$5,000 Bitcoin, A Local Bottom

20 August 201830 March 2019 Arthur Hayes

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

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

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

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

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

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

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

When in Doubt, IPO

Everyone is talking about the Bitmain IPO. Running a public company once you get past the initial ego boost is sub-optimal. One of the main reasons why companies IPO is for long-term investors, employees, and management to cash out at a high multiple. Companies also IPO to raise large amounts of capital to fund expansion efforts.

As a public company, the scrutiny on operations is never ending. Say the wrong thing and you could be in court for years. Do you think Mark Zuckerberg likes being publicly lambasted by know-nothing congressmen and women? If Tesla didn’t need to raise so much money by selling equity in the public markets, I’m sure Elon would have kept it private.

Bitmain is crypto’s most valuable and most profitable company. If the figures publicised are taken as gospel, then they generated over US$2 billion of profit in 2017. Unlike many manufacturers, Bitmain’s clients pre-pay their orders. The only pre-sale outlay is their down payment for chips with their main foundry.

Bitmain has a cash cow business but now wants to IPO. The company does not need capital to fund or expand its business. They have plenty of free cash flow to direct towards R&D. They don’t need to acquire distribution channels by slashing prices since they hold the largest market share. The only conclusion is that they believe the medium-term profitability of mining will decline sharply.

While Bitmain attempts to sell the market on their AI chip growth strategy, the truth is they are a crypto company through and through. Crypto companies trade at massive price to earnings discounts against similar companies in comparable industries.

I speculate that the crypto exchanges that sold this year, Poloniex and Bitstamp, traded at 4x to 6x P/E. [The Bitstamp sale has not been confirmed, but various crypto news outlets reported that a sale likely happened in early 2018]. Public exchanges like ICE and the CME, trade 20x to 30x P/E. During a massive crypto bull market like in 4Q2017, the public markets might pay up, but not when Bitcoin is down 70%.

I further speculate that Bitmain is attempting to top-tick the market before mining profitability slides dramatically. Management takes the view that the price will likely continue down towards $5,000, and possibly below. At these prices sales of their flagship S9 miner will plummet. An IPO allows them to crystallise gains now, and become cash-rich during a bear market. With this war chest, they can acquire some of their less financially well-endowed competitors. When the market turns, they will be in pole position with no challengers in sight.

Upside Risks – SEC Approved ETF

In late September, the SEC will rule on a number of ETF applications. Will they cave to popular pressure? Crypto, even while down 70%, is way more exciting than any other asset class. The exchanges, asset managers, and white-shoe investment banks all want in. The only inhibiting factor is regulators.

With enough K-street lobbyists, you can convince a US member of congress that the world is flat and the earth is the center of the universe. If the crypto lobby prevails on the SEC, and an ETF is approved, watch out for the mother of all short squeezes.

Ether, A Double Digit Shitcoin

20 August 201830 March 2019 Arthur Hayes

It all started in Feb 2017 on a beach in southern Thailand. Thailand’s king passed a few months prior, so the party atmosphere was subdued. Accompanied by a good friend of mine and one of the best shitcoin traders in the game, we headed down the beach in search of a party.

One of his big shitcoin positions at the time was Pepe Cash. This was the precursor to Crypto Kitties. For those not in the know, PepeCash is “rare pepe” memes hashed onto a blockchain. The next killer app to be sure. Pepe Cash was on a mini run, and my boy constantly monitored the market.

We didn’t find a poppin’ party, but we did find special shakes. The bartender didn’t think we were sideways enough so he went in the back to get the real stuff. Over the next few hours we walked for miles, met interesting tourists and locals, and waxed philosophical about shitcoins.

On our ride back to our hotel, I noticed something strange. Our Tuk Tuk driver was wearing a trucker hat with a Pepe the Frog logo on it. Not trusting my eyes, I nudged my friend to confirm what I saw. He concurred that our driver was sporting a Pepe hat. My friend immediately whipped out his phone to check the market. Perhaps they saw what we did. Pepe Cash was pumping and he bought some more.

We both looked at each other and knew it was a sign that something special would happen in 2017. What actually happened was far beyond what we could have ever imagined.

The real profit in 2017 was made by Ether holders, shitcoin projects, and promoters. The seed capital for many of the venerated crypto hedge funds emanated from outsized returns on holdings of Ether and token projects.

Jealous traditional VCs transformed portions of their funds into poorly designed hedge funds so that they too could punt shitcoins. Everyone piled info the same deals, all thinking they “got it”. That worked well all of 2017.

Today, Ether slides towards $200. At best, many token projects are down 50% from 2017. At worst, they are slightly above than zero.

This begs the questions:

Did any funds actually realise any of their outstanding 2016 profits?
Can VC-turned-hedge-fund-punters psychologically handle mark-to-market losses?
How many token projects actually sold a large or hedged portion of the Ether they raised?

Big Door In, Small Door Out

One of the first things you learn as an Asia Pacific trader: how you exit a position is more important than how you enter.

My first trading book was the Vietnam certificates book. Our desk issued USD denominated certificates on a basket of Vietnamese stocks. Calling the Vietnamese stock market “Mickey Mouse” would have been a compliment in 2009.

