The Miner Short Squeeze

Positioning has begun in earnest. In the last newsletter, I highlighted BitMEX futures trading strategies centered around the SegWit2x hardfork. Three weeks hence, the futures basis indicates aggressive positioning by traders heading into the hard fork. In this post, I will examine advanced trading considerations and unwind strategies.

XBTZ17 In Context

Bitcoin is up over 7x since January this year. Given this aggressive bull market, futures should trade in contango. Longs must pay a substantial amount of interest to entice shorts to position themselves against the trend.

The below charts list the annualised % premium for the XBTM17 (June), XBTU17 (September), and XBTZ17 (December) Bitcoin / USD futures contracts.

Each quarterly contract existed during a price rally. However, the Bitcoin Cash and upcoming SegWit2x fork dampened the premium for XBTU17 and XBTZ17 respectively.

Max % Premium PA Max % Outright Discount
XBTM17 122.30% -2.28%
XBTU17 32.38% -5.62%
XBTZ17 42.47% -7.17%

The above chart illustrates that XBTM17, which experienced no hard fork during its existence, had the highest premium and discount. XBTU17 experienced its max discount during the Bitcoin Cash hard fork.

XBTZ17 is already pricing in the SegWit2x hard fork. If the max discount has already exceeded XBTU17’s, then we can expect a substantially larger discount directly preceding the SegWit2x hard fork.

The discount is a combination reflecting traders’ fears of a disorderly hard fork, and traders selling XBTZ17 vs. buying spot to create SegWit2x coins with no Bitcoin price risk. Due to the heightened risk and publicity surrounding the SegWit2x hard fork, the discount could reach up to 15% pre-fork.

The Unwind

This time around most savvy traders are short XBTZ17 basis. Basis = Future Price – Spot Price. Any time the basis trades flat to positive, they increase their short position. However, once the fork is over large percentage of the XBTZ17 open interest must close their positions.

Many traders might close their XBTZ17 short at a mega discount pre-fork, then switch to long basis to play the relief rally. But if everyone is the same way, many will give up profits during the unwind. Additionally, bullish speculators will jump in pre-fork to take naked longs anticipating a sharp rally after the fork occurs.

SHORT SQUEEEZZE

During my time at Deutsche Bank there was a certain French options trader that emitted a high pitched squeaky yell of “Short Squeeze” any time the market gapped higher into the close. The XBTZ17 market is primed for a short squeeze, and I believe profit maximising miners could initiate an even sharper rally higher.

The miners signed the New York Agreement (NYA) in an effort to save face and acquiesce to activating SegWit, while at the same time securing larger blocks in the future. The NYA headed off a chain split due to UASF, but Bitcoin Cash was launched as a direct result.

Bitcoin Cash has an 8MB block size without SegWit. As it stands now, there is no need for SegWit2x Bitcoin. However, the majority of miners continue to signal for the NYA.

Signaling for the NYA costs them nothing, and it does not mean they actually will support the hard fork with hash power.

What would happen to the market if at the last minute all the large miners stopped signalling for NYA and the hard fork didn’t happen? You know the answer, Pump City. The other consequence is a violent resetting of XBTZ17 basis. All those who went short basis to collect the B2X dividend would rush to unwind their trades at the same time.

BitMEX will not credit B2X coins. Therefore, XBTZ17 shorts will remove margin from BitMEX the day before the fork and deposit on an exchange that will credit B2X. That means the leveraged used by shorts will increase further putting their positions at risk of liquidation during a short squeeze.

If I were a profit maximising miner here is what I would do:

  1. Buy Bitcoin Spot
  2. Buy XBTZ17 futures at a large discount.
  3. Shortly before the hard fork deadline, stop signalling for NYA.
  4. Bask in the glory of the annihilation of shorts on margin and futures.

If you believe this thought experiment might become reality here is what you should do:

  1. If you are short basis (short XBTZ17 vs. long spot), unwind that trade at a profit.
  2. Go long basis while it is negative (long XBTZ17 vs. short spot).
  3. If your risk appetite is large, go naked long XBTZ17 at a negative basis.

SegWit2x Bitcoin Is Not a Dividend

B2X is different than BCH in that B2X supporters do not want their coin to be an altcoin. It will either become Bitcoin or nothing.That is why they refuse to implement replay protection which allows exchanges to safely support B2X.

In the event exchanges delay the listing of the B2X by even a day, by the time you theoretically could sell B2X, it might be worthless because it failed at supplanting legacy Bitcoin.

If you went short XBTZ17 basis at a flat to positive level, you are in the money. Closing the trade early and earning the expected dividend is prudent due to the fundamental differences between B2X and BCH.

Trading Tip: Attempt to obtain free Bitcoin Cash on Bitfinex

Abstract: In this piece we explain a reasonably risky way to obtain free Bitcoin Cash (BCH) on the Bitfinex platform, by purchasing the BCC token.  This BCC token represents the Bitcoin Core side of the Bitcoin Unlimited futures contract.

 

Strategy overview

As we explained in our piece a few weeks ago, Bitfinex allow their customers to trade various Bitcoin chain split tokens, however as we explained some of these tokens have overlapping periods.

One of these tokens, Bitcoin Cash (BCH), launched in August 2017, we discussed this token in our earlier piece on the subject.  The launch of Bitcoin Cash occurred during the Bitcoin Unlimited futures contract period.  Therefore in theory, those who held BCC (the “Bitcoin Core” side of the Bitcoin Unlimited contract), had their Bitcoins locked up in this contract at the time of the Bitcoin Cash hardfork.  When this contract settles in December, holders of BCC may receive some Bitcoin Cash.

Bitfinex even eluded to this with the following statement:

CSTs with overlapping contract periods and other forking events may need to be adjusted to reflect the correct economics. We are aware the the BCC/BCU CSTs need retroactive adjustments to reflect BCH, as well as BTG, after the event tomorrow. Similarly, BT1/BT2 may need to be adjusted to reflect any BTG that accrues to the locked up BTC. We have a plan for this and may not be able to implement it immediately, but it is fair to our users and will be applied retroactively in a non-intrusive way. More details will follow on this next week.

Source: Bitfinex

 

Investment recommendation

Due to the recent price rally in Bitcoin Cash, with it currently trading at around 0.35 BTC, in our view, it may be a good idea to invest in the BCC token on Bitfinex, to try to obtain some exposure to Bitcoin Cash, without paying for it.

There are two ways of achieving this:

  1. Buy BCC in the market.  The current price of BCC is around 0.96 BTC and in theory the price could increase and trade at 1.0 (Or in theory BCC could even trade at a premium to BTC, although new units can be created if this occurs).
  2. Deposit BTC into Bitfinex and then split it into BCU and BCC.  Then one could hold the BCC to the settlement date and hopefully obtain the free BCH.

There are some risks to this trade, as we explain in the section below.  However, with the recent rally in the BCH price, in our view, the risk/reward balance is somewhat favorable.

