I’ll Take That

Building wealth is the easy part, securing and storing it for use by subsequent generations is very difficult.

Half a millennium ago, a wealthy family needed a private army to secure its land and wealth. If you couldn’t project violence in the defence of your assets, they would be forcibly taken by an opportunistic person.

As civilisations evolved and we entered the age of the nation state, society agreed that a centralised government should have a legal license to kill in order to secure the interests of property owners. Regardless of the economic “ism” a government claims to practice, the goal is the same. Protect a small group of asset holders against the hoard of commoners who might like to improve their lot at the expense of the elites.

Today the richest humans don’t command standing armies, and their holdings include financial and real assets. Stock and bond ownership relies on a central depository to affirm that you indeed are the owner. Government deed offices proclaim a piece of land or real estate is yours.

You are rich as long as the government allows you to be. The trappings of wealth can be taken at a whim. Should your actions upset a powerful state actor, your bank accounts will be frozen, and assets confiscated through the courts.

The recent Saudi corruption drive is case and point. Mohammad bin Salman (MBS), the crown prince of Saudi Arabia, is on a mission to wean the country off of oil. This is harder said than done, especially since the general population only complies because of generous government handouts. To beef up the government coffers, MBS did what all governments do, go after certain rich people.

MBS certainly wouldn’t subject himself to austerity. Last year he purchased a yacht worth over $500 million while at the same time slashing government spending.

Overnight some of the country’s richest members were herded to the Ritz Carlton, and placed under arrest owing to “corruption” charges. The most famous billionaire ensnared was Prince Alwaleed bin Talal. This Price is a world famous investor and has large stakes in some of the biggest tech darlings globally.

After a few days cooped up in the Ritz, MBS presented his chattel with a choice. Liquidate your assets and give the Saudi government up to 70%, or stay locked up. Even if a large percentage of your wealth is held offshore, due to information sharing between governments, MBS likely knows where the biggest nuggets are held. If he doesn’t think you have been forthcoming enough with the true state of your offshore wealth, well the Yemeni front line is awful fun these days.

Bitcoin presents a different way to secure wealth. Instead of trusting a government staffed with capricious humans, holders of Bitcoin trust cryptography and a decentralised network of profit motivated miners.

Bitcoin is less than a decade old, and is still very much an experiment. But if you possess a sum of wealth, it is prudent to diversify the networks used to secure it. Many people believe if they follow the “law”, they will be alright. However, laws change to serve the growth and power of the government writing them.

The government failures in Venezuela and Zimbabwe illustrate that in times of crisis Bitcoin can be used to grease the wheels of commerce. Unfortunately for most, it takes a time of crisis to elucidate the fatal flaws of a particular economic system. Only then will people take concrete actions, which only moments ago, were diametrically opposed to their belief system. At that point it’s too late.

BitMEX vs. CME Futures Guide

Bitcoin is at a watershed moment. The Chicago Mercantile Exchange (CME), the largest exchange globally by notional traded, deemed Bitcoin worthy of a futures contract. The contract will allow investors to speculate on the Bitcoin / USD price without owning Bitcoin. Prior to this contract, derivatives traders were required to own Bitcoin in order to post margin on futures trading platforms such as BitMEX.

Due to the different client bases that BitMEX (retail), and the CME (professional investors) serve, the price discrepancies between two futures contracts with the same underlying will present enormous opportunities to generate arbitrage profits. This guide will walk traders through how to execute such trades.

Contract Specs

Each CME contract is worth 5 Bitcoin (XBT), and quoted in USD. Margin and profit and loss (PNL) are denominated in USD. This is what I refer to as a linear contract structure.

CME XBT Value = 5 XBT * Contracts
CME USD Value = 5 XBT * Price * Contracts

Each BitMEX contract is worth 1 USD of Bitcoin, and quoted in USD. Margin and PNL are denominated in XBT. This is what I refer to as an inverse contract structure.

BitMEX XBT Value = 1/Price * 1 USD * Contracts
BitMEX USD Value = 1 USD * Contracts

The above chart shows the XBT value of each contract. The CME contract has a fixed value in Bitcoin no matter the spot price. The BitMEX contract’s Bitcoin value follows a 1/x function. Technically speaking the BitMEX multiplier is negative, even though in the graph uses a positive multiplier for a better visualisation.

Assume you are long 10,000 contracts at a price of $1,000.

XBT Value = 1/$1,000 * -1 USD * 10,000 = -10 XBT

Now the price falls to $500.

XBT Value = 1/$500 * -1 USD * 10,000 = -20 XBT

At a lower price, the XBT value is a larger negative number.

XBT PNL = -20 XBT - (-10 XBT) = -10 XBT

This means that the value in Bitcoin declines faster as the price falls, and increases slower as the price rises. That is negative gamma, or negative convexity.

The above chart shows the USD value of each contract. The CME contract’s USD value changes in a linear fashion with respect to the spot price. The BitMEX contract’s USD value is fixed at $1 per contract.

CME Contract Specs

Contract Size

The CME contract is much larger in notional terms than BitMEX’s. If the price of Bitcoin is $8,000, one CME contract is worth $40,000. To achieve a similar notional on BitMEX requires 40,000 contracts.

When I touch on spread trades later, the much larger CME notional means that only traders with large amounts of capital can put on these trades. This limiting factor, along with the lower leverage offered by the CME, means most retail traders will be unable to trade the CME product.

Settlement

The first major difference between the two contracts is the underlying index. The CME settles on the CME CF Bitcoin Reference Rate. This index includes prices from Bitstamp, Gdax, itBit, and Kraken. BitMEX settles on the BitMEX Index that includes Bitstamp and Gdax.

Traders who hold either contract to expiry will need to familiarise themselves with each index, and at a minimum be able to trade on all four exchanges.

Both BitMEX and the CME expire on the last Friday of the contract month. However, BitMEX expires at 12:00 UTC, while the CME expires at 16:00 London Time which is either 16:00 UTC or 15:00 UTC depending on daylight savings. Given that the expiry time differs by only 3 to 4 hours, there is little benefit to adjust the time value when computing relative basis.

Margin

Bitcoin is a call option. The more volatile it is, the more valuable the option. Due to an infinite upside, and a capped downside at 0, the trading pressure on the margin comes from longs. That means that market makers who are price neutral will usually be short derivatives. Their propensity to quote an offer depends on how easily it is to purchase spot Bitcoin, and how their short derivative is margined.