You could only go one way per trading day on a particular stock. If you bought, you could only continue buying intraday, you could not sell. There was a 5% limit up and down each day; any stock in the news would hit either of those limits immediately in the morning auction. That meant you had to fax your orders into the broker and make sure you got in the queue as early as possible. Unfortunately, sometimes your broker front ran you because they knew you had size to trade in a particular stock.

My boss encouraged me to take a view on the market. Given the structure of the market, if I took a position, I was stuck with it for a while. And when I wished to exit, I would have to sell into strength or buy weakness to get out of a long or short position respectively.

When I became an ETF market maker, I routinely traded other “Mickey Mouse” markets like India, Indonesia, and China just to name a few. These markets were and still are marked by snap decisions (often overnight) by regulators which adversely affect traders who aren’t politically connected. I became obsessed with how to get out of any position: a trait which serves me well in the crypto markets.

My first boss taught me that everything was my fault as the trader. Obviously there are many things outside of your control, but if you approach your profession with that mentality you attempt to quantify and mitigate all of the risks within your control.

The point of my sermon is that most VC investors do not approach their investments with this mentality. Due to the illiquidity of their investments, they can mark to fantasy, show amazing returns on paper, and get paid. The only secondary market validation of their investments is the next round of fundraising, which can easily always go up if you get your boys to go in along with you. You pump my bags, I’ll pump yours.

VC investors loved ICOs in the bull market because they could point to an objective and liquid secondary market valuation. They used these eye-popping returns to raise bigger shitcoin funds in 2017, and early 2018. However, objectivity and transparency is undesirable when your shitcoin portfolio is down by a minimum of 50%. Depending on the vintage of the fund, it might be up, however, most money was raised and invested in 2H2017 to 2H2018. That means the suckers who invested recently are most likely down.

The VC investor who has never suffered the vagaries of the market is as green as the noob who thinks he or she can go from 1 to 100 Bitcoin in a few trading days. They don’t have the mental strength to cut positions to limit further losses, or backup the truck and buy opportune dips even though they are down. More importantly, LPs can now see an objective last price for a particular token, and can’t be hoodwinked. They will attempt to be a Monday morning quarterback, and that only adds to the VC investors’ anxiety. At a certain point, they go “fuck it”, and dump everything they can.

It is this moment, that Ether goes from a 3-digit to a 2-digit shitcoin.

Concentration Risk

Before the SAFT and other private token placement monstrosities, the majority of money was raised from retail token punters. Now that projects are scared of federal pound-me-in-the-ass prison, they mostly only accept accredited investors.

Accredited investors always had a way into new technology projects due to their wealth and access. This pool of investors is also highly concentrated. The number of funds that can spray $1 to $5 million into every vapourware project that agrees with their sector thesis is limited. However, these gatekeepers control a vast ocean of institutional money. Softbank’s Vision Fund is $100 billion.

So instead of a more dispersed pool of investors, the number of token holders of projects raising serious money decreased dramatically starting in mid-2017. The liquidation preferences went from dispersed along a price curve, to very concentrated.

VCs all compete with each other for the same pools of capital. These pools of capital all employ professionals from the same schools, and who passed the same financial certification tests. Therefore they will buy together and sell together. The biggest risk in the money management game is career risk. Better to lose money with everyone else, than lose money alone. The latter will cost you your job. And there ain’t no other profession that pays as well as financial services relative to the skills needed to be a practitioner. I remember one of my besties trying to argue he had skills because he could calculate the NAV of an ETF using the sumproduct() function on his excel sheet. #Delusional.

The herd of token VC punters will all decide to sell at the same time. If you don’t sell, and the market continues falling, you lose your job. So everyone sells simultaneously but who can eat all that shit? Retail cannot because the deals would never have gotten so large without institutional money. So we gap lower, first on tokens, then on the mothership Ether.

I don’t know what that tipping point will be, but in hindsight, it will be obvious when the capitulation occurs. There are those who believe that a sustainable token economy can exist. But they won’t be buying at these levels. Sub-$100 takes us back to Spring 2017 levels. At those depressed prices, the carrion is ripe for ingestion.

ETHUSD Perpetual Swap Two Week Update

20 August 201830 March 2019 Arthur Hayes

One of our strengths at BitMEX is financial innovation. We created the XBTUSD perpetual swap, a truly unique product to any financial market. XBTUSD is now the most liquid crypto instrument globally by a factor of 10 and has been emulated by a half dozen crypto markets.

On the back of that success, BitMEX has created a way to replicate the same Bitcoin-margined perpetual swap but on Ether / USD via a quanto pricing model. This product is the ETHUSD perpetual swap. In just under two weeks, this product has become the most liquid Ether / USD (or USD equivalent) pair globally, and has proven to be a vital instrument in speculating or hedging on the ETH/USD price pair.

In the last 24 hours, BitMEX’s ETHUSD swap has traded the equivalent of 800,000 ETH. The next most liquid ETH/USD and ETH/USDT markets, Bitfinex and Binance, traded just under 500,000 ETH each in the same period.

If you are still unsure on the pricing or trading of this instrument, please take a look back at our newsletter from last week where we run through multiple worked examples on hedging and speculating. To aid in your understanding, we have also created a downloadable spreadsheet to work through the math.

