The China Capital Control Chronicles

China’s economy is in trouble and has been the running theme in a number of our blog posts over the previous year. For those coming out of their election-bunkers, let us recap these issues and provide evidence for a forthcoming tipping point:

  • China’s debt is the largest it has ever been at nearly $5.5 trillion, which has rapidly risen the government and household debt to GDP. A large part of this credit was misallocated, and the bill is coming due.
  • After the 2015 stock market collapse, Beijing has pushed desperate savers back into property. The property market contributes a large percentage of economic growth. Prices have become unaffordable for all but the very rich. Bejing’s attempts to prick the bubble might cause a financial crisis.
  • In an effort to increase the Party’s power, Xi Jinping embarked on an anti-corruption drive. Many business people and government officials now fear for the safety of their loot and their hides.
  • If credit growth stalls, the party is over. As a result, the PBOC is forcing state owned banks to lend to state owned companies.
  • A stronger CNY decreases China’s competitiveness on exports. In recent years, China’s export growth has dropped from 31% to a dismal 8% while Vietnam, Cambodia, Laos and Myanmar have been picking up the slack, increasing the growth in their exports by over 20% annually. With a stronger greenback on the cards, further depreciation is needed to remain in the export game.
  • If enough capital flees China before the CNY can be meaningfully devalued, China’s capital account will bear the losses instead of domestic savers.

Cognizant of these facts, comrades are devising more and more cunning ways to export capital outside of the Middle Kingdom. The current annual $50,000 limit is insufficient for the amount of CNY that wants to leave.

Last month, China’s foreign exchange reserves dropped by the fastest amount seen since January by $45.7 billion to $3.12 trillion. [Bloomberg] However, some economists point to this figure as being milder than expected given the depreciation against the greenback. Regardless, FX reserves are down from $4 trillion in June of last year.

How are locals actually getting their cash out? There are legal and obviously illegal methods. Illegal (and unusual) methods involve the following:

  • Underground Banking: “Underground banks” take CNY onshore, and deposit HKD into the client’s offshore bank account.
  • Money Mules: Some pay “trustworthy” individuals to strap loads of notes onto themselves ducking and dodging through customs.

However with recent crackdowns resulting in busts up to $148 billion [Bloomberg], these methods have become increasingly risky. Given this, we were not surprised when we heard (although unconfirmed) reports of underground FX dealers charging rates 14% over spot (effectively a USDCNY exchange rate of 7.8).

Other traditional methods include:

  • Overseas Real Estate: Chinese people bought over $100 billion worth of US real estate between 2010-2015. [FT]
  • Alternative Assets: Buying gold, rare coins, or even internet domain names to be resold to an overseas owned company has become popular. [ZH]
  • Fake Trade Invoices: Companies overstate the value of imports into China or understate the value of exports. The invoice is submitted to the bank, and then the company is allowed to conduce a foreign exchange transaction. Over the past two years, the Hong Kong Monetary Authority (HKMA) has cracked down on this practice.

Here are two of the more creative schemes we have heard of:

  1. A Chinese company reportedly approached a law firm to represent it in a fake arbitrationcase against a US domiciled company they actually owned. If the Chinese company lost, the damages would have to be sent from China to the US. The amount in question was over $3.5 million. [China Law Blog]
  2. In a March blog post, “200 swipes: A New Way Chinese Avoid Capital Controls”, we mentioned how it became popular for local Chinese to buy insurance products in Hong Kong. The government attempted to stop this practice by limiting each transaction on UnionPay cards to $5,000. However, that didn’t stop some users from swiping their UnionPay card more than 200 times, bringing a new meaning to “jimmy hands”.

Furthermore, even when comrades try to do the right thing, they encounter obstacles.

There have been reports that locals are having trouble legally converting their CNY to USD. The common theme heard by many is that the bank would avoid paying dollars. Banks are offering various excuses. Some say they don’t have dollars, some reverse previously approved transfers, and others flat out refuse if the foreign entity receiving dollars has a Chinese owner [Above The Law].

The American EB-5 investor program is a popular route to spirit your capital and family out of a hostile China. For a minimum investment of $500,000, a green card can be granted. Companies have sprung up to consult eager Chinese expatriates. Some are now reporting their qualified clients are having trouble moving the necessary capital out of China.

In fact, some of these companies are seriously considering Bitcoin as a means of moving their client’s money into the US for investment. We’ve been told these customers are willing to pay up to 3%. I suspect with further depreciation and the uncertainty surrounding President-elect Trump’s immigration policies [Forbes], they would be willing to pay much higher costs to get through the door before January 20, 2017.

