Event-Driven Arbitrage Case Study | $OMG - $Boba Airdrop in 2021
Background knowledge of the two network
What is OMG Network and why is it such a thing?
Established in 2017, OMG Network is a layer 2 solution based on the Plasma framework which helps reduce the fee and speeds up transactions on Ethereum. The OMG network would only broadcast completed transactions to the public Ethereum chain to get rid of the unnecessary data in the root chain. This structure allows bigger institutions to participate in transactions with large trading amounts since it reduces cost by one-third of the original design.
In 2020, OMG Network was acquired by the VC Genesis Block in order to facilitate a smoother transaction, which further increased its coin $OMG price by 18%.The $OMG can be used to pay transaction fees or stake in the network when it opens the proof of stake protocols.
As of right now, OMG foundation has relatively less announcements and new developments on their progress than the new Boba Network. The future of the OMG network is still unclear at the moment.
What is Boba Network and the relation with OMG network?
Boba Network is a layer 2 Ethereum network that is founded by the very team of OMG Network and Enya, a company specializing in data security.
Even though OMG was considered as a cost-efficient network, there are issues concerning the network. For instance, the information security of it. As a result, they team up with Enya and build the Boba Network together.
The project was said to be a fork of Optimism Network, however, it got more recognition compared to the pre-existed Network with three times more total value locked for its high efficiency and the launch of its governance token.
As for the prospect of 2022, the Boba network is still functioning and constantly encourages newcomers to build on the network. However, the trading volume and the TVL (10.12 million USD) of the project is relatively low compared to its all time high. The future of Boba Network might encounter weak growth as more and more competitors enter the market.
The airdrop announcement
On 20 September 2021, OMG network announced that anyone who holds OMG coin (buy or lend spot) would receive 1:1 Boba governance coin in the 20 November 2021 airdrop event.
This announcement further intrigued investors’ interests in the OMG coin since at the time, the advised investing strategy was getting as many airdrops as possible. Especially with a layer 2 project and a simple airdrop rule, OMG airdrop soon gained traction in the market. As a result, the trading volume of OMG has doubled from 19 September to 20 September, and spiked to $27 million trading volume on 4 October.
What happened with the price of OMG after the airdrop of Boba?
Figure 1 - The hourly price of OMG/USD-spot, OMG-Perp, OMG-20211231 and the funding rate for perpetual (9/19 - 11/13)Noticeable trend of the incident
After the announcement, the price of three OMG products shows an upward trend, meaning that the majority of the market is buying OMG for the airdrop.
The price of OMG coin rose to its peak on 3 October 2021, meaning more and more people were buying the coin since it hit its low on 21 Sep. and 28 Sep.
Figure 2 - (a closer look) The hourly price of each assets (11/3 - 11/13)The quarterly future price started to diverge with spot price on 12 October 2021. On the other hand, it was not until 7 November 2021 did the perpetual contract diverge.
The funding rate started to increase on 7 November 2021 and increased drastically on 10 November 2021 as divergence between perpetual contract and spot price widened.
The price of three products converged as snapshot finished at 00:00 UTC 12 November and the funding rate instantly dropped from an insane high.
Figure 3 - The price of Boba-spot and Boba-Perp from 2021/11/12 to 2021/12/31Noticeable trend of the incident
The price of Boba rose in the beginning of the launch but the outlook for Boba remained bearish
Event-driven arbitrage
The OMG coin incident is an event-driven arbitrage opportunity, and for this type of investment, it’s important for investors to predict the market sentiment.
Market sentiment
In early October, when the announcement took place for about two weeks, the market started to be aware of the potential growth of the $OMG. Thus, they tended to hold the OMG spot for its $BOBA airdrop afterwards, meanwhile short future contracts to hedge the $OMG price risk. And because of the hedging, the price of both quarterly and perpetual contracts were influenced and experienced a downward trend.
Figure 4 - Spread between assets that indicates divergenceThe divergence between quarterly futures and spot price
It’s worth noticing that people tend to use quarterly futures for hedging instead of perpetual futures since the cost and the risk of quarterly are both relatively low compared to the perpetuals. With quarterly futures, it only requires the initial margin and no additional funding rates. Also, quarterly futures have a fixed date where the future price meets the market price, which provides a predictable price trend.