As I previously mentioned the BitMEX contract is margined in XBT. That means that shorts can purchase spot Bitcoin and use this as collateral against their BitMEX short. If you buy $1,000 of Bitcoin, deposit the full XBT notional with BitMEX, then short 1,000 BitMEX contracts, you cannot be liquidated if the price rises.

BitMEX shorts, due to the inverse contract structure, are long gamma in XBT terms. That means as the price rises, their unrealised losses increase less quickly. Therefore, BitMEX shorts can use more leverage than they otherwise would if the contract used a linear contract structure.

Contrast that with the CME, which margins the contract in USD. For a market maker who is short, their spot Bitcoin hedge cannot be used as margin at the CME. As the price rises, their Bitcoin is worth more; however those unrealised USD gains cannot be deposited as margin. The CME will demand more USD collateral as the unrealised losses mount.

This makes shorting the CME contract very capital intensive. A priori, I expect the CME contract to trade more expensive than BitMEX. CME shorts need to be compensated via a higher basis for their implicit short volatility position.

The CME intends to list a futures curve out to one year. The backend of the curve, due to a larger time value, will be illiquid when compared to the front months, and will trade at a very high basis.

I will now present two spread trades. Assume that you are a USD based investor.

Spread Trade: Long BitMEX vs. Short CME

Assume the following:

Leverage: 5x / Initial Margin of 20%

Spot = $8,000
BitMEX = $8,000
Contracts = Long 200,000
CME = $10,000
Contracts = Short 6
Spread = $2,000

First compute the XBT and USD exposures.

On BitMEX:
XBT Exposure: 200,000 Long Contracts / $8,000 = +25 XBT
USD Exposure: 200,000 Long Contracts * 1 USD = -$200,000
Margin Requirement: 20% * 25 XBT = 5 XBT
Collateral Currency Exposure vs. USD: +5 XBT / -$40,000 (Valued at the spot price)

On CME:
XBT Exposure: 6 Short Contracts * 5 XBT = -30 XBT
USD Exposure: 6 Short Contracts * 5 XBT * $10,000 = +$300,000
Margin Requirement: 20% * $300,000 = $60,000
Collateral Currency Exposure vs. USD = 0

Because you are a USD based investor, you must ensure that you do not have XBT/USD risk at any time. Due to the XBT BitMEX margin requirement, you must short an additional 1 CME contact to hedge the 5 XBT margin required on BitMEX.

Margin XBT/USD Price Risk:
BitMEX: +5 XBT / -$40,000
CME: -5 XBT / +$50,000 (Short 1 Contract)
Net: 0 XBT / +$10,000

Due to the CME’s higher basis, we earn carry on the BitMEX XBT collateral.

Spread XBT/USD Price Risk:

BitMEX: +25 XBT / -$200,000 (Long 200,000 Contracts)
CME: -25 XBT / +$250,000 (Short 5 Contracts)
Net: 0 XBT / +$50,000

As predicted, we earn $50,000 PNL from this spread trade. The below table stresses the portfolio on a large up and down move.

Price BMEX XBT PNL BMEX USD PNL CME USD PNL Total
$4,000 -25.00 XBT -$100,000 $150,000 $50,000
$8,000 0.00 XBT $0 $50,000 $50,000
$16,000 12.50 XBT $200,000 -$150,000 $50,000

The trade continues to return $50,000 regardless of the price movement. However, this is a leveraged trade, we must post additional margin on either BitMEX or the CME depending on the price move.

The below table summarises what actions must be taken to ensure we meet margin requirements.

Margin Action Currency Needed
Price Falls Buy then deposit XBT on BMEX, sell CME contracts XBT & USD
Price Rises Deposit USD to CME USD

Because we are short gamma on our long BitMEX position, we must post XBT and sell CME contracts to hedge the XBT collateral. Both of these derivatives require additional margin. On the upside, we only need to post additional USD with the CME. Depending on your cost of capital, a prolonged down move without any recovery could become very expensive.

Another issue is the sizing of this trade. Each CME contract is worth 5 XBT. If you wish to remain price neutral on your XBT collateral, a 5 XBT loss needs to be a small % with respect to your trade notional. Otherwise you will always be over and under hedged. The below table illustrates this point.

Entry Price: $8,000
Multiplier: -1 USD (for inverse contracts the multiplier is actually negative)

Contracts XBT Value Down % Move Up % Move
50,000 -6.25 XBT $4,444.44 -44.44% $40,000.00 400.00%
250,000 -31.25 XBT $6,896.55 -13.79% $9,523.81 19.05%
500,000 -62.50 XBT $7,407.41 -7.41% $8,695.65 8.70%
1,000,000 -125.00 XBT $7,692.31 -3.85% $8,333.33 4.17%
2,500,000 -312.50 XBT $7,874.02 -1.57% $8,130.08 1.63%
5,000,000 -625.00 XBT $7,936.51 -0.79% $8,064.52 0.81%

The % Move is a measure of how far the price needs to move up or down to generate a contract value change of 5 XBT. As you can see, go big or go home.

Spread Trade: Short BitMEX vs. Long CME

Assume the following:

Leverage: 5x / Initial Margin of 20%

Spot = $8,000
BitMEX = $10,000
Contracts = Short 250,000
CME = $8,000
Contracts = Long 5
Spread = $2,000

First compute the XBT and USD exposures.

On BitMEX:
XBT Exposure: 250,000 Short Contracts / $10,000 = -25 XBT
USD Exposure: 250,000 Short Contracts * 1 USD = +$250,000
Margin Requirement: 20% * 25 XBT = 5 XBT
Collateral Currency Exposure vs. USD: +5 XBT / -$40,000

In order to hedge the 5 XBT of margin required, sell an additional 50,000 BitMEX contracts.

XBT Exposure: 50,000 Short Contracts / $10,000 = -5 XBT
USD Exposure: 50,000 Short Contracts * 1 USD = +$50,000
Net: 0 XBT / $10,000

On CME:
XBT Exposure: 5 Long Contracts * 5 XBT = +25 XBT
USD Exposure: 5 Long Contracts * 5 XBT * $8,000 = -$200,000
Margin Requirement: 20% * $200,000 = $40,000
Collateral Currency Exposure vs. USD = 0

Spread XBT/USD Price Risk:
BitMEX: -25 XBT / +$250,000 (Short 250,000 Contracts)
CME: +25 XBT / -$200,000 (Long 5 Contracts)
Net: 0 XBT / +$50,000

As predicted, we earn $50,000 PNL from this spread trade. The below table stresses the portfolio on a large up and down move.