Bitcoin, up to a certain CNY premium, remains a viable option to liberate modest amounts of capital in China. Given that all major Chinese exchanges conduct thorough KYC, those moving large or illicit sums will not choose the Bitcoin route. This is probably why the PBOC hasn’t stomped on Chinese exchanges.

With a surging dollar and whiffs of American trade protectionism, Beijing cannot forestall the hard economic choices any longer. If Beijing cannot politically force the credit misallocation costs onto large industrial companies and the rich, then a disorderly devaluation looms large in the near future.

 

Faces of REKT

Hillary Clinton was supposed to don red, white, and blue pantsuits and cruise to victory over the clownish Donald Trump. Unfortunately Clinton is not a closer. In the past 8 years she was the heavy favourite to defeat Barack Obama and now Donald Trump in her runs for president. In both cases, she fumbled on the goal line.

Clinton’s sobbing supporters now must make peace with The Donald. Faces of REKT is an apt description of the despair witnessed at any pro-Clinton rally.

Now that the circus is over, what does Trump mean for Bitcoin? Trump and his Republican party captured both the House of Representatives and Senate. He has a unique opportunity to deliver on his campaign economic promises.

Trump promised to reduce personal and corporate tax rates, eliminate burdensome regulation, and increase infrastructure spending. These nationalistic economic goals will crown The Donald as The Strong Dollar President.

America-first economic policies will have profound implications for the USD, Europe, and China.

USD Still King

Will Grandma Yellen raise rates on December 14th? Fed rate-hike odds tumbled below 50% initially as Trump ascended to victory. After the market realised that Trump’s policies will allow the Fed to raise, the odds surged above 80%. [CME]

Central banks globally have lamented the lack of fiscal spending to help revive economies globally. With Trump and a Republican controlled congress committed to fiscal spending, the Fed can normalise rates. This fact was not lost on the market. 10yr and 30yr Treasury yields spiked higher.

Trump plans to reinvigorate corporate America through tax cuts and the elimination of regulation. He also plans to punish corporates who offshore production through high tariffs. The net result of these policies is more investment and production onshore. This is USD positive.

Santa was kind to me with a Trump victory, and it appears my second wish for a Fed rate hike is still in play.

Say Bye Bye to the European Union

The Brexit and Trump victories represent a continuation of economic nationalism. This goes directly against the system EU bureaucrats created. Southern European nations suffer high unemployment and low to no growth due to their inability to correct EU economic imbalances through monetary policy. The suffering plebes have had enough.

British and American citizens will now pursue national interests over global ones. This will fire up Greek, Italian, Spanish, Portuguese, and French people. If these oppressed nations followed their own interests, they would repudiate the economic diktats handed down by Germany and the ECB. That entails the return of national currencies and independent monetary policy.

December 4th, The Beginning of the End

December 4th might be the day that ushers in a violent risk-off period due to the Italian constitutional referendum and Austrian presidential election.

Prime Minister Renzi stated he will resign if the referendum is defeated. The referendum will be a prelude to national elections where Mr. Grillo’s 5-Star Party, which is anti-EU, is slated to win.

“Austrians will vote in a presidential election that could see Norbert Hofer of the Freedom Party become the first far-right head of state to be freely elected in western Europe since 1945.”[Zerohedge] He certainly will not be welcomed by the usual coterie of EU bureacrats.

Feta, Frogs, and Sauerkraut

During the various debt renegotiation talks happening in the months to come, the Greeks might finally discover their backbone. This opens the door for the Greeks say bye bye to the EU and Euro.

French presidential elections will be held in the summer of 2017. Marine Le Pen, who would exit the EU if elected, is polling better and better. Polls still place her behind front-runner Alain Juppe. That could change quickly as other like-minded politicians take the helm of neighboring countries.

The granddaddy of all European elections occurs in the fall of 2017. Frau Merkel is facing a revolt at home over her controversial immigration policies, and her continuation of bailouts for Germany’s lazy European neighbors. The Alternative for Germany party continues to gain momentum. They also plan to exit the EU if voted into power.

Don’t Forget About Deutsche Bank

Before any of these elections cause any choas, a European banking crises precipitated by a banking crisis is more likely to intensify the strain on the EU project. Deutsche Bank has still not raised equity capital or received a lighter penalty from the US Department of Justice. Italian banks are still insolvent, but a national bailout is not permitted under EU rules.

These banks must be recapitalised. A bail-in or bail-out will occur. A depositor bail-in will spark bank runs accross Europe. A bail-out will be deeply unpopular and most likely require printing billions of Euros. Pick your poinson Draghi.

While in America the yield curve is steepening, the ECB has shown no interest in allowing long-end rates to rise. The ECB is killing its member banks.

