The Volatility Blues


The anguish experienced by traders worldwide during the $20,000 to $6,000 slide further proves that recently experienced losses matter more than gains. The financial media and many traders forget that 18 months ago the price was $1,000 and then in the fall of 2015 the price was $200.

Jonny-come-lately traders / investors were eviscerated by the recent moves. To make matters worse, the volatility collapsed alongside the price. For crypto, this is deadlier than white wine and painkillers.

But what about adoption? One of the major facets of Bitcoin preventing further adoption is its high volatility. In a pure Bitcoin economy, how can people trade Bitcoin against real goods if its value violently fluctuates? The underwater trader laments that the market just doesn’t get the “fundamental” value of this new transaction network. Well, what transaction network’s monetary token do you know increased 20x in value in under one year? None. Therefore, the driving force is not about current utility but intense speculation on future utility.

Changing the way in which humans use money is an extremely long and difficult process. This process by its nature must be chaotic. Money and the means by which it is handled is personal and sometimes religious. If you tell a society that tomorrow things will be done differently than how they were done over the past 200 years, there will be an intense reticence to change. A violent upheaval is necessary. Therefore, if Bitcoin is to be used in any productive manner, the period leading up to this new epoch must be extremely volatile.

Bitcoin is a call option on a new monetary system. The most important option pricing input is the underlying asset’s implied volatility. As the above chart illustrates, the realised 30-day annualised volatility crashed alongside the price. When volatility returns, the price will go higher.

We Have Been Here Before

The nuclear bear market of 2015 started in January when the price broke $300. For the next 10 months, the price traded between $200 and $300. While that is a 50% range, the daily movements were very slight.

Without volatility, many traders, investors, and market commentators wrote off Bitcoin. Why should one care about an asset that has crashed over 80% from its recent all-time high, and has barely moved since?

Traders returned to the market because the volatility re-emerged. If Bitcoin can gyrate 100% in annualised volatility terms in a 30-day period, then quick gains can be made. The FOMO “investors” who believe they can change their lot in life with little effort and in little time took us from $200 to $20,000. There were not many things that fundamentally changed about the adoption of Bitcoin in real commerce from 2015 to 2017.

Return to $20,000

The path to parity will not begin in earnest until volatility rises materially. People need to be excited again. 10% pump & dumps in one day will bring back the good times. The real questions are what catalyst will start the party again, and how long will it take.

During the 2017 bull market, the effect of global macro events on Bitcoin was forgotten. For 2H2018, a global macro event will have to prove that Bitcoin is a safe-haven asset. In 2015 Greece almost told Frau Merkel to do one, but chickened out at the crossroads. Bitcoin responded positively when the market believed Greece could actually liberate itself. If a similar type scare happened later this year, would Bitcoin regain its safe haven status?

With the Fed, ECB, and BOJ effectively flatlining or outright reducing their balance sheets, cracks in the financial markets will show later this year. Money printing has never led to prosperity in the long run, and when you shut off the tap the ghosts and ghouls of the financial markets will play.

The MSM Still Loves Bitcoin

Thankfully the mainstream financial press loves talking about crypto. The personalities of the leading figures are larger than life. Even at Bitcoin $6,000 and Ether $400 a whole cadre of individuals are generationally wealthy, and are making interesting life choices the media can’t stop covering. In 2015 no one was watching, in 2018 everyone is.

In order to prove their prescience, MSM outlets will fall over themselves attempting to call the bottom in Bitcoin.  The foolish many who believe these pundits actually can divine the future will attempt to knife catch. Many will fail, but if enough try, some will succeed. These successful retail punters will be paraded on the airwaves as trading gods. This will further increase the FOMO, volatility, and price appreciation.

Nothing goes up or down in a straight line. I still haven’t seen enough pain and anguish to believe we are done bloodletting. In true Bitcoin fashion, the price will go to the level no one thinks is possible and rebound faster than traders can work up the nerve to BTFD.

