Liquidity Risk

Liquidity risk in basis trading arises from the strategy’s own trading actions—buying, selling, and rebalancing—that impact both spot and futures markets. Unlike funding risk, which focuses on the profitability of the funding rate mechanism, liquidity risk deals with the challenges of executing trades efficiently and without excessive market impact. A deep understanding of liquidity risk is crucial for ensuring that the strategy functions effectively across varying market conditions.

1. Initiating Actions and Their Impact

Every trade action in a basis trading strategy—whether it’s a deposit, withdrawal, or rebalancing up or down—triggers a change in the portfolio’s composition:

• Deposit: When a user deposits funds, the strategy increases collateral and expands the spot and hedge positions. While this supports higher leverage, it also adds pressure to the market by requiring additional asset purchases and hedging trades.

• Withdraw: Withdrawals reduce both the spot and hedge positions and remove collateral, freeing up capital. However, executing a withdrawal can force the strategy to sell assets at market prices, potentially incurring slippage.

• Rebalance Up: This process shifts the strategy from a lower (minimum) leverage to the target leverage, reallocating capital between spot and hedge positions to optimize capital utilization without overextending market exposure.

• Rebalance Down: When leverage exceeds a preset maximum threshold, the strategy must rebalance down to the target leverage to reduce risk. This often involves rapidly selling a portion of the spot position, which can create significant price impact.

Each of these actions inherently incurs trade execution costs due to the need to perform offsetting market orders, and they directly influence the overall liquidity risk of the strategy.

2. Trade Execution Costs and Arbitrage Opportunities

• Execution Costs: Trade execution costs occur when market actions—such as selling spot assets or buying futures contracts—push prices in opposite directions. For instance, selling a large position can drive the price down, while buying spot assets can push prices up. The net difference between these prices represents the execution cost.

• Arbitrage Opportunities: In favorable market conditions, the strategy can leverage the spread between buy and sell prices to secure an arbitrage premium. This negative execution cost can offset some of the liquidity risk, but it relies on the market’s ability to quickly eliminate price spreads, a process highly dependent on liquidity.

3. Rebalancing Logic and Desired State

Rebalancing is triggered when the hedge position’s leverage deviates from its predetermined range:

• Ideal State: The strategy aims for a state where the spot exposure exactly matches the hedge exposure. For example, with a target leverage of 2×, the capital allocation ideally splits into two-thirds in the spot market and one-third in the hedge.

• Trigger Points: Rebalancing occurs when leverage exceeds the maximum allowable threshold or falls below the minimum. In extreme cases, such as sudden price spikes, the strategy may need to execute rapid rebalancing—even if it results in some price impact—to prevent liquidation.

4. Basis Vault Capacity and Its Impact on Liquidity

The capacity of the vault—the amount of capital that can be efficiently utilized—is limited by both spot and hedge market conditions:

• Spot Capacity: The spot capacity is influenced by the price spread and the speed at which arbitrage can eliminate that spread. Markets like ETH and BTC typically have very short arbitrage times (a few dozen seconds), whereas less liquid assets might take up to 10 minutes. To prevent excessive slippage, the strategy limits the size of individual transactions (one-batch trades) and defines a "spot reserve"—the fraction of the spot position that must be sold during rebalancing.

• Hedge Capacity: Similarly, hedge capacity is affected by how much capital can be added to the short position without significantly decreasing the funding rate. Excessive hedge adjustments can lower the effective APY, so the strategy sets thresholds to ensure that any single transaction does not negatively impact the overall yield.

5. Managing Liquidity Risk

• Controlled Trade Sizes: By limiting the size of one-batch transactions, the strategy ensures that the price impact remains below critical thresholds (e.g., under 2% slippage for trades representing around 5% of a pool’s TVL).

• Dynamic Adjustments: The strategy continuously monitors market conditions, allowing it to dynamically adjust trade sizes and timing. In periods of low liquidity, it may spread large adjustments over multiple transactions to minimize adverse price movements.

• Predictive Analytics: Historical data analysis and real-time monitoring help predict when the market is likely to recover its liquidity, thereby guiding the timing of trade executions.