Hedging a Quanto Perpetual Swap

14 August 201830 March 2019 Arthur Hayes

Hedging a quanto perpetual swap is not straightforward. The added component of correlation risk between two crypto assets complicates things. I will take things from first principles, then provide a more general formula.

Assumptions:
Symbol: ETHUSD Multiplier: 0.000001 XBT ETHUSD Price: $500 .BETH (ETH/USD Spot Index): $500 .BXBT (XBT/USD Spot Index): $10,000

Scenario 1 – Short ETHUSD and Hedge

You are lifted for 100,000 contracts of ETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * -100,000 = -50 XBT ETH Value = XBT Value / [ .BETH / .BXBT ] = -1,000 ETH

Next you hedge your ETH/USD exposure by purchasing 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase.

You have hedged your underlying currency exposure. At this point your exposure is perfectly hedged. However, as the price of ETHUSD changes, your PNL on ETHUSD will be in XBT, while the PNL on your ETH hedge will be in USD.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts = -25 XBT, USD Value -$125,000

ETH Spot USD PNL = (.BETH Exit Price - .BETH Entry Price) * # ETH = $250,000

Net USD PNL = ETHUSD XBT PNL in USD + ETH Spot USD PNL = +$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you made money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = -25 XBT, USD Value -$375,000 ETH Spot USD PNL = $250,000 Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you lost money.

The short ETHUSD position + Hedge profited when correlation fell, and lost when the correlation rose. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

Scenario 2: Long ETHUSD and Hedge

You are hit for 100,000 contracts ofETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * 100,000 = 50 XBT ETH Value = XBT Value / [ .BETH / .BXBT ] = 1,000 ETH

Next you hedge your ETH/USD exposure by shorting 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase, and there is no cost to borrow ETH for this short sell.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL = 25 XBT, USD Value $125,000 ETH Spot USD PNL = -$250,000 Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you lost money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = 25 XBT, USD Value $375,000 ETH Spot USD PNL = -$250,000 Net USD PNL = $125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you made money.

The short ETHUSD position + Hedge profited when correlation rose, and lost when the correlation fell. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

The below table summaries the two scenarios:

Time Horizon

The correlation between XBT and ETH is not static. The longer you hold a hedged swap position, the more chance that the correlation regime you expect based on the recent past, will change.

Unlike a futures contract, the ETHUSD swap has no expiration date. Therefore your quanto risk is specific to your time horizon. For market makers who are in and out quickly, the quanto effect is negligible. For cash and carry market makers who hold a position for an extended period of time to capture funding, the quanto effect can destroy one’s PNL.

Covariance

Many market makers will not be satisfied leaving their correlation risk unhedged. They will constantly hedge their PNL on the BitMEX and spot leg of their portfolio. Depending on the XBT and ETH volatility, and their correlation, the covariance will determine whether the hedging of PNL positively or negatively impacts your overall profits. If both assets are highly volatile and the correlation is moving in or out of your favour, your gains or losses from hedging the PNL are amplified.

We are in uncharted territory. In a few month’s time, I will observe the past data and attempt to calculate what portion of the funding is attributed to market makers pricing in a quanto risk, and what portion is due to the interest rate differentials between ETH and USD.

Quanto for Speculators

14 August 201830 March 2019 Arthur Hayes

Speculators care about obtaining exposure to risk. How they get that exposure if they can get in and out cheaply is secondary. If BitMEX is able to create a liquid market for Bitcoin quanto’ed derivatives, speculators will flock to them.

As I previously explained in “Why Quanto?”, in order for BitMEX to offer ETH/USD risk, we had to quanto into Bitcoin. This post will explore the concepts speculators care about.

For all the below examples we will use the following assumptions:

Contract: ETHUSD
Multiplier: 0.000001 XBT per 1 USD
Contracts: 10,000

Contract Value

The most important aspect to a speculator is the contract’s payoff function. Since we are speculating on the ETH/USD price, ideally the contract’s Bitcoin value should increase and decrease in a linear fashion with respect to the ETH/USD price.

I assume the speculator denominates their profit in Bitcoin (XBT) terms. Therefore the value of Bitcoin in USD terms at a particular ETH/USD price is irrelevant. Put simply, the speculator wants to use Bitcoin as a margin to earn more Bitcoin.

The above chart illustrates that at different ETHUSD values, the XBT value of the position changes linearly. That is exactly what the speculator desires.

XBT Value = ETHUSD Price * Multiplier * # Contracts

Calculating Margin

How is the amount of Bitcoin margin calculated? The initial margin for the ETHUSD contract is 2%, or 50x leverage.

Initial Margin (IM) = 2% * XBT Value

If you enter the trade at an ETHUSD Price of $500, this is your initial margin requirement:

IM = 2% * $500 * 0.000001 XBT * 10,000 = 0.10 XBT

The next important consideration is what is your liquidation price. That is determined by the maintenance margin. The maintenance margin for the ETHUSD contract is 1%. If the underlying ETH/USD spot price declines by 1%, you will be liquidated.