A brief history of Stablecoins (Part 1)

Abstract: In this piece we look over the history of distributed stablecoins, focusing on two case studies, BitShares (BitUSD) and MakerDAO (Dai). We examine the efficacy of various design choices, such as the inclusion of price oracles and pooled collateral. We conclude that while a successful stablecoin is likely to represent the holy grail of financial technology, none of the systems we have examined so far appear robust enough to scale in a meaningful way. The coins we have looked at seem to rely on “why would it trade at any other price?” type logic, to enforce price stability to some extent, although dependence on this reasoning is decreasing as technology improves.

 

Please click here to download a pdf version of this report

 

Overview

Distributed stablecoins aim to achieve both the characteristics of crypto-coins like Bitcoin (censorship resistant digital transactions) and the price stability of traditional financial assets, such as the US Dollar or gold. These systems are distinct from tokens such as Tether, where one entity controls a pool of US Dollar collateral, ultimately making the system centralised and thus susceptible to being shut down by the authorities.

Along with the somewhat related idea of distributed exchanges, distributed stablecoins have been referred to as the “holy grail” of financial technology, due to their very strong potential benefits. In our view the transformative nature of such a technology on society would be immense, perhaps far more significant than Bitcoin or Ethereum tokens with their floating exchange rates. Distributed stablecoins could have the advantages of Bitcoin (censorship resistance combined with the ability to transact electronically), without the difficulties of a volatile exchange rate and the challenge of encouraging users and merchants to adopt a new unknown token. Such a system is likely to be very successful and therefore it is no surprise that so many people have attempted to launch such projects:

List of stablecoin projects

Name Type Launch Date White paper link
BitShares (BitUSD) Crypto-collateralized 21 July 2014 White paper
Nu (NuBits) Crypto-collateralized 24 Sept 2014 White paper
Steem (SteemUSD) Crypto-collateralized 19 April 2016 White paper
Corion Non-collateralized 14 Oct 2017 White paper
MakerDAO (Dai) Crypto-collateralized 27 Dec 2017 White paper
Alchemint Crypto-collateralized Sept 2018 White paper
BitBay Non-collateralized Sept 2018 White paper
Carbon Non-collateralized n/a White paper
Basis Non-collateralized n/a White paper
Havven Crypto-collateralized n/a White paper
Seignoriage Shares Non-collateralized n/a White paper

The technical challenges involved in creating such systems are often underestimated. Indeed constructing a distributed stablecoin system, which is robust enough to withstand cycles or the turbulence and volatility linked to financial markets may be almost impossible. For instance perhaps most forms of fiat money, even the US Dollar itself, have not even achieved that, with credit cycles putting US Dollar bank deposits at risk. A stablecoin system which builds on top of the US Dollar is therefore never going to be more reliable than traditional banking, in our view.

In economics there is a concept of money supply, with risk and the potential inflationary impact increasing as the number of layers increase. One could add this stablecoin systems on top, as a new high risk layer:

  • M0 – Notes & coins plus deposits at the central banks
  • M1 – Money on deposit in a bank current account (including M0)
  • M2 – Money on deposit in a bank savings account (including M1)
  • M3 – Money in a money market account (including M2)
  • MZM – Money in all financial assets redeemable on demand (including M3)
  • MSC (Synthetic Crypto Money) – Money inside synthetic crypto stablecoin systems  (including MZM)

However advanced or sophisticated the distributed stablecoin technology is, we believe the token is likely to be less robust than the layers above it in the money supply tree.

In this piece we review some of the most prominent and interesting attempts at building these synthetic US Dollar type systems. BitUSD in 2014 and then a more recent project, MakerDAO (Dai).

 

Case study 1: BitShares (BitUSD) – 2014

Factbox
Coin Name BitUSD
Launch Date 21 July 2014
Crypto collateral Yes
Price oracle No

The first stable coin we will discuss is BitUSD, a stablecoin on the BitShares platform. BitShares was a delegated proof of stake (DPOS) platform launched in 2014 by:

  • Daniel Larimer (The primary architect behind EOS and Steem),
  • Charles Hoskinson (the former Ethereum Foundation CEO & Cardano architect), and
  • Stan Larimer (Daniel’s father).