While the market forgot Europe’s troubles in the lead up to the US elections, expect renewed focus on its broke banks.

Yuan Hits New Lows

As I have repeatedly stated, the PBOC doesn’t desire a rising USD. The PBOC is forced to devalue the Yuan as the USD rises. USDCNH in the Trump victory aftermath hit fresh highs of 6.83.

The PBOC will not be measured in its devaluation of the CNY if the Fed doesn’t get the message and hikes in December. Unable stem the creation of credit by China’s banks due to politics, the PBOC will have to export this Yuan liquidity through a weaker currency. A stronger USD makes this process more chaotic as capital outflows will intensify.

Trump’s economic nationalism will fuel the USD rally. This spells trouble for Europe and China. With two of the three largest trading blocs likely to experience currency and banking crisis, Bitcoin will shine. Time and again Bitcoin has proven to be a safe haven asset during times of market volatility.

Imagine what Bitcoin will do when Europe and China’s SARS chickuns arise and come home to roost. I reiterate my $1,000 price target for Bitcoin by year end.

Make Bitcoin Great Again

As Bitcoin roars back to life for various reasons, traders are rotating out of altcoins back into the crypto reserve currency. The above chart shows the performance of Bitcoin against that of a number of altcoins over the past two weeks.

What is abundantly clear is Bitcoin up, altcoins down. Furthermore, the performance of Bitcoin and altcoins is negatively correlated (see the table below). Finally, altcoin prices move more violently than Bitcoin.

Correlations ETHUSD LTCUSD XMRUSD ETCUSD FCTUSD
XBTUSD -91% -65% -67% -86% -77%

There are a few reasons to explain the above results. China’s devaluation of the CNY, the release of Segwit, and a flight to safety during market volatility that resuscitated Bitcoin.

As traders close their positions in altcoins to ride the Bitcoin wave, altcoins are kicked to the gutter without enough liquidity to cushion the fall.

Cryptocurrency Market Cap %
Bitcoin $11,440,078,705
Ethereum $911,356,507 7.97%
Litecoin $185,283,515 1.62%
Monero $82,886,148 0.72%
Ether Classic $77,732,113 0.68%
Factom $20,638,427 0.18%

The above table shows the currency market capitalisations of the above coins. Cryptocurrency traders should keep these numbers in mind when evaluating trading and market impact costs. The market impact or liquidity cost is often ignored by novice traders. When everyone rushes for the exit, the lack of liquidity leads to exaggerated moves and erosion of paper profits.

Grab Them By The Rupee

Governments around the globe fight a constant battle to obtain as much data as possible pertaining to their subjects’ wealth. For governments and banking systems that are viewed as corrupt and unsafe, this battle is even tougher.

The majority of Indians are very poor. However with a population approaching 1.3 billion, the amount of wealth in aggregate held by the poor is substantial. Indians do not trust banks. They trust gold. India consumes the most gold of any nation globally.

The poor aren’t stupid. Depositing their hard earned Rupees at the bank will yield 4.00% per annum. Unfortunately, September 2016 YoY CPI inflation totalled 4.31%. [Trading Economics] If Indians leave their money with the bank the yield is negative. It is much better to hold cash in the form of banknotes and gold outside of the banking system.

As a result of Indian’s propensity to save wealth outside of the formal banking system, the vast majority of plebes are unbanked.

Bloomberg reports:

“In a surprise announcement late Tuesday, Prime Minister Narendra Modi banned 500-rupee ($7.50) and 1,000-rupee notes effective midnight, sweeping away 86 percent of total currency in circulation.”

The party line is that this will help fight corruption and tax evasion. That may be the case, but the vast majority of this money is held by poor Indians trying to save outside of a banking system they don’t trust. Now they must register with a bank, and subject their meager wealth to constant surveillance and the threat of taxation.

In India you need a license to do almost anything. Licenses cost time and money. For those who survive in the informal economy, they may no longer be able to accept payment for their services without rubbing up against mafioso government officials.

Payments companies are overjoyed.

“This is the golden age to be a tech entrepreneur in India. Specially a fintech one,” tweeted Vijay Shekhar Sharma, the founder of Paytm, whose investors include Alibaba Group Holding Ltd. “Keep the money digital.” [Bloomberg]

Keeping the money digital is a laudable goal if it increases financial freedom. The silver lining to this gambit is that awareness surrounding other forms of digital money will rise in India. If one cannot deal in cash, what forms of digital money can achieve the same effect? Regular readers of this newsletter know the answer to this question is obviously Bitcoin.