Price BMEX XBT PNL BMEX USD PNL CME USD PNL Total
$4,000 37.50 XBT $150,000 -$100,000 $50,000
$8,000 6.25 XBT $50,000 $0 $50,000
$16,000 -9.38 XBT -$150,000 $200,000 $50,000

The trade continues to return $50,000 regardless of the price movement. However, this is a leveraged trade, we must post additional margin on either BitMEX or the CME depending on the price move.

The below table summarises what actions must be taken to ensure we meet margin requirements.

Margin Action Currency Needed
Price Falls Deposit USD to CME USD
Price Rises Buy then deposit XBT on BMEX, sell BMEX contracts XBT

Because you have positive gamma on the short BitMEX position, you will not face a doubling of margin requirements when the price falls. This spread trade is more capital efficient; however, I doubt whether BitMEX will frequently trade more expensive than the CME for reasons described above.

Gap Risk

The CME does not trade over the weekend. Longs or shorts depending on the price action over the weekend, could be insta-rekt when the exchange reopens Sunday night US time.

Interactive Brokers, one of the CME’s clearing members, expressed severe reservations about this product due to the high volatility. They are scared shitless about how to deal with underwater shorts. It is not impossible for Bitcoin to gap up 100% in a matter of hours on positive news. Imagine what will happen when an ETF finally is approved.

BitMEX deals with gap risk via Auto-Deleveraging. The CME at the present moment cannot employ a socialised loss feature. Instead, clearing members must pony up the cash. That is why they are being such scaredy cats.

Depending on your broker, margin requirements for short positions could be extremely unforgiving. This will push CME basis up even further, and make putting on the spread trade described above, even more expensive.

Are You Yellow?

Arbitraging BitMEX vs. the CME requires a high level of trading sophistication and attention to detail. The different margin currencies and policies present many opportunities to transform what is a sure profit into a massive loss.

However, owing its the difficulty, these spread trades will be juicy. For students of markets, this is an arbitrage opportunity of a lifetime. Those who put in the time to perfect these strategies, will profit handsomely.

Smell That?

The putrid smell of Bitcoin shorts’ carcasses just became more pungent. The Bitcoin price pump from below $3,000 to almost $6,000 in under one month is truly astounding.

In that span of time China shut down three of the world’s largest exchanges. The New York Agreement signatories proceeded further with the scheduled SegWit2x hard fork. And heads of large banking institutions called Bitcoin a fraud.

Where to from here? How high can Bitcoin go? Is this just a flash of greatness to be followed by a century of misery?

The clues to the future of Bitcoin lie in the global currency and debt markets. The money printing orgy that allows central banks to monetise the debt of governments and large corporates created the environment for Bitcoin to thrive. Therefore, an examination of the total stock of money and government debt could give clues to the future price of Bitcoin.

From Investopedia:

M2 is a measure of the money supply that includes all elements of M1 as well as “near money.” M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits.

The government debt statistics are in USD billions were obtained from a Bank of International Settlements report. The data is as of 30 June 2017.

Money is not just M2, but in our financialised world, sovereign-credit acts as a very important monetary instrument. It is why many economists label the currency system a debt-based monetary system.

Other debt instruments such as corporate debt, provincial or municipal debt also function as money. Each country is different in the ways in which other types of debt function as money. To remain consistent I only considered government issued debt.

Gold (XAU) is the analogue “I don’t trust the government” monetary instrument. Bitcoin (XBT) appears to be the digital version. For gold and Bitcoin I used the current value of the total supply of each currency as its M2 value. For government debt, each has a value of 0.

The above chart depicts the relative size of M2 + Government Debt for the four most important fiat currencies (USD, EUR, JPY, and CNY), Gold, and Bitcoin. The first salient observation is that Bitcoin’s market value barely registers on the graph vs. these larger currencies.

Debt must be paid back at some point with base money, M2. Therefore the more debt a country has vs. it’s base money, the more leveraged their financial system. Governments usually don’t worry about how debt will be repaid because they can continue to issue new debt to pay off old.

However, when the market refuses to roll over debt an affordable interest rate, debt must be extinguished. One theory of how overly indebted governments could reduce the Debt / M2 leverage ratio is to tender debt-backed money at higher and higher prices for real money such as gold. Paul Brodsky in Apropos of Everything I, II, and III lays out an excellent argument for why central banks would extinguish debt-money vs. gold. I don’t believe it is likely that central banks will add Bitcoin to their pool of assets. The more likely scenario is that inflation sensitive investors will tender their debt-money for a relatively cheap real digital monetary instrument such as Bitcoin.

The only reason Bitcoin deserves treatment in is this thought experiment is that against all odds, it is still here after 9 years. The price after falling 80% from 2013 highs to 2015 lows, is now almost 5x higher than the previous 2013 all time high. The other positive aspect is that after years of ignoring Bitcoin, many financial institutions are investigating how they can play the game.

The aggregate amount of government debt outstanding for the four fiat currencies listed is $38,334 billion. At current prices, gold and Bitcoin are worth 20% and 0.25% of the aggregate government debt respectively.

If Bitcoin is digital gold, than theoretically it could reach the same ratio as gold relative to aggregate government debt. That implies a Bitcoin price of $461,333 or an 80x increase in price.

Modesty is a virtue. Assume that Bitcoin achieves a 1% valuation relative to aggregate government debt. That results in a price of $23,065 or a 4x return from current levels.

The battle for $10,000 is one of perception. Bitcoin is still not very useful as a pure monetary transaction instrument given its price volatility. However as a store of value, if savers view it as a hard form of digital money, they will diversify out of debt-money into Bitcoin. This psychological transformation is underway. The longer the price stays at these levels, the more people will believe Bitcoin will exist decades in the future.

Trading ShitCoin2x

The underlying index for BitMEX futures and swaps contracts on Bitcoin / USD and Bitcoin / JPY will not include the SegWit2x coin (B2X). Theoretically the futures and swaps should trade at a discount to reflect the B2X dividend received by all holders of Bitcoin on the ex-date. My trading thesis is that similar to the Bitcoin Cash hard fork, the futures and swaps will behave as expected.

