Abstract: In this piece, we explore why the BitMEX insurance fund is needed and how it operates. We compare the BitMEX insurance fund model, to the systems utilized by other more traditional leveraged market places (e.g. CME). We conclude that crypto-currency trading platforms which offer leverage and a capped downside face some unique challenges, when compared to traditional institutional trading platforms. However, the growth of BitMEX’s insurance fund provides a reasonable level of assurance to winning traders that they will be able to attain their expected profits.

(BitMEX Co-founder & CEO Arthur Hayes (left) and CME Chairman & CEO Terrence Duffy (right))

Leveraged Trading Platforms

When one trades on a derivatives trading platform such as BitMEX, one does not trade against the platform. BitMEX is merely a facilitator for the exchange of derivatives contracts between third parties. A key feature of the BitMEX platform is its leverage, where traders can deposit Bitcoin, then leverage it up, (in theory up to 100x) and purchase contracts with a notional position size far higher than the value of the Bitcoin they deposited.

The combination of offering both leverage and the ability for traders to trade against each other implies winners are not always guaranteed to get back all the profits they expect. Due to the leverage involved, the losers may not have enough margin in their positions to pay the winners.

Consider the following simplified example, where the platform consists of two customers trading against each other:

	Trader A	Trader B
Direction of trade	Long	Short
Margin	1 BTC	1 BTC
Trade execution price	$3,500
Leverage	10x	10x
Notional position size	10 BTC	10 BTC
Current BTC price	$4,000
Expected Profit	$5,000	($5,000)

In the above example, the winning trader A expects to make a profit of $5,000, which is greater than the amount of capital the loser, trader B, put up as collateral for the trade (one Bitcoin is worth $4,000). As such, trader A can only make 1 BTC ($4,000) in profits, perhaps making him/her feel slightly disappointed.

Traditional Exchanges

Traditional exchanges like the Chicago Mercantile Exchange (CME) do not share this problem to the same extent as crypto-platforms such as BitMEX. In traditional leveraged trading venues, there are often up to five layers of protection, which ensure winners get to keep their expected profits:

1. In the event an individual trader makes a loss greater than the collateral they have in their account, such that their account balance is negative, they are required to finance this position by injecting more funds into their account. If they are unable or unwilling to do so, their broker may initiate legal proceedings against the trader, forcing the trader to provide the funds or file for bankruptcy. Each trader must use a broker, who may evaluate the balance sheet and capital of each of their clients, providing each client a custom amount of leverage depending on the assessment of their particular risk.
2. In traditional derivative markets, traders are not typically given direct access to trading platforms. Instead, clients access the market through their brokers (clearing members), for instance investment banks such as JP Morgan or Goldman Sachs. In the event a trader endures losses and the debt cannot be recovered, the broker is required to pay the exchange and make the counterparties whole. From the perspective of the exchange, these brokers are sometimes referred to as clearing members.
3. In the event of a clearing member default, the centralised clearing entity itself is often required to make the counterparties whole. In many circumstances clearing and settlement is conducted by a separate entity to the one operating the exchange. The clearing house often has various insurance funds or insurance products in order to finance clearing member defaults.
4. In the event of a clearing member failing and the centralized clearing entity also having insufficient funds, in some circumstances the other solvent clearing members are expected to provide capital.
5. Many of the larger clearing houses (and perhaps even the larger brokers) are often considered systemically important for the global financial system by financial regulators. Therefore in a doomsday scenario where it looks likely that a major clearing house could fail, it is possible the government may step in and bail out traders, to protect the integrity of the financial system. Traders and institutions often have massive notional positions (multi-trillions of USD) hedged against other positions or instruments, typically in the interest rate swap market. Therefore it is crucial that the main clearing houses remain solvent or the entire financial system could collapse.

CME

CME is the world’s largest derivatives exchange, with an annual notional trading volume of over one quadrillion USD; it is over 1,000x as large as BitMEX. CME has several buckets of safeguards and insurance to provide protection in the event that a clearing member defaults. The funds are financed in various ways:

• Contributions from CME
• Contributions from clearing members
• Bonds placed by clearing members, redeemable by the clearing funds in the event of member default

CME Clearing’s Various Safeguards and Insurance Funds (2018)

Base Financial Safeguards Package
Guaranty Fund Contributions	$4.6 billion
Designated Corporate Contributions	$100 million
Assessment Powers	$12.7 billion
IRS Financial Safeguards Package
Guaranty Fund Contributions	$2.9 billion
Designated Corporate Contributions	$150 million
Assessment Powers	$1.3 billion

(Source: CME)

In exceptional circumstances, CME also has the power to apply “assessment powers” against non-defaulting clearing members to help finance the cost of defaulting members when all the other insurance funds have been drained. The value of the assessment powers is capped at 2.75x for each clearing member guarantee fund per member default.

Based on the size of the insurance funds in the above table, CME has around US$22 billion in various insurance funds. This represents around 0.002% of CME’s annual notional value of trading.

