Important Changes to Bitcoin / USD Swap Funding

Occasionally the BitMEX Bitcoin / USD Swap, XBTUSD, trades at a significant premium or discount to the mark price. This generally happens during periods of extreme volatility.

In order to ensure that the XBTUSD product trades close to the mark price the following change will be made.

Given 8 hours’ notice, BitMEX may decrease the funding interval from 8 hours to 2 hours to allow funding rates to better reflect the market. The leverage will remain unchanged at 100x. The funding interval will subsequently be increased from 2 to 8 hours after the market has stabilised.

An 8 hour funding interval means that the maximum amount of funding paid or received is +/- 1.125% per day. A 2 hour funding interval means that the maximum amount of funding paid or received is +/- 4.50% per day.

To learn more about the BitMEX Bitcoin / USD Swap especially how the mark price is calculated, please read the Swaps Guide.

Basic Basis Trading Strategies

As the popularity and trading volumes of BitMEX grow, I repeatedly receive questions from traders about how to execute interest rate trades using BitMEX products. As I discussed in my previous article, a Eurodollar is a USD deposit held outside of America. The interest rate or basis trades I will describe below all take advantage of higher Eurodollar interest rates in Bitcoin.

A spot Bitcoin exchange essentially is a pseudo-bank that offers USD deposits (aka Eurodollars). The interest rate on these Eurodollars is high mainly because of counterparty risk. There is no deposit insurance, and exchanges routinely get hacked or steal customers’ money.

Traders on derivative exchanges would like to own more Bitcoin than they have cash to purchase. Market makers and arbitrageurs who are usually short Bitcoin, hedge themselves by purchasing it with USD held on the underlying exchanges.

These traders supply USD to speculators for a positive rate of return. This interest or basis compensates them for counterparty risk and the opportunity cost of capital. The three basic basis strategies I will describe below allow traders to capture this basis as profit.

First, it is necessary to have an elementary understanding of the futures and swap contracts that BitMEX offers.

Futures Contract: The buyer or seller is entitled to the difference between the entry and settlement price at maturity. Buyers and sellers pay and receive fixed interest rates depending on whether the basis is positive or negative respectively at entry. Basis is the difference between the futures and spot price.

For the following examples I will use the BitMEX Bitcoin / USD 100x Leveraged 31 March 2017 Futures Contract, XBTH17. Each contract is worth $1 of Bitcoin.

Swap Contract: This derivative is similar to a futures contract, but there is no settlement date. Traders are free to hold their position for as long as their capital allows. To anchor the swap price to the underlying spot price, interest rate payments are exchanged between longs and shorts depending on whether the swap is trading at a premium or discount. A swap contract is an exchange of floating interest rate payments for price performance.

For the following examples I will use the BitMEX Bitcoin / USD 100x Leveraged Swap Contract, XBTUSD. Each contract is worth $1 of Bitcoin.

Both XBTUSD and XBTH17 use the same underlying index. Therefore, trading one against the other in the same quantity eliminates any Bitcoin / USD price risk.

Future vs. Spot

This is the simplest basis trade. This strategy is commonly called cash and carry. Basis can be positive or negative, but usually futures trade more expensive than spot. This is because speculators who are short Bitcoin can only make 100%, but infinity is the maximum return for longs.

Mechanics

  1. Buy $1,000 worth of Bitcoin.
  2. Sell 1,000 contracts of XBTH17.
  3. At expiry, sell the remaining physical Bitcoin.

Margin Considerations

You must deposit at least 1% of the Bitcoin value of the XBTH17 position with BitMEX. The remaining Bitcoin you should store yourself in a properly secured Bitcoin wallet. If the XBTH17 price rises, your position is at risk of being liquidated.

If you are completely comfortable with BitMEX counterparty risk, then deposit the full Bitcoin value. By using 1x leverage, you cannot be liquidated. Otherwise you will have to monitor your liquidation price and occasionally top up your BitMEX account.

Profit Potential

The basis captured is your profit. You must hold the trade until XBTH17 expires to realise the full amount.

Risks

If you do not fully margin the XBTH17 position, you risk getting liquidated if the price rises before you can deposit additional margin on BitMEX.

Swap vs. Spot

This has become a very popular trade due to the historically positive funding rate. A positive funding rate means that longs pay shorts every eight hours. Since May 2016, XBTUSD shorts have been paid a total of 37.60% of interest (47.16% annualised).

Mechanics

  1. Buy $1,000 worth of Bitcoin.
  2. Sell 1,000 contracts of XBTUSD.
  3. Unwind the trade when you believe funding will turn negative for an extended period of time.

Margin

The margin considerations are the same as with the previous trading strategy.

Profit Potential

It is impossible to know the exact amount of profit before entering the trade. This is because the funding rate changes every eight hours. This is the definition of being long a floating rate instrument.

As mentioned earlier, over the past nine months, this strategy yielded a positive 35.58% outright profit.

Risks

The funding rate can and does go negative. When the funding rate goes negative, you lose money. Depending on when you enter the trade, you could experience long periods where you pay funding every eight hours.

During prolonged periods of negative funding, many traders unwind the position rather than continue to bleed. Bitcoin has been in a bull market since this product was launched, it will be interesting to observe the funding rates during a prolonged sideways or bear market.

Future vs. Swap

This is the most advanced strategy I will present today. This is a fixed vs. floating interest rate trade. Unlike the previous two strategies, the performance can be amplified using leverage on both legs of the trade.

Sell Future vs. Buy Swap Mechanics

This is referred to as a curve flattener. If the futures basis decline is greater than the interest you pay being long swap, either due to time decay or an outright movement in the implied interest rate, you make money.

  1. Sell 1,000 XBTH17 contracts.
  2. Buy 1,000 XBTUSD contracts.

If you place the trade when XBTH17’s basis is positive, wait until expiry, and then sell the XBTUSD contracts.

If you plan to trade around the XBTH17 basis, wait for the XBTH17 basis to fall sufficiently, then buy back XBTH17 and sell XBTUSD to unwind the trade at a profit. You will employ this strategy when the XBTH17 basis is already negative but you expect it to decline even further.

Selling XBTH17 at a negative basis means you bleed money each day until expiry (aka negative carry or negative theta). I tend to avoid any situation where my fixed interest leg is entered into at negative carry. It makes turning an eventual profit more difficult.

This type of trade is also a bearish trade with respect to Bitcoin spot movements. During a quick and sharp drop, traders will short futures and swaps. The futures’ basis will decline and turn negative, and the swap funding rate will go negative as well. In this situation, profits due to movements in interest rates will accrue on both legs.

Buy Future vs. Sell Swap Mechanics

This is referred to as a curve steepener. If the futures basis rise is greater than the interest paid being short swap, either due to time decay or an outright movement in the implied interest rate, you make money.

  1. Buy 1,000 XBTH17 contracts.
  2. Sell 1,000 XBTUSD contracts.

If you place the trade when XBTH17’s basis is negative, wait until expiry, and then buy back the XBTUSD contracts.

If you plan to trade around the XBTH17 basis, wait for the XBTH17 basis to rise sufficiently, then sell XBTH17 and buy back XBTUSD to unwind the trade at a profit. You will employ this strategy when the XBTH17 basis is already positive but you expect it to rise even further. Buying XBTH17 at a positive basis means you bleed money each day until expiry.