Savvy and unemotional traders made significant profits without taking any price risk by taking advantage of the market dislocations. The following trade ideas will focus on the XBT/USD spot market, the XBTUSD swap, and the XBTZ17 futures contract.

Trades Pre-Fork

Given the market knows that BitMEX will not adjust the underlying indices, XBTZ17’s basis will trade lower to reflect the implied value of B2X. Thankfully due the current bull market, XBTZ17 trades at a positive basis. This is a perfect entry point for the following trade.

Sell XBTZ17 vs. Buy spot Bitcoin

A few exchanges (Coinbase & Bitfinex) have already announced that they will disperse B2X to all holders of Bitcoin on the ex-date in a 1:1 ratio. Therefore, once the spread is put on, the physical Bitcoin purchased as a hedge should be sent to any exchange that will split the coins for you. This allows you to sell any B2X received immediately. He who sells first, sells best.

On the ex-date (expected to be on or around November 20th), you will receive B2X in a 1:1 ratio. These B2X coins should be immediately sold for USD. At the same time, the futures should trade at a discount or negative basis. The short futures position must covered, and the physical Bitcoin hedge sold as well for USD.

Initial Trade:

Short XBTZ17
Long XBT

At Fork Time:

Receive B2X

Trade Unwind Proceedure:

Close XBTZ17, by buying
Sell XBT
Sell B2X

Trade Profit and Loss

Because you were able to enter the futures vs. spot trade at a positive basis, the B2X you sold is pure profit. Also, because you were able to cover the futures contracts at negative basis you will pick up additional basis related profit.

If the futures are trading at a discount when you entered the spread, then you must predict whether the percentage discount is less than the expected B2X / Bitcoin ratio. Or you must have a longer term positive view on the value of B2X.

What Can Go Wrong

If you entered the futures vs. spot trade at a positive basis and the fork does not occur, you will still profit. However, you will be required to hold the spread until expiry in late December. Depending on your hurdle rate, this opportunity cost may outweigh the basis profit received.

If you entered the futures vs. spot trade at a negative basis and the fork does not occur, you will post a loss in the amount of the negative basis.

When you unwind the futures vs. spot spread, the futures contract might trade at a large positive basis. If this happens, you must hold the spread until expiry. The only thing you lose is opportunity cost on the capital tied up in the position.

Right Before and During the Fork Trades

In the hours preceding the Bitcoin Cash fork, the XBTUSD swap traded at a large discount, and the funding was negative. A negative funding rate means that shorts pay longs. This discount is due to traders selling XBTUSD vs. buying Bitcoin spot right before the ex-date so they can “create” B2X without any price risk.

Or traders fearful of negative consequences for Bitcoin due the hard fork are locking in the USD value of their physical coins. The XBTZ17 futures contract will also be sold such that it exhibits a negative basis as well.

Traders may earn the B2X USD value synthetically by taking these countertrades.

Buy XBTUSD vs. Short Bitcoin spot

Profit is earned two ways. Firstly, XBTUSD’s basis will swing from negative to flat in the hours after the fork. Your are long the basis, therefore you profit. Secondly, the funding rate is negative. You will earn Bitcoin interest ever 8 hours while the rate is negative.

Buy XBTZ17 vs. Short Bitcoin spot

XBTZ17 should trade with a negative basis as well. Traders can purchase the futures contract, and sell it hours after the ex-date once the basis rebounds.

The one wrinkle to these trades is where to short Bitcoin spot. This is a very important consideration. If the exchange where you short Bitcoin forces shorts to deliver B2X, then the trade should not be put on. Additionally, borrow rates for Bitcoin will spike shortly before the ex-date. It is entirely possible that borrow fees eclipse the basis and funding profit earned on the long XBTUSD position.

Most exchanges that offer margin trading will not force shorts to deliver or cover B2X. Forcing a large number of shorts to cover in the illiquid B2X spot market could be disastrous. Therefore, most exchanges will not credit Bitcoin lenders with B2X or force Bitcoin shorts to deliver B2X.

Same Same But Different

Bitcoin and Money Services Businesses (MSB) find it very difficult to open and maintain bank accounts. The global hysteria over possible venues for money laundering (unless of course you are HSBC) has caused banks globally to curtail their support of MSB clients.

Several exchanges figured out that Taiwanese banks would bank them with minimal issues. The two most well known exchanges utilising Taiwanese bank accounts are Bitfinex and OKCoin International.

The American perception of Taiwanese banks lately is that of financial institutions with lax KYC / AML procedures. Read the following excerpt from a Reuters article about problems with Taiwan’s Mega Financial last October.

It is the second bank branch of the state-controlled firm to run afoul of U.S. financial authorities, after its New York branch was fined $180 million for lax compliance and anti-money laundering violations in August.

Mega Financial, which has close ties to Taiwan’s government, has been under scrutiny since about 200 of its customers were named in the so-called Panama Papers, a massive leak of documents from a Panamanian law firm that put the spotlight on the shadowy world of offshore companies used to avoid tax.

In order for Taiwanese banks to maintain their banking relationships in America, they must update their KYC / AML procedures for MSB clients. Unfortunately a large swath of MSB clients will be deemed too expensive to bank, and will be jettisoned.

Compliance is extremely expensive. Banks waste billions of USD a year on compliance and compliance related technology. It only serves to further protect incumbent financial institutions at the expense of small and innovative upstarts.

Bitfinex, OKCoin, and possibly other Bitcoin exchanges are affected. It may be that they have been told their accounts will not longer by active by a certain date. They are now scrambling for alternatives.

Bitfinex officially announced that both USD deposits and withdrawals are halted. OKCoin International has posted a notice that all USD deposits will be refused by their banking partner in Taiwan. Many old-timers know that the suspension of fiat deposits and withdrawals heralds tough times ahead for any Bitcoin exchange.

To some traders, this feeling is all too familiar. Mt Gox’s slow motion bankruptcy began in 2013 when their USD held in America was frozen. As users rushed for the exits, the Bitcoin thought to be held in custody was not there. In early 2014, Mt Gox shut its doors and filed for bankruptcy.