As a result, people choose quarterly futures for hedging purposes in the beginning, which caused an earlier divergence from the spot price (orange line in figure 4)
The divergence between perpetual futures and spot price
However, as the divergence between quarterly and spot widen, the risk of price convergence increases. This is because the market would fear that once the price of the quarter contract converges with the higher spot price, in other word, increases, the short position would encounter loss. Thus, people started to shift to perpetual contracts for hedging (gray line in figure 4) and believe that the funding rate is small enough to neglect.
Why didn’t the divergence between perpetual and spot happen at the same time as quarterly contracts did, but rather, happened a few weeks later?
Normally, when a short investor saw a wide spread between spot and a quarterly contract, he would fear the potential risk of convergence in this situation, and rather switch to shorting perpetual contracts. But in this case, the divergence of perpetual (with the spot) only starts until the spread between spot and quarterly contract comes to 20%, which is really high, and keeps on enlarging until it reaches over 43%.
This might contribute to some big institutions' speculations about the price of $BOBA. They predicted the price of $BOBA to be so high that it might be able to compensate for the loss from the divergence between quarterly and spot, thus holding on to the position instead of switching shorting perpetual.
It was not until more and more retail investors entered the market did perpetual contracts diverge. Since they didn’t have a firm price prediction for the $BOBA, they wouldn’t want to risk the convergence risk of quarterly contracts, and thus, they switch to short perpetual. They would rather spend some funding rate for the trade than to absorb the convergence risk. As more and more investors learned the news and shorted the perpetual, it created a divergence of perpetual contracts, which happened a few weeks later.
Did it really cost less for retail investors to short perpetual contracts instead of quarterly contracts?
As mentioned above, the retail investors were unable to bear the huge spread between spot and quarterly contracts, thus chose to avoid convergence risk by shorting perpetual contracts despite paying funding rate. However, did this decision really reduce the cost or was it just a decision out of physiological reasons?
Figure 5 - Cost of shorting perpetual and shorting quarterly contractsHere, we assume that the investors short the perpetual contracts 72 hour before the airdrop, where the perpetual contracts started to diverge, and calculate the value of spread between spot and perpetual and quarterly contracts respectively, along with the accumulated funding rate for the time period. We can see that the cost of perpetual contracts (the spread + funding rate, blue line) is actually higher than the cost of quarterly contracts (the spread, orange line), stating that it’s actually better to hedge with quarter contracts than the perpetual contracts.
This is an interesting observation showing that sometimes what we think about the market is not necessarily the end result.
Investment thesis for the incident
There are three ways to earn profit that comes from different sources:
1. Profit with quarterly contracts and spot
A. Profit from the divergence of quarterly contracts — Short Spot and Long Quarter
We can learn from the market sentiment that as more and more people hold the $OMG and hedge the price risk by shorting the quarterly contracts, the divergence of the quarterly price and spot price increases. This creates a chance for a profit from the convergence of quarterly contracts and spot when we long the quarter contracts and short the spot. As the divergence increases, our potential profit increases as well since the profit occurs when quarter price goes up and converges with the spot price. In this case, the spread between quarterly contracts and spot widens from 5%, 8%, 13% to 40%, which would generate profit when the two converge.
Figure 6 - Interest rate for $OMG spot from 9/19 to 11/12It’s worth noticing that for this short spot position, we might encounter two potential risks. First, is the shortage of $OMG. When there’s so many people lending $OMG for the airdrop, it’s hard to borrow $OMG from the market, which might hinder us from performing the strategy smoothly. Even if we lend the $OMG, we would have to pay out the interest rate (green line in figure 6) for the lending, which creates an additional cost. And if the demand for $OMG is high, the cost for borrowing would increase and undermine our profit. Second, is the price jump of $BOBA. Remember that once we hold the $OMG, we are eligible for a 1:1 $BOBA airdrop. If our $OMG comes from borrowing, we would have to not only return $OMG but $BOBA. Thus, if the price of $BOBA experiences a jump, our cost would increase and reduce our profit.