BitShares is just one in a long line of decentralised autonomous corporation (DAC) type platforms released by Daniel Larimer, as the below image shows:

(Note: Daniel Larmier’s company Invictus Innovations launched a number of token/DAC platforms including Protoshares, Angelshares and BitShares. The black arrows represent Protoshares coin holders being granted tokens in the new chains, which Invictus Innovations promised to deliver on all new DAC platforms. Source: BitSharestalk)

 

BitUSD Marketing material

(Source: Introduction to BitShares Youtube video)

BitUSD System dynamics

Pools of Funds Description
Bitshares The native currency of the BitShares platform
Bitshares held as collateral Separate pools of Bitshares  held as collateral, used as backing for the stablecoin.
BitUSD The stable token, designed to track the value of the US Dollar

 

Groups of Participants Description
BitUSD holders Investors and users of the BitUSD stable coin. Holders of BitUSD are able to redeem the tokens for the Bitshares held in collateral.
BitUSD creators Those that create new BitUSD, by selling it into the market (creating new loans), by posting BitShares as collateral. This loan may be for a small period of time, after which it needs to be rolled over or have its collateral topped up to the initial margin level.
Traders Those exchanging BitUSD for Bitshares, and vica versa, on the platform’s own distributed exchange. There is therefore a Bitshares vs BitUSD market price.
Block producers Bitshares block producers/miners have a role of spending the BitShares backing BitUSD, something they are only entitled to do if the value of the BitShares is less than 150% of the value of the BitUSD it is backing (based on the BitUSD vs BitShares exchange rate on the system’s own distributed exchange). The miner can then uses the Bitshares to redeem/destroy the BitUSD. (After the launch the 150% margin level was increased to 200%)

 

Price Stability Mechanisms Price Direction Description
Investor psychology (Unclear/”Why not trade at $1?”) Both directions There does not appear to be a specific price stability mechanism in the BitUSD system. One can redeem and create BitUSD, however the price this transfer occurs at is determined by the BitUSD vs BitShares price in distributed exchange, which is not linked to “real USD”. In a way the price references itself. There is therefore no direct mechanism keeping the price of BitUSD at $1, but the argument put forward is “why would it trade at any other price?” In our view this logic is weak.
BitUSD redemption (indirect) Positive Should the value of the collateral currency (BitShares) fall, any BitUSD holder can redeem the BitUSD and obtain $1 worth of BitShares, assuming the market price of BitUSD is still worth $1 and there is sufficient BitShares held in collateral.

This stability mechanism protects the integrity of the system only in the event that the value of BitShares falls and the BitUSD market price remains at $1. It does not directly stabilize the price of BitUSD around $1, in our view. If the price of BitUSD deviates from $1, this mechanism may not help correct the price.

In our view, it is important to draw the distinction between a mechanism designed to protect the value of collateral and that of a mechanism which directly causes the price of the stablecoin to converge.

Weaknesses

Exposure to a fall in the value of collateral – BitShares was a new, untested and low value asset, and therefore its value was volatile. If the value of the token falls by 50% sharply, in a period spanned by one of the loans used to create BitUSD, there may be insufficient collateral and the peg could fail.

Lack of a price oracle – In our view one of the most controversial aspects of this design is the absence of any price oracle mechanism, providing the system with real world exchange rates. However any price oracle system is challenging to implement and may introduce several weaknesses and avenues for manipulation. We will talk more about this in part 2. In our view, the only real way around this may be that any stablecoin system may require a price feed from a distributed exchange, which can in theory publish a distributed price feed from real world US Dollar transactions. The distributed exchange in BitShares did not allow “real USD”. A distributed exchange system like Bisq, without a central clearing could in theory allow “real USD” prices and provide a distributed price feed.   Therefore stablecoins may eventually be considered as a layer two technology on top of liquid and robust distributed exchange platforms, should these systems ever emerge.

Manipulation – Trading volume in the Bitshares vs BitUSD market on the distributed exchange platform was low, it was therefore possible for block producers to manipulate the market by causing the value of Bitshares to fall relative to BitUSD, enabling them to obtain Bitshares at a discount.

Lack of any price stability mechanism – The main weakness of the system is the lack of any mechanism to move the price towards $1, other than the “where else would it trade?” logic.