Bitcoin in India is growing quickly. The Reserve Bank of India has softened its stance on Bitcoin, and small exchanges are beginning to operate. Once the masses are comfortable accessing their wealth via a mobile device, they will begin to question how they can save and accept payments electronically outside of the banking system.

This action should also serve as a wakeup call to savers globally. Governments hate cash. Now that it can feasibly be eliminated, expect similar actions from other developed and developing nations. The ECB ceased printing the 500 Euro note. Various American economists have called for a ban on $100 notes. [Washington Post] The war on cash is real.

Once a government bans cash, it is usually too late to begin the process of converting paper currency wealth into gold, real estate, or Bitcoin without facing some form of taxation. As always, keep calm, and buy Bitcoin.

SEGWIT: Alive Not Dead

The software for SEGregated WITness (SEGWIT) was finally released last week from Bitcoin Core with a proposal for a soft fork that could happen as early as December. Miners will be able to start signaling that they are pro-segwit from November 15th.

Since the announcement, Bitcoin has rallied almost 10% to its currently tradable figure of $745. The Yuan devaluation has sparked the rally, but this release has definitely added fire to it. As discussed in previous newsletters, any path where Bitcoin miners and devs can rejoin as a community and move on from the block size debate is a positive one, whether that be from Bitcoin Unlimited (BU), Bitcoin Classic, or segwit.

Segwit is seen as a better option given that it does not require a hard fork to be implemented, nor does it introduce a democratic hierarchy, which BU and Classic require to succeed. Furthermore, the software is backwards compatible meaning that miners / nodes who do not accept segwit (if it becomes activated) do not need to update.

The timeline is as follows:

  • After 15 November 2016, the first 2,016 block period will begin where miners can start signaling support for segwit.
  • If 95% of those 2,016 blocks show support, then segwit locks-in.
  • If not, then another 2,016 block round will occur.
  • This will keep repeating until a 95% support period has been reached or segwit will recede into the darkness after the last 2,016 block period concludes after 15 November 2017.

Summarising the main benefits of segwit:

  1. Elimination of unwanted transaction malleability – the segregated witness. Essentially this helps hardware wallets that aren’t connected to a blockchain and don’t have the block history to avoid a “fee attack” whereby a transaction can be split up and spend more in mining fees than initially thought. Read this Bitcoin Magazine article to learn more.
  2. Capacity increase – The network will be able to support 70% more transactions. In other words, a Blocksize increase to 1.7MB.
  3. Lightning Network capabilities will available in the future.

There is still a large part of the community unhappy with segwit given that BU and Classic both can support larger than 1.7MB blocks. Initially a 4MB block increase was planned, but that has since been scrapped.

Some people have mentioned that the amount of complexity offered in this soft fork makes it technically difficult for anyone other than the core devs to work on it. Effectively segwit locks out other Bitcoin developers from participating.

If ViaBTC manages to hold its hashrate above 5%, and effectively blocks segwit by choosing to run BU nodes, then Bitcoin could perhaps be stuck in limbo for another year or so.

The percentage acceptance rate during the first 2,016 block period will be interesting to watch come November 15th. Traders anticipating a failure to lock-in segwit will close long positions. If we see a large amount of support, then we could revisit $1,000 by the end of the year.

ZEC Post Mortem

Figure 1

polo zec price.png

October 28, 2016 has set its place in the Cryptocurrency History books with what must be the record for the largest Pump and Dump. (See Figure 1)

While watching the live stream out of the Zcash headquarters for the Genesis block, ZEC futures prices on BitMEX pushed past 1 XBT, from a listing price of 0.025 XBT. As the first block was mined and subsequent blocks followed, the hype was real. Bitfinex started to publish bids for ZEC in an early attempt to gain liquidity; however, their capped prices at 0.55 XBT weren’t as attractive when Poloniex launched the ZEC/BTC market and bids started to pour in at around 10 XBT.

There was chatter about trying to post a high price in an attempt to honeypot BitMEX traders to bid up from the current 1 XBT price, which they initially did. Prices moved up to 2 XBT, and then back down to 1.2 XBT. Around this time ludicrous bids for 1 ZEC were being made on Poloniex: 100 XBT, 1,000 XBT, 2,000 XBT, 2,600 XBT etc.

And then the first few ZEC started to arrive at Poloniex.

Early miners saw an opportunity to capitalise on the hype, and started to offer their precious ZEC at levels up to a high of almost 3,300 XBT.

That is 3,300 Bitcoin for 1 ZEC.

Prices then bounced between 3,000, 2,000 and 1,000 with no end in sight. Having said that, given the amount of supply at this time was less than the age of consent in Japan, the same ZECs were being passed around more than Sasha Grey in Black Power 3.