We can mitigate the risk of $OMG shortage by borrowing the $OMG earlier. However, we have a bigger risk concerning the price of $BOBA. Even though we may predict $BOBA would experience a price drop since people tried to cash out the coins once the snapshot closes, the theory is still full of uncertainty. The assessment of the value of a single token requires a thorough estimation model containing indexes such as tokenomics efficiency, market demand and supply, past performance from developing team, etc, which increases the risk for this strategy.
Key elements of strategy 1A:
Potential Return: The convergence of spot price and quarterly contract, as the long position increases in price and short position plummets.
Cost of the trade: Interest trade when borrowing $OMGPotential risk: Shortage of the $OMG spot loan, price jump of the $BOBA waiting to be returned
Investment timing: enter the market when the divergence between spot and quarterly contract the biggest (when convergence starts to happen ), close position right after the airdrop (when converge)
Despite the fact that in traditional finance, we prefer profit from the convergence since it is more straightforward and easier to execute, the situation would sometimes alter in the world of crypto due to different conditions. In this case, it’s because of the airdrop of $BOBA afterwards that gives us an additional cost which contains great risk. Thus, in this case, we would propose another strategy that also profits from the divergence between quarterly and spot, but carries less risk.
B. Profit from $OMG airdrop – Long spot and short quarter
In the market sentiment analysis, we predict that the price fall of quarterly contracts would diverge as more people short the quarterly contracts for hedging the risk of holding $OMG, enlarging the spread between quarterly contract and spot. Based on this thesis, we may conduct the strategy that profit from the spread between quarterly contracts and spot by longing spot and shorting quarterly.
If we wish to conduct this strategy perfectly, we have to enter the market before the divergence increases, in other words, the highest price of quarterly contracts and the lowest price of spot for enjoying the directional profit. This timing is quite tricky since we can’t really predict the precise starting time for this divergence, which requires careful observance and also a gradual buy-in in a time-weighted method as mentioned previously.
Another uncertainty for this trade is the convergence timing for spot and quarterly, since the convergence would cost us directional loss and make profit impossible to achieve. However, in this case, we believe that the probability of the convergence is rather low and the spread between the two assets will continue to enlarge as mentioned in the market sentiment. With this observation backing our strategy, we may hold onto the enlarging spread between spot and quarterly contracts.
As to the timing for closing the position, it should be the time where the spread reaches its largest, which would be right before the snapshot.
The interesting part for the strategy is that, even if the divergence didn’t continue to diverge and experience a sudden close in this case, we still have an alternative source of profit, which is the airdrop of $BOBA. Because we long the spot for performing this strategy in the first place, we are eligible for the 1:1 $BOBA airdrop, and might enjoy the profit of it by selling it.
This is really different from strategy 1A, because the more uncertain price risk of $BOBA is actually our unrealized gain. As for the other potential risk, the convergence, is less worrisome. Also, we don’t have to suffer from the interest rate for borrowing or shortage of $OMG that hinders us from performing the strategy. Thus, we recommend investors to conduct the strategy 1B in this scenario since it is less risky and provides a more diversified source of profit.
Key element of strategy 1B
Potential return: Spread between spot and quarterly or the value of $BOBA
Cost of the strategy: Buying the spot
Potential risk: The early convergence of quarterly contracts and spot or the low price of $BOBA
Investment timing: enter when the divergence starts. The close position timing depends on the profit source. If we wish to profit from the spread, we should close before perpetual contracts diverge (before the range of spread decreases); if we wish to profit from the $BOBA airdrop, we should close after the snapshot
2. Funding rate arbitrage — long perpetual and short spot
We form this strategy by first observing the trend of quarterly contracts. As mentioned previously, the divergence between quarterly contracts and spot occurs when people short the quarterly contracts for hedging the risk of holding spot. We can predict that this divergence between perpetual contracts and spot would also occur when more and more retail investors enter the market and choose to hedge the risk with perpetual contracts in order to avoid the wide spread risk of quarterly and spot (For more, please refer to the third paragraph in “Event-driven arbitrage”).