While traders are right to be nervous, it is not a given that Bitfinex and or OKCoin will be unable to operate. Yet, careful traders will take action. This post will examine how to get your money off the platform, and for those risk seeking traders, arbitrage opportunities that will arise during this time of stress.

Correspondent Banking

The biggest hurdle to successfully operating a Bitcoin/Fiat exchange is obtaining and maintaining a bank account. The quality of the banking relationships held by the exchange is a large success determining factor.

Most Taiwanese banks have branches throughout the Asia Pacific region. However, most do not have branches in the US. Ultimately that means that movement of USD between non-Taiwanese entities must pass through a correspondent bank in the US.

The correspondent bank is fully licensed to do business inside America, and can clear USD. Without the assistance of a correspondent bank, exchanges’ Taiwanese banks cannot process USD deposits and or withdrawals for foreign entities. Given that the majority of Bitfinex and OKCoin’s customers are not Taiwanese, most if not all incoming and outgoing USD must be processed with the assistance of a correspondent bank.

Wells Fargo, The Canary in the Coal Mine

In late March, according to a lawsuit filed by Bitfinex, Wells Fargo ceased processing outgoing USD SWIFT wire transfers from Bitfinex’s Taiwanese bank accounts. Wells Fargo is the correspondent bank for the various banks Bitfinex uses in Taiwan. The lawsuit alleged that $180 million of USD was effectively frozen.

This lawsuit is one of the only public windows the community received into the struggle between Taiwan banking institutions and their American correspondent banks. A similar situation may have occurred with OKCoin, but they did not choose to fight back through a public lawsuit.

Bitfinex vs. Wells Fargo Lawsuit

Get Me Outta Here

Bitfinex and OKCoin USD IOU holders are rightfully concerned. All is not lost. There are still ways to remove funds from these platforms.

The easiest way is for users to buy Bitcoin and withdraw it. Then they can sell that Bitcoin on another platform. As more users exit via this method, the price of Bitcoin rises on Bitfinex and OKCoin relative to other exchanges. Those exiting these exchanges are pushing up the price globally.

Users can use altcoins such as Litecoin or Ether to exit as well. At the time of writing, the Bitfinex premium to buy alts with USD is similar to buying Bitcoins. Given the low liquidity in altcoins, this may not be cheaper.

Bitfinex first indicated in a blog post,  that users could withdraw funds via Swiss Francs (CHF) and Hong Kong Dollars (HKD). However a few days later, they announced that their bank refused to process any outgoing wires in any currency.

The solution now put forward is to wash funds through their lawyer’s trust account. They claim that as creditors of Bitfinex, users can withdraw via this method only once. Those lucky enough to have domestic Taiwanese bank accounts face no issues withdrawing any fiat currency.

As of right now, OKCoin has not issued any announcements regarding the status of funds in their Taiwan bank accounts.

Arbitrage

Risk and profit seeking traders will be able to conduct arbitrage trades during this funding crunch. The trade I describe below is the most obvious.

  1. Buy Bitcoin outside of Bitfinex.
  2. Sell Bitcoin for USD on Bitfinex at a premium.
  3. Withdraw HKD to your bank account from Bitfinex.
  4. Wire the funds at your bank rate back into USD to a cheap Bitcoin/USD exchange.
  5. Rinse and repeat.

The ability to execute this trade is predicated on the ability to withdraw HKD or another fiat currency easily and quickly from Bitfinex. Given the recent updates, this assumption is questionable. All MSBs globally face similar issues, it may be weeks if not months before Bitfinex, OKCoin, or any other affected exchange is able to establish banking relationships again.

Due to the halt of Bitcoin withdrawals in China, XBT/CNY trades at a 15% discount to Bitstamp and GDAX. Therefore the premium on exchanges where fiat cannot be withdrawn, could easily reach a similar 15% premium.

Bitcoin / HKD: Bitfinex and OKCoin’s Savior

Days after filing, Bitfinex withdrew the lawsuit against Wells Fargo. Suing a correspondent bank in America may have been lights out for Bitfinex’s current and future banking relationships. To make matters worse, it may have attracted attention to other exchanges. If Wells Fargo is blocking Bitcoin exchanges, other banks should be thinking: should we block them too?

For now, there is still some hope. For every HKD issued, the Hong Kong Monetary Authority backs it with an equivalent amount of USD. The Hong Kong Monetary Authority will conduct open market operations to maintain a peg between 7.75 to 7.80 USD. While the peg holds, HKD is a liquid proxy for USD. If Bitfinex and or OKCoin can launch a liquid XBT/HKD market, they can continue to effectively serve as the most liquid XBT/USD spot markets.

Clearing HKD does not require funds to transit through the American banking system. Most of the world just wants to do business, and not worry about hypocritical moralising American politicians’ inspired regulations. Given enough effort, time, and willingness to pay high fees, exchanges will find banking partners willing to process HKD wires.

The on and off-ramps between digital currencies and fiat continue to cause significant friction. However, once traders squeeze through fiat gateways into the crypto universe, the trading opportunities are rich. If you desire a product to speculate on the value of Bitcoin without touching fiat, consider trading the BitMEX Bitcoin / USD Swap, XBTUSD.

Strongman Bullies and Bitcoin

Trump, Xi Jinping, Putin, and Erdogan: these four men are the embodiment of Strongman Bully leaders. Global trends indicate we will soon have more world leaders with similar mindsets.

Over the past 30 years, throngs of Chinese, Russians, and Turks have become rich. The masses held their tongue, while the elite shamelessly lined their pockets. In China, the wealth amassed in coastal cities like Shanghai, Beijing, Shenzhen, and Guangzhou stands in stark contrast to the developing and rural interior. Similar disparities exist in the metro areas of Russia and Turkey.

Xi, Putin, and Erdogan are all promising to restore the bargain with labour at the expense of capital. In previous decades, the masses have accepted disproportionally slow wage growth so long as their standard of living continued to increase. As global growth sputters, the bargain has become less tenable. The plebes are getting restless.

The marginal effectiveness of printing money to generate GDP output is waning. To make matters worse, population growth is shrinking in end markets like America and Europe. In response, central banks are reducing asset purchases. The net result will be higher interest rates and less trade.

All strongman bullies in all countries cannot be successful at the same time. Instead of trading for what they need, these leaders are likely to threaten to take what they need through war. A desperate leader can apply physical force to take resources, disrupt competing markets, and distract the local population from failed promises.