BitMEX shortly followed, with prices rising up to the self-imposed 10 XBT limit. The hangover set in, and prices crashed on both Poloniex and BitMEX. Poloniex crashed down to a low of 15 XBT, with BitMEX falling to 1 XBT.

In a short survey, some successful traders on BitMEX opined that they were bullish on Zcash from the very beginning. Those who got Auto-Deleveraged kept re-entering positions and played into the hype of it, taking profit close to the top. Some traders made stupendous sums in under 10 minutes. Although the more honest of them acknowledged this was “pure gambling”.

Prices have somewhat stabilised. Poloniex trades between 1.2 and 1.5 XBT, and the December BitMEX futures contract, ZECZ16, trades much cheaper at 0.5 to 0.6 XBT. The spot over futures premium has stabilised at around 250%, down from 500% earlier this week. Figure 2 displays these numbers over the past 3 days.

Figure 2

We can estimate a “fair value” for ZECZ16 based on the spot price and the currency’s inflation rate. Currently there are approximately 4,516 ZEC. By 30 December 2016, 333,800 ZEC will be in circulation. That is an outright inflation rate of 7,292%. Spot ZEC/XBT currently trades at 1.25 XBT on Poloniex. If we discount that by the inflation until 30 December 2016, we get an implied ZECZ16 price of 0.016911 XBT. ZECZ16 currently trades at 0.4422 XBT. By this analysis it is 26x overvalued.

Is the hype over? Perhaps, but the fundamentals behind ZEC have not changed. This crypto is definitely a heavyweight when it comes to anonymity. It created panic in what was thought the market leader Monero, which is down 75% off its highs back in early September when Alphabay decided to adopt the currency for usage on its platform.

ZEC may not be worth 3,300 Bitcoin (or approx $2.5m per coin), but with Bitcoin fungibility concerns, anonymous transactions are the way forward for online gambling and darknet markets. It is estimated that over $1 trillion worth of bets and products are offered on these types of platforms globally.

My Xmas Wishlist: President Trump and a Fed Rate Hike

I am structurally long Bitcoin via my ownership stake in BitMEX, as such I want to see more volatility and more people turn to Bitcoin. I believe that a Trump win, and a Fed rate hike will add fuel to Bitcoin’s price rally.

Anthony Weiner’s wiener pics may land both himself and Hillary Clinton in the slammer for the rest of their natural lives. Due to emails recovered on his computer, the FBI is ‘reopening’ its investigation into Clinton. That bombshell was dropped last Friday night, and has caused a complete reversal of the American presidential race polls.

Trump who only weeks ago was behind by double digits, has pulled even. The spectre of a possible criminal indictment for obstruction of justice, and the mishandling classified material has all but finished Clinton’s chance of becoming the nation’s first female president.

I don’t believe that either of these clowns would alter Pax Americana’s crash course. However, a Trump presidency has spooked the markets and it will hasten the inevitable. There are a litany of economic, political, demographic, and social problems afflicting all developed and developing nations.

When traders become afraid, they begin to recognise all the ills of the world. That is how global financial crises begin. After ignoring all these issues for the past 7 years, a good old meltdown is on the cards.

Anything that gold likes, Bitcoin loves. Bitcoin and other digital currencies benefit from market volatility. The rise of Trump has caused gold to retake $1,300, bond yields to rise, and equity markets globally to slide. If he enters the soon to be gold-plated Trump House, I anticipate a Brexit style market meltdown.

The Federal Reserve met on Wednesday this week. As expected, they left rates unchanged one week prior to the election. They did however reiterate their stance that a December rate hike is extremely likely. Trump in various speeches has called the Fed’s policy of money printing irresponsible. Grandma Yellen will grant Trump his wish and hike. It would be just deserts for Trump to watch the S&P 500 freefall below 2,000 after his victory.

The election takes place next Tuesday, November 8th. Given how close the race is, I do not expect a clear winner announced for many days after the polls close. The 2016 election will be very similar to the 2000 election where the United States Supreme Court effectively crowned George W. Bush consul.

This uncertainty will do more damage to the markets than a clearcut Trump victory. During this vacuum, I expect Bitcoin and gold to perform tremendously. Add in the threat of a Fed rate hike, and continued devaluation of the Chinese Yuan, and you have the recipe for a $1,000 Bitcoin.

Bitcoin to $700 and Beyond


Figure 1.

Bitcoin has started to gain a significant amount of traction this past month with the devaluation of CNY. Previous blog articles (USDCNY 7.00 Equals Bitcoin $1,000 and Yuan Internationalisation and Bitcoin) have discussed why the Yuan is currently going through a devaluation process, where it is headed, and what it means for Bitcoin. If you want to save time, just look at Figure 1.