 

Investment risks

  • Distribution coefficient – Although the Bitcoin Unlimited futures contract launched prior to BCH, the split tokens could be created both prior to and after the launch of BCH.  Therefore there may not be sufficient BCH in reserve to allocate to all BCC token holders.  A distribution coefficient may be required in order to adjust for this.  Actually some market participants may create new BCC in order to benefit from the trading idea mentioned in this piece, which would make any distribution coefficient less favorable to BCC investors.
  • Bitcoin Cash price – The market value of BCH could fall substantially prior to the Bitcoin Unlimited contract settlement date.
  • Bitfinex Policy – Bitfinex policy with respect to this matter is uncertain and could change.
  • Counterparty risk – The risk that Bitfinex becomes insolvent prior to the Bitcoin Unlimited contract settlement date.

 

Non Empty Smaller Block Data By Mining Pool

Abstract: In this piece we present data displaying the proportion of smaller blocks produced by the different mining pools, over time.  This follows on from our piece last week looking at empty blocks.

 

Smaller blocks overview

Following on from our analysis on empty blocks last week, some readers asked for a similar analysis to be conducted for non empty but smaller blocks, by mining pool.  For your consideration, we present some data trying to capture the proportion of smaller blocks by mining pool.  We are not unable to draw any interesting conclusions from this analysis.

 

Charts illustrating the proportion of smaller blocks by mining pool

 

Figure 1 – Blocksize bucket analysis by mining pool (in bytes) – 2017

Source: Bitcoin Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  Data up to 22nd October 2017. Mining pool with less than 800 blocks in the period is excluded

 

Figure 2 – Blocksize bucket analysis by mining pool (in bytes) – 2016

Source: Bitcoin Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  Mining pool with less than 800 blocks in the period is excluded

 

Figure 3 – Blocksize bucket analysis by mining pool (in bytes) – 2015

Source: Bitcoin Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  Mining pool with less than 800 blocks in the period is excluded.  BTCC Pool had many blocks with 2 transactions in this period

 

Figure 4 – Percentage of non empty blocks smaller than 10,000 bytes by mining pool – monthly

Source: Bitcoin Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  Mining pool with less than 250 blocks in the the month is excluded

 

Methodology

We chose 10 blocksize buckets:

  1. Less than 500 bytes
  2. 500 bytes to 5,000 bytes
  3. 5,000 bytes to 10,000 bytes
  4. 10,000 bytes to 25,000 bytes
  5. 25,000 bytes to 50,000 bytes
  6. 50,000 bytes to 75,000 bytes
  7. 75,000 bytes to 100,000 bytes
  8. 100,000 bytes to 250,000 bytes
  9. 250,000 bytes to 500,000 bytes
  10. 500,000 bytes to 1,000,000 bytes

The selection of the bucket boundaries was entirely arbitrary and therefore this could weaken the analysis.  Figure 1 appears to indicate that the 10,000 byte bucket may be most significant, due to the apparent spike for some miners in 2017.  Therefore non empty blocks less than 10,000 bytes were chosen as the range for the monthly chart, which is shown in figure 4.

 

Concluding remarks

As a reminder we do not believe any of the above data is strong evidence for covert ASICBOOST.  Others have argued that smaller or empty blocks by some mining pools could be considered as circumstantial evidence for covert ASICBOOST, without always providing data backing up these claims.  Our objective here was simply to produce charts illustrating the prevalence of these smaller blocks by mining pool.

Empty Block Data by Mining Pool

Abstract: In this piece we present data displaying the proportion of empty blocks (blocks containing only the coinbase transaction) produced by the different mining pools, over time.  We look at the mining methodologies pools could choose and how these policies could impact the proportion of empty blocks.

 

Empty Block Overview

We recently published a piece describing covert ASICBOOST and we explained the allegation that particular mining pools may be using this methodology.  Some claim that circumstantial evidence supporting this allegation, is that some mining pools produce more empty blocks (or more smaller blocks) than other mining pools.

Readers have asked us for data backing up this assertion, as only limited data has been published on this specific topic, as far as we are aware.  We are not going to draw any firm conclusions from the data on the prevalence of empty blocks, however we present it for your consideration.  We also explain some of the other potential reasons for empty blocks, including SPV mining and SPY mining.

 

Figure 1 – Summary chart – Rolling average percentage of empty blocks (over 1,000 block period) by pool

Source: Bitcoin Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: Data up to 25th August 2017. Due to the different frequency with which different pools find blocks, the same dates on the chart could reflect different periods

 

Charts illustrating the proportion of empty blocks by mining pool

 

Figure 2 – Percentage of empty blocks by pool – 2017 YTD

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  Data up to 22nd October 2017

 

Figure 3 – Percentage of empty blocks by pool – 2016

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Figure 4 – Percentage of empty blocks by pool – 2015

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Figure 5 – Percentage of empty blocks by pool – 2014

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Figure 6 – All time percentage of empty blocks by pool – Monthly data

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: Data only included if the pool found 300 blocks or more within the month, Data up to 22nd October 2017

 

Figure 7 – 2016 onwards – percentage of empty blocks by pool – Monthly data

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: Data only included if the pool found 300 blocks or more within the month, Data up to 22nd October 2017

 

Figure 8 – 2017 YTD – percentage of empty blocks by pool – Monthly data

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: Data only included if the pool found 300 blocks or more within the month, Data up to 22nd October 2017

 

Summary statistics by year (top 11 pools ranked by the last 12 months)

 

Figure 9 – Summary table for 2017 (to 25th August)

Pool # of blocks Average block size % Empty blocks
Antpool 6,298 897KB 1.8%
F2Pool 3,897 919KB 1.3%
BTCC 2,733 896KB 0.7%
Bitfury 2,852 965KB 0.0%
BW Pool 2,034 933KB 0.1%
ViaBTC 1,990 952KB 0.4%
BTC.TOP 3,199 978KB 0.7%
Slush 1,921 947KB 0.4%
BTC.com 2,265 951KB 2.4%
HaoBTC 931 957KB 2.3%
BitClub 1,236 980KB 0.0%
All Blocks 35,899 936KB 1.1%

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Figure 10 – Summary table for 2016

Pool # of blocks Average block size % Empty blocks
Antpool 11,479 747KB 4.2%
F2Pool 11,444 772KB 0.9%
BTCC 7,023 718KB 0.8%
Bitfury 5,298 834KB 0.0%
BW Pool 5,373 710KB 2.5%
ViaBTC 1,995 822KB 0.7%
BTC.TOP 27 961KB 0.0%
Slush 2,842 720KB 0.5%
BTC.com 657 976KB 2.1%
HaoBTC 1,443 982KB 1.5%
BitClub 1,662 964KB 0.0%
All Blocks 54,851 776KB 1.8%

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Figure 11 – Summary table for 2015

Pool # of blocks Average block size % Empty blocks
Antpool 9,815 484KB 8.2%
F2Pool 10,851 499KB 4.0%
BTCC 5,780 390KB 0.1%
Bitfury 5,459 604KB 0.0%
BW Pool 4,129 495KB 4.5%
ViaBTC 0 n/a n/a
BTC.TOP 0 n/a n/a
Slush 2,445 492KB 1.2%
BTC.com 0 n/a n/a
HaoBTC 0 n/a n/a
BitClub 210 509KB 0.0%
All Blocks 54,311 480KB 3.1%

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)

 

Validationless mining – SPV mining & SPY mining

SPV mining

In order to build on top of the previous block and extend the chain, mining pools need the hash of the previous block, but not necessarily the full block with all the transaction data.  Mining pools are in a rush to make the chain as long as they can as fast as possible to increase profits.  Therefore miners often have a policy of trying to find the next block before they have even had time to download and verify the previous block.  If this occurs, a miner typically avoids putting any transactions in the block (apart from the coinbase transaction), as the miner may not know which transactions were in the previous block and including any transactions could result in a double spend, resulting in an invalid block rejected by the network.  The term used to describe this type of activity is “SPV mining”.

