Convexity: Rektum? Damn Near Killed ‘Em

Since BitMEX launched on 24 November 2014, cryptocurrency derivatives trading exploded. I tried in vain to seduce various venture capital firms with the vision of the future that was all about derivatives trading. At that time, succour was not forthcoming; however, I could not be more pleased with my failures now standing in 2019.
 
The BitMEX XBTUSD perpetual swap and various other contracts traded on OKEx and Deribit are of the same ilk. These contracts all allow you to trade a fixed USD amount of Bitcoin. We call these inverse derivatives contracts. Many OG traders have heard me speak at length about the subtle yet profound implications of this contract structure. However, as many new traders now try their hand at derivatives trading, a refresher course is necessitated.
 
Contrary to popular belief, I don’t delight when I see the BitMEX Rekt twitter feed going bananas. I’m long-term greedy. I would rather you enjoy a long trading career earning a profit and paying BitMEX trading fees along the way, than blow up your equity capital during a liquidation. Therefore, it is in mine and BitMEX’s best interest that our traders are sufficiently educated about best trading practices.
 
I love our traders, but when I hear people smile and laugh about getting liquidated it makes me cringe. A real trader practices proper risk management, and that means never being liquidated.
 
You Gotta Go Down, To Go Up
 
Convexity or gamma is the second derivative of a contract’s value with respect to price. Used correctly convexity can supercharge your portfolio’s returns. However, if you do not understand how convexity affects a derivative you trade, you will get rekt repeatedly.
 
With inverse contracts, the margin currency is the same as the home currency. I will use the XBTUSD contract throughout this post.
 
Home Currency: XBT (Bitcoin)
Foreign Currency: USD
Margin Currency: XBT
USD Value: 1 USD
XBT Value: 1 USD / Price (XBT/USD exchange rate or .BXBT index)
 
I will dwell on how the XBT exposure of a long 100,000 contract position changes with respect to the price (.BXBT Index).

First, let’s look at the long side. In bull and bear markets, these will most likely be speculators. This makes sense because being long Bitcoin offers asymmetric returns. Bitcoin can rise to infinity, but can only fall zero. It is better from a return on equity perspective to go long the bottom, then go short the top. Those who picked up ETH below $100 know this acutely. Therefore, coupled with leverage, on the margin, longs in most market environments will be predominately speculators.

The first chart shows XBT PNL profile and curvature. The straight line is the PNL %  return if the contract moved in a linear fashion, the curved line is the long inverse contract position’s PNL % return. What you immediately notice is that you will lose more money when the market falls, and make less money as the market rises. This is suboptimal as you must post margin in XBT. Thus, your margin requirements increase in a non-linear fashion, and this is why longs get rekt quickly in a falling market. 

Now let’s examine the short side.  In bull and bear markets, these will most likely be hedgers and market makers. In both cases, these market participants want to lock in the USD value of Bitcoin. With inverse contracts, a long physical Bitcoin position coupled with an equivalent short XBTUSD position creates a synthetic USD position. If 100% of the physical Bitcoin is placed at cross-margin with BitMEX, you cannot be liquidated.

Unlike the long side, shorts benefit from positive XBT convexity. Shorts make more and more XBT as the price falls, and lose less and less as the price rises.

The take away from these two examples is that long speculators will be liquidated faster on the way down. This explains why dumps in these derivatives dominated markets are now more extreme than pumps and will continue so long as inverse style derivatives dominate the cryptocurrency derivatives markets.

The CME contract has a fixed XBT exposure regardless of the price, and the USD exposure varies linearly with respect to price. While this is great for USD benchmarked investors, it becomes problematic for those hedging their exposure. Bitcoin purchased to hedge a short CME position cannot be used as collateral with the CME. This presents some challenges for hedgers who hold physical Bitcoin, and market makers who must divide precious capital between derivatives and spot markets with no cross-collateral relief.



 

The Road to $10K

Did you take your losses like a champ, or bottom tick the market with your market close order? The first quarter of 2019 witnessed depressed volumes, volatility, and price. The local lows of late 2018 have not been retested; however the market chop makes me feel like I’m at the Saudi embassy.

The repair of crypto investors balance sheets is not done yet. Losses must be digested, and the unlucky masses must wage cuck a bit longer to get back in the game.