This type of trade is also a bullish trade with respect to Bitcoin spot movements. During a bull market, traders will buy futures and swaps. The futures’ basis will rise and turn positive, and the swap funding rate will go positive as well. In this situation, profits due to movements in interest rates will accrue on both legs.

Profit Potential

The interest rate differences captured are small. In order to earn a respectable return on equity, leverage must be employed. If the interest rate differential received is 1% unlevered, your return on capital is only 0.5%. Each leg must be margined separately.

Using the same example but with 10x leverage, your return on equity increases to 5%. The one benefit to curve trades is that you do not need to hold until expiry of the futures contracts. You can go one way, then reverse quickly as conditions change. In this way, you become an interest rate day trader.

Speculating on curvature is more difficult, but there are less people employing such strategies. Those who understand the mechanics will be presented with many no-brainer profit opportunities.

Risks

For a curve flattener, you are long swap. If the total net swap funding payments (i.e. the funding rate is positive) exceed the basis income from selling the futures contract, you lose money.

For a curve steepener, you are short swap. If the total net swap funding payments (i.e. the funding rate is negative) exceed the basis income from buying the futures contract you lose money.

In general, when the futures basis is positive, longs pay and shorts receive swap funding. When the futures basis is negative, longs receive and shorts pay swap funding. This is because traders will arbitrage the two products to keep the interest rate differentials in line. Profiting from this strategy requires excellent foresight into how the interest rate curve will move.

Conclusion

The most important part of the three strategies that I outlined is that none of them take any Bitcoin price risk. Bitcoin to basis traders is just another asset with an interest rate curve that can be arbitraged. This curve becomes distorted during highly leveraged speculator induced spot price moves. This allows savvy traders to earn excellent volatility adjusted returns.

USD, Too Hot to Handle

Jeffrey Snider from Alhambra Partners recently gave an excellent interview on the economic effects of Eurodollars with Eric Townsend from MacroVoices. Eurodollars are USD that are held by banks outside of America.

The Eurodollar market began in the 1960’s. For various reasons such as international trade, sovereign USD depositors fearful of the US government confiscating their assets, and or American banks looking to escape domestic interest rate controls, the Eurodollar market grew. The interest that banks paid each other to borrow USD abroad is the foundation of the London Interbank Offered Rate (LIBOR). In 1971, Nixon was forced to violate the Bretton Wood’s agreement and suspend the USD’s gold convertibility. The Eurodollar thus became the global reserve currency.

Buttressing its supremacy was the need for oil-exporting countries to recycle their USD into the banking system. The Petrodollar and Eurodollar are one in the same, and the interplay between the two has a significant impact in today’s economic regime.

As the financialisation of the global economy intensified from 1990 to 2008, banks heaped on greater and greater amounts of derivatives exposure and in effect created larger Eurodollar balances. The Global Financial Crisis in 2008 marked the turning point where Eurodollar balances began declining. Jeffrey argues that 2008 was not about US subprime mortgages, but a banking crisis predicated on declining Eurodollar balances.

The Fed’s medicine of quantitative easing is a useless tool when aimed at the Eurodollar market. Apart from USD FX swap lines to other central banks, it is questionable which tools the Fed can legally use to alleviate the USD shortage. To properly address the situation, the Fed would need to become an even larger hedge fund than it currently is today. They would thus need to be active in all manner of FX and interest rate derivatives (e.g. cross currency basis swaps).

Jeffrey concludes with a sober assessment that due to an inability or unwillingness of the Fed and other central banks to address the actual problem, we could be left with a stagnant global economy for decades much like Japan. However unlike Japan, most nations’ subjects won’t sit by and calmly watch hentai porn while their economic situation progressively worsens.

Choyna

What is of interest to Bitcoin traders is how this Eurodollar shortage affects China. Jeffrey spells it out succinctly:

Currency exchange rates don’t tell the price of any currency, rather they show us a measurement of eurodollar flow and flexibility. As CNY appreciated before and after 2008, not during the crisis, it was as ‘dollars’ flowed in such that they had to be locked up in higher bank reserve requirements. Conversely, since 2013, as CNY ‘devalues’ as ‘dollars’ disappear leaving the PBOC to either supply them itself or allow banks greater RMB flexibility through lower RRR.

I experienced a Eureka moment after reading and rereading this passage. Using the two charts below, he puts all the pieces together.

The PBOC’s balance sheet peaked in 2013 alongside the value of the Yuan. State owned enterprises (SOE) effectively arb’d the PBOC. They borrowed dollars cheaply offshore, and then imported them into China to take advantage of the higher domestic interest rates. This caused the CNY to appreciate.

Large Eurodollar inflows masked as CNY would have been bigly inflationary. Therefore the PBOC raised rates through the Reserve Ratio Requirement. However, as rates rose further it became even more profitable to attempt to bring Eurodollars onshore.

Currency appreciation was part of the government’s plans, but too severe an upward movement would be detrimental to exporters. A smooth appreciation required the PBOC to sell Yuan and purchase dollars. These dollars were then converted into US Treasuries. That is why their balance sheet rose as the currency appreciated.

Far from a monolithic Party that cooperates harmoniously for the mutual benefit of all comrades, factions of the Chinese government (SOEs) were undermining the financial health of the Middle Kingdom.

The dollar and rates began rising in 2013, dollars began flowing out of China. The short position needed to be covered. As the hot money flowed the other direction, the PBOC had to sell down reserves and decrease interest rates to help the Banks replace the lost deposits. The PBOC in the face of rising domestic inflation continues to lower the RRR; the banks are toast otherwise.

The faster and larger the US rate normalisation and currency appreciation, the larger the short squeeze.

March Is Green Lit

Grandma Yellen during various interviews and communiques proclaimed that a March rate hike is on the table. A hike so soon after December would prove the Fed is deadly serious about normalising rates. It would also spoil the PBOC’s plans for a calm period before the October National Congress.

After a period of currency appreciation, the PBOC reactivated its favourite rate hike dissuasion tool. USDCNY after hitting a low of 6.83, has risen above 6.88 in the last month. Unless the PBOC can push the S&P 500 lower through aggressive devaluations, the Fed could hike in their face, exacerbating the Eurodollar short squeeze.

The Perception Battle

Onshore, the PBOC faces a perception battle. Bitcoin hitting an all time high in January is perceived by many as a vote of no-confidence by disloyal comrades. While the PBOC can reliably control large SOE’s if need be, if a hoard of retail punters decide that they want to convert a small amount of CNY into USD, the jig is up.

The likelihood that Bitcoin withdrawals are re-enabled in China by the large exchanges is miniscule. Those will remain in place until at least October, or when the PBOC feels it has spooked Yellen away from raising rates.

Interview Transcript

Full Presentation

COIN ETF Mechanics

My 5 year trading career was spent as the head Asia Ex Japan Australia ETF market maker for Deutsche Bank and then Citibank. If the Winklevoss COIN ETF is approved, the price of Bitcoin will decisively punch through the last all time high. However the ways in which the ETF and the trading surrounding it will affect the Bitcoin exchange and trading ecosystem is just as important as the price spike.

A thorough understanding of how ETFs trade in both the primary and secondary market is essential to predicting the ways in which the ecosystem will change.

Below are useful definitions.

Primary Dealer (PD) or Authorised Participant (AP): These firms are allowed to create and redeem ETF units directly with the fund manager at the Net Asset Value.