The efficacy of SPV mining is debated in the Bitcoin community, with advocates claiming this is legitimate profit maximising activity. While opponents of this policy claim it reduces the transaction capacity of the network (since empty blocks still keep the mining difficulty up) and that it increases the probability of an invalid block receiving more confirmations, ensuring the network is less reliable for payments as double spends are more likely.

 

SPY mining

Another term often used is “SPY mining”.  When a mining pool wants to get the previous block even faster, they often participate as a miner on a competing pool, but instead of adding actual hashpower to the pool, they use the access to the network to get access to the previous block hash even faster and then use this information obtained by “spying” on their own pool.

 

Pool policies

Different mining pools are said to have different policies.  For example AntPool is said to conduct SPV mining, while Bitfury is said to not engage in this practice.  As figure 9 shows, Bifury produced 0.0% empty blocks in 2017, compared to Antpool on 1.8%.  SPV mining is believed to be the primary cause of this difference.

 

The ASICBOOST allegation

The above factors may explain the difference in the proportion of empty blocks, rather than covert ASICBOOST.  Alternatively, there could be another factor which we are not aware of, neither SPV mining nor ASICBOOST, causing the variation.

However, those supporting the covert ASICBOOST theory have been able to use the empty block data to generate circumstantial evidence supporting their theory.  For example figure 8 could be said to demonstrate the following:

  • Up until April 2017 Antpool (orange) produced the highest proportion of empty blocks, at a rate far higher than its peers
  • In April 2017 this switched to BTC.com (dark blue) a pool owned by the same company as Antpool
  • In October 2017, unknown miners (light green) started to produce empty blocks, as Antpool tried to conceal its policy even further

In our view this hypothesis is certainly possible, but also reasonably weak. Further evidence may be required to draw any firm conclusions.

 

The time gap between blocks

Another factor to consider is timing.  SPV mining occurs because miners are keen to get to work on the next block quickly, before they have had time to validate the previous block.  Therefore, in the majority of cases where miners do not quickly find the next block, say within 30 seconds, the impact of SPV mining should be limited, since miners do have time to validate.

Figure 12 below is a repeat of figure 3 above, except this time we have excluded the empty blocks which occurred within 30 seconds of the previous block being found.  This may partially remove the impact of SPV mining.  Although the data with respect to timing may not be reliable.

 

Figure 12 – Percentage of empty blocks by pool – 2016 (30 second gap or more from the previous block)
Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes:  The time gap may not be reliable

 

Smaller but non empty blocks

The analysis in this piece only looks at empty blocks.  The ASICBOOST allegation is not only about empty blocks, but also smaller blocks. Smaller but non empty blocks can also assist with covert ASICBOOST due to the smaller size of the Merkle tree.  In a later piece we plan to look at the proportion of these smaller blocks in more detail.

In the below analysis we compared the timing between the previous blocks and the blocksize, for two particular pools.  One which claims to do SPV mining (Antpool) and one which claims not to (Bitfury).

The charts illustrate that the variations between pools are not just about empty blocks, but also smaller blocks.  The charts show that Bitfury has a more “tidy” chart, with smaller blocks only occurring when the time gap between the previous block was small.  In contrast the Antpool chart appears more “messy”, with empty and smaller blocks more prevalent regardless of the time gap between the previous block.

 

Figure 13 – Antpool (2017 YTD) – Blocksize compared to the time gap between the previous block

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: The y-axis is the time gap from the previous block in seconds, the x-axis is the blocksize in bytes.  The time gap may not be reliable

 

Figure 14 – Bitfury (2017 YTD) – Blocksize compared to the time gap between the previous block

Source: Blockchain, BitMEX Research, Blockchain.info (For mining pool name)
Notes: The y-axis is the time gap from the previous block in seconds, the x-axis is the blocksize in bytes.  The time gap may not be reliable

 

It is difficult to draw any firm conclusions from these charts.  However one ironic thing stands out to us, from this analysis.  The pools arguing most vigorously for larger blocks, tend on average, to produce smaller blocks.

 

The Bitfinex chain split tokens

Abstract: In this piece we look at the ten different chain split tokens that could exist on the Bitfinex platform in 2017 and some of the complexities and challenges involved.  There are circumstances in which the policies Bitfinex has chosen are unfair and place a burden on customers, however perhaps this could not be avoided.

 

Chain split token overview

Bitfinex chain split tokens – 2017

Source: Bitfinex, BitMEX Research
Notes: It is not known if the Bitcoin Unlimited chain will exist as a different coin to Bitcoin at the time the contract is due to settle in December 2017

 

The above diagram illustrates the 10 chain split tokens which could exist on the Bitfinex platform in 2017.  During the year various groups created spin-off coins of Bitcoin and Bitfinex provided its customers the opportunity to trade these tokens.  Typically each spin-off can result in three new tokens.  For example SegWit2x resulted in:

  • BT1 – The futures contract token redeemable for BTC after the fork
  • BT2 – The futures contract token redeemable for B2X after the fork
  • B2X – The SegWit2x token itself

As we explain below, allowing the trading of all these tokens results in operational problems for Bitfinex, places inconvenient burdens Bitfinex customers and results in various scenarios which are “unfair” for customers.  However, avoiding any of these issues is difficult and perhaps potentially impossible, given the complexities involved.  In many ways Bitfinex has done a service to the community by rising to the challenge and supporting these tokens.  Although, in some respects its actions may have been unfair to customers and the platform could have handled the situation better.

A full timeline of the events related to the 10 chain split tokens is provided in the table below.

 

Bitfinex 2017 Chain Split Token Timeline

Date Event From To Margin longs receive tokens Margin shorts owe tokens BTC lenders receive tokens* BTC borrowers owe tokens*
 18/03/2017 Optional Split BTC BCC + BCU n/a n/a n/a n/a
 01/08/2017* Distribution BTC BCH    
 06/10/2017 Optional Split BTC BT1 + BT2 n/a n/a n/a n/a
 23/10/2017 Optional Split BTC BG1 + BG2 n/a n/a n/a n/a
 24/10/2017 Conversion BG1 BTC n/a n/a n/a n/a
 24/10/2017 Conversion BG2 BTG n/a n/a n/a n/a
 24/10/2017 Distribution BTC BTG  
 27/10/2017 Buy back BTG BTC n/a n/a n/a n/a
 16/11/2017* Conversion BT1 BTC n/a n/a n/a n/a
 16/11/2017* Conversion BT2 B2X n/a n/a n/a n/a
 16/11/2017* Distribution BTC B2X  
 XX/12/2017* Distribution BTC BTU  ?  ?  ?  ?
 31/12/2017 Conversion BCC BTC n/a n/a n/a n/a
 31/12/2017 Conversion BCU BTU n/a n/a n/a n/a

Source: Bitfinex, BitMEX Research
Notes:

  • The BCH distribution had a coefficient of 0.85 for lenders
  • 16/11/2017 is the expected date of the SegWit2x hardfork
  • The date of the Bitcoin Unlimited hardfork is not known, its not easy to define if the fork occurs due to some of the nuances in Bitcoin Unlimited and it may not occur at all
  • With respect to BTG and B2X distributions, lenders only receive the token when BTC is in “use as financing collateral”
  • We apologies for any inaccuracies in the above table

 

Margin positions & lending

As we mentioned in our previous piece on the SegWit2x hardfork, the spin-off token distribution decision for financial platforms is not straight forward.  There are essentially four options:

 

Potential financial platform policies regarding the distribution of spin-off tokens

Policy A Policy B Policy C Policy D
Split user Bitcoin deposit balances into BTC & spin-off  
Split user Bitcoin margin long positions into BTC & spin-off long positions
Split user Bitcoin margin short positions into BTC & spin-off short positions    
Bitcoin lenders are due back BTC & spin-off
Bitcoin borrowers owe BTC & spin-off  

Note: It is also possible to have a different policy with respect to Bitcoin lending and Bitcoin margin positions, which is not illustrated in the above chart.