Figure 1 above shows Bitcoin / USD (an average comprised of Bitstamp, Coinbase and OKCoin USD), Trading Volume, and the offshore CNH and the onshore CNY exchange rates. The trend is up and to the right. CNY had the first large official devaluation on the 10th October (CNH surged higher the week prior), and in less than 20 days it has moved 10 fen or about 1.5%. Bitcoin has gone from trading at $605 at the start of this month, past the ominous level of $666, and through $680 towards $700.

Figure 2 below shows the same Bitcoin spot price against its Volatility and the China Premium (scaled up 15x). When Bitcoin / USD is viewed against these variables, a similar up and to the right trend appears. Below is a table with the observed correlations.

Correlation CNY Trading Volume Volatility
Spot USD 0.25 0.16 0.71

Figure 2.

What’s happening with the rest of the world outside of Bitcoin? In spite of the continued devaluation of the Yuan, financial markets remain in risk-on mode. When viewed against the USD Index which strenghtened 3.6% in the past month, the Yuan is still relatively overvalued. [WSJ]

December presents the perfect time for the Fed to raise said Federal Reserve Bank of San Francisco President John Williams. [WSJ] The US election circus concludes in under two weeks. In addition, US economic data contiues to improve. That is why the odds of a rate hike are north of 70%.

Will the financial markets crash if the PBOC devalues CNY above 7.00 by December? It might take much more muscle this time around to force Gradma Yellen to duck and cover.

To take advantage of this, buy XBTZ16 futures contracts expiring 30 Dec 2016 at 12:00 UTC. Currently the annualised premium is trading at 28%. By historical standards, this is quite low for a contract with 2 months of remaining time value. Expect this to blow out if we see continued price appreciation in Bitcoin due to a weaker Yuan.

Need to Hide 200 Million Yuan? Use Bitcoin Instead

200_million_yuan_official2_0

Since October 10th, the first trading day in China after Golden Week, the PBOC has weakened the Yuan by over 1.00%. USDCNH is approaching 6.80. CNH is the offshore and freely tradable version of the restricted onshore CNY.

China recently published its 3Q16 GDP. Surprise, GDP grew at 6.70% exactly what analysts expected. If you believe any economic data from any government globally, I have some Paycoin to sell you. The data point of most interest is China’s monthly FX reserves. Goldman Sachs analyst MK Tang estimates that capital outflows in September accelerated to US$78 billion up from US$32 billion in August. He also stated that the official number released by China was bogus.

The PBOC needs to sequester as much capital inside China as possible to mitigate the massive amount of credit being extended by the nation’s banks. As of September the Banking Regulatory Commission reported China’s domestic banking assets totaled CNY217.3 trillion (US$32 trillion), which is up 14.7% YoY. [Zerohedge] They have been closing the gates since August 2015. SCMP reports that SAFE closed 56 illegal underground banks involving more than CNY1 trillion.

To make matters worse, Xi Jinping’s anti-corruption drive has rich comrades running scared. If they look hard enough, almost every wealthy person could be convicted of some sort of graft. What is worse is that the “law” changes to fit the prerogatives of the party. If you do not fall in line with Xi Jinping, you will be made an example of. As a result, government officials and wealthy citizens desperately try to spirit their capital outside of China.

A recent story illustrates the plight of rich Chinese officials. Wei Pengyuan, the former vice chairman of the National Energy Administration’s coal department, was charged with accepting bribes. Police seized CNY200 million (US$29.5 million) worth of cash from his apartment. [Zerohedge]

The conduits through which cash moves abroad are being shuttered. Desperate officials have turned to hiding vast amounts of cash in their primary residence. One problem in China is is the largest denomination bill is worth 100 CNY. This was deliberately done to make it very hard to hold large amounts of wealth outside the government controlled banking system.

Wei’s stash of cash weighed an estimated 1 ton. Wealthy Chinese need a store of wealth that is outside governmental control, and easily portable. Enter Bitcoin. Many people perceive China’s appetite for Bitcoin to be predicated on a desire to get money out of the country. Getting the wealth out of the country is proving to be very tough, therefore the more important concern is hiding in plain sight.

Bitcoin is weightless, and can be accessed using any internet connected device. As of December 2015, China had 620 million users of internet connected mobile devices. Bitcoin can be purchased in as little as 30 minutes from one of the large Chinese Bitcoin exchanges. Bitcoin / CNY is the most liquid pair globally. Put all these factors together, and it is a no brainer for wealthy individuals to store a portion of their wealth in Bitcoin.