Designated Market Maker (DMM): These firms have a contractual obligation to the exchange to provide continuous bid and ask quotes at a specified maximum spread through the trading day. Usually PDs and APs are also DMMs.

Net Asset Value (NAV): At the end of each trading day, the fund manager will value the assets held by the ETF and produce an NAV. The fund’s management fees will be taken from the NAV each day.

Indicative Net Asset Value (INAV): During the trading day, the INAV is calculated by valuing the underlying assets at current market prices.

Portfolio Composition File (PCF): Each morning the fund manager will publish the PCF file. This file tells traders what assets and in what quantities the ETF holds. Using the PCF file, traders compute the INAV or fair value of the ETF throughout the trading day.

Creation and Redemption Unit: This is the multiple of ETF shares that can be created or redeemed by the PD.

Creation Process

The most relevant aspect of the ETF is how units will come into existence.

DMMs initially will not carry inventory. One privilege they have is the ability to naked short the ETF. If a DMM is short ETF units by the end of the trading day, they must create new units by the settlement day which is trade date plus two business days (T+2).

As the DMM sells ETF units to the market, they will purchase Bitcoin in the quantities specified by the PCF file. Assume that 1 COIN share represents 0.01 Bitcoin. If the DMM sells 10,000 shares, they must buy 100 Bitcoin.

At the end of the trading day, the DMM will submit a creation request to the fund manager. The fund manager will give instructions for where the DMM must deposit Bitcoin.

If the creation unit is 1,000 shares, the DMM will submit an order for 10 creation units. The fund manager will supply instructions on what address to deposit Bitcoin. After the Bitcoin is sent, the fund manager will legally bring new ETF shares into existence and deposit them into the DMM’s Depository Trust Company (DTC) account.

The DMM will then deliver these shares to the exchange by the settlement date, and the exchange will credit customer accounts with ETF shares.

Large asset managers may not wish to purchase ETF shares in the secondary market because they intend to purchase a large amount. Instead they will contact a PD and ask them to create units on their behalf. The PD charges a fee for such trades.

Being a PD and or DMM of a popular ETF is a license to print money. PDs for the COIN ETF will make a killing.

Redemption Process

Assuming DMMs start with no Bitcoin inventory, if they become net long ETF shares then by the end of the trading day they can redeem. As traders sell ETF shares into the DMM, the DMM will hedge this long exposure by short selling Bitcoin.

Given that many of COIN’s DMMs are traditional trading houses and or banks, I do not believe they will avail themselves of margin or futures trading on non-US based and regulated exchanges. As a result the likely outcome is that DMMs will negotiate with Gemini and other US exchanges to borrow Bitcoin from the exchange’s inventory to short sell on the market.

In exchange for tendering ETF shares to the fund manager, the DMM will receive an amount of Bitcoin as specified by the PCF file. Once this Bitcoin is received, they will pay back their Bitcoin loan.

Hedging Exposure

The listed APs for COIN are Convergex, KCG, and Virtu Financial. I suspect that these firms will also act as DMMs.

None of these firms have a history of Bitcoin trading. That means that their comfort level with exchanges other than Gemini will be nil.

If COIN is as popular as we all expect, then DMMs will need to day trade a significant amount of Bitcoin. Liquidity on Gemini, Coinbase, and itBit will be challenging.

Due to regulations, US exchanges offer the least amount of Bitcoin trading products. Margin and futures trading is not offered. Even worse, the majority of supply is mined abroad. The over the top KYC requirements to open accounts in America scare many miners away from selling their coins on these exchanges. The stringent requirements also mean that exchanges can only service Americans.

Except for the Gemini auction, DMMs will not be able to cheaply trade Bitcoin on US-regulated exchanges. They will rely upon OTC brokers. The largest US-domiciled broker is Cumberland Mining, a subsidiary of DRW Trading. Cumberland can access the largest pools of liquidity through their long standing relationships with large traders and exchanges globally.

Market Structure Implications

Gemini sans Bitcoin ETF is irrelevant. If the ETF is approved, volumes on the exchange will ratchet higher. Coinbase and itBit will bite the dust. Traders arbitraging the ETF vs. Bitcoin will primarily trade on Gemini. It will be the most direct and easy hedge.

The daily Gemini auction will become the most important pricing signal. As the assets under management (AUM) of the ETF grows, the daily flows of creations and redemptions will underpin strong auction volumes.

International spot exchange volumes will benefit from OTC brokers sourcing intra-trading day liquidity. Those platforms where miners and traders feel comfortable buying and selling spot Bitcoin will benefit.

Let’s all come together and pray to our deity of choice for an approval. Also it would help if the twins deposit large brown paper bags of cash with relevant SEC decision makers. Make Bitcoin great again!

Pikeys, Rednecks, and Pineapples

I will speak heresy. Marine Le Pineapple Pen will win the 2017 French presidential election.

The first round of voting occurs in April. If no candidate receives a majority of votes, a runoff is held between first and second place.

Le Pen currently leads the pack. She is polling at 25% to 30%. Macron is the first loser; however, bookies expect him to carry the ultimate prize in the runoff.

Just like during the Brexit vote and US presidential election, the establishment cannot fathom a Le Pen victory. They comfortably believe she cannot overcome the racist stigma of her father. Also her plan to immediately remove France from the EU and redenominate all French law bonds into Francs is described as financial suicide by mainstream financial analysts.

Those who vote the “right” way portray those who dare dissent as racists, misogynists, and xenophobes. These pikeys are unanointed in the faith of Whole Foods, vinyasa yoga, and soylent. However the inability to conduct a good faith debate without branding your adversary with one of above mentioned epitaphs means that all polling data is bunk.

The polls said Brexit was doomed and Crooked Hillary would pantsuit walk her way into the oval office. People lied to pollsters to fit in. Le Pen’s support during the final runoff is misunderestimated.

Le Pen is “evil” because she dares to remove continental Europe’s second largest economy from the German economic ghetto that is the EU. Germany has gained the most from the vendor financing model enacted in Europe.

In order to buy German industrial goods, European countries gorged on debt. The TARGET 2 balances, which are the net liabilities between EU central banks, illustrate that Germany is owed nearly EUR 800 billion by the rest of the EU.

The off-again on-again risk of an EU breakup has weakened the Euro significantly. Since 2008, EURUSD has weakened by 30%. A weak EUR helps Germany compete with Japan and South Korea for the export of industrial goods. The economic misery suffered by Greece and other southern European nations actually helps Germany.

Germany even after all the benefits it received at the expense of their European brothers refuses to run a looser monetary policy to help the rest of Europe recover. Germany is not without its problems. Don’t forget about Deutsche Bank (DB). The bank is living on borrowed time. Should France pull out of the EU. DB will be toast. Any European bank that borrowed in EUR but holds EUR denominated local law bonds as assets is at risk of insolvency. These bonds will be redenominated into weaker domestic currencies during an EU breakup.

To save the banks, Der Spiegel and similar publications will work overtime to scare the plebes out of their desire to regain competitiveness. However in 2017, there are examples around of globe of how the establishment was neutered. The presidential race is Le Pen’s to lose.

Bitcoin devours market instability and produces stellar returns. 2017 will be no different. Traders globally sense a paradigm shift. That is one reason why the PBOC’s repeated attempts to crush the price are met with fierce resistance by Bitcoin bulls.

