Onwards and Upwards

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

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

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

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

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

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

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

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

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

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

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

No Means No

A retail Bitcoin ETF is proving as elusive as entrance into the Elysian fields. The SEC issued a scathing rebuke as to why they disapproved a Bats exchange rule change that would have allowed the COIN ETF to list. The reasons for denial given by the SEC display a fundamental problem with the market structure of Bitcoin.

After reading the document, it is clear that the SolidX and Greyscale ETF applications are destined for the dustbin as well. Changing the thought process of a regulatory body takes years. A US-listed Bitcoin ETF will not be forthcoming any time soon.

Bitcoin Exchanges and Trading Volume

The COIN ETF daily Net Asset Value is calculated using the daily Gemini Bitcoin auction price. To create and redeem units, Authorised Participants (AP) must trade in the auction.

The SEC’s major issue with the application was that the auction volume was insufficient to support trading.

From the SEC:

Moreover, self-reported statistics from the Gemini Exchange show that volume in the Gemini Exchange Auction is small relative to daily trading in bitcoin and to the number of bitcoin in a creation or redemption basket for the Trust. As of February 28, 2017, the average daily volume in the Gemini Exchange Auction, since its inception on September 21, 2016, has been 1195.72 bitcoins, compared to average daily worldwide volume of approximately 3.4 million bitcoins in the six months preceding February 28, 2017. Also, as of February 28, 2017, the median number of bitcoins traded in the Gemini Exchange Auction on a business day (when a creation or redemption request might be submitted to the Trust) has been just 1,061.99 bitcoins,129 barely larger than the 1,000 bitcoins in a creation or redemption basket.

Gemini’s volumes are so low they barely can transact one creation or redemption basket. Unable to obtain liquidity on Gemini, AP’s would be forced to transact on other exchanges. The location of these “other” exchanges gave the SEC pause.

US-based and regulated exchanges account for a relatively small percentage of global Bitcoin / USD spot trading volumes. The most liquid exchanges are based in Asia or Europe. Bitfinex, the largest Bitcoin / USD spot exchange by volume, is insolvent. These facts are troubling to the SEC.

The agency worries that the majority of trading volume occurs on “unregulated” (read: Non-US domiciled) exchanges and this could endanger ETF investors. The agency cited inadequate surveillance of the major trading centers.

Even though Gemini has a trust license and is overseen by the NYDFS, the SEC found that even Gemini’s exchange was not on par with national exchanges such as the New York Stock Exchange or Nasdaq in terms of trading rules and procedures.

From the SEC:

The Exchange represents that it has entered into a comprehensive surveillance-sharing agreement with the Gemini Exchange with respect to trading of the bitcoin asset underlying the Trust and that the Gemini Exchange is supervised by the NYSDFS. Additionally, the Exchange states in its comment letter that it “agrees that less liquid markets, such as the market for bitcoin, may be more manipulable, but believes that … such concerns are mitigated as it relates to the Shares of the Trust and trading activity on the Gemini Exchange.” As explained below, however, the Commission does not believe this surveillance-sharing agreement to be sufficient, because the Gemini Exchange conducts only a small fraction of the worldwide trading in bitcoin, and because the Gemini Exchange is not a “regulated market” comparable to a national securities exchange or to the futures exchanges that are associated with the underlying assets of the commodity-trust ETPs approved to date.

Next Steps

In order to be in the running again, an ETF sponsor must demonstrate how the proposed venue for the trading of physical Bitcoin is regulated on-par with large established exchanges such as the NYSE, and has a significant market share globally. That will be almost impossible.

If Bitcoin traders desired heavily regulated exchanges, they wouldn’t prefer trading on an insolvent exchange over one registered with various alphabet letter agencies. Many large Bitcoin traders trade Bitcoin expressly because the trading venues are less regulated. They believe the operators are allowed to focus more on the customer experience and provide exactly what traders desire instead of fluffing regulators.

The absence of margin or other leveraged trading products on heavily regulated US-based exchanges means they will forever play second fiddle to Asian and European exchanges. Given the “America is the best” mentality of its national regulators, convincing them to allow an asset whose price is set by the “shifty Chinese” (insert the international boogiemen of the year) is a tall order.