 

BitMEX may choose policy A (or perhaps B in some circumstances), however Bitfinex typically chooses policies (or variant of the policies) C or D. While Bitfinex’s policies can be considered “fairer” in many respects, it can lead to some problems.  Supporting additional tokens can not only put additional burdens on the exchange, but also on customers, as the situation with Bitcoin Gold below illustrates.

 

Bitcoin Gold (BTG)  – The forced buyback

Bitfinex clients who were short BTC on margin at the time of the fork had a BTG liability added to their account when the fork occurred.  This needed to be done to balance out the impact of users who were long BTC on margin at the time of the fork and benefited by receiving BTG.

This places a burden on customers who were short, as they now have to go into the market and buy BTG to cover their positions, despite potentially having no interest or knowledge in BTG.  This may frustrate some customers as they were not given much notice in this particular case (perhaps under 24 hours).  Since margin trading may not be enabled on BTG, customers have been given three days to cover their BTG shorts, or Bitfinex may buy back the BTG for them in the market with their BTC.

 

Anyone with a negative balance resulting from being a BTC borrower at the time of the fork will need to buy back into BTG within 3 days or risk having the system do it for them

Source: Bitfinex

 

The issue may be of particular concern to Bitfinex customers, since the BTG token does not exist yet, nor is the client ready to be released, as further development work may be required.  The date Bitfinex enabled trading, 24th October, was only the date of the snapshot of Bitcoin balances, not when the token actually launched.  Therefore Bitfinex customers who were short BTC at the time of the snapshot will not be able to deposit BTG to the platform to cover their short positions, as the token does not yet exist and instead they appear to be forced to buy it on the market at Bitfinex.  There may be insufficient liquidity, which could cause problems.

Although this is “unfair” and likely to frustrate some customers, it is easy to criticize and there are no perfect policies.

 

The chain split tokens do not consider the impact of the other chain split tokens

The above contracts do not fairly reflect each other.  For example there was a distribution of BCH tokens in August given to holders of BTC.  However, holders of BCC never received any BCH. This problem is illustrated by the overlapping nature of the contracts in the chart above.

If Bitfinex wants to increase the complexity of the above even further, the following additional distributions could be conducted:

  • When the SegWit2x hardfork occurs, distribute BTG to holders of BT1
  • On 31 December 2017, the Bitcoin Unlimited contract settlement date, distribute BCH, BTG and B2X tokens to holders of BCC

Bitfinex may actually make adjustments for these events and even eluded to this possibility in a recent post.  It would be interesting to see if any of their customers actually demand this.

Smell That?

The putrid smell of Bitcoin shorts’ carcasses just became more pungent. The Bitcoin price pump from below $3,000 to almost $6,000 in under one month is truly astounding.

In that span of time China shut down three of the world’s largest exchanges. The New York Agreement signatories proceeded further with the scheduled SegWit2x hard fork. And heads of large banking institutions called Bitcoin a fraud.

Where to from here? How high can Bitcoin go? Is this just a flash of greatness to be followed by a century of misery?

The clues to the future of Bitcoin lie in the global currency and debt markets. The money printing orgy that allows central banks to monetise the debt of governments and large corporates created the environment for Bitcoin to thrive. Therefore, an examination of the total stock of money and government debt could give clues to the future price of Bitcoin.

From Investopedia:

M2 is a measure of the money supply that includes all elements of M1 as well as “near money.” M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds and other time deposits.

The government debt statistics are in USD billions were obtained from a Bank of International Settlements report. The data is as of 30 June 2017.

Money is not just M2, but in our financialised world, sovereign-credit acts as a very important monetary instrument. It is why many economists label the currency system a debt-based monetary system.

Other debt instruments such as corporate debt, provincial or municipal debt also function as money. Each country is different in the ways in which other types of debt function as money. To remain consistent I only considered government issued debt.

Gold (XAU) is the analogue “I don’t trust the government” monetary instrument. Bitcoin (XBT) appears to be the digital version. For gold and Bitcoin I used the current value of the total supply of each currency as its M2 value. For government debt, each has a value of 0.

The above chart depicts the relative size of M2 + Government Debt for the four most important fiat currencies (USD, EUR, JPY, and CNY), Gold, and Bitcoin. The first salient observation is that Bitcoin’s market value barely registers on the graph vs. these larger currencies.

Debt must be paid back at some point with base money, M2. Therefore the more debt a country has vs. it’s base money, the more leveraged their financial system. Governments usually don’t worry about how debt will be repaid because they can continue to issue new debt to pay off old.

However, when the market refuses to roll over debt an affordable interest rate, debt must be extinguished. One theory of how overly indebted governments could reduce the Debt / M2 leverage ratio is to tender debt-backed money at higher and higher prices for real money such as gold. Paul Brodsky in Apropos of Everything I, II, and III lays out an excellent argument for why central banks would extinguish debt-money vs. gold. I don’t believe it is likely that central banks will add Bitcoin to their pool of assets. The more likely scenario is that inflation sensitive investors will tender their debt-money for a relatively cheap real digital monetary instrument such as Bitcoin.

The only reason Bitcoin deserves treatment in is this thought experiment is that against all odds, it is still here after 9 years. The price after falling 80% from 2013 highs to 2015 lows, is now almost 5x higher than the previous 2013 all time high. The other positive aspect is that after years of ignoring Bitcoin, many financial institutions are investigating how they can play the game.

The aggregate amount of government debt outstanding for the four fiat currencies listed is $38,334 billion. At current prices, gold and Bitcoin are worth 20% and 0.25% of the aggregate government debt respectively.

If Bitcoin is digital gold, than theoretically it could reach the same ratio as gold relative to aggregate government debt. That implies a Bitcoin price of $461,333 or an 80x increase in price.

Modesty is a virtue. Assume that Bitcoin achieves a 1% valuation relative to aggregate government debt. That results in a price of $23,065 or a 4x return from current levels.

The battle for $10,000 is one of perception. Bitcoin is still not very useful as a pure monetary transaction instrument given its price volatility. However as a store of value, if savers view it as a hard form of digital money, they will diversify out of debt-money into Bitcoin. This psychological transformation is underway. The longer the price stays at these levels, the more people will believe Bitcoin will exist decades in the future.