The first round of voting will be held on April 23rd. If needed, the runoff will be held on May 7th. The markets still don’t believe in Le Pineapple Pen. It is the perfect time to position one’s crypto portfolio to benefit from an “unlikely” victory.

From now until the COIN ETF decision on March 11th, there will be various opportunities to BTFD. The PBOC isn’t done yet. While the marginal effectiveness of their actions is waning, when they act it is a great opportunity to increase your exposure. The price will fall if the ETF is not approved. This might be the last best chance to acquire cheap Bitcoin before the French fireworks. This time, France might not raise the white flag.

Lockdown

The PBOC popped the 2013 Bitcoin bubble by instructing banks to close accounts of the exchanges. This spooked the market and lead to the initial drop. Then MtGox failed and the party was over for 2 years.

When Bitcoin flirted with 9,000 CNY in early January of this year, the PBOC sprung into action again. This time after jawboning the price lower, they brought the hammer down upon the Chinese exchanges. Over the past few weeks the following things have been implicitly banned by the PBOC, margin trading, zero fee trading, and Bitcoin withdrawals.

It is obvious that the PBOC feels threatened by the relentless rise of Bitcoin. However in this instance the marginal effectiveness of their actions is diminishing rapidly. After the initial standard warning from the PBOC that Bitcoin is volatile and not a nationally recognised currency, the price dropped 30%.

Undeterred, bullish traders bid the price back above $1,000 and it appeared that a full retrace would occur. Then the PBOC removed the Chinese secret success sauce of leverage and zero fees. The price went below $1,000, only to rally back in less than a week.

The PBOC continued with on-site “inspections” of all Chinese exchanges. They believed that KYC and AML regulations were not being followed correctly. Why all of a sudden is the PBOC interested in how exchanges conduct compliance? Surely it would have been appropriate to conduct similar site checks in 2014. However in 2014 the price went down and stayed down.

The inspections failed to produce enough fear needed to cause a serious correction. The ultimate bombshell was then dropped late last week: in order to comply with more stringent KYC and AML requirements, Chinese exchanges began halting Bitcoin withdrawals.

KYC and AML violations are used by governments worldwide to harass companies. CNY withdrawals were unaffected. If there really were lax KYC and AML controls at the exchanges, all withdrawal functions should have been ceased. It is obvious the PBOC intended for spooked traders to dump Bitcoin and withdraw CNY to the safety of national banks.

The big three exchanges (BTCC, Huobi, and OKCoin) have all shut Bitcoin withdrawals until mid-March. It appears that exchanges will be required to integrate systems that pass client information to the police and other relevant agencies.

This integration takes time and development resources. Smaller exchanges threw in the towel. HaoBTC was one exchange that decided to close its exchange business rather than completing the upgrade. Expect more second and third tier exchanges to shutter. Regulation always favours the incumbents.

If Bitcoin still creeps higher as the fear subsides, what else can the PBOC do to curtail the trading of Bitcoin in China and how will it affect the market structure?

Close All Exchanges

The PBOC could close all the known Bitcoin exchanges in China. Given that they have been unwilling to do that since 2013, I don’t think they will choose that nuclear option in this instance.

By threatening large exchange owners with the closure of their business and possible civil and criminal charges, the PBOC can effectively control the trading of Bitcoin. If they were to close the large exchanges, Bitcoin trading would move underground and would become uncontrollable.

In China, people build illegal power plants. Given the right financial incentives, underground Bitcoin exchanges will proliferate. The PBOC will be powerless to stop them. Chinese people will be able to fully use the pseudonymous features of Bitcoin.

Currently, moving large amounts of RMB offshore via Bitcoin for clients unwilling to go through KYC is impossible. If less scrupulous operators are given a business opportunity, black money will gush through Bitcoin.

The PBOC can barely control state owned banks, they won’t risk opening a gaping hole in their capital account by relinquishing leverage over the large Bitcoin exchange operators. Bitcoin withdrawals will be re-enabled in time with caveats.

Add Bitcoin to the FX Quota

Some traders speculate that Bitcoin purchases will be subtracted from each comrade’s $50,000 annual FX quota. That would mean that the PBOC re-classifies Bitcoin as a real currency. This is very unlikely.

If Bitcoin is re-classified as a real currency, it would give it legitimacy. Normal investors who shied away from Bitcoin due to the constant pronouncements from government agencies about its inherent risk and price volatility, might decide to place small amount of their investable assets in the cryptocurrency. The price would skyrocket.

In order for Bitcoin purchases to be properly debited against each citizen’s quota, all exchanges would need to interface direcly with the State Administration of Foreign Exchange (SAFE). There is a small possibility that the current KYC/AML upgrades are a step in that direction.

Bitcoin Birdcage

During a recent CCTV report about Bitcoin, commentators expressed a view that Bitcoin should not be banned but properly regulated. They used the metaphor of a birdcage. Bitcoin can still move, but its range of motion is restricted. Any views aired by CCTV come directly from the Party.

China like all other governments since the industrial revolution believe that through science, resources can be allocated effectively by government diktat. The command and control economy is sexy to bureaucrats. I fully expect China to attempt to create a Bitcoin walled-garden.

Withdrawals will be permitted to certain white-labelled addresses. Bitcoin may not leave these approved platforms. That effectively destroys the fungibility of Bitcoin.

If Bitcoin isn’t fungible, why would someone buy or trade it? Chinese traders may still trade on approved platforms if they believe one day the walled-garden will be removed. That may happen once the PBOC drastically devalues the Yuan.

OTC Trading

Bitcoin over-the-counter (OTC) platforms are the biggest beneficiaries. Bitcoin / CNY volumes on LocalBitcoins, the largest OTC Bitcoin trading exchange, spiked. The merits of owning unencumbered Bitcoin grow with each desperate action of the PBOC. Traders are willing to pay a significant premium to acquire coins they can actually use.

Some Chinese exchanges recognising the shift away from on-exchange trading, are even allowing OTC brokers to advertise openly in their WeChat and QQ groups. They want more deposits, so it is advantageous if clients are able to acquire Bitcoin and then deposit on the exchange. Why anyone would do that in the face of a withdrawal freeze is beyond me.

Price Implications

Chinese people will find a way to trade Bitcoin even if it is not officially permitted. Chinese people do not trust the government. Throughout history the ability for the central government, whether that was the Emperor or the Communist Party, to effectively govern outside of the capital is tenuous.

The financial incentives are too great for entrepreneurs not to offer the ability for comrades to trade Bitcoin. The transaction costs may rise, but Bitcoin in China is here to stay.

XBTUSD: The Philosopher’s Stone

Over the past 5 years, the USD has strengthened aggressively. This poses problems for many emerging markets (EM).

Most global commodities are priced in USD. As the USD strengthens, prices usually fall. In addition, most EM governments borrow USD denominated debt. The strong dollar decreases their commodity earnings, and makes it more expensive to roll over expiring sovereign debt. The result is a depreciating local currency.

Michael Pettis wrote an excellent book, “The Volatility Machine”, on why country balance sheet funding mismatches are the cause of most EM financial crises.

Below is a list of selected EMs whose currencies have experienced severe weakness over the past 5 years. The percentage listed is the amount the currency has depreciated vs. the USD.