During times of war, assessing financial counterparty risk becomes a key investment survival skill. Will a USD deposit held in a Russian bank be worth the same as one held in an American bank? Every asset that you own must be evaluated on the basis of two concerns: beating domestic inflation and movement friction. In times of war, we are very likely to see inflation in necessity goods and deflation in other goods.

Where will the masses turn? Gold has value everywhere and is likely to triumph during these times. Recently, gold rallied when Trump authorised a missile strike against Syria, and when North Korea announced a potential nuclear missile test. Further rallies will come if global instability grows.

Bitcoin fits into this dynamic. Despite all of the issues it faces, it has persevered for over 8 years and still has substantial global value. Consider that as a vote of confidence in its ability to serve as a safe haven asset for a small pool of global capital.

Regardless of your political stance, the next 30 years will not be like the last. Highly intense regional conflicts are likely to flare up again. As desperate citizens look to store and transport wealth in the digital era, Bitcoin looks more attractive than ever.

The Rock Is In The Building

Litecoin is affectionately referred to as “rock” by many crypto traders. Litecoin has acted like a rock in trader’s bags since it hit its all time high of $40 in 2013. The technical merits of why Litecoin should be worth more than $0 are few and far between. Litecoin exists on life support only because Chinese traders for some reason enjoy trading it. Mainly that is because it is the only shitcoin the big three Chinese exchanges (BTCC, Huobi, OKCoin) offer.

During the current 2017 altcoin bubble, rock caught a stray bid. The pump and dump operators finally decided it was Litecoin’s time to shine. Rock is up almost 200% since late March.

The narrative supporting the rally is that SegWit is close to being activated. The activation threshold on Litecoin is 75% vs. 95% for Bitcoin. Litecoin is a CTRL+C, CTRL+V of Bitcoin. The slight changes include being Scrypt mined, and a block time of 2.5 minutes on average.

Many traders point to Litecoin as proof that if Bitcoin activates SegWit the price should explode higher as well. Some seriously delusional traders con themselves into believing Litecoin could actually serve as a replacement for Bitcoin if the Core vs. Bitcoin Unlimited civil war results in a contentious hard fork.

Oblivious traders are filling their bags with new shiny rocks. How do I know? Because in a recent tweet, Coinbase CEO Brian Armstrong said they will list a Litecoin / USD pair. Altcoin pumps begin in earnest on Poloniex, and end when exchanges such as Coinbase and / or Bitfinex decide to list them.

A recent example of this phenomenon was Ether in Spring 2016. After a lacklustre performance in the secondary market from listing in August 2015 until January 2016, Ether ignited and went asymptotic. The peak during that particular rally was reached when Bitfinex announced it would list ETH. As soon as ETH listed on Bitfinex, the dump began.

Exchanges late to the party, even BitMEX is guilty of this from time to time, signal that peak fomo is near. Those traders tempting fate by holding Litecoin should be cautious. It isn’t called rock for nothing.

Baby Got BOOST

Before today, I would have thought ASICBOOST was a new form of energy drink. It even could be the long awaited reincarnation of 4Loco. Sadly that would not be nerdy enough.

An email from Greg Maxwell made the rounds yesterday, and is causing an uproar. Bitcoin Magazine published an article about the email that is going viral throughout the Bitcoin industry.

TLDR

  • An unnamed leading mining equipment manufacturer is using a patented technology, called ASICBOOST, to achieve efficiency gains of up to 30%.
  • If activated, Segregated Witness (SegWit) would eliminate any advantage for miners using the ASICBOOST technology.
  • Therefore the reason why large miners refuse to support SegWit activation is because they would lose their economic advantage.
  • Maxwell proffered a Bitcoin Improvement Proposal to eliminate gains achieved by using the ASICBOOST technology.
  • Although not explicitly mentioned, everyone assumes Maxwell spoke of Jihan Wu’s Bitmain.

Let’s Assume It’s True

The purpose of this piece is not to argue whether or not I believe Maxwell. Rather I believe for good or bad, many in the community will agree with Maxwell’s analysis and there will be a discernible impact on the Bitcoin price.

My base case is that SegWit will not be activated, and there will be no hard fork this year. If Jihan Wu is truly a Chinese devil (or Gweilo if he was white), and can secretly mine Bitcoin 30% cheaper than everyone else, my base case will hold.

If Bitmain captures above average profits mining Bitcoin as it currently stands, they have no reason to actually desire a contentious hard fork. They also would not want SegWit to smash the piggy bank. Therefore the optimal strategy is to vocally support a hard fork to erode support for SegWit.

SegWit to many is a convoluted way to scale Bitcoin. Many would just prefer a simple increase in the block size from 1MB to 2MB. However, Bitmain would never go so far as to actually conduct said hard fork.

In essence, Jihan can buy a new pad on the Hong Kong Peak each year under the status quo. Despite high Bitcoin network transaction fees, the price keeps rising. Users prefer Bitcoin as a store of value and a global form of money good collateral, to a fast and cheap payments network.

A continuation of the status quo is bullish for the price. The price dipped from $1,200 to below $900 on fears of a paradigm shift. If you believe the arguments put forth by Maxwell, then it makes business sense for Jihan to prefer the current small block, high fee, rising price situation.

The Market Hath Spoken

The price is steadily rising post publication of said article. If the community believes in the veracity of the claims put forward, the price will shortly surpass $1,200 and retest $1,300.

I’m All Blocked Up

Will Segwit be activated? Will a hard fork occur? Will the block size ever increase? These are the burning questions that act as a drag on further Bitcoin price appreciation. I don’t know how it will all pan out, but that doesn’t mean that BitMEX can’t allow its clients the ability to profit by predicting how Bitcoin will or will not scale.

BitMEX is pleased to announce the launch of two prediction futures contracts themed around the ongoing Bitcoin scaling debate.

Segwit

SEGWIT, symbol: B_SEGWITZ17, is a prediction future on whether or not BIP141, also known as Segregated Witness, will be activated on the longest Bitcoin chain by the expiry date (31 December 2017, 12:00 UTC).

SEGWIT will settle at 100:

  • If BIP141 is activated during an “activation period” by the expiry date, and
  • The Bitcoin chain that activated SegWit must remain the Bitcoin chain with the largest hash power for 1,512 out of the following 2,016 blocks (75%). These 1,512 blocks must have passed by the expiry date.

