Delta neutral yield

I’ve wanted to write a post on decentralized delta neutral yield strategies for a while, and with the Shapella fork behind us, it finally compelled me to get going.

If you don’t know, the Shapella fork enable staking withdrawals on Ethereum mainnet, and it makes the case for LSDs more compelling as their market dynamics have now been greatly improved.

What are LSDs? It’s short for Liquid Staking Derivatives and is a way to create derivatives on top of staked Ether. Hence, if you take Ether, stake it, you’re not just participating in the running of the Ethereum network, at the cost of capital lockups, but you’re also able to leverage this capital indirectly through LSDs in the broader DeFi ecosystem.

This dramatically improves the case for staking, as the LSDs maintain their value by the backing collateral, the staking yield and other such extracted value through MEV. We can apply some DeFi on this to start making decentralized structured products.

What’s the use case?

Say you want decentralized yield, as generated by staked Ether, but you don’t want exposure to the Ether price? This is where the “delta neutral” part comes in.

Delta is one of these measures typically found in options, where it describes the rate of change in value of the option vs the underlying.

Can we create a delta neural position between Ether and some LSD? Yes, very easily by shorting the same amount of Ether as a comparable long LSD position. What’s a comparable LSD? Rocket Pool’s rETH is one such comparable LSD, as it allows us to maintain the decentralized nature of Ether and it tracks the underlying Ether value.

But it does more than just track the underlying Ether value. While we expect rETH and Ether to be highly correlated and move up and down together, rETH gives us an additional cash flow, namely the staking yield, priority fees and MEV rewards. We wouldn’t be getting this if we just held Ether.

Because of this, we can expect the value of 1 rETH to grow faster than the value of 1 Ether. Our long short position would then capture this while shielding us from Ether price fluctuations as measured against some other currency like USD. Voila, we’ve created a decentralized delta neutral yield earning structured product.

What’s the catch?

I’ve specifically above used rETH in the example. I did that because I wanted to show an example making use of decentralized LSDs. This is different from a centralized LSD, like when staking through an exchange, as it removes this counterparty risk.

But there are of course risks, specifically technical risk. A bug in Rocket Pool could be detrimental to the value of rETH, and it’s hard to isolate ourselves from this risk, as is the case with most if not all DeFi.

We must also assume the market to correctly price rETH, but with staking withdrawals enabled I would expect arbitrage opportunities to take care of any obvious mispricing, hence why this opportunity is so much more relevant now after the fork.