  • Turkish Lira: 53.91%
  • Russian Ruble: 46.68%
  • Brazilian Real: 42.19%
  • South African Rand: 37.68%
  • Indian Rupee: 21.83%

Unfortunately, these countries import many foreign goods from developed markets. Food, clothing, and other essentials that are priced in USD or EUR must be paid for with a dwindling stock of foreign currency. As a result, consumer price inflation is high.

For local savers, the challenge is to obtain assets denominated in hard currencies. Ideally they want to own USD denominated assets. Due to immature banking systems and or capital controls, ordinary citizens find it difficult to save in USD terms.

A friend of mine in Kenya uses Bitcoin for payment. He emailed me asking if there was a way to use BitMEX to help people hedge against currency devaluation. I previously wrote about this same person in a blog post titled, “Case Study: Using Bitcoin Derivatives in Global Trade”.

BitMEX doesn’t offer a product on Bitcoin trading pairs aside from USD, CNY, and JPY. However, assuming you can obtain Bitcoin, using the BitMEX Bitcoin / USD Swap, XBTUSD, one can turn toilet paper local currency into synthetic USD held digitally. This same friend then asked if I would write a post explaining how to create synthetic USD.

 

Hedging Local Currency at BitMEX

Assume you have 100 units of local currency (LOC) and wish to turn this LOC into synthetic USD. The first step is to acquire Bitcoin. This may be easy or hard depending on your country. The LOC/XBT exchange rate is 100; therefore, you purchase 1 Bitcoin.

In many cases, the LOC price of Bitcoin will be more expensive than the equivalent USD price of Bitcoin. The magnitude of this premium is a representation of how difficult it is for traders to obtain USD. I will come back to this premium later.

Currently you are long 1 Bitcoin and short 100 LOC. You are exposed to Bitcoin price volatility, which is not the end goal. Now you must convert your Bitcoin into a USD asset. After that conversion, your risk becomes short LOC vs. long USD.

The BitMEX Bitcoin / USD Swap, XBTUSD, is worth $1 of Bitcoin at any price. If you are long Bitcoin, and sell XBTUSD, you lock in the USD price of Bitcoin. Since each XBTUSD contract is worth $1, you must sell 1,000 contracts to hedge your $1,000 worth of Bitcoin.

You now own 1 Bitcoin and are short 1,000 contracts of XBTUSD. BitMEX requires margin to place an order. At the minimum you must post 0.01 XBT as margin to open the short 1,000 position (100x leverage). This trade is not speculative so it is advisable to post the full 1 XBT as margin with BitMEX. By using no leverage, if the price rises your position cannot be liquidated. This may seem unintuitive, but because XBTUSD is an inverse contract, there is not unbounded potential loss for shorters.

Regardless of where the price of Bitcoin is, you will always have $1,000 worth of Bitcoin. If the price declines, the reduced USD value of your purchased Bitcoin will be offset with Bitcoin profit on the short XBTUSD position. If the price of Bitcoin rises, the increased USD value of your purchased Bitcoin will be offset with Bitcoin losses on the short XBTUSD position.

Therefore, gaining USD exposure is as simple as:

Long Synthetic USD = Long Physical Bitcoin + Short XBTUSD Swap

 

Earning Interest on Synthetic USD

Your synthetic USD also earns or pays interest. The XBTUSD product is a leveraged total return swap. Longs and shorts exchange interest payments every 8 hours. We call this funding, and it is used to anchor the XBTUSD price to the underlying spot price of Bitcoin.

As many like to say, Bitcoin will either be worth a lot or very little. If you short Bitcoin, the maximum unlevered return is 100%. If you go long Bitcoin, the maximum unlevered return is infinity. As a result, speculators are willing to pay high interest rates to go long Bitcoin using leverage. The funding rate swings both ways, but since May 2016, XBTUSD longs have paid shorts a total of 34.75%.

Your long synthetic USD position will most likely earn Bitcoin interest income. It is also a BitMEX liability, meaning you have BitMEX counterparty risk. Any investor must consider that the Bitcoin we custody may not be there in the future. Once created, your synthetic USD position cannot be moved off BitMEX. The possible interest income must be weighed against BitMEX counterparty risk.

In the future, you may wish to sell your synthetic USD and hold LOC again. To unwind the trade, you must first buy back your 1,000 XBTUSD contracts. The net Bitcoin amount you can withdraw from BitMEX is the sum of:

Net Profit + Net Interest Income + Initial Bitcoin Deposit

You next then convert your Bitcoin back into LOC. You initially purchased Bitcoin at a premium (P_Initial) vs. USD. At the end of the trade, you sold Bitcoin at a premium (P_Final) vs. USD. If P_Initial = P_Final then the premium did not impact your return. The degree to which P_Initial is greater or less than P_Final when you unwind the position decreases or increases your LOC return respectively.

At no time does BitMEX touch or hold physical USD on your behalf. Using derivatives and financial engineering, BitMEX can create synthetic USD exposure.

Bitcoin Backwardation

The problem with shorting a deflationary asset: unlevered, the maximum you can make is 100%. When longing, the maximum you can make is infinity. Helping the case for bulls is the fixed supply of Bitcoin. Leveraged speculators prefer to go long Bitcoin rather than short. As a result, quarterly Bitcoin futures usually trade at a premium (positive basis) to the spot price.

It is puzzling to many why BitMEX March 2017 Bitcoin / USD futures contracts, XBTH17, currently trade at a discount to the spot price. The same has been true of OKCoin quarterlies. This phenomenon is called backwardation. It is even stranger considering the impressive bull-run Bitcoin has experienced over the last year.

Why are quarterly futures are in backwardation? When will the curve normalise? I will attempt to answer these questions, but the result is speculative; I am using only publicly available information and logic to arrive at this hypothesis.

What Is Bitcoin Good For?

What can one do with Bitcoin after it is purchased? If you don’t use it as collateral to gamble or place speculative trades, most Bitcoin lies dormant in a wallet. Bitcoin as a means of payment is still in its infancy.

Holders constantly search for ways to earn a return on their Bitcoin. No sovereign governments, banks, or companies borrow in Bitcoin yet. Therefore there are no “safe” fixed-income Bitcoin products.

To meet this need, savvy entrepreneurs have set up funds that pay a guaranteed daily rate of interest if you invest Bitcoin. These funds are based purely on trust. They are especially popular in China. Figures well known in the industry would leverage their personal brand to get holders to invest in their funds. I commonly saw 0.01% per day offered.

Depending on your personal network, you could also borrow Bitcoin from large miners or holders and pay them interest as well. If you are able to take down a large size, you may borrow cheaper than 0.01% per day.

What safe investment pays out a daily nominal return in Bitcoin over 0.01%? Prior to this week, I assumed that most funds invested in mining operations. But now I have another theory.

The major Chinese exchanges (BTCC, Huobi, and OKCoin.cn; aka The Big Three) operated popular P2P margin platforms. Users lent each other Bitcoin and CNY, allowing the exchange to offer margin trading. The lenders would earn a healthy return without taking any Bitcoin price risk.

The most profitable trade was lending CNY. Speculators going long borrowed CNY to purchase Bitcoin. Interest rates averaged 0.10% per day.

Investors in the fund gave Bitcoin, and the fund operator paid them 0.01% in Bitcoin per day. This is what the fund operator did next:

Step 1

Sell a portion of the Bitcoin for CNY. I will assume 50% of Bitcoin assets are sold.