All is not lost; nothing goes up or down in a straight line. 2019 will be boring, but green shoots will appear towards year end. The mighty central bank printing presses paused for a while, but economic sophists could not resist the siren call of free money. They are busy inventing the academic crutches (here’s looking at your MMT), to justify the next global money printing orgy.

Do not despair. CRipple is still worth more than zero. And Justin Sun’s new age religion TRON, paired with the Pope CZ, tells us there are those still willing to eat shitcoins with a smile.

Electric Cars and Sand Schmucks

While Bitcoin is an innovative technology, the technical merits of the protocol do not exist in a vacuum. The world’s monetary situation is very important. It determines how willing investors are able to suspend disbelief and believe crypto fan boys and girls.

Throughout 2018 the omnipotent Fed began reducing the size of its balance sheet and raising short term interest rates. The world still beats to the tune of the USD. Financial institutions and governments require cheap dollars, and the Fed happily obliged since the 2008 GFC.

Tech VC funds won’t admit it, but cheap dollars are key to their business. How else can you convince LPs to continually fund negative gross margin businesses, until they “scale” and achieve profitability? Everyone wants to become the next Facebook.

When investing in government bonds yields zero or negative, desperate investors will do whatever it takes to obtain yield. Tesla is a perfect example. Lord Elon is a master at creating open-faced pits, and torching his investors’ money in them. Tesla does not belong on the Nasdaq, but rather as a speciality flavour at the New York Bagel Co.

The market disagrees with my Tesla melancholy, investors continue to line up to eat Elon’s sexy Tesla hot shit cakes. Can you blame them, after you are fully invested in the S&P500 where else will you be able to show alpha to your investors?

Another example of this free money folly is the Vision Fund.

  1. Top tick the “Value” your investments while still on the Softbank’s books.
  2. Find a group of schmucks from the sand (That’s where the former Deutsche credit boys come in, “Be Bold”)
  3. Sell your mark-to-fantasy private Unicorns into the vehicle populated by your sand schmucks
  4. Take your cash and payout to your Japanese investors as dividends.

These entities thrived while the Fed held rates at 0% and reinvested their treasury and MBS roll off. TSLA hit its all-time high in mid-2017. Since then Elon has struggled to generate enough buzz to keep his stock elevated. I’m sure he isn’t thrilled that bondholders are due close to $1 billion in cash because the stock price failed to scale $360.

The Vision Fund’s sand schmucks also got cold feet. They baulked when the fund proposed to invest an additional $20 billion into the We-Broke company. The check size got sliced down to $2 billion.

When dollars get scarce suddenly investors discover value investing all over again.

The height of crypto silliness in December 2017 occurred just before the Fed embarked on its quantitative tightening. The 2018 pain train spared no crypto asset or shitcoin.

But things are a changin’. The Fed couldn’t stomach a 20% correction in the SPX. In the recent Fed minutes, the dot plot now shows no rate increases for the rest of 2019. The Fed will start reinvesting its runoff in the third quarter. We are only a hop, skip, and a jump away from an expanding Fed balance sheet.

Beijing knows China must rebalance its economy away from credit-fueled fixed asset investment. However, Xi must not have the political cojones to push this sort of painful change through. Therefore, the PBOC said “fuck it” to any attempt to reign in credit growth. The two most important central banks are creepin’ back into a super easy credit regime.

Easy money will manifest itself in other higher profile and more liquid dogshit before crypto. 2019 will feature an IPO beauty pageant of some of the best cash destroying businesses. Uber, Lyft, AirBnB, and possibly the We company all are rumoured to IPO this year.

Lyft is apparently oversubscribed for its upcoming IPO. Oh baby, this is going to be a fun year.

If these beauties can price at the top of the range, and trade above the IPO price, we know that party time is back. Crypto will be the last asset class to feel the love. Too many people lost too much money, in too short a time period, to immediately Fomo back into the markets.

Get Excited

Green shoots will begin to appear in early Q4. Free money and collective amnesia are powerful drugs. Also after two years of wage cucking, punters should have a few sheckles to rub together.

The 2019 chop will be intense, but the markets will claw back to $10,000. That is a very significant psychological barrier. It’s a nice round sexy number. $20,000 is the ultimate recovery. However, it took 11 months from $1,000 to $10,000, but less than one month from $10,000 to $20,000 back to $10,000.

Melissa Lee peep this. $10,000 is my number, and I’m stickin’ to it.

Two sides of the coin: the bifurcated near-future of money

 

A digital society requires digital cash. You hear the word cryptocurrency a lot. But there’s a very big difference between a truly decentralised cryptocurrency like Bitcoin and what could be called centralised ‘e-money.’