BitMEX and other crypto-currency trading platforms that offer leverage cannot currently offer the same protections to winning traders as traditional exchanges like CME. Crypto-currency is a retail-driven market and customers expect direct access to the platform. At the same time, crypto-trading platforms offer the ability to cap the downside exposure which is attractive for retail clients, therefore crypto-exchanges do not hunt down clients and demand payments from those with negative account balances. Leveraged crypto-currency platforms like BitMEX offer an attractive proposition to clients: a capped downside and unlimited upside on a highly volatile underlying asset. But traders pay a price for this, as in some circumstances there may not be enough funds in the system to pay winners what they expect.

BitMEX Insurance Fund

In order to mitigate this problem, BitMEX developed an insurance fund system, to help ensure winners receive their expected profits, while still limiting the downside liability for losing traders.

When a trader has an open leveraged position, if their maintenance margin is too low, their position is closed forcefully (i.e. liquidated). Unlike in traditional markets, the trader’s profit and loss does not reflect the actual price their position was closed on the market. On BitMEX if a trader is liquidated, their equity associated with the position always goes down to zero.

Example trading position
Direction of trade	Long
Margin	1 BTC
Bitcoin price (at opening)	$4,000
Leverage	100x
Notional position size	100 BTC = $400,000
Maintenance margin as percentage of notional position	0.5%

In the above example, the trader has a 100x long position.  If the mark price of Bitcoin falls 0.5% (to $3,980) the position is liquidated and the 100 Bitcoin position needs to be sold on the market. From the perspective of the liquidated trader, it does not matter what price this trade executes at, whether its $3,995 or $3,000, either way they lose all the equity they had in their position, they lose the entire one Bitcoin.

Now, assuming there is a liquid market, the bid/ask spread should be tighter than the maintenance margin. In this scenario, the liquidations result in contributions to the insurance fund (e.g. if the maintenance margin is 50bps, but the market is 1bp wide), then the insurance fund will rise by almost as much as the maintenance margin when a position is liquidated. Therefore, as long as healthy liquid markets persist, the insurance fund should continue to grow at a steady pace.

The two graphics below attempt to illustrate the above example. In the first chart, at the time of liquidation, market conditions are healthy and the bid/ask spread is narrow, at just $2. As such, the closing trade occurs at a price higher than the bankruptcy price (the price where the margin balance is zero) and the insurance fund benefits. In the second chart, at the time of liquidation the bid/ask spread is wide. The closing trade occurs at a price lower than the bankruptcy price, therefore the insurance fund is used to ensure the winning traders receive their expected profits. This may seem like it would be a rare occurrence, but there is no guarantee such healthy market conditions will continue, especially in times of heightened price volatility. In these times, the insurance fund can drain much faster than it builds up.

Illustrative example of an insurance contribution – Long 100x with 1 BTC collateral

(Note: The above illustration is based on opening a 100x long position at $4,000 per BTC and 1 Bitcoin of collateral. The illustration is an oversimplification and ignores factors such as fees and other adjustments. The bid and offer prices represent the state of the order book at the time of liquidation. The closing trade price is $3,978, representing $1 of slippage compared to the $3,979 bid price at the time of liquidation.)

Illustrative example of an insurance depletion – Long 100x with 1 BTC collateral

(Notes: The above illustration is based on opening a 100x long position at $4,000 per BTC and 1 Bitcoin of collateral. The illustration is an oversimplification and ignores factors such as fees and other adjustments. The bid and offer prices represent the state of the order book at the time of liquidation. The closing trade price is $3,800, representing $20 of slippage compared to the $3,820 bid price at the time of liquidation.)

The BitMEX insurance fund currently sits at around 21,000 Bitcoin or around US$70 million based on current Bitcoin spot prices. This represents only 0.007% of BitMEX’s notional annual trading volume, of around one trillion USD. Although this is slightly higher than CME’s insurance funds as a proportion of trading volume, winning traders on BitMEX are exposed to much larger risks than CME traders through the following:

• BitMEX does not have clearing members with large balance sheets and traders are directly exposed to each other.
• BitMEX does not demand payments from traders with negative account balances.
• The underlying instruments on BitMEX are more volatile than the more traditional instruments available on CME.

Auto-deleveraging

In the event that the insurance fund becomes depleted, winners cannot be confident of taking home as much profit as they are entitled to. Instead, as we described above, winners need to make a contribution to cover the losses of the losers. This process on BitMEX is called auto-deleveraging.

Auto-deleveraging has not occurred on the BitMEX Bitcoin perpetual swap contract since March 2017. In early March 2017, the SEC disapproved the Winklevoss’ application for the COIN Bitcoin ETF. On that day, the market dropped 30% in five minutes. The sharp price drop depleted the insurance fund entirely. Many XBTUSD shorts were ADL’d (Automatic Deleveraging) and their profits were capped.

Although the BitMEX insurance fund has grown considerably since then, crypto-currency trading is a volatile and uncertain industry. Despite the current healthy periods of reasonably high liquidity, sharp movements in the Bitcoin price going forwards is a possibility, in our view. One cannot be certain that ADL’s won’t occur again, even on the BitMEX Bitcoin perpetual swap contract.