SEGWIT will settle at 0 if the above conditions are not met.

What is an Activation Period?

An activation period spans one difficulty period (2016 blocks). 95% of the blocks mined during an activation period must signal acceptance of BIP141 for SegWit to be activated.

View Activation Periods

Big Blocks

BLOCKS, symbol: B_BLOCKSZ17, is a prediction future on whether a block larger than 1MB will be mined on the longest Bitcoin chain.

BLOCKS will settle at 100:

  • If a greater than 1MB block is mined on the Bitcoin chain with the largest hash power, and
  • If the Bitcoin chain that mined the greater than 1MB block must remain the Bitcoin chain with the largest hash power for 1,512 out of the following 2,016 blocks (75%). These 1,512 blocks must have passed by the expiry date.

BLOCKS will settle at 0 if the above conditions are not met.

Note that blocks of size > 1MB due to SegWit activation shall not mean a block greater than 1MB has been mined; BLOCKS is contingent on an actual base block size limit increase.

Trading Prediction Futures

Each contract can either settle at 100 or 0. The value of each contract is 0.0001 XBT multiplied by the futures price. For example, if you bought one contract at 50.00 , it would be worth 0.005 XBT. If the contract settled at 100, you would make 0.005 XBT. If the contract settled at 0, you would lose 0.005 XBT.

No leverage is offered on prediction futures contracts.

You will find all BitMEX prediction futures contracts under the tab entitled “Binary”. All prediction futures contracts’ symbols will begin with “B_”. This prefix denotes that contracts are binary, meaning they will either settle at 100 or 0.

Prediction Futures Series Guide

Hold The Line

Throughout China’s history, northern rulers struggled to effectively control those to the south and west of them. The varied ethnicities, topography, and economies of China meant that no ruler was able to retain absolute power for long. Due to relative global peace and globalisation since WW2, the Communist Party of China (CCP) has been able to maintain control by bribing the masses with employment.

Rich people don’t have kids. As a result, after the baby boom in the mid-20th century, the global developed and developing population rate has fallen or will soon fall below the replacement rate. The replacement rate is defined as a woman birthing 2.1 children over her productive lifetime. Africa is the one exception, but unfortunately their consumption power cannot replace dying first-world consumers.

Xi Jinping’s mission to solidify the political base of the Communist Party of China occurs at a time when global demand for goods is falling, wages in China are rising, and the population is aging. Any perceived threat to the continuation of the CCP’s rule cannot be tolerated. 99% of humans aren’t communist, capitalist or any other “ist”, they are hungry.

China must feed its billion plus population by providing employment. Without employment, young men transform from docile workers to cannon fodder for skilled orators and politicians.

These trends explain why this year’s National Congress is of extreme importance. Calm must be maintained at all costs. However, internal monetary pressures continue to build.

Grandma Yellen unleashed another 0.25% rate hike last week. She also did not alter the forward guidance. Another two rate hikes are expected this year, and some analysts believe the Fed could and should increase the pace of hikes.

The Fed should raise rates faster while the market shrugs them off. The S&P 500, which is the only economic indicator of importance, has not reacted negatively to rising rates. Yellen has cover to raise more aggressively. The higher rates go now, the more they can be cut when the next financial crisis strikes.

For China, USD interest rate normalisation puts increasing pressure on the CNY. In a normal year, this would not be an issue. The PBOC could raise rates onshore, or allow the CNY to weaken. However the directive is for a calm period before the National Congress.

The PBOC can’t materially tighten rates onshore lest they pop the gargantuan property bubble. The Chinese property market is a government sanctioned ponzi scheme. Developers, which are some of the most valuable companies in China, borrow money from financially repressed savers. The developers then purchase land from local governments, who “buy” land from their peasant subjects at below market rates.

The developer must build, sell, and refinance before the bill comes due for past loans. Should rates rise materially, developers will be forced to dump inventory en masse.

Over 70% of household wealth is trapped in property. Each time it appears that Beijing will allow the market to correct, they relent in the face of sure losses from a wide swath of the population.

Tiananmen Square essentially was an inflation inspired middle class protest against the CCP. However in 1989, the middle class were mostly teachers, in 2017 they are hundreds of millions of property punters. Impoverish them, and the CCP will see its mandate to rule evaporate.

The second option of a material currency devaluation is also off the table for the time being. A 20% to 30% one-off devaluation is needed. However, an action of that magnitude would portray China’s economy as both weak internally and externally. A perceived “weak” China will not be tolerated while the new leadership ascends.

A recent Bloomberg article illustrates that Xi Jinping is not relenting in his dive to tame China.

For the first time local party committees are using “negative lists” — including everything from bribe-taking to involvement with illegal construction projects — to screen delegations to the 19th Party Congress, which will set China’s political hierarchy for the next five years. A front-page article endorsing the moves in the party’s flagship People’s Daily newspaper Monday showed the push has support from the highest levels.

The negative lists — a concept often associated with trade negotiations in which anything not specifically mentioned is allowed — gives Xi yet another tool to shape the key party gathering in Beijing. While no date has been set, it’s expected to occur in the second half of the year.

The twice-a-decade congress is crucial for Xi to secure lasting influence beyond 2022, when his own tenure would be expected to end. At this year’s meeting, 11 of 25 Politburo members — including five of seven members on its supreme Standing Committee — could be replaced.

Bitcoin Withdrawals

Mandated by the PBOC, the large exchanges are implementing new KYC and AML policies. Certain accounts must now travel in person to the exchanges’ offices for physical checks of identity. If followed, this will make client onboarding expensive and extremely bureaucratic. The end result will be less people trading on exchange, and more trading on OTC platforms such as LocalBitcoins.

I believe that withdrawals will not resume until after the National Congress and a subsequent CNY devaluation. However, a recent notice from Huobi implies an imminent lifting of the withdrawal ban. To withdraw Bitcoin, clients must state and prove where the coins will go, and state the purpose of the withdrawal. Responses such as “I want to escape a weak CNY” will certainly not fly.

True to form, the government is saddling exchanges with needless bureaucracy to bankrupt those with weak balance sheets. The PBOC will keep inventing new KYC / AML policies until they are ready to allow Bitcoin to be freely traded again.