Daniel Larimer’s defence of the system

In Daniel’s view, the mechanism of BitUSD creation is analogous to how USD are created in the economy, in that financial institutions lend them into existence.

It’s the same way dollars are created in the regular banking system. Dollars are learnt into existence backed by collateral, in the case of the current banking system the collateral is your house. In the case of our system its shares in the DAC itself.

(Source: Lets talk Bitcoin episode 129)

 

In a way Daniel is correct here, however as we explained in the introduction to this piece, these synthetic dollars are far less reliable than those created by more traditional banks, and can be considered as a whole new layer of risk, as they are even further away from base money. In addition to this, when obtaining a bank loan, the bank typically has a legal obligation to provide the customer physical cash should they demand it. While such an outcome for BitUSD holder is possible, its not a legal obligation for the creators of BitUSD. Although obviously banks typically do not have the cash in reserve to pay back their deposits, we think the fact they have a legal obligation to do so is an important distinction to draw when comparing BitUSD to US Dollar banking deposits.

In response to the supposed weakness of a lack of a price peg, Larimer argues in favor of his “hypothesis that the price feed is unnecessary” as follows:

It implements automatic margin calls, such that if the price moves against someone who is effectively short, it forces them to cover and buy it back in the market and that creates a peg. The market peg works on the premise that all market participants buy and sell based on what they think market participants will be buying and selling in the future. The only rational choice is to assume that it’s going to trade based on the peg in the future. If you don’t believe that they you have to decide on which way it’s going to go, up or down. And if you don’t have a way of saying you abstain from the market. If you don’t think it works you sell the shares and get out, as the systems going to fail in the first place. So its a self reinforcing market peg, that causes the asset to always have the purchasing power of the dollar.

(Source: Lets talk Bitcoin episode 129)

 

In our view this idea that a price of $1 is the “only rational choice” is a weak argument. It is basically saying that if the price is not $1, then what will it be? This logic may hold true for some periods, but it is not sustainable and will not scale, in our view.

Conclusion

The volume of BitUSD in existence was a lot lower than many had hoped, in some periods there was only around $40,000 in issuance. At the same time liquidity was very low and the price stability was weak, as the below chart illustrates. The main architect of BitUSD went on to propose a new stablecoin SteemUSD in 2017, this time including a price feed system. Therefore we consider BitUSD as an interesting early experiment, it did not achieve what was hoped nor did it build a robust stablecoin.

(Source: Coinmarketcap)

 

Case Study 2: MakerDAO (Dai) – 2017

Factbox
Coin Name Dai
Launch Date 27 Dec 2017
Crypto Collateralized Yes
Price Oracles Yes (indirect)

The next stablecoin we look at is Dai, which exists on the Ethereum platform. This system is highly complex, with four relevant pools of funds and six possible stability mechanisms. There are currently around $50 million worth of Dai in issuance and the peg seems to be holding up reasonably well.

System dynamics

Pools of Funds Description
Ethereum Ethereum is the native token of the Blockchain platform used for Maker & Dai
Pooled Ethereum Ethereum is placed in pools used as collateral for issuance of the Dai token. These are often referred to a collateralized debt positions (CDPs)
Dai Dai is an ERC-20 token that is generated by collateralizing pooled Ether. Dai is the stablecoin token, designed to be valued at $1.
Maker The Maker token is MakerDAO’s governance token. It is used to vote on various initiatives that pertain to the stability of the ecosystem. It is also mandatory to possess during the collateral unlocking process. During such a process, a stability fee is garnered from the user, where payment is accepted exclusively in Maker. Maker is also an ERC-20 token.

 

Groups of Participants Description
Dai Creators An individual who sends Ethereum to a smart contract, locking up Ethereum in exchange for Dai. These people are also known as CDP owners.
Dai Holder/User A Dai holder may or may not be a Dai creator. They may invest in or use the Dai stablecoin token.
Maker Token Holders Maker token holders vote on several functions and parameters of the MakerDAO system. They manage aspects such as stability fees and liquidation ratios, as well as having responsibility to nominate other groups.
Keepers These traders monitor the Dai collateral and if it falls to an insufficient level, purchase the collateral in an open auction, by spending Dai.
Oracles Price feed producers submit price information that is aggregated and used to select a given price for both Maker and Ethereum (but not Dai itself). These agents are nominated by MakerDAO token holders.