Trading ShitCoin2x

The underlying index for BitMEX futures and swaps contracts on Bitcoin / USD and Bitcoin / JPY will not include the SegWit2x coin (B2X). Theoretically the futures and swaps should trade at a discount to reflect the B2X dividend received by all holders of Bitcoin on the ex-date. My trading thesis is that similar to the Bitcoin Cash hard fork, the futures and swaps will behave as expected.

Savvy and unemotional traders made significant profits without taking any price risk by taking advantage of the market dislocations. The following trade ideas will focus on the XBT/USD spot market, the XBTUSD swap, and the XBTZ17 futures contract.

Trades Pre-Fork

Given the market knows that BitMEX will not adjust the underlying indices, XBTZ17’s basis will trade lower to reflect the implied value of B2X. Thankfully due the current bull market, XBTZ17 trades at a positive basis. This is a perfect entry point for the following trade.

Sell XBTZ17 vs. Buy spot Bitcoin

A few exchanges (Coinbase & Bitfinex) have already announced that they will disperse B2X to all holders of Bitcoin on the ex-date in a 1:1 ratio. Therefore, once the spread is put on, the physical Bitcoin purchased as a hedge should be sent to any exchange that will split the coins for you. This allows you to sell any B2X received immediately. He who sells first, sells best.

On the ex-date (expected to be on or around November 20th), you will receive B2X in a 1:1 ratio. These B2X coins should be immediately sold for USD. At the same time, the futures should trade at a discount or negative basis. The short futures position must covered, and the physical Bitcoin hedge sold as well for USD.

Initial Trade:

Short XBTZ17
Long XBT

At Fork Time:

Receive B2X

Trade Unwind Proceedure:

Close XBTZ17, by buying
Sell XBT
Sell B2X

Trade Profit and Loss

Because you were able to enter the futures vs. spot trade at a positive basis, the B2X you sold is pure profit. Also, because you were able to cover the futures contracts at negative basis you will pick up additional basis related profit.

If the futures are trading at a discount when you entered the spread, then you must predict whether the percentage discount is less than the expected B2X / Bitcoin ratio. Or you must have a longer term positive view on the value of B2X.

What Can Go Wrong

If you entered the futures vs. spot trade at a positive basis and the fork does not occur, you will still profit. However, you will be required to hold the spread until expiry in late December. Depending on your hurdle rate, this opportunity cost may outweigh the basis profit received.

If you entered the futures vs. spot trade at a negative basis and the fork does not occur, you will post a loss in the amount of the negative basis.

When you unwind the futures vs. spot spread, the futures contract might trade at a large positive basis. If this happens, you must hold the spread until expiry. The only thing you lose is opportunity cost on the capital tied up in the position.

Right Before and During the Fork Trades

In the hours preceding the Bitcoin Cash fork, the XBTUSD swap traded at a large discount, and the funding was negative. A negative funding rate means that shorts pay longs. This discount is due to traders selling XBTUSD vs. buying Bitcoin spot right before the ex-date so they can “create” B2X without any price risk.

Or traders fearful of negative consequences for Bitcoin due the hard fork are locking in the USD value of their physical coins. The XBTZ17 futures contract will also be sold such that it exhibits a negative basis as well.

Traders may earn the B2X USD value synthetically by taking these countertrades.

Buy XBTUSD vs. Short Bitcoin spot

Profit is earned two ways. Firstly, XBTUSD’s basis will swing from negative to flat in the hours after the fork. Your are long the basis, therefore you profit. Secondly, the funding rate is negative. You will earn Bitcoin interest ever 8 hours while the rate is negative.

Buy XBTZ17 vs. Short Bitcoin spot

XBTZ17 should trade with a negative basis as well. Traders can purchase the futures contract, and sell it hours after the ex-date once the basis rebounds.

The one wrinkle to these trades is where to short Bitcoin spot. This is a very important consideration. If the exchange where you short Bitcoin forces shorts to deliver B2X, then the trade should not be put on. Additionally, borrow rates for Bitcoin will spike shortly before the ex-date. It is entirely possible that borrow fees eclipse the basis and funding profit earned on the long XBTUSD position.

Most exchanges that offer margin trading will not force shorts to deliver or cover B2X. Forcing a large number of shorts to cover in the illiquid B2X spot market could be disastrous. Therefore, most exchanges will not credit Bitcoin lenders with B2X or force Bitcoin shorts to deliver B2X.

Bitcoin Economics – Credit expansion and the characteristics of money which make it possible (Part 1)

Abstract: In this piece on economics, we look at misconceptions with respect to how banks make loans and the implications this has on the ability of banks to expand the level of credit in the economy.  We analyze the inherent properties of money which ensure that this is the case and the impact this could have on the business cycle.

 

Dynamics of Credit Expansion

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

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

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

Please consider the following simplified example:

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

 

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

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

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

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

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

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

 

The credit cycle

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

 

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

 

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

 

 

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

However, there are alternative views.  For example another successful investment firm, Marathon Asset Management, identifies the “capital cycle” as the main driver of the business cycle, rather the credit cycle.  In their view a cycle emerges with respect to investment in production, as the below diagram illustrates.

 

The capital cycle

Source: Capital Account

 

The fundamental cause of the credit expansionary dynamic

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

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

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

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

 

Advantages of bank deposits compared to physical notes and coins

Factor Bank deposit Physical cash
Security

Keeping money on deposits in financial institutions, increases security

The money is protected by multiple advanced security mechanisms and insured in the unlikely event of theft

Large physical cash balances at home could be vulnerable to theft or damage

Physical cash cannot be insured and storage costs can be expensive

Electronic transfers Using the banking system, it is possible to quickly send money effectively over the internet or by phone, across the world at low cost and at high speed If physical cash is used, then a slow, inefficient, insecure physical transfer must take place
Convenience

Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or on your computer

Precise amounts can be sent so there is no issue with receiving change

Handling cash is often a difficult and cumbersome process. Precise amounts cannot be specified and one may need to calculate change amounts
Auditability Traditional banks offer the ability to track, control and monitor all transactions, which can help prevent fraud.  This improves reporting and accountability With physical cash, effective record keeping is less automated, increasing the probability of fraud

 

Bitcoin Economics – Credit expansion and the characteristics of money (Part 2)

Abstract: In this piece we look at why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money.  We examine the implications this could have on the ability of banks to engage in credit expansion.

 

The main features of the different types of money

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

 

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

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

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

 

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

 

The unique properties of Bitcoin

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

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

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

 

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

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

 

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

 

Bitcoin’s limitations

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

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

 

The implications of these characteristics on credit expansion

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

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

 

Physical cash vs bank deposits compared to Bitcoin vs Bitcoin deposits

Factor Physical cash compared to deposits Bitcoin compared to Bitcoin deposits
1. Security

Keeping money on deposits in financial institutions, increases security relative to keeping large physical cash balances at home, where the cash is vulnerable to theft or damage

Bitcoin can potentially allow a high level of security, without putting the funds on deposit at a bank

For example Bitcoin can be concealed or encrypted

2. Electronic transfers

Using the banking system, it is possible to send money effectively over the internet or by phone, across the world at low cost.