However, this is not a death sentence. The SEC and other organisations are puppets of the large vested financial players. At the point when Bitcoin is too large to ignore, and daily trading volumes are robust and healthy, the iShares, Vangaurd, and Spdr’s of the ETF fund management industry will sponsor a Bitcoin ETF.

These heavyweights only care about generating fees. The underlying asset is an afterthought. When Bitcoin is large enough to support a healthy AUM that generates large management fees, they will get behind Bitcoin.

Unfortunately the biggest problem with the Winklevoss’ application was their outsider status. The objections put forward by the SEC could easily apply to any number of currently listed ETFs. If the fund manager was one of the good ‘ole boys, the ETF would stand a chance of approval.

The Investors’ Exchange LLC (IEX) applied and was approved to be designated a National Exchange by the SEC. This was not an easy process. IEX, written about in the Michael Lewis’ book Flash Boys, aims to level the playing field by enacting policies that equalise trading between low and high latency traders. The HFT lobby went into overdrive to dissuade the SEC from approving the IEX application.

IEX gives retail investors a level playing field against HFT firms. Who doesn’t favor leveling the playing field for the grannies and grandpa’s. However, this was a very heated and drawn out approval process. The SEC did the right thing in the end, but the big boys brought out all the guns.

Imagine if the big boys wanted a Bitcoin ETF. They would get it.

SEC Ruling

Indefinite Detention

Hedge Fund Brother No. 1 Xu Xiang, pictured above, was once a high flying hedge fund manager who never lost. Then one day he was disappeared. He resurfaced months later, after being convicted of securities fraud and now sits in jail. Some feared Bitcoin exchange heads could face a similar fate; however, the PBOC showed mercy.

Another week, another “meeting” between the PBOC and the heads of large Bitcoin exchanges in China. Shortly after the meeting held on March 7th, the PBOC released a statement reiterating that they have the authority to shut down errant exchanges. A list of actionable offences surfaced a few days later via Caixin. [News.bitcoin.com]

The following activities are prohibited:

  1. Offering leverage and margin trades.
  2. Producing fake volume and manipulating the market using zero fees.
  3. Violating AML laws.
  4. Violating regulations on foreign currency management and cross-border capital transfer with bitcoin.
  5. Replacing fiat by using bitcoin to purchase goods.
  6. Tax Evasion.
  7. Engaging in false advertising or participating in Ponzi schemes.
  8. Providing financial services without a permit, including credit, securities, and futures trading.

After the “friendly” meeting, exchange after exchange announced an indefinite suspension of Bitcoin withdrawals. No further guidance was given as to when Bitcoin withdrawals would resume. The price sagged a bit, then shrugged off the news. By the end of last week, Bitcoin would hit fresh all time highs in USD terms.

Chinese regulators recognise that they cannot shut down the exchanges. Regarding said exchanges, one regulator noted:

If oversimplified measures such as closing them down were taken, [investors] will be led into the underground black market or OTC markets, which are more difficult to control. Therefore, it is necessary to explore the establishment of long-term regulatory mechanisms. [News.bitcoin.com]

The new strategy is to starve the weak, and regulate the strong. This strategy is classic China. The government lets an industry compete unimpeded for a time, then they pick the strongest companies and destroy the rest through denial of critical licenses or enforcement of opaque regulations.

By removing the elixir of leveraged and zero fee trading, only exchanges with diversified business lines will survive. Earnings from spot Bitcoin trading will only be significant for the largest of exchanges (BTCC, Huobi, and OKCoin). Exchanges not on that list, will most likely not exist in 2018.

All three of those exchanges either have mining operations, payment solutions, and or offshore derivatives trading markets. Once the weaklings fold, the PBOC will bless the large incumbents and subject them to rigorous monitoring.

Viewed on a longer time frame, the developments over the past three months are positive. One of the Damocles swords hovering over Bitcoin slowly is being removed. Bitcoin will not be “banned” by the regulators. They recognise the power of the underlying technology and are attempting to rationalise Bitcoin within existing goals for China’s monetary system.