Step 2

Use the 50% of Bitcoin remaining as margin to buy quarterly futures contracts to cover the 50% short Bitcoin exposure. You don’t convert 100% of Bitcoin into fiat-cash so that you have sufficient Bitcoin-denominated margin to buy futures contracts. USD denominated futures contracts are the most liquid, so it’s likely that most simply bore the USDCNY currency risk.

In the past, XBTH17 and other competing quarterly futures contracts have traded at a premium to spot. Assume that you buy at an annualised premium of 20%, this then means that you effectively pay 0.055% per day. On a blended fund basis (remember you only used 50% of assets), you pay 0.0275% daily.

Your fund owes 0.01% per day to clients, and you pay 0.0275% per day on your long futures contract hedge. Your total cost is 0.0375% per day.

Step 3

Lend the CNY on a margin trading platform. Assume you can lend your CNY at 0.1% per day on one of the big three Chinese exchanges. On a blended fund basis, you receive 0.05% per day.

Your net carry is 0.05% minus 0.0375%, or 0.0125% per day.

If you have 10,000 Bitcoin under management, you earn a profit of 1.25 Bitcoin per day. You can increase daily earnings by increasing the amount of Bitcoin assets sold for CNY. If you sold 75% of assets, your net carry would be 0.02375% per day.

Step 4

After three months, the futures contracts will expire. At that point, you must long roll your contracts into the next quarterly. The spread between the two contracts represents the cost of carry for the next three months.

Redemption

It is necessary to understand the mechanics that fund-operators must undertake when they pay back investors.

Suppose an operator raised 2 XBT. He sold 1 XBT and received $1000. He took the other Bitcoin and bought 1000 XBTH17 (March 2017) futures contracts at $1000.

The price of Bitcoin rises to $2000 and at that point the investor recalls his loan. The operator must return 2 XBT.

The 1000 long XBTH17 futures have a profit of 0.5 XBT: (1/$2000 – 1/$1000) * -$1 * 1000. He is still 0.5 XBT short. He receives the $1000 principle back from the margin loans he made. With that he purchases 0.5 XBT at a price of $2000. He can now return the full 2 XBT.

Inverse Futures PNL = (1/P1 - 1/P0) * -$1 * Contracts

The important fact is that he must sell futures and buy spot, which at the margin causes basis to fall. If too many investors unwind at the same time, the falling basis will move a futures contract into backwardation.

The Great Unwind

From 24 December 2016 to 5 January 2017, the price of Bitcoin went from $800 to over $1,200 equivalent in China. Volumes spiked and bulls were borrowing everything in sight to go long Bitcoin. To satisfy the demand the CNY need to come from somewhere. I don’t believe exchanges were re-hypothecating customer CNY. I believe the increased CNY demand was met by credit whales operating in the manner I describe above. The hedging pressure from credit whales and Bitcoin bulls caused the XBTH17 premium to reach 54% annualised on January 5th.

All of a sudden, the PBOC turned on the lights at the club. In response to pressure from regulators, Chinese exchanges ceased offering margin trading on January 11th. The very next day, XBTH17 entered backwardation. Existing loans were allowed to expire, but no new loans could be taken out.

Margin loans had 2 to 30 day terms. As loans expired, credit whales need to unwind their trades. That meant selling futures and buying spot with released CNY. This helped move the futures’ basis into backwardation.

The Fear Uncertainty and Doubt (FUD) surrounding what the PBOC would or wouldn’t do prompted speculators to short Bitcoin via futures. There was no more margin trading therefore futures were the only bearish instrument available. Even today, the PBOC has released no statement as to what policy actions will be undertaken as a result of their “investigations”.

In short:

Margin Book Unwind + FUD = Futures Backwardation

Curve Normalisation

By mid-February all margin loans will expire. Afterwards, selling pressure will be removed.

If the PBOC does not say anything directly pre or post Chinese New Year, it will be safe to assume the exchanges heard and heeded the intended message. The FUD selling pressure will cease.

The basis will slowly creep higher as longs regain confidence and bargain hunt. A violent short squeeze could happen, should one of these three following black swan events transpire before the expiry of March 2017 futures:

  • The PBOC aggressively devalues the Yuan. Bitcoin will catch a bid again as comrades look to preserve what purchasing power they have remaining.
  • Marine Le Pineapple Pen is polling well in French elections. If Le Pen becomes the favourite, global contagion fears will skyrocket as an EU breakup will look more likely.
  • Trump passes a massive infrastructure spending bill. This is “bigly” inflationary and will cause US rates to rise which will exacerbate the pressure on the PBOC to slice the Yuan.

Bitcoin will respond positively if any of these scenarios come to pass. If you believe these situations are remotely possible, it behooves you to begin building a long XBTH17 position and take advantage of the backwardation.

All Quiet on the Eastern Front

In October of this year, China will hold the 19th National Congress of the Communist Party. During this rocking party, new members of the Politburo Standing Committee will be chosen. The Committee is the nation’s highest governing body.

The number one goal of the Chinese Communist Party (CPC) is the continuation of the one-party rule. In the months preceding the conference it is paramount that China not lose face, internally or externally. No issue is allowed to overshadow this important jamboree.

Unfortunately, 2017 appears to be the year when tough economic decisions cannot be delayed any longer. China must rebalance its economy by growing household wealth. This comes at the expense of the previous “winners”, such as credit-intensive heavy industry companies.

Everyone knows what must be done, but it is proving very difficult to disenfranchise the wealthy and connected. To date, the PBOC has engineered a slow but steady depreciation of the CNY. Depreciation is the escape valve that must be activated to export the money being printed onshore; new money must be printed to help engineer a soft landing during the economic rebalancing. In reaction, citizens fearing future weakness are attempting to spirit their capital out of the country.

The PBOC aggressively closed the obvious ways that capital fled. After tickling 7.00, the PBOC began strengthening USDCNY. In Orwellian fashion, they combined this with a direct instruction to financial analysts: refrain from discussing future Yuan depreciation.

The word from Zhongnanhai was stability and above all else, silence. In any other year the PBOC might stand a chance to achieve the holy monetary trinity. That is, having a closed capital account, a fixed exchange rate, and independent monetary policy. Unfortunately for China, Trump won the 2016 election.

Jobs For The Boys

America and China are more alike than many would like to believe. Trump and the CPC both received a mandate to rule by creating an iron burrito and rice bowl. While Minnie’s Haberdashery don’t allow no Mexicans, the current demographics of America leave Trump no choice.

Trump will put the good ‘ole boys back to work by building roads, bridges, and airports. He will also coerce American companies to onshore production of products intended for the American market through punitive taxation.

Pepe Escobar had this to say about Trump’s true handlers:

The Masters have decided to reindustrialize the United States and want to take jobs back from China. This is advisable from the Chinese viewpoint; for why should they sell their work to the US for a dollar that has no intrinsic value and get really nothing back for the work.