Calculating Profit and Loss (PNL)

The PNL is denominated in Bitcoin. In Bitcoin terms, the PNL changes linearly with the ETHUSD price. If the contract goes up 1%, your Bitcoin PNL also goes up 1%. The chart above illustrates that.

XBT PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts

In the above example, if the ETHUSD price moves from $500 to $600, this is the XBT PNL:

XBT PNL = ($600 - $500) * 0.000001 XBT * 10,000 = 1 XBT

Number of Contracts

To get a certain amount of Bitcoin exposure requires a little math.

The following describes how to calculate how many contracts it takes to equal a desired Bitcoin notional.

Contracts = XBT Notional / [ ETHUSD Price * Multiplier ]

If you want 100 XBT of risk, how many contracts of ETHUSD must you trade:

Contracts = 100 XBT / [ $500 * 0.000001 XBT ] = 200,000 Contracts

The quanto structure satisfies the desires of a Bitcoin-based speculator. The major components that speculators care about all vary linearly with respect to the ETH/USD price. The relative rich or cheapness of the contract vs. the underlying is not a major concern if the contract is liquid.

The factors that govern whether the contract will be at a premium or discount will be explored in the subsequent piece. These considerations heavily depend on how to hedge a quanto derivative from first principles. The hedging of the contract is where the non-linear effects matter.

Why Quanto?

14 August 201830 March 2019 Arthur Hayes

The USD is the biggest shitcoin out there. However, all assets are priced against it. Crypto is not immune. The Bitcoin / USD price is the most important cross in the crypto asset universe.

Moving into the altcoin space, the most active crosses are against the USD as well. To replicate our inverse style derivatives on an altcoin / USD cross requires us to accept the altcoin in question as collateral. The next natural altcoin BitMEX could accept is Ether. However, to fit into our multi-sig security process, it requires us to use/code an Ethereum multi-sig smart contract.

Unfortunately, due to various exploits of popular Ethereum multi-sig smart contracts, we never felt comfortable custodying Ether. Rule 1, to infinity minus 1, of operating a crypto trading platform, is don’t lose the crypto. Anything we can do to limit our risk surface area we must do. Therefore, taking Ether as collateral given the current state of the protocol is a non-starter.

Given these constraints, we cannot launch an Ether margined inverse ETHUSD contract. An inverse style contract is one where the margin and PNL currency is denominated in the home currency (ETH), the quote currency is denominated in the foreign currency (USD), and the contract value is a nominal amount of the foreign currency (USD).

Inverse Contract Example: XBTUSD Swap

Margin Currency: XBT (Bitcoin) Quote Currency: USD Contract Value: $1

In order to offer risk on ETH/USD where Bitcoin is used as the margin and PNL currency, the quanto derivative type is necessary.

From Wikipedia:

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.

Quantos are exotic derivatives that can move non-linearly with respect to the underlying. However, they are very beneficial for speculators and hedgers in search of liquidity, where they can post margin in a currency in which they feel comfortable. In my time as a delta one trader, we routinely traded USD quanto derivatives to get exposure to local currency futures contracts in countries that restricted the trading ability of foreigners (e.g. India and Taiwan).

The recently launched BitMEX ETHUSD Perpetual Swap is a quanto derivative. The contract pays out 0.000001 XBT per 1 USD. This means that the Bitcoin multiplier is constant regardless of the nominal USD price of ETH. This is great for speculators, the Bitcoin return varies linearly with respect to the ETHUSD price. For those using this contract to hedge the ETH/USD cross or market makers, it gets a bit trickier. I will get into the mechanics of hedging and market-making later in this newsletter.

Quanto Worked Example Spreadsheet
We have created a spreadsheet for users to download and work through some of the below use cases that can be accessed here.

Announcing the new ETHUSD Perpetual Contract

3 August 201830 March 2019 Arthur Hayes

On the back of the success of the XBTUSD Perpetual Contract, Bitcoin’s most liquid market, BitMEX is proud to launch the all-new ETHUSD Perpetual Contract.

Trading is now live! Full contract specs are available here and summarised below:

Symbol: ETHUSD
Expiry Date: Perpetual
Bitcoin Multiplier: 0.000001 XBT (100 Satoshis)
XBT Contract Value: ETHUSD Price * Bitcoin Multiplier (100 Sat/$1)
Underlying: .BETH (Bitstamp, GDAX, and Kraken equally weighted)
Max Leverage: 50x
Funding Min/Max: -0.75% to 0.75%
Session Interval: 8 hours

Calling the Curve

10 July 201830 March 2019 Arthur Hayes

The BitMEX Bitcoin / USD 28 December 2018 futures contract, XBTZ18, recently began trading. The following trade ideas assume that spot in the short term will continue to fall and bottom in 3Q2018, and then aggressively rebound into 4Q2018. This scenario also assumes that trader sentiment will not fall out and enter a protracted bear market.

However, if you have very high conviction in that scenario, the riskiest and potentially most profitable strategy would be to:

Go short XBTU18 from now until you believe Bitcoin has bottomed.
Cover the short XBTU18, and then go long XBTZ18.

The reason to go short the 3m initially is that it should be more responsive to spot movements due to its lower time value. It is also more liquid so panicked speculators and hedgers will use that futures contract. Its annualised basis should trade at a steeper discount than XBTZ18.