Insurance Fund Data

Although the absolute value of the insurance fund has grown, as the charts below show as a proportion of other metrics from the BitMEX trading platform, such as open interest, the growth is less pronounced.

BitMEX Insurance Fund – Daily data since January 2018

(Source: BitMEX)

BitMEX Insurance Fund as a proportion of the BitMEX Bitcoin perpetual swap open interest – Daily data since January 2018

(Source: BitMEX)

Incentives

Assuming the insurance fund remains capitalized, the system operates under a principle where those who get liquidated pay for liquidations, a losers pay for losers model. While this approach may be considered somewhat novel, in a way there is a degree of fairness to it, that isn’t present in some alternative models mentioned above. It begs the question, why should traders who do not engage in risky leveraged bets have to pay for those that do?

Conclusion

Although 21,000 Bitcoin inside an insurance fund, worth around 0.1% of the total Bitcoin supply may seem large, BitMEX cannot offer the same robust guarantees to winning traders, compared to those provided by traditional leveraged trading platforms. While the insurance fund has achieved a healthy size, it may not be large enough to give winning traders the confidence they need in the volatile and unpredictable bumpy road ahead in the crypto-currency space. Given such volatility, it’s not impossible that the fund is drained down to zero again.

Between 05:40 and 07:11 UTC today, a subset of the requests to the BitMEX REST API experienced slow API responses and eventual API timeouts due to resource contention at the API layer. Upon detection via our internal alerting mechanisms we identified the cause and mitigated the immediate impact within a few minutes. There is currently no ongoing issue and there was no impact to the trading engine or user data during this time.

Fixes for the underlying root cause of the issue have been identified and are being worked on as a priority. We will follow up with another announcement once these are live. We have also increased the sensitivity of our system monitoring to detect and resolve potential similar issues much sooner. We apologise for any inconvenience this may have caused.

Earlier today, the testnet.bitmex.com website and the API were not available for approximately 16 minutes from 19:42 to 19:57 UTC. We identified the cause, made adjustments and service has resumed immediately. We apologise for any inconvenience this may have caused.

In response to last week’s post, yesterday we successfully released an enhancement to our internal market data distribution component’s re-subscription logic. This addresses the root cause of the previous week’s issue and along with the additional safety mechanism to prevent impact to the trading engine deployed at the time, we don’t anticipate a reoccurrence of last week’s issue.

On 9 January BitMEX experienced two unrelated minor outages.

At 02:44:10 UTC the WebSocket API saw a degradation in performance for a minute where 7% of commands sent by clients failed. Connections continued undergoing a 1% failure rate of commands until servers recovered at 02:47:00 UTC.

Clients may have also seen an increase in response times for some market data REST endpoints up during this period. This was due to a rolling restart of the API servers that occurred in too tight of a timeframe.  

In addition, at 05:48:10 UTC and 06:10:10 UTC, BitMEX experienced minor outages for approximately 30 seconds whereby requests to the trading engine were load-shed as the engine was busy. During these times, clients would have observed a lack of updates over the WebSocket API for the same reason. The outages were due to data replay complications during a regularly scheduled market data distribution component restart.  

There was no data loss during these events and an additional safety mechanism to prevent a similar situation from impacting the trading engine has already been deployed. The root causes have also been identified and we are currently working on permanent fixes to prevent a recurrence. Updates will follow in the future.

We apologise for the inconvenience. If you have any questions, please contact customer support.

 

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

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

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

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

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

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

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

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

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

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

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

Thankfully, That’s Where Bitcoin Enters the Conversation

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

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

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

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

Grounds for Optimism in General

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

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

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

Abstract

We look at common misconceptions with respect to how banks make loans and the implications this has on the ability of banks to expand the level of credit in the economy. We analyse the inherent properties of money which ensure that this is the case. We then consider why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money, namely the ability to transact electronically and avoid a third party financial intermediary, thereby avoiding the need for bank deposits, which fuel the credit cycle. We explain the implications this could have on the ability of banks to engage in credit expansion.

 

Click here to download the pdf version of this report

 

Dynamics of Credit Expansion

The core characteristic of the traditional banking system and modern economies, is the ability of the large deposit taking institutions (banks) to expand the level of credit (debt) in the economy, without necessarily needing to finance this expansion with reserves.

An often poorly understood point in finance, is the belief that banks require reserves, liquidity or “cash”, in order to make new loans. After-all where do banks get the money from? It is true that smaller banks and some financial institutions do need to find sources of finance to make new loans. However, in general, this is not the case for the main deposit taking institutions within an economy.

If a main deposit taking institution, makes a new loan to one of their customers, in a sense this automatically creates a new deposit, such that no financing is required. This is because the customer, or whoever sold the item the loan customer purchased with the loan, puts the money back on deposit at the bank. Therefore the bank never needed any money at all. Indeed there is nothing else people can do, the deposits are “trapped” inside the banking system, unless they are withdrawn in the form of physical notes and coins, which rarely happens nowadays.

