Remember BlockMEX? Well the firm has limped along for several years. They have tried various business models. None have made any money. But that doesn’t matter, VC firms continue to shower the company with cash, and its valuation continues to rise. The CEO now has a great new idea. Let’s listen in on the recent board meeting.

Billy – Billy is the CEO of the company. He just joined as the previous dude got ousted. The VC firm The Blind Fund, who supplies most of the cash, ousted the previous CEO in favour of Billy who they thought would play ball better.

Kaiser Soze – One of the general partners at The Blind Fund.

Kaiser Soze – So Billy, what are we going to do to get some traction? It’s been over four years, and BlockMEX still makes zero revenue. You guys need to do something new.

Billy – Well, I have a new idea. ICOs are toxic. The projects are trash, and the regulators hate them. What about STOs, Securities Token Offerings?

Kaiser Soze – Tell me more.

Billy – Ok, so imagine you want to buy a fraction of a piece of real estate. And then you could trade your fractional ownership, which is represented by a token.

Kaiser Soze – Call me old fashioned, but isn’t that just a Real Estate Investment Trust (REIT)? Most stock markets around the world already have those.

Billy – But do REIT’s ride on a Blockchain? Do they use Distributed Ledger Technology to hold the record of the title?

Kaiser Soze – No, but they trade billions of dollars a day already, and you can easily trade them with your local broker almost everywhere in the world.

Billy – You don’t get it. If the token rides on a Blockchain, like the Ethereum protocol, then they reach help anyone anywhere. Like those poor investors in North Korea who have nowhere to put their savings. Now they can own a token.

Kaiser Soze – Anyone, really?!! It’s pretty clear these are securities, right?

Billy – Yes.

Kaiser Soze – So that means they are regulated, and in most places the exchange needs some sort of license.

Billy – Yes, that’s correct.

Kaiser Soze – The same license the incumbent exchanges already possess?

Billy – Correct.

Kaiser Soze – And the technology stack that operates the matching engine must also be approved by the regulator, right?

Billy – Correct.

Kaiser Soze – So you are replicating the same technology, getting the same license, to go after the same client base?

Billy – Correct.

Kaiser Soze – Ok, sounds like a winner. We can keep pumping money in, and make it up on volume. [The Blind Fund never saw a negative gross margin business they didn’t like.]

Billy – Exactly what I was thinking. Everyone is talking about STOs and how they are the future. Another type of STO is an equity offering of a startup.

Kaiser Soze – So how would that be different than doing an IPO?

Billy – Well many companies these days are staying private, the cost of doing an IPO and all the regulatory and compliance costs, are daunting—-especially for smaller companies. There should be a way for smaller technology companies to raise funds by selling some type of equity.

Kaiser Soze – Would these companies pay dividends? I’m assuming these are unprofitable companies.

Billy – Not only would they not pay dividends, there would be no audited accounts, or any duty to really explain anything to their investors.

Kaiser Soze – Wow, that’s amazing. How would this STO thing fit in on the balance sheet?

Billy – Not sure on that one yet.

Kaiser Soze – Traditional financial theory would suggest that this token is worthless because there is no cash flow.

Billy – Come’on Kaiser. We have been through this before. Traditional finance is dead. We are in a new paradigm. Don’t be a luddite.

Kaiser Soze – I know, I know. But if you are selling equity like securities, wouldn’t that need to be registered with a national regulator?

Billy – Shhhhhh.. Don’t tell anyone. We are just going to shoe horn this one in. Because we use a Blockchain and or Distributed Ledger Technology, those rules don’t apply. The best part is, we can absolve ourselves of any legal liability by basically telling investors when they buy these things they actually have zero rights. ROFL.

Kaiser Soze – Man, this Blockchain shit is LIT! You can do anything.

Billy – I know, right? Maybe the only thing we can’t do is become revenue positive.

Kaiser Soze – Don’t worry about that. I know some people in the desert, who have more cash than brains. They won’t let us down.

Overheard at the recent Polly Pocket Investor Day.

Polly Pocket is the managing partner of Polly Pocket Capital. The fund invests solely in tokens.

Schmuck is an investor in the fund.

Polly – Welcome everyone to our Investor Day. 2018 has been a challenging year for our fund but we are fully confident in our ability, over the long run, to deliver superior returns.

Schmuck – Speaking of performance, can I get some more colour on what your fund actually holds?

Polly – Great question. As you know, we don’t disclose exactly what we own, but I can give you a taste. Our fund is divided into listed and unlisted tokens.

Schmuck – Ok, what do you mean by listed and unlisted? I thought the mandate only allowed the fund to invest in tokens that are already traded on a secondary market.