You go long XBTZ18 on the rebound because it has more time value. If the market does perform as you expect, speculators will bid up the backend of the curve. A lot of things can happen by the end of December. Given that Bitcoin is a call option, the future implied volatility has a greater probability of causing the price to rise rather than fall. The more time value housed in the instrument you are trading, the better change the long convexity can work in your favour.

If you believe this a credible sequence of events, but want to reduce risk, a spread trade is advisable. The reduced risk comes at a the cost of reduced profit potential.

Go short XBTU18 vs. long XBTZ18 from now until you believe Bitcoin has bottomed.
Replace the above short XBTU18 with a short on XBTUSD

Because you expect the sell pressure to happen at the short-end of the curve, the term structure will steepen causing the profit made on the short XBTU18 position to offset losses on the long XBTZ18 position. The term structure chart shown above shows the current curvature of the BitMEX Bitcoin / USD futures markets. It is relatively flat, which indicates now is the time to enter into this spread trade.

This is a price neutral trade; however, be aware that each position is margined separately. Unrealised profit from the short XBTU18 position cannot be used to offset unrealised losses from the long XBTZ18 position.

The second trade is a funding plus long 6m basis trade. As the market rebounds, the swap will be pushed into a premium which means shorts will receive funding. The long end of the curve will also get bid up in annualised basis terms due to the greater time value. You earn money from the swap funding, and futures basis appreciation. Again this trade is price neutral, and you must be cognizant of each positions’ margin.

The reason why I prefer the use of spread trades to express directional moves is that if my prediction is wrong, it does not destroy my capital base. The more conviction around the prediction, the more leverage I employ on each leg to juice up my return on equity.

The Volatility Blues

10 July 201830 March 2019 Arthur Hayes

The anguish experienced by traders worldwide during the $20,000 to $6,000 slide further proves that recently experienced losses matter more than gains. The financial media and many traders forget that 18 months ago the price was $1,000 and then in the fall of 2015 the price was $200.

Jonny-come-lately traders / investors were eviscerated by the recent moves. To make matters worse, the volatility collapsed alongside the price. For crypto, this is deadlier than white wine and painkillers.

But what about adoption? One of the major facets of Bitcoin preventing further adoption is its high volatility. In a pure Bitcoin economy, how can people trade Bitcoin against real goods if its value violently fluctuates? The underwater trader laments that the market just doesn’t get the “fundamental” value of this new transaction network. Well, what transaction network’s monetary token do you know increased 20x in value in under one year? None. Therefore, the driving force is not about current utility but intense speculation on future utility.

Changing the way in which humans use money is an extremely long and difficult process. This process by its nature must be chaotic. Money and the means by which it is handled is personal and sometimes religious. If you tell a society that tomorrow things will be done differently than how they were done over the past 200 years, there will be an intense reticence to change. A violent upheaval is necessary. Therefore, if Bitcoin is to be used in any productive manner, the period leading up to this new epoch must be extremely volatile.

Bitcoin is a call option on a new monetary system. The most important option pricing input is the underlying asset’s implied volatility. As the above chart illustrates, the realised 30-day annualised volatility crashed alongside the price. When volatility returns, the price will go higher.

We Have Been Here Before

The nuclear bear market of 2015 started in January when the price broke $300. For the next 10 months, the price traded between $200 and $300. While that is a 50% range, the daily movements were very slight.

Without volatility, many traders, investors, and market commentators wrote off Bitcoin. Why should one care about an asset that has crashed over 80% from its recent all-time high, and has barely moved since?

Traders returned to the market because the volatility re-emerged. If Bitcoin can gyrate 100% in annualised volatility terms in a 30-day period, then quick gains can be made. The FOMO “investors” who believe they can change their lot in life with little effort and in little time took us from $200 to $20,000. There were not many things that fundamentally changed about the adoption of Bitcoin in real commerce from 2015 to 2017.

Return to $20,000

The path to parity will not begin in earnest until volatility rises materially. People need to be excited again. 10% pump & dumps in one day will bring back the good times. The real questions are what catalyst will start the party again, and how long will it take.

During the 2017 bull market, the effect of global macro events on Bitcoin was forgotten. For 2H2018, a global macro event will have to prove that Bitcoin is a safe-haven asset. In 2015 Greece almost told Frau Merkel to do one, but chickened out at the crossroads. Bitcoin responded positively when the market believed Greece could actually liberate itself. If a similar type scare happened later this year, would Bitcoin regain its safe haven status?

With the Fed, ECB, and BOJ effectively flatlining or outright reducing their balance sheets, cracks in the financial markets will show later this year. Money printing has never led to prosperity in the long run, and when you shut off the tap the ghosts and ghouls of the financial markets will play.

The MSM Still Loves Bitcoin

Thankfully the mainstream financial press loves talking about crypto. The personalities of the leading figures are larger than life. Even at Bitcoin $6,000 and Ether $400 a whole cadre of individuals are generationally wealthy, and are making interesting life choices the media can’t stop covering. In 2015 no one was watching, in 2018 everyone is.