These policies if enacted will be highly inflationary. The secular bond bull market that began with Reagan will end with Trump. Trump has shown it is fatal to campaign against providing middle-class jobs. Regardless of their hemming and hawing, his inflationary spending proposals will be approved by a so-called deficit conscious Republican Congress. [Sputnik]

Artemis Capital, whose pieces on volatility investing are excellent, had this to say:

He [Donald Trump] will lever, and lever, and lever, and lever… and lever… and then restructure his way to success, or whatever success is defined as by the broadest measure of popularity at any given time. Trumponomics, if it delivers, will be a supply side free for all: massive tax cuts, deficit spending to create jobs, financial and energy deregulation, business creation, and trade protectionism all driving inflation. More importantly, Trump sees bankruptcy as a tool and not an obligation and will have no problem pushing the US to the limits of debt expansion.

The largest debtor and creditor nations cannot both embark on the same economic policies. The world must soak up both USD and CNY paper. Unfortunately, most of the world would rather look at Ben Franklin than Chairman Mao.

The Dot Plot from Hell

Grandma Yellen and Trump will become fast enemies. In the minutes of the latest meeting, Fed governors explained their fears about inflationary fiscal policies. Many believe this prompted the Fed to forecast three 0.25% rate hikes in 2017, versus previous expectations of only two.

The Fed even floated a trial balloon that it may begin to unwind its portfolio. They rightly fear massive mark-to-market losses should rates spike higher in anticipation of the enactment of Trumponomics.

For China to suppress CNY currency volatility, they cannot have the USD continue surging higher. If the Fed actually raises rates as per schedule, China will be in a very bad predicament. Not only will China’s portfolio of US Treasuries decline in value as rates rise, unpatriotic comrades will find new and more imaginative ways to turn Yuan into stable USD assets.

The measure to watch for is CPI food inflation: especially the oink oink flavour. The PBOC continues to bail out local governments and SOE banks through monetary liquidity injections via Reserve Ratio Requirement cuts and reverse-repo operations. If this new CNY paper cannot be exported abroad because of tightening capital controls, the pressure will show up in food prices.

If there is a piece of data that doesn’t paint a pretty picture of China, authorities silence the messenger. Recently Beijing instructed the meteorological agency to stop producing smog alerts. Pollution in north-eastern cities such as Beijing and Tianjin has hit records this winter.

When the inflationary pressures present themselves in accelerating CPI inflation, the government may decide to omit this crucial economic statistic from publication. That is when you know something big will happen.

To alleviate the pressure, the PBOC will aggressively depreciate the Yuan.

Before or After

When will the PBOC release the pressure? Chinese New Year, which starts this Friday and lasts until February 2nd, presents a perfect opportunity. Banks are closed for a week. Central banks love to impoverish their citizens over bank holidays.

A one-off devaluation during New Year gives China breathing room leading up to October. If the USD strength continues and the PBOC does not devalue, the PBOC might be forced to rock the boat just a little too close to the big dance.

If they delay, then no action will likely happen before the October National Congress. For those expressing a view through digital currencies, the absence of CNY currency volatility may dampen the price of Bitcoin in the interim.

The October to end of year Bitcoin price performance was +70% and +84% in 2015 and 2016 respectively. In both cases, the PBOC took the scythe to the Yuan. Fall 2017 will see similar stellar price performance if the PBOC delays the inevitable.

Marine Le Pineapple Pen

Risk-off will rule if Le Pen claims victory in the April French presidential elections. She is tired of France waving the white flag in the face of German economic onslaught. She has vowed to offer a referendum on EU membership. Should a vote be held, there is a non-zero probability that the frogs will leap into a new boiling cauldron of their own making.

A real risk of an EU breakup launched by the zone’s 2nd largest economy will send the USD soaring. The rush to safety will decimate emerging market currencies. If the PBOC delays the devaluation, they run a real risk of emergency cuts in the summer due to European contagion.

Make Bitcoin Boring Again

The absence of margin and zero trading fees will certainly temper the desires of Chinese punters to trade Bitcoin. However, these actions by themselves do not preclude a bullrun, should the domestic currency continue to stumble.

The Empire Strikes Back

Trading without leverage is like driving a Lamborghini in first gear: you know it’s safer, but that’s not why you bought it.

Well, maybe, anyway. A little story: my first boss at Deutsche Bank drove a white Lambo to work daily. Driving in Hong Kong can be rough. Because of the topography and traffic, driving fast is very difficult. I asked him where in HK he could really go with it. He replied, “I didn’t buy the car to drive fast”. Legend.

Last week, the PBOC announced it was conducting on-site inspections of the largest Bitcoin exchanges. Almost immediately, Chinese traders began reporting that margin trading had been disabled. This week, the exchanges confirmed what was already known: margin trading is toast.

Trading Bitcoin in China is not about getting money out of the country, it’s just the latest asset retail traders could freely trade with leverage. Due to a lack of investment options, Chinese retail traders gravitate towards any asset which is volatile and where a positive return can be earned.

Chinese financial regulators will tolerate insane price action and large trading volumes for a time. But if it appears too many ordinary comrades will lose their shirts, they’ll step in to stop the party. Ironically, the market intervention usually leads to a disorderly crash. After reaching a new all time high, the PBOC sprang into action and poured cold water on Bitcoin.

The PBOC is hardly finished. On January 18th the PBOC declared that the investigated exchanges offered illegal margin trading and did not properly conduct KYC and AML procedures. They implored traders to take the illegal operations of these exchanges into consideration before trading on the platforms.

The PBOC will either close the offending exchanges or issue fines. I don’t believe the PBOC wants to push Bitcoin trading underground. They can exert more control by co-opting the leading exchanges. The CEOs have no choice: follow instructions, or lose their businesses and brush up on their soap handling skills.

The likely outcome is fines. The magnitude of the fine speaks to how much humble pie the PBOC wishes to administer.

Margin Trading Is Extremely Profitable

Even though trading fees are zero, depending on the size of the loan book, exchanges can earn handsome profits through margin trading.

The first profit center is the daily funding rate. Chinese exchanges charged between 0.05% to 0.10% per day to borrow CNY or XBT. At 36.5% per annum on the high end, an exchange could borrow money from WenZhou loan sharks and still have positive carry.

The second profit center is rehypothecation of assets. Margin trading happens on the spot orderbook. If you sell Bitcoin, you buy CNY. Exchange rates are just interest rate differentials. You pay a rate to borrow Bitcoin, and receive interest to loan out CNY. However, the exchange does not provide any income on the CNY realised.

If the other side is a leveraged Bitcoin long, that makes sense. The counterparty has borrowed the CNY, that CNY is allocated as collateral for a leveraged trade. It cannot be lent out again without risk of causing cascading margin calls should the original position be liquidated.

If the counterparty is an unleveraged buyer, then the exchange now has extra unallocated CNY that it can lend to another speculator. The reverse is true if a speculator buys Bitcoin and sells CNY. They do not receive any interest on the Bitcoin received.

The money multiplier will vary depending on the ratio of levered to unlevered speculators on the exchange. The exchange can fund a portion of its margin book at zero cost from the positions of its clients.

Will Exchanges Raise Fees?

The PBOC destroyed the margin trading money printer. What will exchanges do in response to regain lost earnings?

The zero-fee model that begun in China is catching on worldwide. The next largest Bitcoin trading pair after CNY and USD is JPY. Japanese exchanges also do not charge execution fees and they offer up to 25x margin trading. Western exchanges are also beginning to follow suit: Coinfloor, of the UK, just announced that it too will move to zero trading fees.