PBOC Governor Zhou in a recent interview stated that China Bitcoin trading platforms are not exchanges but rather only “websites”.

If it (trading platform/website) is called an exchange, it is not allowed unless a relevant department of our country permits it. Many people regard bitcoin online trading platforms as exchanges. These are actually two different concepts. [News.bitcoin.com]

That is encouraging that the PBOC permits mere “websites” to accept deposits like banks, and offer the trading of currency like an exchange. There is a bright future for Bitcoin in China for those who can survive. The PBOC tacitly approves Chinese people trading Bitcoin.

The current purgatory will end once the PBOC right sizes the Yuan. Calm must be maintained up until the October National Congress. After October, Beijing will greenlight the PBOC to relieve the pressure and devalue. After a large devaluation, the PBOC can loosen capital controls because once the damage is done the desire to flee is lessened. At that time Bitcoin withdrawals will be re-enabled.

On Potential Post-Fork Contract Settlement

Traders,

Recently, we published A Statement on the Possible Bitcoin Unlimited Hard Fork, a statement of our views on the potential fork to Bitcoin Unlimited, its consequences, and further requirements we consider necessary for adoption.

Many have asked us about the settlement of our existing Bitcoin futures: the Bitcoin/USD series (XBT), the Bitcoin/CNY series (XBC), and the Bitcoin/JPY series (XBJ).

In the event of a fork in which both chains remain viable into the future and maintain double-digit percentages of the original Bitcoin hash rate (a “Contentious Fork“), we will take the following actions:

Contracts

  • As we predict the value of Bitcoin to then be split between BTC and BTU, currently-listed futures at the time of the fork will settle on the sum of BTC and BTU.
    • It may not be possible to predict or plan to get reliable pricing data from our current Index exchanges, or they may not list the minor coin at all. In the event of a Contentious Fork BitMEX reserves the right to move all Bitcoin derivatives to Last Price Protected Marking, until a stable index can be composed.
    • We will compose two indices representing the majority and minority chain, and the sum will be taken to compose the Mark and Settlement Prices. The indices will be separated in case not all component exchanges list the minority chain.
  • Contracts listed after the fork will settle on the BTC or the BTU price, but not both. Only contracts listed pre-fork will settle on the sum.
  • Perpetual swap contracts will be timed to switch underlying indices in tandem with a futures contract. Ample notice will be given. Like futures, the new index will reference only one chain.

Wallets

  • During the time immediately after the fork, BitMEX reserves the right to suspend withdrawals to avoid replay attacks and double-spending and account for the development effort required to accommodate a hard fork.
  • Users will be able to withdraw the minor currency, but not deposit it. We have no plans to support multiple margin currencies. Balances of the minor currency will be calculated via a snapshot at the time of the fork and maintained separately to major currency’s margin balance, as further mixing of the currencies thereafter could lead to improper attribution.

A Statement on the Possible Bitcoin Unlimited Hard Fork

As proposed in the multi-exchange hard-fork contingency plan, there is significant doubt that a Bitcoin Unlimited (BU) hard fork could be done safely without additional development work.

In the case of a fork, we support the plan as proposed by Bitfinex, Bitstamp, BTCC et al.

It will not be possible for any exchange, including BitMEX, to support both chains separately. For these reasons, BU will not be listed or used as a deposit/withdrawal currency until replay protection is implemented and BU is not at risk of a blockchain reorganization if the Core chain becomes longer.

If the BU fork does succeed, we intend to take every possible step to ensure the safety and integrity of customer deposits on both chains. As BitMEX does not offer margin lending, there is no concern about Bitcoin in active positions at the time of the fork.

Notice Regarding Bitcoin/USD Products (Index, Tick Size)

Bitcoin / USD 30 June 2017 Futures Contract

The BitMEX Bitcoin / USD 30 June 2017 Futures Contract (XBTM17) listed today, 17 March 2017 at 12:00 UTC. This contract is similar to XBTH17, but uses a new index, described below.