Please consider the following simplified example:

1. A large bank, JP Morgan, provides a mortgage loan to a customer, who is buying their first home, for $500,000
2. JP Morgan writes a check to the mortgage customer for $500,000
3. The mortgage customer deposits the check into his deposit account, at JP Morgan
4. The mortgage customer writes a new check, for $500,000 and he hands it over to the seller of the property
5. The seller is also a banking client of JP Morgan and as soon as she receives the check, she deposits it into her JP Morgan bank account

 

Illustrative diagram of a new home mortgage with one dominant bank in the economy

As one can see, the above process had no impact on the bank’s liquidity or reserves, the bank never had to spend any “cash” at any point in the above example. Of course, the seller of the property does not necessarily have to have an account with the same bank as the one which provided the loan. However large deposit taking institutions, such as JP Morgan, HSBC or Bank of America, have large market shares in the deposit taking business, in their local markets. Therefore, on average, these large banks expect more than their fair share of new loans to end up on deposit at their own bank. Actually, on average, new loans in the economy increases the available liquidity for these large banks, rather than decreasing it.

The accounting treatment of this mortgage, for the bank, is as follows:

• Debit: Loan (asset): $500,000
• Credit: Deposit (liability): $500,000

The bank has therefore increased its assets and liabilities, resulting in balance sheet expansion. Although from the point of view of the home seller, she has $500,000 of cash. The above transaction has increased the amount of loans and deposits in the economy. From the customer’s point of view, these deposits are seen as “cash”. In a sense, new money has been created from nothing, apart from perhaps the asset, which in this case is the property. In the above scenario, M0 or base money, the total value of physical notes and coins in the economy, as well as money on deposit at the central bank, remains unchanged. M1, which includes both M0 and money on deposit in bank accounts, has increased by $500,000. Although the precise definition of M1 varies by region.

Cash reserves from the point of view of a bank are physical notes and coins, as well as money on deposit at the central bank. The ratio between the level of deposits a bank can have and its reserves, is called the “reserve requirement”. This form of regulation, managing the reserve requirement, leads to the term “fractional reserve banking”, with banks owing more money to deposit customers than they have in reserve. However, contrary to conventional wisdom, in most significant western economies, there is no regulation directly limiting the bank’s ability to make these loans, with respect to its cash reserves. The reserve requirement ratio typically either does not exist, or it is so low that it has no significant impact. There is however a regulatory regime in place that does limit the expansionary process, these are called “capital ratios”. The capital ratio, is a ratio between the equity of the bank and the total assets (or more precisely risk weighted assets). The bank can therefore only create these new loans (new assets) and therefore new deposits (liabilities), if it has sufficient equity. Equity is the capital investment into the bank, as well as accumulated retained earnings. For example if a bank has $10 of equity, it may only be allowed $100 of assets, a capital ratio of 10%.

 

The credit cycle

To some extent, the dynamic described above allows banks to create new loans and expand the level of credit in the economy, almost at will, causing inflation. This credit cycle is often considered to be a core driver of modern economies and a key reason for financial regulation. Although the extent to which the credit cycle impacts the business cycle is hotly debated by economists. These dynamics are often said to result in expansionary credit bubbles and economic collapses. Or as Satoshi Nakamoto described it:

 

Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve

 

Ray Dalio, the founder of Bridgewater Associates (a leading investment firm), appears to agree that the credit cycle is a major driver of swings in economic growth, at least in the short term, as his video below explains:

 

 

The view that the credit cycle, caused by fractional reserve banking, is the dominant driver of modern economies, including the boom and bust cycle, is likely to be popular in the Bitcoin community. This theory is sometimes called Austrian business cycle theory, although many economists outside the Austrian school also appreciate the importance of the credit cycle.

The fundamental cause of the credit expansionary dynamic

The above dynamic of credit expansion and fractional reserve banking, is not understood by many. However, with the advent of the internet, often people on the far left politics, the far right of politics or conspiracy theorists, are becoming partially aware of this dynamic, perhaps in an incomplete way. With the “banks create money from nothing” or “fractional reserve banking” narratives gaining some traction. The question that arises, is why does the financial system work this way? The underlying reasons for this, are poorly understood, in our view.

Individuals with these fringe political and economic views, may think this is some kind of grand conspiracy by powerful elite bankers, to ensure their control over the economy. For example, perhaps the Rothschild family, JP Morgan, Goldman Sachs, the Bilderberg Group, the Federal Reserve or some other powerful secretive entity deliberately structured the financial system this way, so that they could gain some nefarious unfair advantage or influence? Actually, this is not at all the case.

The ability of deposit taking institutions to expand credit, without requiring reserves, is the result of inherent characteristics of the money we use and the fundamental nature of money. This is because people and businesses psychologically and for very logical practical reasons, treat bank deposits in the same way as “cash”, when they could alternatively be considered as loans to the bank. This enables banks to then expand the amount of deposits, knowing they are safe, as customers will never withdraw it, since they already think of it as cash.