As Bitcoin today officially heads into its second decade of existence, this is a ripe moment to familiarise yourself with some of the fundamental changes in modern money, including the ways people store and transmit value, that I think you can expect to see in the near future

We Gave Them an Inch, Now They’re About to Take a Mile

The first type of new money I believe we’re going to see is centralised e-money. This descends directly from the current system, taking government (fiat) currency and updating it for the digital age. It’s a natural — and I imagine inevitable — synthesis of the existing central bank system and our increasingly corporatised economy.

The keystone phenomenon that makes e-money possible is the way in which we as a society have grown accustomed to handing over our entire private lives to corporations. We’ve done so in exchange for entertainment and convenience, and we’ve certainly received ample supplies of both. It’s only a small step now, however, to our accepting (or being forced to accept) the corporate issuance of money and the further diminution of privacy that comes with that.

The clearest glimpse into where e-money is heading is probably WeChat Pay, which has now practically eradicated cash in China. The WeChat Pay system works like this: using QR codes and mobile phones, merchants deduct credits from your WeChat wallet, which is connected directly to your bank account. Instantly, while standing at a market stall, Chinese renminbi (CNY) is debited from your account, and credited to the merchant’s account. They get their money, you take your dumplings, and the friction and annoyance of using physical cash evaporates.

As someone who travels around China frequently, I actually love WeChat Pay. However, as someone who built a career in banking and now makes his living in Bitcoin, I also know the privacy limitations of centralised payment systems.

The various mobile payment systems now offered by major players in different parts of the world differ in their details. But in some cases, they know almost everything about you: what goods and services you purchase, as well as where and when you purchase them, which can presumably be linked to all the other data they have on you.

At the same time, we’ve seen our governments in the West, when the spirit moves them, lean hard on our corporate friends to cough up our personal information. Unsurprisingly, the corporations tend to comply with these requests. We have also witnessed private sector payment networks and crowdfunding platforms kick people out for having too close an association with offending ideas or speech, or for being bad actors. Not all of this is necessarily unreasonable, but who gets to draw the line? They do.

Furthermore, monetarily, you can see where this leads: whether it happens gradually or suddenly, at some point central banks and governments, in accord with their nature, may start directing the monetary functions of corporations in a more hands-on way. The way they would do it, I expect, is by deputising commercial banks and large social media companies, who shall become nodes on a payment network, with the authority to participate in the e-money system and earn transaction fees.

Significantly, the payment network’s rules can be enforced instantly and flawlessly via code. The only place left in the system for inefficient or corruptible humans to participate will be at the apex of the network, where the authorities can issue credit directly to people, tax every transaction immediately, and determine who can and can’t be part of the network. In theory, your entire financial existence can be governed this way.

Thankfully, That’s Where Bitcoin Enters the Conversation

Although such a monetary system as I’ve just described may or may not be warehoused on a blockchain look-alike, make no mistake: it is centralised, top-down, and censored (meaning you can be barred from using it if you fall afoul of the centralised powers).

Bitcoin, by contrast, is decentralised, peer-to-peer, and censorship resistant. Bitcoin runs via a network of voluntary, independent, and self-interested actors, who neither demand nor require any favours or permissions; a few basis points in transaction fees is literally all they want from anyone — and all they’re allowed to take. And while the public address of any Bitcoin wallet, and its transaction history, are visible to all, no personally identifiable information is contained in any transaction.

Which means that Bitcoin, or something like it, is perhaps society’s best hope for a private form of electronic money. And privacy, I argue, is an important part of a well-functioning society. For moral and even psychological reasons, citizens deserve the ability to keep certain details about their lives to themselves.

To sum up: for a long time, physical cash has been the best form of money with respect to privacy. But armed with a more efficient and transparent form of e-money, government after government will gradually make physical cash obsolete. Sooner than you think, cash will not be an option for privacy, or for anything else. And private citizens will come to appreciate the inherent value of Bitcoin, as their ability to discreetly hold and transfer value evaporates once cash goes the way of the dodo.

Grounds for Optimism in General

Bitcoin is still very much an experiment. However, after 10 years of operation, the Bitcoin protocol has not been hacked — despite offering what’s effectively the biggest ‘bug bounty’ in software history. Bitcoin is an amazing achievement of disparate private individuals working together towards a common goal.