Unfortunately Chinese comrades aren’t stupid. They recognise the perilous state of the economy and still hold Bitcoin IOU’s on exchanges. The expected stampede for the exits by selling Bitcoin to withdraw CNY has not happened en masse. Held long enough, this Bitcoin IOU could protect wealth against the imminent devaluation. This is one reason why the price still hovers around $1,000.

OPEC : Oil :: Miners : Bitcoin

Jihan Wu, CEO of Bitmain the world’s largest operator and producer of mining equipment, made an apt comparison between the Bitcoin scaling issue and the oil market.

OPEC in their quest to maintain high oil prices sowed the seeds for American shale oil. The high oil price allowed engineers to explore and drill for more expensive shale oil. Shale oil’s extraction price continues to decline as technology improves. As the supply of oil increased, prices fell, and OPEC’s hold on the market withered.

According to Jihan, Bitcoin miners are like OPEC. A small number of players control the majority of the hashrate. Bitcoin transaction volumes have increased, but the network can only process a finite amount of transactions. Therefore, transaction fees rose alongside the price.

Miners are happy. Some users are not. As a work around, some developers (core) altered the Bitcoin protocol allowing it to process more transactions without the need for a larger miner produced hashrate. If these off-chain scaling solutions are successful (e.g. The Lightning Network), miner’s earnings from transaction fees could decline.

On the margin, either you view Bitcoin more as a store of value akin to gold, or a payments network. If Bitcoin is more a store of value, the price of transactions is of little concern. Gold is rarely used for day to day commerce. It is used to store large amounts of wealth, and as a settlement currency for large notional transactions. Therefore the velocity of gold is low.

If Bitcoin is more a decentralised payments network, then the price and speed of a transaction is paramount. Bitcoin must be able to compete with credit card networks such as Visa and Mastercard if it is to become a real payments solution. Currently Bitcoin is clunky and expensive and is no match to these incumbents.

If neither SegWit nor a block size increase reaches consensus, Bitcoin will continue to travel down the road to becoming another form of money good collateral that is expensive in small quantities to move. To many miners this is a perfectly acceptable solution as long as the price remains high. Given that blocks are full, transaction fees are high, and the price continues to rise, users view Bitcoin more a store of value than a payments protocol.

The question is, can another cryptocurrency become a store of value, and be cheap and fast to send. Should another coin achieve this feat, it will become a major challenger to Bitcoin. To date, no coin is within striking distance of Bitcoin. Many claim that Ether will unseat Bitcoin, but it does not command the same global mindspace as Bitcoin.

Will a group of miners engage in a contentious hard fork, I don’t know. But I do know humans. Humans are lazy and greedy. Regardless of the temper tantrums thrown on various social media platforms, miners care about their bottom line. Doing nothing will not harm them in the short to medium term.

A Bitcoin hard fork will not be as cute and cuddly as Ethereum’s. The Ether market cap was barely $1 billion when the DAO disaster necessitated a face saving hard fork. Bitcoin is worth $17 billion. The amount of money invested in mining equipment, exchanges, and wallets tailored for Bitcoin is orders of magnitude larger than for Ethereum.

A failed hard fork that leaves a minority chain commanding a double digit percent of the network hashing power will not be viewed kindly. Unlike Ether and Ether Classic, the sum of the newly formed majority and minority chains will be drastically lower than the pre-fork value of Bitcoin. Ether never positioned itself as a store of value or a payments protocol. It is fuel for decentralised applications.

Bitcoin’s value is its relative stability vs. other cryptocurrencies. Disrupt that stability and its status as the reserve currency of crypto will evaporate. The challenger that does emerge will certainly not use Bitcoin’s Proof of Work algorithm. If successful, the challenger will render all Bitcoin ASIC mining equipment worthless.

Is Jihan going to stake the future of his Billion dollar mining company on a hard fork that could go pear shaped? No chance.

Onwards and Upwards

“If you mess with the bull, You get the horns!”

A managing director on the sales trading desk at Deutsche Bank used to scream that out when the market ripped higher. Equities almost makes up for the lack of pay vs. fixed income by employing some of the most colourful characters.

What do you call Bitcoin sans China or an ETF approval? All Time High. Two of the most central bullish tenants have been removed, yet Bitcoin still trades above $1,200.

The next issue that could crater the price is the ongoing scaling debate. The Segwit vs. Bitcoin Unlimited civil war is spoken of not only where internet trolls hide, but also in mainstream financial news outlets such as Bloomberg. No matter, the price continues to slowly grind higher.

With the Mt. Gox all time high surpassed, we are in the beginning stages of a secular rally. This rally will completely re-rate the entire cryptocurrency complex. The Ether market cap is now over $2 billion. DASH continues to rip higher. Three cryptocurrencies with >$1 billion market caps would be something to behold. All hail Shitcoins.

What is encouraging about the 2017 Bitcoin rally is that realised volatility is muted. The above chart displays the 30 day realised volatility and the XBT/USD price. Volatility rose during the initial PBOC crackdown, but then continued to fall as the price surpassed $1,200.

For Bitcoin, this rally was calm. Traders are still in disbelief. While the price continues to crawl higher, haters keep hatin’ because of China, scaling, and or lack of legitimisation by regulators. While they wait, others get rich. As a result, the crack up boom (aka Fomo) phase has yet to begin.

Another encouraging sign is the relatively low basis level exhibited by futures contracts. During the first quarter, the BitMEX Bitcoin / USD 31 March 2017 Futures Contract, XBTH17, traded with a maximum outright basis of 10% – 13%.

During the 2013 bubble, the ICBIT March 2014 quarterly future, featuring only 3x leverage, traded at a 100% outright basis at the end of December 2013. Shortly thereafter, the price crashed below $1,000 then $800 then $600, and finally we entered a nuclear winter for two years.

The market has matured since then. However, the market fomo will manifest itself in a sky high basis for the soon to be listed 30 June 2017 futures contract, XBTM17. Basis even with constant selling pressure from cash and carry arbitrageurs, can and will go substantially high due to 100x leverage engjoyed by longs.

A sustained 30 day realised volatility over 100%, and elevated outright basis levels of over 30% on XBTM17, will provide clues during the second quarter as to whether Bitcoin’s run is nearing completion. As the intensity of price action accelerates, the next upside physiological barrier is $2,000.