In order to prove their prescience, MSM outlets will fall over themselves attempting to call the bottom in Bitcoin. The foolish many who believe these pundits actually can divine the future will attempt to knife catch. Many will fail, but if enough try, some will succeed. These successful retail punters will be paraded on the airwaves as trading gods. This will further increase the FOMO, volatility, and price appreciation.

Nothing goes up or down in a straight line. I still haven’t seen enough pain and anguish to believe we are done bloodletting. In true Bitcoin fashion, the price will go to the level no one thinks is possible and rebound faster than traders can work up the nerve to BTFD.

Waiting for Godot

4 June 20184 June 2018 Arthur Hayes

“Nothing happens. Nobody comes, nobody goes. It’s awful.”
― Samuel Beckett, Waiting for Godot

The crypto community has been waiting for a variety of Godots since its inception. For traders, our Godot is the mythical Institutional Investor. When they get involved in a big way, our bags will transform into Lambos, and we will live happily ever after. When they get involved, liquidity will magically improve and the market will “behave” as it is supposed to.

Many crypto commentators including myself, proclaimed 2018 as the year institutional investors get involved in a big way. This flood of new money would help support a Bitcoin price above $10,000; and take us to Valhalla in short order.

With northern hemispheric summer approaching, are institutional investors actually flocking to our new space? News of a Goldman and JP Morgan crypto trading desk aside, what is the best proxy for insto interest in crypto?

The CME and CBOE Bitcoin futures contracts trading volumes are the best proxy. Both of these contracts are USD margined and settled. Anyone who trades these contracts obtains Bitcoin price exposure without ever touching Bitcoin. At BitMEX, our contracts are margined and settled in Bitcoin. That means to trade, you must own Bitcoin. Most instos love the idea of Bitcoin, but are terrified of actually buying, storing, and transferring it.

The Numbers

The above graphs show the USD trading volumes of the CME, CBOE, and BitMEX Bitcoin / USD contracts YTD.

The first takeaway is that BitMEX dominates. BitMEX’s retail client base, trades multiples of the insto client base of the CME and CBOE. BitMEX retail traders for the most part would find it very difficult to open an account with a broker that offers connectivity to the CME and CBOE. These brokers will require relatively high account minimums. The lower leverage offered and higher contract notionals at the CME and CBOE mean that even if a typical BitMEX client had connectivity, they would not be able to afford to trade even one contract.

It is clear from this data that retail traders still dominate the flows. Anecdotally, if you hang out long enough in Telegram, WeChat, Reddit etc. you will hear traders talk about spot movements triggered by quirks of a particular derivatives market. Friday settlement for OKex quarts on many occasions has completely whipsawed the market. Trading behaviour is also affected by an upcoming large funding payment on the BitMEX XBTUSD swap. What there is scant mention of, are market changes in response to the CME or CBOE expiry.

Tomorrow Is Another Day

The CME and CBOE volumes point to tepid involvement by instos. The Jan to May MoM CAGR is 3.94%. However, that will change. As banks gin up their trading activities over the next 6 to 12 months, they will begin hand-holding their clients in their crypto baptism. If a bank is going to take the reputational risk by publicly announcing the creation of a trading desk, they will do whatever they can to generate business to justify the risk. The easiest product to trade is the one that doesn’t require anyone to actually touch the underlying asset.

An easy win for a newly minted trading desk is to provide risk pricing on CME and CBOE listed futures. A client wants to trade a chunky block immediately; the sell-side desk will quote a two-way and clear their risk on-exchange over the trading day. The client gets instant liquidity in excess of the screen, and the bank can take healthy bid-ask margins on meaningful flow.

As volumes and open interest grows, the interplay between the USD settled and Bitcoin settled derivatives markets will lead to profitable distortions in the market. Before that happens, interested traders should read the BitMEX vs. CME Futures Guide. The non-linear components of the BitMEX products complicates things, but ultimately means there will be profitable arbitrage and spread trades between the two universes.

Money Launderers Use Property, not Bitcoin

4 June 201830 March 2019 Arthur Hayes

For some, crypto-coins have a bad reputation: “it facilitates money laundering” is a common belief. Enlightened Hodlers retort that Bitcoin is a terrible way to launder money: it has a public ledger and relative illiquidity vs. the USD. While USD is the preferred method of account, which USD assets do money launderers favour? Pro-Tip: It ain’t Bitcoin.

In these modern times, washing $1 million of crisp cocaine-tainted Benjamins is no easy feat. If you walk up to a teller and attempt to deposit into a bank, they most likely will turn you away or call the police. You could call Saul in New York’s diamond district and attempt to wash it through precious stones; but, fencing those diamonds at close to par will prove difficult.

Governments always want more money parked in their jurisdictions. However, sometimes they have to play the coy mistress and profess their desire to stop terrorist financing (except for the Saudis). Below I will show that the property market is the preferred washing machine for the world’s unclean cash.

I will take a look at the real estate purchase and holding disclosures in Hong Kong, where China launders its money, and the United States where the world launders its money. I will look at both through the lens of the Common Reporting Standard (CRS). We will step into the shoes of our average USD millionaire Zhou from China. How would he clean his cash, and keep the eye Xi from knowing where his loot is?