In order to prevent manipulation, there is a one hour lag between the price publication and when it impacts the system. In addition to this a median type mechanism is used to select the price, which involves ignoring the highest and lowest prices. In our view this may not prove to be robust enough if the oracles have a conflict of interest and try to engage in manipulation.

Global settlers This is another group nominated by the MakerDAO token holders. This group can unwind the entire Dai system, by giving Dai holders the right to redeem their collateral at a fixed price.

 

Price Adjustment Mechanics Price Direction Description
Dai Redemption Positive The primary stability mechanism is the ability, in theory, to redeem Dai for $1 worth of Ethereum. Redemption can only be conducted by CDP owners (unless there is insufficient collateral). If the price of Dai falls, CDP owners need to either use Dai they currently hold or buy it in the market, and then they can redeem/delete Dai for $1 worth of Ethereum based on the price feed provided by the price oracles.
Dai Creation Negative To complement the Dai redemption process, the mechanism to prevent the price of Dai climbing too high, is the ability of Ethereum holders to create new Dai, by placing Ethereum inside of CDPs.
Target rate (Not active) Both directions There is a “Target Rate Feedback Mechanism” (TRFM), which appears to be another price stability mechanism in the system. However, it is not yet active nor have several specifications of the mechanism been worked out yet.

The the idea is that a target rate is set by the MakerDAO token holders. The target rate is essentially a spread which applies to the creation or redemption of Dai, designed to correct the price.

CDP liquidation (indirect) Positive There is a mechanism by which traders/keepers can redeem the Ethereum collateral held by another CDP. This can only occur if the value of this collateral falls to an insufficient level to backup the Dai, in this case 150% of the value of Dai. This should incentivise CDP owners to keep topping up their CDPs to ensure there is a large buffer of Ethereum.

This is a necessary mechanism to ensure the integrity of the system and ensure the value of the collateral is always sufficient. However it is not clear if this directly keeps the value of Dai at $1. This mechanism can be thought of as a building block on the stability mechanism, which merely ensures the level of collateral is sufficient. Other redemption systems are needed to make this meaningful, in our view.

Global Settlement Positive This mechanism can be triggered at any time. The triggering essentially gives all Dai holders an option to convert back to a fixed value of Ethereum, worth $1 according to the oracle price feed, at the time of the triggering (or whatever price is possible given the total level of collateral in the system). The difference between this and normal redemption, is that the price is fixed and its open to all Dai token holders and not paired to a particular CDP.

The idea is that this mechanism can be used as a threat against CDP holders, to ensure they keep redeeming Dai in the event the price falls, rather than holding out for an even lower price.

Global settlement can also be used in the event of bugs or other emergencies.

MakerDAO token issuance (indirect) Positive MakerDAO token holders act as the buyer of last resort. If the collateral (pooled Ethereum) in the system were to drop below 100% collateralization, MakerDAO is automatically created and auctioned on the open market to raise additional funds to collateralize the system. Hence, if the system becomes undercollateralized, Maker holders absorb the damage.

Again this mechanism protects the value of collateral, but does not directly help the price of Dai converge to $1, in our view.

Analysis of the core stability mechanism – Dai redemption

The primary stability mechanisms appear to be the ability of CDP owners to redeem if the price of Dai is too low and for people to create new Dai if the price is too high. For example if the price of Dai falls to 80 cent, CDP owners could purchase Dai in the market and redeem it, unlocking $1 worth of Ethereum and making a nice profit. This is how the system should work under normal circumstances.

The above appears to be a robust stability mechanism which should keep the price of Dai at or near $1. However, the theory may only work if CDP owners expect the price of Dai to correct back to $1. If the price of Dai has fallen to 80 cent, CDP owners may be reluctant to redeem if they expect the Dai price to fall further to 60 cent, as such a price would enable them to make even more profit. There is no guarantee that once the price reaches 80 cent, it won’t continue to fall.