Spot Bitcoin trading fees will trend to zero as exchanges compete with one another for market share in particular jurisdictions. The cutthroat competition in China precludes any exchange from raising fees. Any exchange that dares to charge will promptly see its trading volumes plummet. If they plan to raise money, the only “objective” figure they can reliably be judged is in the toilet. Only if all Chinese exchanges announce in tandem will a fee hike work. This may happen; BTCC put up a notice about the prospect of charging fees. (Twitter)

Chinese exchanges will have to wait out the PBOC. The PBOC’s 2013 proclamation that financial institutions could not trade Bitcoin caused the large exchanges to lose their corporate bank accounts. To survive, a voucher system arose whereby clients sent CNY deposits to third party voucher sellers who magically were able to fund exchange bank accounts. After the PBOC lost interest in Bitcoin, direct deposits resumed.

Chinese exchanges must lay low until the party congress in October. If they attempt any workarounds to the “ban” on margin trading, punishment will be swift and severe. After the leadership has been shuffled, the PBOC may tolerate more volatility in the country’s financial markets. At that point in time, creative ways of offering leverage to trade Bitcoin onshore will emerge.

2016: The Year of REKT

Significant 2016 Events

  • Bitcoin reached 3-year highs; then lost 20% in minutes.
  • Significant cryptocurrency heists totaling to almost US$160M in assets.
  • Vitalik changed his name to Sir Forks-A-Lot.
  • Sterling traded at 30 year lows.
  • Oil hit a 13-year low, then doubled.
  • China cracked down on capital flight, causing USDCNY to hit fresh local highs.

2016 was the year where cryptocurrency traders were made or destroyed.

Bitcoin started 2016 at a price of $430. It traded sideways for 5 months before pumping to $789.7 in mid June. After the Bitfinex hack, it crashed to $600 where it remained range bound until November. Bitcoin on western exchanges ended the year just shy of $1,000, a 132% annual return.

Contrary to what the media tells you, Bitcoin was not the best performing currency this year. In fact, in Dollar terms, Monero rose 2,745%; the party started after it was adopted by several Darknet markets. The entire altcoin complex posted impressive YoY gains:

  • Ethereum, +770%
  • Factom, +390%
  • Ethereum Classic post fork, +215%
  • Zcash (using the first traded price on BitMEX as a reference), +210%
  • Bicoin’s little brother Litecoin, +29%

“Buy and hodl” appears to have been a good trading strategy, so long as you were not subject to any hacks. Almost US$160 million worth of cryptocurrency at current prices was stolen, the largest being 119,756 Bitcoin (currently worth over $123 million) from Bitfinex on August 2nd. The “hot wallet hack heard around the world” sent shockwaves throughout the community, and caused a 20% collapse in the price of Bitcoin. Further controversy arose over the 36.067% haircut that applied to all accounts, Bitcoin or not, to cover the losses.

Bitfinex was not the only exchange or protocol that was hacked. Gatecoin lost $2 million, and the almighty DAO lost $60 million at the time, which necessitated an Ethereum hard fork to bail-out investors. This hard fork then eroded faith in Ethereum, creating Ethereum Classic. Doh.

The initial success of the DAO crystalized fears about Bitcoin’s future survival. The DAO was the most successful crowdfunding campaign – ever. Over $150 million worth of funds were raised during its 28-day Initial Coin Offering (ICO) which ended in May 2016. The DAO’s light shined bright, and the Ethereum Foundation couldn’t resist trumpeting its success. They may have even bought a significant amount of the tokens during the ICO.

Unfortunately like many aspects of this industry, the hype was unwarranted. Only three weeks after launch a “recursive call” attack vector was exposed and the attacker made off with over 3.6 million ETH. This represented close to one-third of assets held in the DAO.

The Ethereum Foundation advocated a hasty hard fork of Ethereum to bail out DAO investors. Self preservation is a powerful force. The foundation faced possible legal actions (it is possible that illegal “securities” were sold to retail investors). A bigger motivator was the huge sum of money they possibly stood to lose via their thought to be DAO investment if there was no hard fork.

To their chagrin, the hard fork spawned the brother that never died. China decided that if they can’t have any say in pumping and dumping a currency, then they would back the original chain, now coined Ethereum Classic (ETC). ETC is now the currency of choice behind Bitcoin in China. ETC is now gaining more popularity, with Western exchanges (e.g. Coinbase) accepting their mistake and thinking about listing it. To their credit, Poloniex grasped the opportunity and listed ETC shortly after the hard fork. BitMEX followed a few hours later with a futures contract.

Zcash (ZEC) is 2016’s most spectacular pump and dump. Zcash rose from its original listing price on BitMEX of 0.025 XBT ($15 at the time), to a high of 3,299.999 XBT ($2.276 million) on Poloniex directly after the genesis block. It’s true, someone bought Zcash at a price of $2.276 million per ZEC. Granted, it wasn’t a whole coin.

In the end, Newtonian physics prevailed. Zcash became Zcrash. ZEC closed the year out at 0.048 XBT ($48), creating a whole new generation of bag holders.

Not all movements in this crypto bull market were organic. Brexit played a major role in pumping Bitcoin up 15% on Black Thursday / Friday. “There is no way the Brits will leave the EU” they said, and then the Pound crashed over 13% in a single session. It has since hit a low of 1.1145 and now trades at 1.2232.

The biggest global macro upset was the U.S. Presidential election. The number of celebrities vowing to give up their precious penthouse apartments in NYC and their luxurious beach-front mansions in Malibu upon a Trump victory have since gone into hiding. They now resort to ordering their Beluga caviar at home facing the harsh reality that no one cares what they think. Tough life.

The Trump Effect not only touched Bitcoin in that special place, but also economies globally. Federal Reserve chair, Grandma Yellen, continued normalising interest rates with a 0.25% hike of the Fed Funds rate. Since the election, the S&P500 rallied over 10%, the Dollar continued strengthening (although not as much as Bitcoin), and market sentiment is the highest it has been in a long while.

Life is full of ironies. The “populist” candidate might be the saviour of American banker bonuses. Donald Trump is no Andrew Jackson.

China has played its part by cutting off a number of capital flight options over the last year in a frantic effort to cut the steady decline of the country’s reserves.

2017, The Year of the Chicken

The world is waking up to Bitcoin. Whether it is being used by only 100 merchants or 100,000, the general public is realising it holds value. Bitcoin has become the crypto reserve currency. This is why it remains on the Iron Throne. Whether you believe ETH and the smart contract war will outshine Bitcoin, you need to remember that most traded volume on ETH is done against Bitcoin. Traders buy Bitcoin to trade altcoins. 2016 started the ICO revolution. 2017 will no doubt have its own DAOsaster, and its own Zcrash.

The premium in China will stay strong as the Yuan weakens towards 8.00, pushing Bitcoin towards new ATHs. In an attempt to curb this, China will try to control Bitcoin, and fail.

This year will Japan will eliminate the 8% consumption tax on Bitcoin sales. This will boost its adoption as traders search for the next Pachinko hit.

The SEC might allow a US listed Bitcoin ETF. Although the Winklevoss ETF, COIN, has been delayed by over 3.5 years, the chorus calling for an outright decision grows. A hard rejection will not crush Bitcoin. In the slim chance the ETF is approved, the price should spike as Bitcoin traders front-run retail and institutional investors that will now be able to buy the cryptocurrency.

This all points to a exciting year for Bitcoin.