If physical cash is used, then a slow, inefficient, insecure physical transfer must take place

Bitcoin can allow users to efficiently transmit money over the internet, without using deposits at financial institutions
3. Convenience

Using a banking system to manage your money, can result in a convenient set of tools. For example the ability to use money using your mobile phone or use your computer.

Precise amounts can be sent so there is no issue with receiving change

Bitcoin can allow users to make payments on a mobile phone or without manually calculating change amounts.  Deposits at financial institutions are not required
4. Ability to redeem deposits In the traditional banking system, withdrawing physical cash from a financial institution is a long administrative process which takes time.  Banks therefore do not need to worry about keeping large quantities of physical cash in reserves Bitcoin can allow users to withdraw money from deposit taking institutions quickly, which may encourage banks to ensure they have adequate Bitcoin in reserve at all times
5. Auditability

Banks offer the ability to track and monitor all transactions, which can help prevent fraud and improve accountability.

Physical cash cannot offer this

Bitcoin’s blockchain or other electronic databases can allow users to effectively audit and monitor transactions, without using third party financial intermediaries
6. “Hybrid banking”

In traditional banking models there are only two fundamental choices:

1. Physical cash which provides full user control of the money

2. Money on deposit at a financial institution

This is a binary choice with no middle ground options, forcing consumers to make a difficult choice with no compromise option available

Bitcoin allows a wider spectrum of deposit and security models, resulting in a more complex credit expansionary dynamic.

For example:

1. 2 of 2 multi-signature wallet, where the bank holds one key and the user holds another key; or

2. 1 of 2 multi-signature wallet, where the bank holds one key and the user holds another key

 

The economic consequences of less credit expansion

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

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

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

Policy on Bitcoin Hardforks (Update) and SegWit2x (B2X)

Anyone can create a chain fork of Bitcoin at any time. The possibility of a SegWit2x hardfork (B2X) in November 2017 requires that we, once again, clarify our position on any and all potential hardforks.

 

BitMEX Hardfork Policies

At BitMEX, our top priority is protecting the assets of our customers. In order for us to effectively do this, we insist that any Bitcoin hardfork includes the following:

  • Strong two way transaction replay protection, enabled by default, such that transactions on each chain are invalid on the other chain.
  • A clean break, such that the new chain cannot be “wiped out” by the original chain.
  • A modification to the block header, such that all wallets (including light clients) are required to upgrade to follow the hardforked chain.
  • A change in address format, to prevent people inadvertently sending coins to an address on the wrong chain.
  • New P2P network magic, to ensure a functioning and reliable node network for both coins.

Strong replay protection and wipeout protection, in particular, are considered absolutely crucial.  Should a hardfork not follow these policies, we will not support the new coin. To be clear, we do not intend to access or keep these coins. The administrative overhead of distributing any and all hardforked coins (including Bitcoin-based distributions like Byteball/Lumens) is prohibitive and BitMEX will not monitor or maintain balances of hard-forked coins.

Additionally, support of any forked currency is solely at the discretion of BitMEX. While we may snap users’ margin balances at the time of the fork in case we decide to distribute, there is no guarantee that it will be safe, desirable, or practical to do so. If this concerns you, you should withdraw your funds before any given fork and handle the split on your own.

 

SegWit2x (B2X) – BitMEX Policy

The SegWit2x (B2X) proposal is aimed at increasing the blocksize. It is scheduled to take place in November 2017. This change is incompatible with the current Bitcoin ruleset and therefore a new coin may be created.  

Proponents of this new coin hope it becomes known as Bitcoin, however which coin is known as Bitcoin is not up to the proponents of the new token. Investors and traders may decide which coin has the highest value.  In order for this process to work smoothly, strong two way  transaction replay protection is necessary.

It is our understanding that the SegWit2x proposal does not include two way transaction replay protection, enabled by default. Therefore BitMEX will not be able to support SegWit2x.

As such, BitMEX will not support the distribution of B2X, nor will BitMEX be liable for any B2X sent to us.  This policy applies even if the SegWit2x chain has the majority hashrate. Therefore, it is up to our users to withdraw their Bitcoin’s from BitMEX prior to the fork if they wish to access B2X.

BitMEX considers any and all contentious hardfork tokens as altcoins. The .BXBT and .BXBTJPY indices will remain unchanged and will not include B2X.

The SegWit2x (B2X) Hardfork – Protecting Yourself and Your Coins, Part 1: Coin Splitting

Abstract: The upcoming SegWit2x hardfork lacks replay protection.  In this piece we look at what you can do to protect yourself, by analyzing various ways you could split your coins.

 

Overview

SegWit2x (B2X) is a proposal to double Bitcoin’s capacity limit. This is an increase in the maximum block weight to 8MB from 4MB.

The upgrade is an incompatible with Bitcoin’s current consensus rules (known as a hardfork), which means it is likely to result in a new coin, such that Bitcoin holders prior to the fork will receive both original Bitcoin (BTC) and SegWit2x coin (B2X) after the fork. In many ways this is similar to the recent Bitcoin Cash hardfork (also an increase in the blocksize limit to 8MB). A key difference is that unlike Bitcoin Cash, B2X does not include strong transaction replay protection. Therefore many users could lose funds, on the other hand, those that do successfully protect their funds could make positive investment returns.

The hardfork is expected to occur on around Saturday 18th November 2017. (Block number 494,784)

 

Why bother splitting?

The SegWit2x split will result in two coins, the existing Bitcoin (BTC) and a new “spin-off” coin SegWit2x (B2X). This is likely to lead to significant price volatility, which may present investment opportunities. Due to the lack of replay protection, whatever your view on the situation or your investment strategy, it is sensible to split your coins as soon as possible, to ensure as much flexibility as possible and also to protect your coins.  Many users are likely to intend to send only one of the two coins in a transaction, but accidentally send both, which may result in an irrecoverable loss of funds.  If you do not split, you could be one of these users incurring losses.

Unfortunately the lack of strong replay protection may also present an opportunity for scammers/attackers. For example scammers could repeatedly deposit and withdraw from exchanges, hoping to find any weaknesses. If any exchange has not implemented replay protection, attackers are likely to exploit this quickly, which could make the exchange insolvent. In addition to this, individual users could be targeted by scammers. Scammers could sell the victim Bitcoin, knowing their wallet is following the wrong chain or scammers could acquire Bitcoin from a victim who is expected to replay coins on both chains to the buyer.

These kind of losses and attacks could damage the reputation of the ecosystem, therefore a contentious hardfork without strong replay protection is a high risk event with potentially significant negative consequences. However, there are actions you can take to protect yourself.

 

Splitting your coins

When the hardfork occurs, your Bitcoin will exist separately on both chains BTC & B2X, in the same output. Since the B2X hardfork does not contain transaction replay protection enabled by default, when spending your coins, in either chain, the transaction could be replayed on the other chain.  Therefore the prudent thing to do is split your coins, so that your BTC and B2X exist on different outputs on each chain, which means that your transactions can no longer be replayed.

Unfortunately this is not a simple process and many people are unlikely to be able to achieve this. You cannot split your coins prior to the hardfork, however a prudent strategy may be to prepare how you plan to split beforehand, for example moving your coins to a different wallet before the fork occurs. For many users this is not likely to be easy, however if you act fast, there could be investment rewards, if you are able to sell the spin-off coin before others have a chance to do so.