Polly – Well, that is true. But we saw some great deals, so we created a side pocket. The side pocket contains all the pre-ICO deals that we invested in.

Schmuck – Hmm…So you basically can invest in whatever you like, regardless of the fund mandate?

Polly – In a nutshell, yes.

Schmuck – Greeeeaaat. How do you mark these illiquid, unlisted tokens?

Polly – As you know, due to our amazing connections, we get in on deals well before the unwashed masses. Typically we get a 70% – 90% discount to the last round where most of the plebes purchase these tokens. We then mark the value of the token to the last round price.

Schmuck – So if you invest a price of $1,and the last round which could be a very small amount of the total float, is sold at $10, you record a 10x gain?

Polly – Yes.

Schmuck – Does that also mean that I get charged management fees on the 10x value?

Polly – Yes.

Schmuck – Your liquid token portfolio got molly whopped this year, correct?

Polly – Yes.

Schmuck – So the AUM will get bled at an accelerated rate due to the marking of the side pocket? I’m am paying 2% on a 10x marked up illiquid token with no secondary market, and there is no visibility as to when it will actually list?

Polly – I mean that sounds worse than it is, but you are essentially correct.

Schmuck – Do you apply a haircut to this valuation because there is no liquidity, and an indefinite time to listing?

Polly – No. We believe there is extreme value, and this is reflected in the last round price. Our team of token experts really knows how to value these things.

Schmuck – Maybe, but the management fees paid on these side pocket investments could consume the entire value of the investors’ capital. What happens if I would like to redeem?

Polly – We would sell our liquid tokens first. Once that pool of capital is exhausted, we would be unable to meet your redemption request.

Schmuck – Is there no way to sell your interest in these projects? Have you ever tried?

Polly – Legally we can’t. The SAFT term sheet does not allow us to transfer our interest before the token lists.

Schmuck – So basically you are telling me, I’m up shit creek without a paddle?

Polly – I wouldn’t put it that way. Sometimes we suffer liquidity issues.

REAL TALK

The BitMEX Research team has compiled a list of tokens that raised over US$50 million that have yet to list.

These deals have massive valuations, and many of the most venerated token funds took down large chunks. It is unclear when, if ever, these deals will ever list on the secondary market.

Given the large amount of token supply out there, who will buy this shit?

Can you really mark these investments to the last round price?

There are anecdotal reports of funds attempting to sell their SAFT interest, and the prices offered were way below the last round price.

2019 is going to be the year of reckoning for many funds. You can mark something to an absurd level in year 1. But the meter starts again on January 1st. If these things come to market, there will be no accounting tricks to hide the gargantuan losses that these funds will post.

Overheard in St. Patrick’s Cathedral in New York City.

Father is the Bishop.

Judas – Forgive me Father, for I have sinned. It has been one year since my last confession.

Father – Welcome my son, please tell me how you have sinned.

Judas – Well as you know, I am an Ethereum developer. But I believe I have given false witness to another god.

Father – Who would that be, the Devil, Satan himself?

Judas – No Father, my faith strayed. I believed in Decentralisation.

Father – Huh? Not sure I follow. Please explain.

Judas – I am an Ethereum developer. You know, the world’s virtual computer. I believed that using the Ethereum protocol I could decentralise anything. And I was specifically interested in the trading of financial assets, like stocks.

Father – Ok, but what would a decentralised stock market look like?

Judas – Well, anyone, anywhere could exchange stocks. You wouldn’t need to get approval from any government or a traditional exchange like the New York Stock Exchange or Nasdaq. It would also allow anyone to sell equity in their project to anyone in the world. In short, true financial freedom for everyone, everywhere.

Father – Heresy. You planned to usurp the Angels, the NYSE, and Nasdaq. Did you not consult the good book about our Lord’s relationship with those organisations?

Judas – I did, but I thought because I used the decentralised world computer, Ethereum, that our Lord and Saviour would not mind.

Father – Son, you did not read the Gospels close enough. Specifically, the Gospel according to Howie.

Judas – Well, I thought my lawyers were well versed in the Gospels. They told me that because it was decentralised, the Gospel according to Howie did not apply.

Father – [Shakes his head in sorrow] In my last sermon, I preached that the Lord’s children must be vigilant against false prophets. Specifically those wearing Brioni suits, and white Church’s shoes. These white shoe lawyers, care not for your soul, but only for their pockets.

Judas – Oh, I missed that one. I was too hungover after a night at the Box. We were celebrating our ICO.