.BXBT: The New BitMEX Bitcoin / USD Index

.BXBT is an equally weighted index using the Bitcoin / USD spot price from the following exchanges:

  • Bitfinex
  • Bitstamp
  • GDAX
  • OKCoin International

XBTM17 uses the .BXBT index. Any exchange that is down or displays stale pricing data for 15 minutes or more will be removed temporarily from the index. Once the price feed is operational at least 5 minutes, we will reinstate the exchange.

A page detailing each constituents’ individual price and history will be live soon.

The BitMEX Bitcoin / USD 31 March 2017 Futures Contract, XBTH17, will continue to use the existing Bitcoin / USD Index (Symbol: .XBT; Weights: 50% Bitstamp, 50% OKCoin International) until it expires.

The BitMEX Bitcoin / USD Swap, XBTUSD, will continue to use the existing Bitcoin / USD Index (.XBT) until 31 March 2017 12:00 UTC. It will then switch to the new index. This is the same moment that XBTH17 expires.

Increase to Bitcoin / USD Products’ Tick Size

Also effective 31 March 2017 12:00 UTC, the tick size for Bitcoin/USD products (XBTUSD, XBTM17) will change from 0.01 USD to 0.1 USD.

Bitcoin Algo Trading and Market Making Seminar

BitMEX CEO, Arthur Hayes, will lead an interactive seminar on the basics of algo trading and market making in the Bitcoin markets.

Arthur will touch on API connectivity through the use of an example python trading bot. He will also talk about the basic principles of market making Bitcoin spot and derivatives.

Participants should bring a laptop, and visit this GitHub repository for the example trading bot.

Date: Wednesday 22 March 2017

Time: 7pm to 9pm

Location: The Hive, 23 Luard Rd, 21/F The Phoenix, Wanchai, Hong Kong

Cost: Free

Please RSVP on Eventbrite.

COIN ETF, Event Horizon

After the PBOC curtailed Bitcoin trading inside China, America reasserted itself as the most important price setting location. The SEC’s decision on a rule change that could allow the listing of the world’s first Bitcoin ETF is the most anticipated binary outcome of 2017. Traders will make and lose tremendous sums over the next few weeks.

ETF Approval

If the SEC approves the Bats rule change, all manner of American muppet retail investors can yolo into Bitcoin via a regulated ETF. The pool of eligible money that can easily obtain exposure to Bitcoin will dramatically rise. There are various predictions about the amount of money that could flow into Bitcoin. In short, it will be Yuge.

I expect the price to appreciate by at least 100% by the end of March. This is pure speculation as no actual cash will flow into Bitcoin until the ETF begins trading later this year. The price may go up well over 100% only to sharply correct as animal spirits are tamed.

Those wishing to play the initial pump should buy the BitMEX Bitcoin / USD 31 March 2017 futures contract, XBTH17. The nitty gritty of when and how the ETF will be launched may dampen enthusiasm in the medium term. A future that expires during the height of the fomo leaves the best chance for longs to be forced into closing at a profit.

Those bullish over the medium-term, should purchase the BitMEX Bitcoin / USD 30 June 2017 futures contract, XBTM17. XBTM17 will list Friday 17 March 2017. The basis or implied interest longs pay for three month exposure will open high and rise aggressively.

During the height of the December 2013 bubble, the ICBIT March 2014 futures contract traded at an outright 100% basis. By selling futures and buying spot, you would double your money in USD terms. ICBIT only featured 3x leverage at the time, imagine how high basis could go with 100x. XBTM17 basis could trade into 100’s of percentage points throughout the contract’s life.

The Deny

The number of reasons why the SEC should not list the ETF is as numerous as those in favor of an approval. A significant amount of traders have not drank the Jim Jones koolaid. The BitMEX COIN Prediction Futures Contract, COIN_BH17, places the probability at 50%.

China took a backseat in this first quarter rally due to the actions by the PBOC. Since Bitcoin withdrawals were shut in February, hope of an ETF approval became the bullish narrative.

After Bitcoin withdrawals ceased in China, the price fell below $1,000 and quickly recovered to the kilo mark (who isn’t in love with the CoCo). That is the baseline support level sans an ETF approval.