 

Which wallets to use

In order to split your coins, you would either need to manually construct your own transactions or use two wallets, one for BTC and one for B2X, since most wallets will not allow you to broadcast two conflicting transactions. You will then need two separate wallets, to receive the coins on each side of the split.

Unfortunately two full node wallets are likely to be necessary to protect your coins, for example Bitcoin Core for BTC and BTC1 for B2X. A full node wallet means it verifies all the consensus rules on the entire blockchain. Two fully verifying nodes may be needed because:

  • On the BTC side you may need a wallet that enforces the 4 million unit weight limit (which B2X plans to breach), and;
  • On the B2X side you need a wallet that enforces the coin wipeout protection rule, which requires non witness data in the first B2X block to be greater than 1MB.

You need to ensure each respective wallet enforces each of these rules, to make sure your wallets do not follow a different chain to the one on which your coins are located on.  Otherwise your coins could disappear from your wallet.

In order to prudently prepare for the hardfork, it might be a good idea to run full nodes of each client on a separate computer. The syncing process can take several days, therefore perhaps you could start to run the nodes before the fork, as you may want to be ready to split your coins and spend them as soon as possible.

 

The splitting methods

Method 1: The trial and error approach

The most basic way of splitting is to run a BTC client and a B2X client, import your private keys, and then try to send your coins to yourself, to two different outputs on each chain. Either both transactions confirm, in which case you succeeded, or the same transaction occurs on both chains, and you simply try again.

The trouble with this method is that it could be expensive, in terms of both time and money. Many people may try this approach and therefore network congestion could be high, and the more failed attempts occur the more one needs to pay in fees. In addition to this, at least one of the two chains is guaranteed have minority hashpower, which could increase the block interval in the short term, resulting in more transaction congestion and you would need to wait for your transaction to confirm on both sides of the split to ensure you are protected.

Unfortunately, the trouble with B2X, is not only did this fork not implement strong replay protection, so that BTC transactions are valid on B2X and vica versa, but B2X also uses the same network magic as BTC. Therefore, by default your B2X wallet will broadcast its transactions to the BTC network, making transaction replay likely.

 

Method 2: Locktime

Locktime is a transaction field, which ensures a transaction is only valid after a certain block height. By default some wallets, including Bitcoin Core, add the current block height to the locktime field for their transactions. There are several motivations for this transaction type, one of which is to reduce the incentive for miners to orphan the current leading block, in order to get more fee income, by scooping up the fees from transactions already confirmed in the last block and the transactions in the memory pool. This is expected to be a potential problem in the future when the block reward is low.

One could try to use this feature to split BTC and B2X coins. For example, if the BTC chain has a 5 block lead over the B2X chain, you could send a BTC transaction with the current block height as the locktime, therefore this transaction will be invalid on B2X for the next 5 blocks. If the transaction confirms on BTC, you could then send another different transaction spending the same output on the B2X network, before the 5 block period is over. This could also work the other way around if B2X has the block height lead.

This method sounds complicated, and involves monitoring both chains. However, using the Bitcoin Core wallet this may happen by default and can be combined with the trial and error method described above. In theory, all you need to do is see which chain is in the lead, with respect to block height, and then send your transaction on that chain first.

 

Method 3: The “official” opt in replay protection

The B2X chain is considering adding opt in replay protection. This essentially means B2X client defines a subset of existing valid transactions and then prohibits these transactions on the B2X chain. Therefore you could send a transaction in this format on the BTC network and it would be invalid on B2X, resulting in a successful split.

However, this could be technically challenging to do, as it is not clear if any BTC wallets will support this feature and there may not be enough time for wallets to implement this for ordinary users. In addition to this, it is not known what type of opt in replay protection B2X will use or if this feature will be enabled at all. The official B2X client appears to have gone through the following iterations:

  • Initially there was no opt in transaction replay protection
  • A method of replay protection using OP_Return was merged into the codebase
  • A new replay protection method, banning transactions with an output to a particular P2SH address was merged
  • Problems were found with the latest method, which could apparently result in the loss of funds. Therefore a few days ago this opt in replay protection was removed from the B2X client

Therefore it is not clear what the opt in replay protection for B2X will be and it’s possible there could be no option here at all.

 

Method 4: Taint the coins with already split coins

Somebody else may have successfully been able to split their coins. They could then send you an output from their split coins. You could then use this output as an input for your new transaction. Since this input only exists on one chain, your transaction would be invalid on the other chain. Ideally this could be the coinbase reward from a block mined after the split, that way you can be sure your transaction can only occur on one side of the split, regardless of any potential re-orgs.

This process seems easier than the above methods, although you must ensure you get your coin control in your wallet arranged correctly to ensure you spend the desired transaction input. This method requires waiting for somebody else, therefore it could be slow, which may be a problem if you want to split as soon as possible.

 

Method 5: Let an exchange do it

You could send your coins to an exchange which supports both BTC and B2X, the exchange could then handle the split for you. You need to check if the policy of the exchange is to split your coins before the split or to also split coins sent to them after the split.

A disadvantage of this policy is that your need to take counterparty risk, which you may not want to do with your long term savings.  Taking such a risk could be particularly problematic during a high risk, high volume period such as a chain split without strong replay protection, which may present operational challenges for the exchanges. This method also goes against a common narrative or mantra in the Bitcoin community, which is you should always control your private keys, especially during a hardfork.

Although an advantage of sending your coins to the exchange before the fork, is that you may be able to trade the two coins very quickly, perhaps even faster than those doing the above split methods. This could provide you better investment opportunities.

 

Conclusion

Perhaps the best strategy is to combine the above methods. After reviewing the policy of the exchanges, you could send some of your coins to an exchange of your choice before the fork and then attempt to split the remainder of your coins using method 2 explained above.

However, despite all this advice, it’s probably likely that the overwhelming majority of Bitcoin holders will take no preparatory action for the split. Therefore if you do any above, you are probably well ahead of the majority, which could hopefully lead to some financial rewards or at least help you avoid losses.

The SegWit2x (B2X) Hardfork – Protecting Yourself and Your Coins, Part 2: Investment Strategies

Abstract: The upcoming SegWit2x hardfork is likely to lead to price volatility.  In this piece we look at some potential investment strategies which could allow you to capitalize on the event.

 

Strategy 1: Do nothing

The most popular investment strategy following the split is likely to be to take no action and remain a holder of both BTC and B2X. This is probably the most prudent approach, as your assets may be protected whichever coin becomes more valuable. Most people may pursue this strategy out of laziness rather than choice.  However, even if this is your preferred investment strategy, it may still be sensible to try and split your coins anyway; to increase the flexibility of your investment strategy and protect your funds in case you need to make a transaction.

 

Strategy 2: Invest in your favored coin

Many investors may support either the BTC or B2X coin for ideological reasons or because they feel their chosen coin has the best characteristics.

  • Supporters of BTC typically prefer the consensus rules to be robust, as they feel this results in superior or more unique monetary characteristics. Also they typically value the cautious and meticulous approach of the current development team. BTC supporters may want flexibility and innovation to come from other layers in the system above the consensus rule layer.
  • In contrast to this B2X supporters may value a more flexible consensus ruleset to ensure the system is dynamic and able to cater to user requirements more quickly. B2X supporters typically value the user experience over the monetary characteristics of the system. Typically they draw less distinction between changes in the consensus layer and other types of changes to the system.