Father – Ah, the ICO. I also lead a vigil against that tool of the Devil. But son, how is your project decentralised, if you personally launched an ICO, and profited from it? Surely, a truly decentralised project has no identifiable leader, and no one entity profits from its operation?

Judas – I realised the errors of my ways now.

Father – How has the Lord made you repent?

Judas – The Lord decreed that I must pay a large sum of money to absolve my sins.

Father – Better that, than the Lord sending you to Sodom and Gomorrah, a.k.a. Rikers.

Judas – I know, I am forever grateful to the mercy of our Lord.

Father – I am glad you have learned son. Our Lord is merciful. But he will strike rath down upon those who threaten his kingdom.

Father – Let us pray to our Lord and Saviour. In nomine patris et filii spiritus sancti JAY CLAYTON.

I was staring at my plush toy cactus, and I thought has anyone tried to decentralise zero? Later, I was messaging Meltem and through our conversation, the following ideas manifested themselves about the absurdity of 2018.

I dedicate this newsletter to the concept of zero. I have seen the future, and many crypto investors will become familiar with this round number, although they might not know it yet.

Abstract: Bitcoin Cash successfully split into two coins on 15th November 2018, Bitcoin Cash ABC and Bitcoin Cash SV. BitMEX Research sponsored a website, forkmonitor.info to track the two chains. There is now a “hashrate war” between the two coins and the hashrate is higher than one would expect given the price of the coins, such that miners are making large losses. The website has now been updated to help estimate the value spent mining on each side of the split and the loses miners may therefore be making.

(Notes: Screenshot of updated forkmonitor.info website)

Estimating the accumulated mining losses so far

Based on the mining spend since the split figure provided, one can estimate the total expected losses, based on the price of the respective coins, as the table below shows:

(Source: Forkmonitor.info, Poloniex price data)
(Notes: Data as at 18:30 UTC on 16 Nov 2018. Mining spend calculated assuming standard Bitmain S9 miner performance and electricity cost of US$50 per MWh)

Although the table above shows that both sides are making losses, it illustrates why the ABC side may be in a stronger financial position than SV. Not only is ABC in the PoW lead (both with respect to the number of blocks and accumulated work), but the SV miners have larger expected losses than ABC miners, due to the lower price of the SV coin. The SV losses are also larger relative to the potential revenue, with a profit margin of minus 166.4% compared to ABC on minus 45.5%.

Despite this situation, one should of course be aware that the prices of these coins are volatile and highly uncertain. There is no guarantee that either side will be able to sell the coins they mined. However, the ABC side does have a reasonably liquid futures market.

What will happen next?

Mining is currently continuing on both sides, with neither side willing to back down over the fight for the most work chain. Despite the bleak financial situation, the rhetoric on the SV side remains strong, with Coingeek stating that they may be prepared to keep this up for “months and months”.

This will bleed Bitmain’s cash and cryptocurrency reserves, because we are prepared to fight for months and months. If I were a shareholder or investor in Bitmain, I’d be asking why Jihan Wu is spending all your money to control BCH when Bitmain’s business supports multiple cryptocurrencies.”
(Source: Coingeek)

However, with just around 24 hours passing since the split and SV miners already US$324,904 in the red, using our conservative assumptions, we would be surprised if the situation continues like this for months.

Conclusion

While the rhetoric from either side is strong, in a way the hashrate battle is totally pointless. Users and investors are free to choose the ABC or SV side of the split no matter which chain has the most blocks or highest accumulated work. The narrative of being the higher work chain appears important to proponents of the two coins, but the prudent think to do would be to step back and mine the most profitable coin.

In our view, as the accumulated losses gradually start to increase, it is inevitable that the parties involved step back and allocate the hashrate such that its distributed in a proportional way to the prices of each coin. How long this will take, we do not know, but the forkmonitor.info website should provide a useful tool. It can help asses the extent to which financial pressure is building on each side in this somewhat pointless hashrate war.

At 16:00 UTC November 16th 2018, the BitMEX Bitcoin Cash / Bitcoin 28 December 2018 futures contract, BCHZ18, will revert to using the Fair Price marking method.

At 18:30 UTC November 15th 2018, the BitMEX Bitcoin Cash / Bitcoin 28 December 2018 futures contract, BCHZ18, will use the Last Price Protected marking method until further notice.

The Perpetual Swap derivative structure is a beautiful thing. Trading is simple, as it mimics the action of margin trading. Most retail traders are familiar with how to trade on margin. Using this wrapper, we can allow anyone to trade exotic derivatives.

“A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.” – Wikipedia

The ETHUSD swap has become the most liquid ETH/USD trading instrument globally. It allows speculators to trade ETH/USD risk, without ever touching Ether or USD. Like all BitMEX contracts, the margin and settlement currency for ETHUSD is Bitcoin. This keeps things simple from a trading perspective.