Bank deposits are treated this way for perfectly reasonable and logical reasons, in fact bank deposits have some significant advantages over physical cash. Bank deposits are simply much better than physical cash. It is these inherent and genuine advantages that cause fractional reserve banking, not a malicious conspiracy, as some might think.

 

Advantages of bank deposits compared to physical notes and coins

Factor	Bank deposit	Physical cash
Security	Keeping money on deposits in financial institutions, increases security The money is protected by multiple advanced security mechanisms and insured in the unlikely event of theft	Large physical cash balances at home could be vulnerable to theft or damage Physical cash cannot be insured and storage costs can be expensive
Electronic transfers	Using the banking system, it is possible to quickly send money effectively over the internet or by phone, across the world at low cost and at high speed	If physical cash is used, then a slow, inefficient, insecure physical transfer must take place
Convenience	Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or on your computer Precise amounts can be sent so there is no issue with receiving change	Handling cash is often a difficult and cumbersome process. Precise amounts cannot be specified and one may need to calculate change amounts
Auditability	Traditional banks offer the ability to track, control and monitor all transactions, which can help prevent fraud. This improves reporting and accountability	With physical cash, effective record keeping is less automated, increasing the probability of fraud

 

The main features of the different types of money

Despite the strong advantages of bank deposits mentioned in part 1 of this piece, namely the ability to use it electronically, physical notes and coins do have some significant benefits over electronic money. The following table aims to summarize the main features of the different types of money, bank deposits, physical cash and Electronic Cash (Bitcoin).

 

Features of electronic bank deposits, physical notes & coins and electronic cash

Feature	Bank deposit	Physical cash	Electronic Cash
Advantages of physical cash
Funds are fully protected in the event the bank becomes insolvent or inaccessible*
It is difficult for the authorities to confiscate funds
Funds can be effectively hidden from the authorities
Transactions cannot easily be blocked
Transfers can be highly anonymous
Transfers can be irrevocable
Transfers can occur instantly	?		?
Payments can occur 24×7	?
Transaction fees are zero	?
Payments work during power outages or when communication networks are unavailable
Money can be used without purchasing or owning a device
Anyone can use the system, without seeking permission
Advantages of electronic systems
Payments can be made over the internet
Change does not need to be calculated
Payments can easily be recorded
Funds can easily be secured to prevent theft			?

Note: * Physical cash still has a potential problem with respect to the solvency, related to the policy of the central bank which issues the currency

 

Due to the strengths mentioned in the above table, physical cash will always have its niche use cases. However, on balance, banking deposits are superior to physical cash, for the majority of users. The ability to use bank deposits electronically is particularly compelling, especially in the digital age. As we explained in part one of this piece, it is this ability to use the money electronically that ensures there is always high demand for bank deposits, giving banks the ability to freely expand the level of credit.

 

The unique properties of Bitcoin

Bitcoin shares many of the advantages of physical cash over electronic bank deposits. Although Bitcoin does not have the full set of advantages, as the table above demonstrates. However the key unique feature of Bitcoin, is that it has both some of the advantages of physical cash and the ability to be used electronically.

Bitcoin aims to replicate some of the properties of physical cash, but in an electronic form, an “electronic cash system”. Before Bitcoin, people had to make a binary choice, between physical cash or using a bank deposit.

Although technically physical cash is a kind of a bank deposit, a deposit at the central bank, physical cash still has unique bearer type properties which could not be replicated in an electronic form. For the first time ever, in 2009, Bitcoin provided the ability to use a bearer type asset, electronically. The simple table below illustrates this key unique feature of Bitcoin and blockchain based tokens.

 

The binary choice in legacy finance & the new option Bitcoin provides

	Bearer type instrument	Electronic type instrument
Physical Cash (Notes & Coins)
Electronic money (Bank Deposit)
Electronic Cash (Bitcoin)

 

Therefore Bitcoin can be thought of as a new hybrid form of money, with some of the advantages of physical cash, but also some of the advantages of bank deposits.

 

Bitcoin’s limitations

Although Bitcoin has inherited some of the strengths of both traditional electronic money systems and physical cash. Typically Bitcoin does not have all the advantages of either electronic money or physical cash, however it is uniquely positioned to be able to have a subset of the features of each. This provides a new middle ground option.

For example, Bitcoin may never have the throughput of traditional electronic payment systems or the ability to use without electricity such as with physical cash. Although as technology improves, Bitcoin may slowly develop more strengths and gradually improve its capabilities, to narrow the gap.

 

The implications of these characteristics on credit expansion

Understanding the dynamics of these characteristics, can be useful in evaluating the potential economic significance of Bitcoin, should the ecosystem grow. Bitcoin has at least six properties which provide some level of natural resilience against credit expansion, which traditional money does not have. This is because the advantages of keeping money on deposit at a bank are not always as pronounced in Bitcoin, compared to the alternatives. However, Bitcoin is certainly not immune to the same credit expansionary forces which exist in traditional systems, indeed people can keep Bitcoin on deposit at financial institutions just like they can with physical cash. Bitcoin may merely have greater resistance to the same credit expansionary forces.