Chinese people are under no illusion about the rapacious nature of their government. While many have benefited handsomely over the past 30 years, one wrong political misstep could send them back to the countryside penniless. The complete lack of financial freedom means that Beijing, if it wants to, can completely bankrupt you on a whim with no due process.

America, the home of the free, decided that it needed to know where all the financial assets of its tax donkeys globally reside. They required any financial institution to report on the assets of any American. China and many other countries also thought this was a great idea. Hence, the Common Reporting Standard was born. The CRS allows member countries to share financial data between themselves. Under the CRS, China can call up Hong Kong and request information on any Chinese national.

There were two very interesting developments in the history of the CRS:

America failed to ratify the CRS. Which means, for example, that America is not obliged to share financial data on Chinese people with assets in America with China. Things that make you go ‘Hmmmm…’ for $200, Alex – America wants all countries to follow FACTA and inform on Americans, but it won’t return the favour. I wonder where all those assets held by non-Americans will end up?
Hong Kong exempted property from the assets deemed reportable.

As this SCMP article notes, Chinese people rushed to convert bank deposits into property. Property is one of the best generators of economic activity. Many jobs are created on the back of a property boom. From a policy perspective, anything a government can do to encourage an increase in the property stock will make it look like it knows how to run a successful economy.

That’s the date the country falls in line with the Common Reporting Standards, or CRS – a Foreign Account Tax Compliance Act (FATCA)-type regime developed in response to a G20 request, aimed at combating cross-border tax evasion and protecting the integrity of the international tax system. The Chinese government pledged to join in with CRS in 2014.
Details on financial assets held by foreign individuals within mainland China will also start being collected.
The agreement means information will be exchanged with tax authorities in 100 countries and regions from next year, including Hong Kong.
The city has been considered a tax haven for many mainland investors, as there is no capital gains tax levied here. But now they are being forced to convert those financial investments into property, prior to the July deadline to avoid declaring any financial assets held abroad, to the Chinese authorities.

When it comes to the US, the National Association of Realtors is hell-bent on property purchases being exempt from KYC / AML regulations. FinCEN recognised that property became a blatant cash washing machine in certain hot markets, and imposed some disclosure requirements in August 2017.

Set to expire on February 23, 2017, FinCEN discovered that a significant portion of the reported covered transactions in the latest GTOs were linked to possible criminal activity by the individuals revealed to be the beneficial owners of the shell company purchasers. As a result, FinCEN is extending the current GTOs for an additional 180 days, until August 22, 2017, and may consider permanent data collection requirements later this year for more cities.

The GTOs require certain title companies to identify natural persons with a 25 percent or greater ownership interest in a legal entity purchasing residential real property without a bank loan or similar external financing in the following geographic areas meeting specific transaction thresholds:

$500k and above – Bexar County, Texas

$1m and above – Miami-Dade, Broward, and Palm Beach Counties, Florida

$1.5m and above – New York City Boroughs of Brooklyn, Queens, Bronx, and Staten Island

$2m and above – San Diego, Los Angeles, San Francisco, San Mateo, and Santa Clara Counties, California

$3m and above – New York City Borough of Manhattan

This is a step in the right direction to fight those evil money launders at the very high end of the market, but for your average Zhou with a few million big ones to stash, it is still business as usual.

America remains the favoured place to stash cash away from Beijing’s prying eyes, or, indeed, those of any other government bent on stemming capital flight. As long as someone stays below those investment limits, he or she can expect to have little difficulty obtaining a clean bank account and making a property purchase with cash.

Let’s Try With Bitcoin

It is clearly easy to wash and hide a few million USD in the liquid property markets of Hong Kong and America. What about using the favourite monetary boogeyman, Bitcoin?

Assume you want to move $1 million in cash into Bitcoin.

There are two options: either you can open an account on an exchange, or trade over-the-counter (OTC) with a dealer.

Any exchange that can handle this sort of volume has a serious banking relationship. Their bank will require extensive KYC / AML checks on all accounts. If the purpose is to hide the flow of funds, this is suboptimal. Presented with a subpoena, the exchange will be obligated to present the customer details.

If you can’t use an exchange, perhaps an OTC dealer would trade with you. Unfortunately the large dealers also must follow KYC / AML regulations. They again have banking relationships to maintain.

The major liquidity sources are exchanges and compliant OTC dealers. There are dealers who will onboard a client without KYC checks; however, their spread vs. the market will be extremely aggressive. A 20%+ vig to clean your money, assuming they can handle your size, is to be expected.

Washing money through the crypto capital markets is very difficult if you are unwilling to provide KYC information. Property is much easier, and vested interests from the government to the real estate brokers want you involved. They will do all they can to alleviate KYC / AML reporting requirements. Satoshi ain’t the biggest illegal finance enabler: no, it’s Uncle Sam.

Why UPs?

30 April 201830 March 2019 Arthur Hayes

BitMEX is proud to launch its first optionality products: UPs and DOWNs. This marks a very significant milestone in the product development history of the platform. With futures, swaps, and now options, BitMEX is inching closer to the goal of offering all manner of derivative products for the crypto-coin industry.

Why UPs and DOWNs?