So, the important question comes, how can we perform arbitrage according to this information?
If we anticipate the divergence between perpetual and spot price to occur and widen as quarterly contracts did in the future, a funding rate return for people who long the perpetual contract would take place, and the return would increase as the gap widens. Thus, we can long perpetual in the hope of gaining funding rate returns and short the spot for hedging the risk.
Simple as it sounds, it still contains two potential risks that are in need of being mitigated. The loan of the $OMG and the timing for closing the position. The first concern is the same as the strategy 1A, where $OMG coins encounter shortages and create a high interest rate (Figure 6), or worse off, can’t be borrowed at all. However, if we want to perform this strategy, shorting spot is necessary. What we can do in advance is to lend the spot first when we see the divergence of quarterly, since this phenomenon makes the divergence of perpetual contracts predictable. Then, we won’t encounter a shortage of $OMG loans though we will suffer a bit of an interest rate before shorting, but that’s compensatable.
Second risk is the timing of entering the perpetual long position. If we miss out the time where it starts to converge, and suffer directional loss from the fall of perpetual for a long time, it might diminish our profit. Thus, it is recommended that we enter the market when perpetual falls closer to quarterly contracts, which can be seen as the lowest point for perpetual contracts. At this time, we can reach our greatest funding rate profit since it diverged far more from the spot and also enjoy a directional profit as the price of perpetual contracts turns into an upward trend.
People might ask, “Isn’t it a bad thing for the direction of perpetual contracts to move upward, since it would decrease the funding rate and thus decrease the profit?” The answer is yes, if our sole profit is from the funding rate. However, in this case, we do have two sources of profit, funding rate and the convergence between spot and perpetual. Even though our profit from funding rate decreases, it’s still positive and would generate profit from the convergence, which further proves the importance of conducting a strategy with two assets for hedging.
key point for strategy 2:
Potential return: Funding rate from longing perpetual and the spot price drop from shorting spot
Cost of the strategy: Interest rate from the loan, directional loss from perpetual contracts
Potential risk: $OMG shortage, high interest rate
Investment timing: borrow spot when seeing divergence between quarterly and spot, short spot and long perpetual when perpetual approaches price of quarterly contracts, close right before the snapshot (before convergence, avoid returning $BOBA)
3. Hybrid strategy 1b + 2 — long perpetual and short quarter
This strategy is one of the safest, flexible strategies, but requires patience for the market. As we saw the divergence between spot and quarterly, we could anticipate the divergence between perpetual and spot would increase as reasons mentioned in the previous strategy. But this time, instead of shorting the spot, we would short the quarter position and long the perpetual contracts.
The profit is from the downtrend of quarterly and the funding rate of the fund, where the cost is the directional loss of the perpetual contract, with no cost from lending interest rate since it’s all contracts. For this strategy, there might be some questions on the table, “, How can you assure the funding rate wouldn’t disappear?”, “How can you assure that quarterly contracts would continue to fall, giving us profit from the short position?”, “Will there be any liquidation risk for this strategy?”
How can you assure the funding rate wouldn’t disappear?
The funding rate of perpetual contracts would increase when the gap between perpetual contract and spot price widens way too much for balancing the prices. If the perpetual price lies above the spot price, the funding rate would be positive, where the long position would have to pay for the short position, in order to create incentives for more people to short the position. And in this case, since the majority of the perpetual contracts were short positions, the funding rate was negative, meaning that the long position was being paid. Thus, it’s really important for us, the long position holder, to anticipate a continuous shorting in perpetual contracts.According to the observation we have in the quarterly contracts, investors would continuously hold spot and short positions for hedging the risk, which created a price fall of the quarterly contract. Thus, we can predict that the perpetual contract would have more and more shorting positions and also create a price fall so dramatic that would cause a consecutive funding rate payment for the long position holders.
How can you assure that quarterly contracts would continue to fall, giving us profit from the short position?
As we mentioned previously, the majority of the investors would short quarterly rather than perpetual since quarterly does not contain funding rate. It was because of the wide divergence that forced them to short perpetual. If the price of quarterly contracts increases, the divergence would diminish, which attracts people shorting the quarterly contracts and thus bringing the price down again. So the price fall of quarterly contracts would continue due to market demand.