As I consider how a community of people collectively created an alternate monetary system, I am greatly optimistic about what other aspects of our global society we can improve through a collective, decentralised effort.

And I say this even in the face of the various centralising forces currently being marshalled: humanity’s bifurcated monetary future will be better than our monopoly monetary past, as some money becomes more convenient while other money becomes far more private.

The Price Crash & The Impact On Miners

Abstract: Cryptocurrency prices have fallen significantly in the past few weeks. In this note, we analyse the impact this price decline may have on the mining industry. The Bitcoin hashrate has fallen around 31% since the start of November 2018, equivalent to around 1.3 million Bitmain S9 machines. We conclude that many miners are struggling; however, we point out that not all miners have the same costs and that it’s the higher cost miners who switch off their machines first, as the price declines.

 

Overview

Since the start of November 2018, the Bitcoin price is down around 45%, while in the same period the amount of mining power on the Bitcoin network has fallen by around 31%. According to our estimates, this represents around 1.3 million Bitmain S9 miners being switched off. The mining industry may therefore be under considerable stress right now, due to the falling prices of cryptocurrency.

The prices have so far caused two large downward difficulty adjustments to Bitcoin, 7.4% and 15.1%, on 16th November and 3rd December, respectively. The 7.4% adjustment was the largest since January 2013 and the 15.1% adjustment was the largest since October 2011. The charts below are based on the daily chainwork and therefore reflect changes in network difficulty.

Bitcoin Daily Work Compared to the Falling Price

(Source: BitMEX Research, Poloniex)

Daily Mining Revenue and Cost

As the chart below illustrates, Bitcoin mining industry revenue has fallen from around $13 million per day at the start of November to around $6 million per day, at the start of December. This drop in incentives was even larger than the fall in the Bitcoin price, due to a delay in the way difficulty adjusts. In the six-day period ending 3rd December, 21.8% fewer blocks than the expected 144 per day were found, as miners left the network before the difficulty adjusted, and as a result, fewer blocks were found. Therefore in the short term, there was a 21.8% fall in mining incentives on top of the impact of the declining price.

Bitcoin Daily Mining Revenue and Expected Electricity Spend – US$m

(Source: BitMEX Research, Poloniex)

(Notes: Assumes an electricity cost of US$0.05 per KWH, assumes advertised Bitmain S9 specification)

 

Bitcoin Cash ABC Daily Mining Revenue and Expected Electricity Spend – US$m

(Source: BitMEX Research, Polonies)

(Notes: Assumes an electricity cost of US$0.05 per KWH, assumes advertised Bitmain S9 specification)

 

Ethereum Daily Mining Revenue and Expected Electricity Spend – US$m

(Source: BitMEX Research, Polonies)

(Notes: Assumes an electricity cost of US$0.05 per KWH, assumes 32Mh/s at 200W)

Miner Profit Margins

The chart below shows that prior to the recent crash, the industry was making gross profit margins of around 50% (these figures assume electricity is the only cost included in gross profits), while after the price crash, this fell to around 30% for Bitcoin and 15% for Ethereum.

Miner Profit Margin

(Source: BitMEX Research, Poloniex for prices)

Ethereum Mining Profitability

In the period, the Ethereum hashrate has only fallen by 20%, much lower than Bitcoin, (representing around 1.5 million high-end graphics cards), while the price decline has been more significant than Bitcoin, at 54%. Therefore, gross profit margins have declined even more sharply for Ethereum, but it is not clear exactly why this is the case.

There are a few potential reasons. It could be that Ethereum miners are more hobbyist minded and less profit focused, or Ethereum miners could have started from a higher gross profit margin position than Bitcoin, so they are less inclined to monitor the network and switch the miners off when necessary. As the data shows, Ethereum miner gross profit margins now appear significantly lower than Bitcoin, falling to 15% in the last few days, so this could change (Note: This analysis only included electricity costs, when including other costs, mining may be a loss making operation).

Bitcoin Cash ABC Mining Profit Margins

As the above chart shows, the Bitcoin Cash ABC gross profit margin went negative during the split into two coins, Bitcoin Cash ABC and Bitcoin Cash SV. The two camps mined uneconomically in a race to have the most work chain. Ten days after the split, on 25th November, the profitability of mining Bitcoin Cash ABC rapidly climbed up to around the same levels as Bitcoin. This appeared to indicate the end of the “hashwar,” which proved to be almost completely pointless, as the war ending had no clear noticeable impact on either the coins or their value.