UPs or Upside Profit Contracts, and DOWNs or Downside Profit Contracts are similar to call and put options. One of our biggest strengths at BitMEX is in engaging with the community and listening to our customers, and we have heard the roar for such products as the level of sophistication grows in this industry.

Why Now?

The liquidity profile of Bitcoin derivatives trading has changed dramatically over the past 12 months. The BitMEX XBTUSD Perpetual Swap is now the most heavily traded instrument in the entire crypto trading industry. Average daily trading volumes are in the billions of USD notional.

Before non-linear products like options are viable, linear products (Perpetual Swaps and Futures) must be sufficiently liquid. Given the liquidity profile of XBTUSD and the quarterly Bitcoin / USD futures contracts, we now believe there is sufficient liquidity in order to launch a successful options product.

What’s the Use Case?

Imagine Bitcoin is currently trading at $10,000 and you believe that by the end of the week, it will move 10% higher to $11,000. However, you don’t want any exposure to the price unless it hits your target. Also, you do not want your position to be liquidated before your target is reached, irregardless of the intra-week spot movements. For example, if the price drops to $5,000 but recovers to $12,000 by the settlement date, you will still profit and will not be liquidated.

Hence, you want the ability to participate above your target of $11,000 on the long side. The UPs product allows you to express this view, however this “optionality” comes at a cost which is the premium you pay to the seller of the option.

Why Can You Only Buy?

Selling naked (i.e. unhedged) options is one of the fastest and easiest ways to financial ruin given the potential for unlimited losses. On BitMEX, traders are limited to the margin they deposit on the platform, hence if the seller of the option cannot make good on potential losses, then socialised loss systems will need to be put in place which we want to avoid. As a result, we require sellers of the options to post the full notional value of the UP or DOWN contract.

Because no leverage is offered to sellers, it is very expensive from a capital perspective to make a market. In order to guarantee tight spreads at sufficient size, the BitMEX affiliated anchor market maker will be the only entity allowed to sell options initially.

Many of you may have concerns that the BitMEX affiliated entity is the sole market maker, however here are some points to consider:

As further discussed below, one cause of the engine overload issue is that we have many market makers constantly updating quotes on currently listed products. This consumes a vast amount of precious engine capacity. Until our engine performance is fixed, we refrain from listing any new product that exacerbates the issue. (E.g. this is one of the reasons why we delisted a number of our quarterly altcoin futures contracts, since the volumes they generated did not justify the engine resources consumed.) Hence, if only one market maker quotes on the UPs and DOWNs product, then the impact will not be meaningful on the engine.
The UPs and DOWNs products need to be fully margined. That is, buyers must pay the premium in full and sellers must post the full notional of the option in margin. That means that irregardless of where the price settles, neither buyers nor sellers will ever be liquidated. If the contract settles in the money, buyers are assured they will always receive their profit. Furthermore, this means that the anchor market maker cannot manipulate the UP or DOWN market in any way to liquidate any customer.
The anchor market maker is tasked with keeping a tight market so that buyers can enter and exit trades as they wish throughout the contract’s length. We want to increase liquidity, having wide markets or an empty order book is not in BitMEX’s interest.
As we respond to customers’ feedback about the products, changes will be made to the UPs and DOWNs contracts. The anchor market maker will be able to adjust to the new product structure faster than any third party. That means that we can fail fast, and relaunch the product quickly with guaranteed liquidity.

What Are We Doing About Engine Performance?

At BitMEX, our top priority is improving the performance of our engine. In a detailed blog post, BitMEX Technology Scaling: Part 1, our CTO Samuel Reed explains in detail the issues we face and what we are doing to resolve these issues. However I will reiterate some points here.

The solution is not as simple as adding more servers or more engineers. The engine has a maximum throughput that is constrained by risk checks and calculations which are performed on each order, position, trade or price change so that we can maintain mathematical consistency on a platform that allows for 100x leverage. We have a two-pronged strategy to solve for this unique problem that BitMEX experiences:

Optimise as many existing functions as possible to obtain efficiency gains. We have been rolling out improvements weekly; however, that extra capacity is consumed very quickly as the demand increases to match engine performance improvements.
Re-architect the engine from the ground up so that the aforementioned issues can be scaled horizontally which will allow for more products and more users without overload issues. This work is ongoing, it won’t be solved overnight, but we are working towards this goal.

I want to emphasise that we will not list any products that worsen engine performance until we increase capacity sufficiently.

Additionally, we are scrutinizing which API users cost us the most in resources. Further API rate limits on traders with non-optimal Quote / Trade ratios are forthcoming. I remember how hard I fought as a CEO to convince traders to provide liquidity on our platform. This action pains me deeply and further sharpens my focus on finding a solution to this problem so that anyone who desires to provide liquidity may do so.

Launching the UPs and DOWNs products does not mean that BitMEX has forgotten or ignored the overload issue. Rather, we must continue to launch and test new products within reason so that in a year’s time we have another wildly successful product like XBTUSD.

If you are a talented engineer who believes he or she has a solution to this problem, we want to hear from you / hire you. Please reach out to us via the careers page or email, and a senior member of staff will review your qualifications or suggestions.

– Arthur Hayes, CEO and co-founder