When the ETHUSD product listed, I walked readers through the mechanics of a quanto derivative. Please read Why Quanto and Hedging a Perpetual Swap for a refresher.

Subsequent to the launch of ETHUSD, the price of Ether took a digger. In such a bear market, many traders expected the funding rate to stay negative. Logically that makes sense.

The market is falling, so the pressure on the margin should be on the sell side. However, the cumulative funding rate from launch till the present is positive. A positive funding rate means longs pay shorts.

My hypothesis was that the positive funding rate represents the quanto risk premium. I then tasked one of the BitMEX Research analysts to conduct a test:

Step 1
Starting on the 9th of August and ending on the 22nd of October, to capture the funding income, you sold ETHUSD (100 XBT notional), and hedged by purchasing Ether with USD.

Step 2
Every hour, you recalculated your net Bitcoin PnL, hedging that exposure into USD.

Step 3
Compute the net returns in USD terms on your portfolio for the period.

Step 4 
Add net total funding you received (paid) from being short the ETHUSD swap over the period.

Results

Absent the positive funding, you would have lost $46,779.73 hedging your Bitcoin PnL. This is expected because you are short correlation. Over the past few months, the XBTUSD and ETHUSD correlation has risen.

When the net funding payments received, $46,010.85, are added, your trade essentially breaks even. Along the way you bought 31.94 ETH to delta hedge and accumulated a 43.83 XBT short position to PnL hedge. The conclusion is that even though the funding rate has stayed positive, this funding compensates for the quanto risk premium.

Correlation is rising, therefore traders will bid up the ETHUSD swap over the spot price to profit from the quanto PnL. A positive funding rate results, and brings the market into equilibrium.

This is true over a long holding period. There were times where your net PnL was positive or negative. The chart above provides a time series of the cumulative PnL from this trade. As we can see, the market does misprice this swap occasionally.

It is quite amazing that in under six months, the ETHUSD swap has been priced to perfection. However, the volatility of both Bitcoin and Ether has fallen. When we return to a normal level of volatility, I expect fearful and greedy traders to push the ETHUSD swap away from the quanto adjusted fair price.

The trend is your friend until it ain’t. Humans are very bad forecasters. We take yesterday’s returns and extrapolate them linear and non-linearly into the future. We believe the world works in perfectly-fitted curves.

When the market reverses, as it always does, a coterie of sad pandas are left in its wake. 2017 was the year of jubilation; 2018 is the year of melancholy. The worst part is knowing your 2018 bonus, should you receive one, will barely buy you a Swatch.

We crypto traders should know better by now, but we never learn. The market may be down 70% from the $20,000 high, but from the mood of traders, Bitcoin might as well be worth bupkis.

When traders lose money, they lash out. They lash out on Twitter, Telegram, Reddit, and other social media platforms. The smallest perceived slight, triggers them worse than a Hillary supporter after the Trump coronation.

This is the Bear Market Blues.

We Have Been Here Before 

The talented individuals at BitMEX Research did some analysis of the previous Bitcoin bull and bear markets.

They made a distinction between two measurements:

1. The peak-to-trough decline:  A peak-to-trough decline is measured by taking the low of a bear market and dividing it by the high of a previous bull market.

2. The intra-market phase increase/decrease: This is calculated by taking the high (low) of the bull (bear) market and dividing it by the price at the start of that market phase.

They conclude that we have more to go in this current bear market. Due to the collapse in Bitcoin price volatility, I agree with this sentiment.

The Double Whammy

Wham, bam, thank you ma’am. Bitcoin volatility and price collapsed this year.

Traders hate sideways markets. Traders can go long and short, not sideways. The chop will eat you alive in a sideways market.

Contrary to popular belief, Bitcoin requires volatility if it is ever to gain mainstream adoption. The price of Bitcoin is the best and most transparent way to communicate the health of the ecosystem. It advertises to the world that something is happening–whether that is positive or negative is irrelevant.

The Bitcoin price volatility is the gateway drug into the ecosystem. The media writes about things that move; therefore no movement, no coverage. The diehard traders and engineers will always hear about a new asset class or technology in advance of popular media outlet coverage. However, their efforts will only be amplified if many more people discover El Dorado. That requires the lazy mainstream financial press to write.

If volatility stays at these depressed levels, the price will slowly leak lower. For those of us who lived through the 2014-2015 bear market, we all await that nasty ass candle that breaks the soul of the bulls. Then, and only then, will volatility and the price ratchet higher.