As the latest data in the below table shows, the two sides are getting closer again with respect to total work since the split and its possible uneconomic mining resumes.

Bitcoin Cash ABC Bitcoin Cash SV
Log2(PoW) 87.753365 87.747401
Blocks                          560,091                              560,081
Cumulative total since the split
Log2(PoW) 82.189 81.875
Blocks                                   3,325                                   3,315
Mining electricity spend $7,939,318 $6,389,264
Coin price (Poloniex) $108 $94
Estimated mining gross profit/(loss) ($3,450,568) ($2,494,139)
Gross profit margin (76.9%) (64.0%)
Assume leased hashrate
Estimated leasing costs $14,608,345 $11,756,245
Estimated mining gross profit/(loss) ($10,119,595) ($7,861,120)

(Source: BitMEX Research, Poloniex for prices)

Flaws in the Above Analysis

The above gross profit margin charts do not show a complete picture. While the revenue figures are likely to be accurate, the only cost included is electricity. Obviously miners have other costs, such as the capital investment in the machinery as well as maintenance costs and building costs. Therefore, although the charts below show that the industry is highly profitable when only considering electricity costs, given other costs, the recent price crash is likely to have sent almost all the miners into the red. This indicates that miners invested too much in equipment and have achieved large negative ROIs.

Electricity Cost is Not Uniform

Another crucial point not reflected in the above analysis is the variance in electricity rates. The charts above assume a flat cost of $0.05 cent per KwH; however, not all miners have the same electricity costs and there will be a distribution.

As we mentioned above, 31% of the hashrate was shutdown in the period, logically those with the highest electricity costs should turn off their machines first. Therefore the average electricity cost on the network should have fallen considerably in the past month.

The below chart is an illustration of the above, it assumes that electricity costs are normally distributed with a standard deviation of $0.01 per KwH and that higher-cost miners switch their machines off first. Although this assumption is likely to be highly inaccurate and energy prices will not be normally distributed across the mining industry, from a macro level it illustrates a point and it may be more accurate than the above chart.

According to this analysis, average Bitcoin mining gross margins have only declined from around 50% to 40%, implying a far more healthy situation for the remaining miners.

Bitcoin Mining Gross Profit Margin (Illustrative)

(Source: BitMEX Research, Poloniex for prices)

When evaluating the potential negative impact of price declines on Bitcoin, analysts sometimes forget that not all miners have the same costs. It is these cost variances that should ensure the network continues to function smoothly despite large sudden price declines and allows the difficulty to adjust.

What Caused the Price Crash?

There has been considerable speculation around the causes of the price crash, with some saying miners sold Bitcoin in order to finance a costly hashwar in Bitcoin Cash. The cryptocurrency intelligence monitoring platform Boltzmann flagged to us that their platform had detected unusually large miner selling of Bitcoin on 12th November, a few days before the Bitcoin Cash split.

Boltzmann detected that net Bitcoin sales from miners were “17.5 standard deviations below [the] 3-month trailing average.” On further analysis, it appears these miners may have been a member of Slushpool.

Bitcoin miner net flow & price

(Source: Boltzmann, 12 hour aggregation of miner net flow)

Conclusion and Price Commentary

While it may be true that mining pools selling Bitcoin to fund losses in the Bitcoin Cash hashwar may have been a catalyst for the reduction in the price, we think it’s easy to overestimate the impact of this. We are in a bear market and prices are falling regardless of the news or investment flows.

Furthermore, in a bear market prices seem to fall on non-news or bad news and ignore good news, while in a bull market the reverse appears true. We think it’s likely that prices would have been weak regardless of any miner selling prior to the Bitcoin Cash split. For cryptocurrency, trader sentiment is king.

This is likely to be a very tough time for the mining industry. However, for miners with lower costs, our basic analysis indicates that the situation may be better than people expect. If the miners acquired their equipment from Bitmain at below-cost prices, they could still be in the green, even when including depreciation and other administrative expenses.

BlockMEX STO

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.

 

Polly Pocket Has Liquidity Issues

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.

The Confession

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

Judas is an Ethereum developer; he’s had some bad luck. He is now at Church giving a confession.

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.

Decentralise Zero

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.

Is The ETHUSD Swap Fairly Priced

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.

Bear Market Blues

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.

Stablecoins: Sophistry At Its Best

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.

XBT/USD Index Change Announcement

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