Will there be any liquidation risk? How can you assure that quarterly contracts would continue to fall?
Well, every investment strategy contains liquidation risk, it’s just a matter of severeness. And in this case, the liquidation risk is the possibility of an upward trend of both perpetual and quarterly contracts, in other words, it’s when the price of perpetual contract and quarterly contract increases at the same time. If this happens, we would suffer directional loss from quarterly contracts, may not be able to have much funding rate as before, and would not be able to profit from the spread between perpetual and quarterly contracts since now they are moving in the same direction.
As mentioned in previous answers, the possibility for an upward trend of quarterly contracts is rather small because of the strong demand for short hedging. However, for the rise of the price of perpetual contracts, it’s hard to predict whether the upward trend would not occur, but since most of the investors are shorting the perpetual for hedging purposes according to our thesis, the probability can be seen as negligible.
In addition to the market efficiency, the liquidation risk for our margin is also low in this situation since both of our positions are contracts. Despite the fact that we have two different initial margin accounts, we would encounter loss in one position and profit in another due to our hedging strategy, which gives us a dynamic balance of our margin, and thus dramatically decreasing our margin call probability or liquidation risk in this situation.
To sum up
From the previous questions asked and answered, we can see that it’s important to predict different market conditions and consider how the condition influences our strategy before conducting a fully hedge investment thesis. It’s never easy, but once we go through the logic behind, everything just seems so straightforward and so lucrative.
Figure 6 - Funding rate and spread between perpetuals and quarterly that indicates convergenceFor the third strategy, it would be a strategy that requires patience since we are in a long haul, waiting from the very beginning of divergence to near the snapshot. However, the profit is rather guaranteed and stable.
Our profit would be the funding rate and the spread between quarterly contracts and perpetual contracts (Figure 6). The funding rate is rather straightforward, however, some might ask how “the spread between the two contracts” calculated as our profit.
It’s because our profit is based on the price fall percentage of quarterly (the one we short) while our cost is the price fall percentage of perpetual (the one we long), thus, the difference between the two contracts would be our net profit. In other words, we can profit more when the spread between the two grows wider. Thus, it’s recommended that we close the position right before the airdrop when the spread reaches 20%. If this strategy contains leverage of, let’s say 5x, we can then have a 100% return for this trade, which sounds like a good profit.
An interesting fact for this strategy is that, even if we miss out the widest spread between quarterly and perpetual contracts, we can close our position after the airdrop for maximizing our profit from the funding rate. The other good news is that we don’t have to suffer from the uncertainty of the price of $BOBA since all the trades are contracts where no spots are involved. And this provides a second source of profit of the strategy and lowers the risk for the wrong closing timing.
Key point for strategy 3
Potential return: Funding rate from loning perpetual and the the spread between perpetual and quarterly contracts
Cost of the strategy: Price fall from perpetual contracts
Potential risk: Quarterly and perpetual contracts show an upward trend at the same time
Investment timing: enter when slight divergence between perpetual and quarterly occurs, out before they converge (before the snapshot). If missout the widest spread, we may close after the snapshot to maximize the funding rate.
Conclusion
$OMG and $BOBA was a famous crypto incident that happened in 2021, at which time all the exchanges and investors were discussing the trend, contracts, and loans about $OMG, in the hope of performing profitable arbitrage strategies during this time of extreme. In this article, we hope to bring out different investment thesis when facing an event-driven opportunity, and derive different investment strategies from different cases.
As a wise investor, it’s always to screen all the possible conditions in the market and find ways to hedge the potential risk as thoroughly as possible. We may do it by expanding our position little by little, longing for one asset and shorting another contract with the same underlying assets, or anticipating what the market and our counter parties are thinking. With the skill of hedging, we would not just earn profit out of a lucky bet, but a steady and reasonable income that is attributed to a delicate arrangement.
Taking risk is inevitable in the financial market, but how to take it neutrally, that’s the mindset that all participants dream to achieve, and is also the mission MK2 capital wishes to carry on.