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.

As a market leader in the crypto trading space, we are constantly looking at ways to improve and innovate new and existing products.

To further strengthen the trading of our XBT/USD products, BitMEX is proud to announce an introduction of Kraken’s XBT/USD price feed into the BitMEX .BXBT Index.

This change will take place on 16 September 2018 at 12:00 UTC on the XBTUSD Perpetual Swap product, new Futures products and on our Option products. Existing XBT/USD futures products that have not settled will remain under the existing index.

New Index Change
.BXBT will change from (0.5 * Bitstamp + 0.5 * Coinbase Pro) to (⅓ * Bitstamp + ⅓ * Coinbase Pro + ⅓ * Kraken).

Products Affected:
– XBTUSD
– XBT7D_D95
– XBT7D_U105
– XBTH19

Old Index Change
A new index, .XBT will be created that will be based on the old .BXBT index: (0.5 * Bitstamp + 0.5 * Coinbase Pro).

This new index will be phased out after the settlement of the affected products (28 Dec 2018 12:00 UTC).

Products Affected:
– XBTU18
– XBTZ18

Bitcoin is now down close to 70% from the $20,000 all time high. The bear market is here. What level is the bottom, and when?

My hunch tells me that similar to the 2015 bear market, the price at which the average miner turns off their ASICs will be the local bottom.

During the last bear market that range was $200 – $250. While the price languished, various high profile miners went under. KnC and Spondoolies were two casualties. Most surprisingly, in March of 2015 the difficulty actually dropped. That was 7 months before the price ticked up, but it illustrates the amount of pain that miners faced.

Now assuming there is no positive catalyst, like an SEC approved ETF to save us, at what price do we bottom? I believe the key consideration will be when miners begin to shut off their machines; and hence the question, what is the marginal cost of a Bitcoin?

A few days ago I chatted with one of the largest mining facility operators globally. He told me that the average electricity cost of Chinese miners all-in is 6 to 7 cents kWh. At that level, he estimated that at a price of roughly $5,000 is when miners would begin altering operations and look to move machines to cheaper areas. At $3,000 to $4,000, these miners would begin to shut off machines completely.

However, these rough anecdotes assume that miners using 7nm chips either do not work efficiently well, or will not be sold until 2019. Bitmain, Dragonmint, and GMO are all racing to build such miners. The firm that successfully brings a 7nm miner to market, will absolutely lower the marginal cost of the average mining farm, and decimate the older generation mining rigs.

Price leads the hashrate and the final confirmation of the breakeven level will be whether difficulty actually drops. That would require a sustained period of price weakness to shutter enough miners for the hashrate to fall.

When in Doubt, IPO

Upside Risks – SEC Approved ETF