At the core of our reasoning, is looking at the advantages of bank deposits compared to physical cash, which are the characteristics that enable large banks to freely expand credit and evaluating to what extent they apply in Bitcoin. As the table below shows, the advantages of keeping money on deposit at a bank are less significant in the Bitcoin world, therefore we think Bitcoin does have some unique resilience against the forces of credit expansion.

 

Physical cash vs bank deposits compared to Bitcoin vs Bitcoin deposits

Factor	Physical cash compared to deposits	Bitcoin compared to Bitcoin deposits
1. Security	Keeping money on deposits in financial institutions, increases security relative to keeping large physical cash balances at home, where the cash is vulnerable to theft or damage	Bitcoin can potentially allow a high level of security, without putting the funds on deposit at a bank For example Bitcoin can be concealed or encrypted
2. Electronic transfers	Using the banking system, it is possible to send money effectively over the internet or by phone, across the world at low cost. If physical cash is used, then a slow, inefficient, insecure physical transfer must take place	Bitcoin can allow users to efficiently transmit money over the internet, without using deposits at financial institutions
3. Convenience	Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or your computer. Precise amounts can be sent so there is no issue with receiving change	Bitcoin can allow users to make payments on a mobile phone or without manually calculating change amounts. Deposits at financial institutions are not required
4. Ability to redeem deposits	In the traditional banking system, withdrawing physical cash from a financial institution is a long administrative process which takes time. Banks therefore do not need to worry about keeping large quantities of physical cash in reserves	Bitcoin can allow users to withdraw money from deposit taking institutions quickly, which may encourage banks to ensure they have adequate Bitcoin in reserve at all times
5. Auditability	Banks offer the ability to track and monitor all transactions, which can help prevent fraud and improve accountability. Physical cash cannot offer this	Bitcoin’s blockchain or other electronic databases can allow users to effectively audit and monitor transactions, without using third party financial intermediaries
6. “Hybrid banking”	In traditional banking models there are only two fundamental choices: 1. Physical cash which provides full user control of the money 2. Money on deposit at a financial institution This is a binary choice with no middle ground options, forcing consumers to make a difficult choice with no compromise option available	Bitcoin allows for a wider spectrum of deposit and security models, resulting in a more complex credit expansionary dynamic. For example: 1. 2 of 2 multi-signature wallet, where the bank holds one key and the user holds another key; or 2. 1 of 2 multi-signature wallet, where the bank holds one key and the user holds another key

 

The economic consequences of less credit expansion

The consequences of the lower level of credit expansion this analysis implies, does not really say much about whether this potentially new economic model will be more beneficial to society, nor does it say much about whether Bitcoin will be successful or not. The former is something that has been heavily debated by economists for decades and the latter is a separate topic, in our view. Although, despite decades of economic debate, perhaps Bitcoin is sufficiently different to the money which came before it, such that the debate is required again, with new very different information. For example inflation or deflation, caused by cycles of credit expansion, may have very different consequences in a Bitcoin based financial system, than on one based on bank deposits and debt. A key problem with deflation in a debt based money system, is that it increases the real value of debt, resulting in a downwards economic spiral. For non debt based money systems like Bitcoin, it is less clear what the implications of deflation are.

Although Bitcoin may not necessarily result in a superior economic model, we think this analysis may suggest that Bitcoin may have some properties that make the economic model somewhat unique or perhaps interesting, compared to the possible models that came before it. Therefore it does look like an area worth examining.

To many, the ultimate objective of Bitcoin is to become sufficiently dominant, such that there is a significant decrease in credit expansionary forces, which can neutralize the credit cycle and therefore the business cycle. Although, this should be considered as an extremely ambitious objective, which we consider as extremely unlikely. And even in the remarkable circumstance that Bitcoin grows to this scale, other unforeseen economic problems, particular to Bitcoin, may emerge.

On 27 December at 18:38 UTC, BitMEX experienced a minor outage for approximately 1 minute whereby the trading engine was unavailable. During this time, market data updates were not published over the Websocket API.

Additionally, REST API queries for trading related data (read-only HTTP GET requests, not order management requests) took longer to return than usual over a period of 23 minutes from 18:13 UTC to 18:36 UTC.

The root causes of both issues have been identified and we are working on permanent fixes to prevent a recurrence. Updates will follow in the future.

We apologise for the inconvenience. If you have any questions, please contact customer support.

On 17th December 2018, the March 2019 quarterly ADA, BCH, EOS, ETH, LTC, TRX, and XRP futures contracts will be listed:

• BitMEX Cardano / Bitcoin 29 March 2019 futures contract (ADAH19)
• BitMEX Bitcoin Cash / Bitcoin 29 March 2019 futures contract (BCHH19)
• BitMEX EOS Token / Bitcoin 29 March 2019 futures contract (EOSH19)
• BitMEX Ether / Bitcoin 29 March 2019 futures contract (ETHH19)
• BitMEX Litecoin / Bitcoin 29 March 2019 futures contract (LTCH19)
• BitMEX Tron / Bitcoin 29 March 2019 futures contract (TRXH19)
• BitMEX Ripple / Bitcoin 29 March 2019 futures contract (XRPH19)

On the same date, the June 2019 quarterly BTC futures contract will be listed:

• BitMEX BTC / USD 28 June 2019 futures contract (XBTM19)

Remember BlockMEX? Well the firm has limped along for several years. They have tried various business models. None have made any money. But that doesn’t matter, VC firms continue to shower the company with cash, and its valuation continues to rise. The CEO now has a great new idea. Let’s listen in on the recent board meeting.