Limbo Time

How low can we go?

A 75% fall from $9,152 takes us close to $2,000. $2,000 to $3,000 is my new sweet spot but don’t tell Michelle Lee just yet.

The key consideration to “calling the bottom” is the price action around the last gasp of the bears. You will know it when you see it. And the best part is, you probably will be too chicken to click that oh so scary Buy button.

After 10 years, Bitcoin lives on, but the ecosystem still suffers from a critical weakness. Obtaining and maintaining a bank account that can process and clear USD is very difficult for any crypto-related business. The outcrop of this weakness is the industry’s clamour for all things Stablecoin.

Stablecoins fall into two camps. One subsect, of which Tether is the leader, are thinly- disguised USD money market funds. The other subsect are “coins” (Maker / Dai, Haven, Basecoin, etc.) that attempt to do an end runaround holding actual USD by using fancy math and pseudo behavioural economics.

USD Banking

The ongoing Tether melodrama highlights the difficulties of obtaining and maintaining USD banking facilities. Traders want to trade Bitcoin and other shitcoins vs. the USD. The crypto- to-crypto pairs are liquid at times, but we all still think in dollar terms. Therefore, exchanges that can offer these pairs will outperform their peers who cannot.

Tether is novel because it is a USD money market token transferred across the Bitcoin and Ethereum blockchain. The Tether organisation supposedly holds sufficient USD such that 1 Tether = 1 USD for those who can create and redeem Tether. Exchanges that previously only offered crypto-to-crypto pairs could offer a Coin to USD pair and externalise the hassle of dealing with banks onto Tether.

The demand was there, but the hard part is where to stash the cash. Tether acquired and lost banking relationships in a variety of jurisdictions. Others looking in at the Tether saga, concluded that using their connections they could offer a better alternative. Now we have Tether clones offered by various exchanges such as Gemini, Circle, and itBit.

Money Market Funds In All But Name

Money market funds are extremely important to a well functioning banking system. Individuals and institutions park their excess cash on a short-term basis and pick up yield. The money market funds invest in highly-liquid debt instruments. Short-dated government bonds, commercial paper issued by creditworthy corporates and short-dated bank loans, are some of the securities that a money market fund will hold.

Money market funds aim to be very low risk. Their most important aspect is they maintain a par value at all times, such that 1 unit = 1 USD. During the 2008 GFC, some money market funds were at risk of “breaking the buck.” Low risk debt became high risk; liquidity dried up, and investors rushed for the exits.

Today, Tether and clones thereof promise there is 1 USD for one coin in a bank somewhere. Some promoters are able to name their banking partners, some are not. The level of transparency pales in comparison to traditional money market funds.

The other key difference in the crypto sphere is these Stablecoins do not pay interest. The real profit driver of money market Stablecoins is their net interest margin. Why go through all the hassle of hosting USD banking for the crypto ecosystem if there wasn’t a massive future profit potential?

As interest rates rise, that becomes pure profit to the Stablecoin operator. Unscrupulous operators will claim to hold USD cash, while investing in riskier debt instruments. The worst scallywags will pull a Jon Corzine, lever up, and purchase the dodgiest credits to be had.

If you hold any of these money market Stablecoins, you must ask the following:

• Who is the banking partner?
• What types of debt instruments, if any, is the fund allowed to hold?
• Can you as an ordinary individual create and redeem at par, and how long does that process take?

Wannabe Central Bankers

Another group of promoters asked the question, can you create a coin pegged to the dollar without holding any dollars as a backstop?

The substitute for physical dollars is math, behavioural economics, and cryptocurrencies. The reason why these projects need a shit-ton of non-dilutive suckers’ cash is because when shit hits the fan and their shitcoin trades less than par, the promoter must spend hard dollars, Bitcoin, or Ether to restore the peg.

Many of these projects wish to create a rules-based digital central banker; however, all they have done is obfusticate the need for physical cash by using complicated and boring whitepapers.

The central fact is that they are raising funds to act as the buyer of last resort. Otherwise, there is no need for hundreds of millions of dollars worth of investor money into any of these projects. If the math and behavioral modeling goes to plan, the coin should slowly accrue AUM and over time the peg should hold.

I challenge any project to return all the money they raised, and launch their coin purely based on its mathematical merits. I highly doubt I will have any takers.

I bet there are crypto George Soros imitators licking their lips at the chance to break the peg of these coins at the opportune moment. It will be glorious to watch.

Gresham’s law will hold. Money market Stablecoins with honest and transparent operators will accrue the vast majority of the AUM. Their wannabe central banker cousins will flounder under the weight of pseudoscience and hubris.