Bitcoin purchased need not ever be converted into USD. Bitcoin can be the final destination of wealth for Chinese citizens. When viewed in this light, the China premium for Bitcoin could rise to levels not seen since 2013. In 2013, the China premium reached a high of 40%.

The main stumbling block is education. However, with more and more wealthy comrades meeting a bullet for economic graft related offenses, their life could depend on learning.

 

Can You Survive An Interest Rate Hike?

This week I attended a Bitcoin meet-up in Hong Kong where a serial Bitcoin / Blockchain angel investor gave a talk. His investment framework consisted of investing in companies that had low margins but could scale easily.

One audience member asked what he would do in a situation where margins went to zero or even negative. Many blockchain application businesses fall into this category. Part of his response was that due to quantitative easing (aka money printing) money was free, so investing in businesses with zero or negative gross margins can be done. If rates are more negative than the cash flow burn of the company, in our bizarro world that actually is outperforming.

I then followed up with a question on how his thesis would be impacted if interest rates rose. He responded that in the near future that wouldn’t happen, and even if it did policy makers would realise their errors and quickly revert back to printing gobs of money.

Whenever someone completely dismisses the possibility that a central tenet of their investment thesis cannot be invalidated, alarm bells ring. During the 2003 to 2007 US subprime housing bubble, the common refrain was that housing prices NEVER went down. By 2008, that central tenet of faith was proven grossly erroneous.

Central banks over the past 25 years have conditioned investors to expect lower interest rates every time there is a financial hiccup. In 1990 the US 10-Year Treasury Bond yielded 7.94%, today it yields 1.75%. The effect of falling interest rates has pushed investors further out on the risk curve to generate stable income.

Bitcoin / Blockchain startups primarily fund themselves by selling equity to investors, by issuing tokens through Initial Coin Offerings (ICO), or through retained earnings (assuming the company is profitable). Most startups in the early stages sell equity.

A Thought Experiment

Assume you are an angel investor and you share the worldview of the speaker I spoke about earlier. Essentially you invest in scalable Bitcoin / Blockchain businesses with the hope that a greater fool will emerge, allowing you to exit your investment. Remember it’s the 4th Industrial Revolution; you don’t want to miss out. You have a pool of capital that you will spread amongst various startups. Here are some assumptions about your investing strategy:

Initial post-money valuation: $5 million
Years to exit: 7

Your portfolio’s performance is benchmarked against owning high-yield US corporate bonds. While many think that money is “free”, it definitely is not unless you are an AAA-rated developed market corporation. Everyone else must pay to play.

I chose the BofA Merrill Lynch US High Yield Effective Yield as a proxy for what an investor can earn buying riskier corporate bonds. Investing in startups is infinitely riskier than buying high-yield corporate bonds, as these companies produce actual cash flow.

The Federal Reserve Bank of St. Louis publishes the historical effective annualised yield. The below table lists current and historical annualised yields for the index.

Annualised Yield 7-Year Compounded Return
Current 6.14% 51.76%
Minimum 5.16% 42.22%
Maximum 23.26% 332.27%
Average 9.28% 86.12%

The majority of the startups that you invest in will die within 7 years, and you will lose 100% of the money invested. A small percent will exit at a valuation that is multiples higher. Your performance depends on your ability to pick winners.

Break-even Success Rate = (1 + Opportunity Cost) / (1 + Exit Return)

Break-even Success Rate: The success rate at which you are indifferent to investing in startups vs. buying high-yield US corporate bonds

Success Rate: Defined as the % of startups in your portfolio that complete a successful exit

Opportunity Cost: The 7-year compounded return of the high-yield index

Exit Return: The return generated after the startup has completed an exit

Exit Return = (Initial Valuation / Final Valuation) – 1

The below table lists the Break-even Success Rate under different scenarios

Current Minimum Maximum Average
Avg Exit Valuation vs. High-Yield Returns 6.14% 5.16% 23.26% 9.28%
$50mm 15% 14% 43% 19%
$100mm 8% 7% 22% 9%
$250mm 3% 3% 9% 4%
$500mm 2% 1% 4% 2%
$1bn 1% 1% 2% 1%

It is hard to pin down the global average exit valuation for startups. From various articles I have read, startups on average exit with valuations between $50mm to $100mm. If we assume bond yields normalise near 10% per annum, 9% to 19% of your startup portfolio must successfully exit. Even in the current “low” interest rate rate environment, you still must be a very skilled investor to break-even (8% to 15% success rate).