If the rule change is denied, the price will quickly test $1,000. Due to the underlying bullishness of the market, traders will BTFD. If not now, the general consensus is that one of the many ETF applications will be approved. The market will focus on the next application approval deadline for the SolidX or Greyscale ETF.

One Week Expected Value (EV)

Assuming a 50% probability of approval, traders must compute the EV of the looming decision.

(50% * 100% Price Appreciation) + (50% * -30% Price Depreciation) = +35% EV

The EV is positive, meaning it behooves traders to be net long Bitcoin into the decision.

BitMEX offers a complete Bitcoin / Fiat trading suite. The most liquid option is to buy the Bicoin / USD Swap, XBTUSD. Be early. The enthusiasm and hype surrounding the decision will only grow throughout the week. Every major financial paper is covering this event. I have never seen so much interest in a mundane exchange rule change before.

Hallelujah, Glory Be To Growth

Glory be to growth. Reality be damned, China will continue attempting to grow at unsustainable levels. That is the message from the Chinese Premier Li Keqiang given this Sunday during his Two Sessions speech. He decreed that annual GDP growth target is +6.5%, which is slightly lower than the recently reported growth of +6.7%, [ZH]

China is not alone in its adherence to the gospel of growth. Real growth can only be achieved by productivity and population gains. These two factors are very difficult to predict or command and control with success over a long period of time. Many have tried, all of have failed.

When in doubt, governments world-wide regardless of their economic “ism” resort to rampant money printing to goose up “growth” numbers. GDP measures of the flow of goods, it is a poor yardstick for the real health of an economy. With more money, more goods flow. Voila, growth!

China did miraculously transform itself over the last 30 years. However, recent growth is merely the result of aggressive money printing. The Party talks the talk about reining in credit growth; however, in practice they are impotent to stop it.

Xi Jinping is one of the most powerful Chinese leaders since Mao. However, even he cannot politically stop the expansion of bank credit. If he were confident in his ability to, he would proclaim a more realistic growth target.

Michael Pettis, professor at Peking University and former Bear Stearns bond trader, argues that real growth over the next 10 years cannot rise above 3% to 5% without a financial crisis. The financial crises is predicated on too much credit chasing too few positive yielding investments.

Beijing knows this. The PBOC continues to slay paper tigers by removing liquidity on hand, and increasing it in other ways. For Bitcoin traders, it means that one of the main drivers of global monetary policy will continue to act as they have done in the past.

Yuan liquidity and loans will continue to be provided to zombie state owned enterprises (SOE). The iron rice bowl must hold, or peasants will reassert their displeasure with immense wealth big city elites amassed by depressing wage growth and financially repressing savers.

Excessive Yuan liquidity will push up inflation. The escape valve will be a devaluation of the Renminbi. Premier Li implicitly confirmed that arguments I have been presenting for almost two years will continue to be relevant.

The Ides of March

The next “most important ever” Federal Reserve rate decision will ironically occur on the Ides of March. That is March 15th. Various Fed governors voiced support of a hike at the next meeting. Grandma Yellen in her recent speeches has done nothing to temper the rate hike talk.

Fed Funds futures price in an 80% chance of a March 0.25% rate hike. A rate hike would be devastating to China. [CME]

Beijing refuses to use political capital to put forward economic policies to rebalance growth. They refuse to drastically curtail banks’ issuance of credit. From Queen Victoria to Chairwoman Yellen, China is once again at the mercy of an old white lady.

The Fed rarely disappoints the market when traders price in a >75% probability of a rate hike. The S&P 500 is strong, and investors seem willing to ignore reality; case and point, the Snap IPO. The company’s expertise is losing money with style. Masochistic investors propelled the latest tech darling up over 50% from the IPO price.

The Fed has perfect rate hike cover. The amount of balance sheet pain the PBOC endures to save face internationally is unimaginable. Calm must remain before the October National Congress. The lack of a pressure releasing devaluation in the face of a market assured rate hike, means when it comes it will be enormous.

The Bitcoin angle is well known. USD up, CNY down, Bitcoin moon!

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.