If you agree with one of these visions more than the other, it might be a good idea to invest in the coin that matches your vision, this may not only help you obtain larger returns if your vision is correct, but may also help ensure your favoured token is the “winner”, as it may contribute to the value of the coin.

Alternatively you may not care which vision “wins”, but want to back the winner. In this case it’s important not just to gage opinion, but also the level of conviction those on each side of the debate have. Somebody slightly favouring one of the visions but also wanting to hedge their bets may have less of an impact than a die hard supporter of one of the visions, who is willing to sell all their coins on one side of the split no matter what. This factor could favor the BTC side, since many die hard “large blockers” may have already sold some BTC to invest in Bitcoin Cash.

The most common investment strategy after the fork may be to do nothing. However, of the tiny minority of people that do act, many of those people may be sellers of B2X. This is because the section of the minority that took action in favor of the large block chain in August, will not be allocated either BTC or B2X for the coins they sold for Bitcoin Cash. In contrast, the minority that quickly sold Bitcoin Cash in August, will be allocated BTC and B2X this November. Although, obviously this is highly speculative and nobody really knows what will happen.

 

Strategy 3: Invest in whichever coin is the cheapest/the “bad” coin – The Joel Greenblatt strategy

The top investment tip in one of our favorite books on investing, Joel Greenblatt’s “You can be a stock market genius” (bad title but a great read), appears to be that if a stock split occurs, one should buy the less favored company, the spin-off.  In this case B2X is the spin-off token.

Joel Greenblatt’s Gotham Capital achieved annualized investment returns of 50% from 1985 to 1994. One of the core strategies of the fund in this period was to invest in “bad” spin-off companies. As Greenblatt explains:

There are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off. There is really only one reason to pay attention when they do: you can make a hole of money investing in spin-offs. The facts are overwhelming. Stock of spin-off companies, and even shares of the parent companies that do then spinning off, significantly and consistently outperform the market averages. One study completed at Penn State, covering a twenty five year period ending 1988, found that stocks of spin-off companies outperformed their industry peers and the S&P 500 by about 10% per year in their first three years of independence.

Greenblatt mentions that spin-offs tend to be driven by a “desire to separate out a bad business so that an unfettered good business can show through to investors”. The bad company or spin-off company is typically sold by investors, with the negative narrative around the bad company dominant at the time of the split, causing negative sentiment. As Greenblatt explains:

The spin-off process itself is a fundamentally inefficient method of distributing stock to the wrong people. Generally, the new spin-off stock isn’t sold, its given to shareholders who, for the most part, were investing in the parent company’s business. Therefore, once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to the price of fundamental value. The initial excess supply has a predictable effect on the spin-off stock’s price: it is usually depressed. Supposedly shrewd institutional investors also join in the selling. Most of the time spin-off companies are much smaller than the parent company. A spin-off may be only 10 or 20 percent the size of the parent. Even if a pension or mutual fund took the time the analyze the spin-off’s business, often the size of these companies is too small for an institutional portfolio.

Greenblatt goes on to cite four spin off case studies, Host Marriott/Marriott International, Strategic Security/Briggs & Stratton, American Express/Lehman Brothers and Sears/Dean Witter, where this thesis applied.

In many ways there are some analogies between the opportunities which may arise from Bitcoin spin-offs such as B2X and stock spin-offs. Perhaps B2X is being distributed to the “wrong people”. Bitcoin investors typically value robust rules and the resulting highly resilient monetary properties. Perhaps, some of the Bitcoin investors who value other characteristics such as flexibility and user experience may have already divested into Ethereum or Bitcoin Cash, therefore the remaining investors may “dump” B2X. The risk for B2X proponents is they allocate their new coin to the “wrong people” and the price becomes “depressed”.  However, this could provide contrarian investors an opportunity.

The price of B2X could fall to cheap levels and there could be significant amounts of negative sentiment with some people writing the coin off. This could then be a good time for contrarians to invest in B2X. This investment philosophy seems to go against a common narrative in the Bitcoin space that “network effect is king” or “the most work chain wins”, meaning a minority chain has limited prospects. However, there may be little investment basis for this view.

However, whether the Greenblatt spin-off philosophy really applies to Bitcoin spin-offs such as B2X is not clear. Greenblatt still does fundamental analysis on the bad spin-off company, and whether one can take this type of fundamental approach to Bitcoin or its spin-offs, is not obvious. It’s certainly more risky. Although, in my view, after the hardfork, if B2X is trading at c5% or less of the price of Bitcoin and the prevailing narrative is that B2X is dead, then the “bad” coin may be worth a small punt.

 

Strategy 4: Take advantage of different policies on different exchanges

During the Bitcoin Cash hardfork, different financial platforms had different policies. For example BitMEX essentially ignored Bitcoin Cash, and the futures price just followed Bitcoin. However, Kraken for example, supported Bitcoin Cash, in such a way that those with long margin positions on Bitcoin were also given Bitcoin Cash. Critically on Kraken if you were short Bitcoin at the time of the fork, you were then automatically short Bitcoin Cash. These different policies between exchanges provide asymmetry, which in theory can be used to earn free money.

For example going into the Bitcoin Cash hardfork, an interesting strategy was to open a margin long position of 1 BTC on Kraken and then hedge the position by taking a margin short position of 1 BTC on BitMEX. Thereby after the hardfork, you receive one Bitcoin Cash token on Kraken, essentially for free, since there was no corresponding Bitcoin Cash liability on BitMEX associated with the short.

When it comes to the upcoming fork, there are four relevant potential exchange policies one needs to consider, when trying to engage in this type of arbitrage.

 

Potential financial platform policies regarding the B2X spin-off token

Policy A Policy B Policy C Policy D
Split user Bitcoin deposit balances into BTC & B2X
Split user Bitcoin margin long positions into BTC & B2X long positions
Split user Bitcoin margin short positions into BTC & B2X short positions
Bitcoin lenders are due back BTC & B2X
Bitcoin borrowers owe BTC & B2X  

Note: It is also possible to have a different policy with respect to Bitcoin lending and Bitcoin margin positions, which is not illustrated in the above chart.

An interesting investment strategy to engage in before the B2X fork could be to open long Bitcoin positions with exchanges with policy C and D, and potentially open short Bitcoin positions on exchanges with policies A, B and C.  In theory, this should allow you to get B2X tokens for free.

One may think that policy C may seem a slightly inappropriate choice, as it results in an asymmetry. However some exchanges did have a policy similar to this with respect to Bitcoin Cash. The rational for this was that the burden on customers who were short Bitcoin, to go out into the market and buy Bitcoin Cash may have been too high, particularly if the liquidity of Bitcoin Cash was low.

As the B2X fork approaches, we may write a piece summarizing the policies of the main exchanges and how one could engage in this type strategy. Although, if you wait for it to be clearly explained, it could be too late and spreads could have already opened up, reflecting the opportunity. On Bitfinex, B2X is already trading at over $1,000, therefore there could be money to be made by engaging in these types of strategies. Perhaps a good idea, if you really like taking risks, may be to review the policies exchanges took with respect to Bitcoin Cash, to get an idea of what their policies might be with respect to B2X and then open your positions before the policies are officially announced.