technical Glitch

Traders face significant risks, including potential losses, when the smart contracts supporting various Web3 investment protocols are compromised by hackers or cybersecurity threats. Such breaches can lead to the (permanent) loss of invested assets.

Conclusion

Carry trading is a viable trading strategy for crypto investors, looking to make passive income without having to put much of their funds except for the collaterals on the assets they borrow. Also, there are diverse Web3 protocols that allow investors to earn interest without having to do much.

When executed effectively, carry trading allows investors to profit from the interest rate differential between the funding and investment assets. However, the cryptocurrency market is highly volatile, prospective investors should conduct intensive research and quantitative analysis before venturing into carry trading.