Billy – Billy is the CEO of the company. He just joined as the previous dude got ousted. The VC firm The Blind Fund, who supplies most of the cash, ousted the previous CEO in favour of Billy who they thought would play ball better.

Kaiser Soze – One of the general partners at The Blind Fund.

Kaiser Soze – So Billy, what are we going to do to get some traction? It’s been over four years, and BlockMEX still makes zero revenue. You guys need to do something new.

Billy – Well, I have a new idea. ICOs are toxic. The projects are trash, and the regulators hate them. What about STOs, Securities Token Offerings?

Kaiser Soze – Tell me more.

Billy – Ok, so imagine you want to buy a fraction of a piece of real estate. And then you could trade your fractional ownership, which is represented by a token.

Kaiser Soze – Call me old fashioned, but isn’t that just a Real Estate Investment Trust (REIT)? Most stock markets around the world already have those.

Billy – But do REIT’s ride on a Blockchain? Do they use Distributed Ledger Technology to hold the record of the title?

Kaiser Soze – No, but they trade billions of dollars a day already, and you can easily trade them with your local broker almost everywhere in the world.

Billy – You don’t get it. If the token rides on a Blockchain, like the Ethereum protocol, then they reach help anyone anywhere. Like those poor investors in North Korea who have nowhere to put their savings. Now they can own a token.

Kaiser Soze – Anyone, really?!! It’s pretty clear these are securities, right?

Billy – Yes.

Kaiser Soze – So that means they are regulated, and in most places the exchange needs some sort of license.

Billy – Yes, that’s correct.

Kaiser Soze – The same license the incumbent exchanges already possess?

Billy – Correct.

Kaiser Soze – And the technology stack that operates the matching engine must also be approved by the regulator, right?

Billy – Correct.

Kaiser Soze – So you are replicating the same technology, getting the same license, to go after the same client base?

Billy – Correct.

Kaiser Soze – Ok, sounds like a winner. We can keep pumping money in, and make it up on volume. [The Blind Fund never saw a negative gross margin business they didn’t like.]

Billy – Exactly what I was thinking. Everyone is talking about STOs and how they are the future. Another type of STO is an equity offering of a startup.

Kaiser Soze – So how would that be different than doing an IPO?

Billy – Well many companies these days are staying private, the cost of doing an IPO and all the regulatory and compliance costs, are daunting—-especially for smaller companies. There should be a way for smaller technology companies to raise funds by selling some type of equity.

Kaiser Soze – Would these companies pay dividends? I’m assuming these are unprofitable companies.

Billy – Not only would they not pay dividends, there would be no audited accounts, or any duty to really explain anything to their investors.

Kaiser Soze – Wow, that’s amazing. How would this STO thing fit in on the balance sheet?

Billy – Not sure on that one yet.

Kaiser Soze – Traditional financial theory would suggest that this token is worthless because there is no cash flow.

Billy – Come’on Kaiser. We have been through this before. Traditional finance is dead. We are in a new paradigm. Don’t be a luddite.

Kaiser Soze – I know, I know. But if you are selling equity like securities, wouldn’t that need to be registered with a national regulator?

Billy – Shhhhhh.. Don’t tell anyone. We are just going to shoe horn this one in. Because we use a Blockchain and or Distributed Ledger Technology, those rules don’t apply. The best part is, we can absolve ourselves of any legal liability by basically telling investors when they buy these things they actually have zero rights. ROFL.

Kaiser Soze – Man, this Blockchain shit is LIT! You can do anything.

Billy – I know, right? Maybe the only thing we can’t do is become revenue positive.

Kaiser Soze – Don’t worry about that. I know some people in the desert, who have more cash than brains. They won’t let us down.

 

Overheard at the recent Polly Pocket Investor Day.

Polly Pocket is the managing partner of Polly Pocket Capital. The fund invests solely in tokens.

Schmuck is an investor in the fund.

Polly – Welcome everyone to our Investor Day. 2018 has been a challenging year for our fund but we are fully confident in our ability, over the long run, to deliver superior returns.

Schmuck – Speaking of performance, can I get some more colour on what your fund actually holds?

Polly – Great question. As you know, we don’t disclose exactly what we own, but I can give you a taste. Our fund is divided into listed and unlisted tokens.

Schmuck – Ok, what do you mean by listed and unlisted? I thought the mandate only allowed the fund to invest in tokens that are already traded on a secondary market.

Polly – Well, that is true. But we saw some great deals, so we created a side pocket. The side pocket contains all the pre-ICO deals that we invested in.