Achieving a $50mm+ exit valuation is no easy task. Most likely after your angel / seed investment, the company will subsequently attempt to raise a Series A and then B to grow into a juicy acquisition target. Most likely after each round, your equity stake will be diluted.

The below table reproduces the Break-even Success Rate assuming each successful startup does two subsequent financing rounds and existing investors are diluted 20% in each round.

Current Minimum Maximum Average
Avg Exit Valuation vs. High-Yield Returns 6.14% 5.16% 23.26% 9.28%
$50mm 24% 22% 68% 29%
$100mm 12% 11% 34% 15%
$250mm 5% 4% 14% 6%
$500mm 2% 2% 7% 3%
$1bn 1% 1% 3% 1%

Instead of achieving a 9% to 19% success rate, you now must achieve a 15% to 29% success rate if interest rates normalise. Remember, you are only breaking-even. For all the hard work of identifying promising startups and mentoring them, you have not generated outsized returns. Wouldn’t it be much easier to log onto Interactive Brokers and buy a high-yield bond ETF?

Because you invest in companies with low to zero gross margins, your only hope is to pass the hot potato onto investors who are more risk seeking than yourself. You have no expectation of dividend income. As interest rates rise, the universe of assets that yield high returns with less risk grows. The pool of fools will decline, and your portfolio will struggle to break-even vs. investing in a basket of high-yield corporate bonds.

There are many Bitcoin / Blockchain businesses and business models that generate real revenue, and are defensible. One only has to look at Bitfinex to see how profitable a “properly” run Bitcoin exchange can be. For the full year 2015, Bitfinex generated US$7.03 million of Net Income on US$9.35 million of revenue.

Do The Twist

The BOJ was the first central bank to explicitly target a steeper yield curve. In a recent speech, Federal Reserve Governor Eric Rosengren stated that the Fed should engineer a steeper yield curve. Many financial analysts are calling this new form of yield curve targeting a “Reverse Operation Twist”. The original “Operation Twist” involved the Fed buying long-dated bonds and sellings short-dated ones in order to lower long-term interest rates.

Banks need a steep yield curve to make money. After printing money to stave off insolvency of commercial banks, central banks must now steepen the yield curve so that their stakeholders can return to profitability. The effects of a steeper yield curve are already working. JP Morgan, Bank of America Merrill Lynch, and Goldman Sachs have all reported impressive 3Q16 earnings.

As yields on the long-end rise, it will be easier to find positive yielding investments that are not as risky as punting startups that have no plan to ever generate a profit.

Fork Me Baby One More Time

The Ethereum Foundation successfully completed another hard fork of Ethereum (ETH) at block 2,463,000, which occurred Tuesday October 18, 2016. A second (well technically third) fork is due later this month. The original and “immutable” Ethereum Classic (ETC) chain is also due for a hard fork on October 25th.

What The Fork Is Going On?

Since September 18th, the Ethereum network has been constantly under attack by a person or group attempting denial of service (DoS) attacks on the Ethereum blockchain. This resulted in the network becoming “bloated” and filling up with a large number of pending transactions, increasing network confirmation times. They were able to achieve this by introducing an operation code (opcode). EXTCODESIDE opcode is the most well known, which caused miners and nodes to spend more energy processing the blocks than the reward they received.

Every operation that an Ethereum contract performs on the network pays a fee (called the gas fee). The attacker called the computationally expensive opcode, while paying low gas fees. Take a look at some of the transactionshere.

The introduction of Geth by the Ethereum Foundation is being hindered by the network bloat. That is why a hard fork was deemed necessary. This fork is known as the Ethereum Improvement Project 150 or EIP150. The next fork will attempt to remove empty accounts the attacker used to flood the network.

Since Ethereum Classic has the same code as Ethereum, the same attacks are happening. ETC devs have also introduced a fix, raising questions about the immutability of the chain and where the line in the sand is drawn for hard forks. Under what circumstances is a hard fork deemed necessary for a chain that markets itself as immutable?

What’s the point of the attacks? Is someone sending thousands and thousands of empty transactions, paying gas fees, just so they can get the Ethereum Foundation to enhance the network? Unless they intend to destroy the network (and fail to think the devs will fix it), then I think the below chart illustrates the main reason.

Both ETH and ETC have dropped more than 20% since the attacks started. Any shorts during this time have become extremely profitable, perhaps more so than the gas fees the attacker has been paying.

This presents an interesting opportunity. Let’s assume the attacks caused the price drop, and the subsequent forks fixed the underlying issues. This sets up ETH and ETC for a sharp move upwards.

Trade Idea: Go long ETH by buying ETHXBT; go short ETC by selling ETC7D. Hold the spread trade until the ETC hard fork on October 25th.