Schmuck – Hmm…So you basically can invest in whatever you like, regardless of the fund mandate?

Polly – In a nutshell, yes.

Schmuck – Greeeeaaat. How do you mark these illiquid, unlisted tokens?

Polly – As you know, due to our amazing connections, we get in on deals well before the unwashed masses. Typically we get a 70% – 90% discount to the last round where most of the plebes purchase these tokens. We then mark the value of the token to the last round price.

Schmuck – So if you invest a price of $1,and the last round which could be a very small amount of the total float, is sold at $10, you record a 10x gain?

Polly – Yes.

Schmuck – Does that also mean that I get charged management fees on the 10x value?

Polly – Yes.

Schmuck – Your liquid token portfolio got molly whopped this year, correct?

Polly – Yes.

Schmuck – So the AUM will get bled at an accelerated rate due to the marking of the side pocket? I’m am paying 2% on a 10x marked up illiquid token with no secondary market, and there is no visibility as to when it will actually list?

Polly – I mean that sounds worse than it is, but you are essentially correct.

Schmuck – Do you apply a haircut to this valuation because there is no liquidity, and an indefinite time to listing?

Polly – No. We believe there is extreme value, and this is reflected in the last round price. Our team of token experts really knows how to value these things.

Schmuck – Maybe, but the management fees paid on these side pocket investments could consume the entire value of the investors’ capital. What happens if I would like to redeem?

Polly – We would sell our liquid tokens first. Once that pool of capital is exhausted, we would be unable to meet your redemption request.

Schmuck – Is there no way to sell your interest in these projects? Have you ever tried?

Polly – Legally we can’t. The SAFT term sheet does not allow us to transfer our interest before the token lists.

Schmuck – So basically you are telling me, I’m up shit creek without a paddle?

Polly – I wouldn’t put it that way. Sometimes we suffer liquidity issues.

REAL TALK

The BitMEX Research team has compiled a list of tokens that raised over US$50 million that have yet to list.

 

 

These deals have massive valuations, and many of the most venerated token funds took down large chunks. It is unclear when, if ever, these deals will ever list on the secondary market.

Given the large amount of token supply out there, who will buy this shit?

Can you really mark these investments to the last round price?

There are anecdotal reports of funds attempting to sell their SAFT interest, and the prices offered were way below the last round price.

2019 is going to be the year of reckoning for many funds. You can mark something to an absurd level in year 1. But the meter starts again on January 1st. If these things come to market, there will be no accounting tricks to hide the gargantuan losses that these funds will post.

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

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

Father is the Bishop.

Judas – Forgive me Father, for I have sinned. It has been one year since my last confession.

Father – Welcome my son, please tell me how you have sinned.

Judas – Well as you know, I am an Ethereum developer. But I believe I have given false witness to another god.

Father – Who would that be, the Devil, Satan himself?

Judas – No Father, my faith strayed. I believed in Decentralisation.

Father – Huh? Not sure I follow. Please explain.

Judas – I am an Ethereum developer. You know, the world’s virtual computer. I believed that using the Ethereum protocol I could decentralise anything. And I was specifically interested in the trading of financial assets, like stocks.

Father – Ok, but what would a decentralised stock market look like?

Judas – Well, anyone, anywhere could exchange stocks. You wouldn’t need to get approval from any government or a traditional exchange like the New York Stock Exchange or Nasdaq. It would also allow anyone to sell equity in their project to anyone in the world. In short, true financial freedom for everyone, everywhere.

Father – Heresy. You planned to usurp the Angels, the NYSE, and Nasdaq. Did you not consult the good book about our Lord’s relationship with those organisations?

Judas – I did, but I thought because I used the decentralised world computer, Ethereum, that our Lord and Saviour would not mind.

Father – Son, you did not read the Gospels close enough. Specifically, the Gospel according to Howie.

Judas – Well, I thought my lawyers were well versed in the Gospels. They told me that because it was decentralised, the Gospel according to Howie did not apply.

Father – [Shakes his head in sorrow] In my last sermon, I preached that the Lord’s children must be vigilant against false prophets. Specifically those wearing Brioni suits, and white Church’s shoes. These white shoe lawyers, care not for your soul, but only for their pockets.

Judas – Oh, I missed that one. I was too hungover after a night at the Box. We were celebrating our ICO.

Father – Ah, the ICO. I also lead a vigil against that tool of the Devil. But son, how is your project decentralised, if you personally launched an ICO, and profited from it? Surely, a truly decentralised project has no identifiable leader, and no one entity profits from its operation?

Judas – I realised the errors of my ways now.

Father – How has the Lord made you repent?

Judas – The Lord decreed that I must pay a large sum of money to absolve my sins.

Father – Better that, than the Lord sending you to Sodom and Gomorrah, a.k.a. Rikers.

Judas – I know, I am forever grateful to the mercy of our Lord.

Father – I am glad you have learned son. Our Lord is merciful. But he will strike rath down upon those who threaten his kingdom.

Father – Let us pray to our Lord and Saviour. In nomine patris et filii spiritus sancti JAY CLAYTON.