Therefore the stability mechanism could depend somewhat on the power dynamics between two groups, Dai owners and CDP owners. These two groups are essentially trading against each other in the market, Dai owners are selling of Dai and CDP owners are the potential buyers. If the power balance shifts towards CDP owners, such that they are well capitalised, patient, collaborative and determined, this group could outmaneuver the Dai token holders, drive the price down, and then buy it back and make a large profit. This may seem unlikely, but in our view the stability mechanism may not work in all market scenarios. Although we consider Dai as superior to BitUSD, in some limited ways, the Dai peg relies on market psychology and investor expectations, in the same way as BitUSD. Therefore the Dai peg is also weak and unlikely to scale.

The global settlement system can mitigate the above risk. If CDP owners are successfully manipulating the price of Dai down too far, this could trigger global settlement. Dai holders would then get around $1 of Ethereum back. Therefore the threat of global settlement may keep the price of Dai up. However again the effectiveness of this threat depends on the determination of the various groups, the CDP owners, MakerDAO token holders and global settlement activators.

Conclusion

We consider Dai to be one of the most sophisticated and advanced stablecoins systems which has been produced so far. In our view, when digging into Dai’s stability mechanisms, there is no one powerful mechanism which ensures stability. Instead we have a complex network of systems, which to some extent reference each other and use circular logic.  One could claim this complexity was created to obfuscate the lack of a strong and clear stability mechanism, but it is more likely to be an indication of an experimental trial and error type approach to the design of the system.

Therefore the system is still reliant on investor expectations and psychology, although to a lesser extent than the BitUSD. While the stability systems in place could work, at least for a while, we think they are not robust enough to withstand market turmoil or some types of power imbalances between Dai holders and CDP owners. Therefore, the search for the holy grail continues.

 

Waiting for Godot


“Nothing happens. Nobody comes, nobody goes. It’s awful.” 
― Samuel Beckett, Waiting for Godot

The crypto community has been waiting for a variety of Godots since its inception. For traders, our Godot is the mythical Institutional Investor. When they get involved in a big way, our bags will transform into Lambos, and we will live happily ever after. When they get involved, liquidity will magically improve and the market will “behave” as it is supposed to.

Many crypto commentators including myself, proclaimed 2018 as the year institutional investors get involved in a big way. This flood of new money would help support a Bitcoin price above $10,000; and take us to Valhalla in short order.

With northern hemispheric summer approaching, are institutional investors actually flocking to our new space? News of a Goldman and JP Morgan crypto trading desk aside, what is the best proxy for insto interest in crypto?

The CME and CBOE Bitcoin futures contracts trading volumes are the best proxy. Both of these contracts are USD margined and settled. Anyone who trades these contracts obtains Bitcoin price exposure without ever touching Bitcoin. At BitMEX, our contracts are margined and settled in Bitcoin. That means to trade, you must own Bitcoin. Most instos love the idea of Bitcoin, but are terrified of actually buying, storing, and transferring it.

The Numbers



The above graphs show the USD trading volumes of the CME, CBOE, and BitMEX Bitcoin / USD contracts YTD.

The first takeaway is that BitMEX dominates. BitMEX’s retail client base, trades multiples of the insto client base of the CME and CBOE. BitMEX retail traders for the most part would find it very difficult to open an account with a broker that offers connectivity to the CME and CBOE. These brokers will require relatively high account minimums. The lower leverage offered and higher contract notionals at the CME and CBOE mean that even if a typical BitMEX client had connectivity, they would not be able to afford to trade even one contract.

It is clear from this data that retail traders still dominate the flows. Anecdotally, if you hang out long enough in Telegram, WeChat, Reddit etc. you will hear traders talk about spot movements triggered by quirks of a particular derivatives market. Friday settlement for OKex quarts on many occasions has completely whipsawed the market. Trading behaviour is also affected by an upcoming large funding payment on the BitMEX XBTUSD swap. What there is scant mention of, are market changes in response to the CME or CBOE expiry.

Tomorrow Is Another Day

The CME and CBOE volumes point to tepid involvement by instos. The Jan to May MoM CAGR is 3.94%. However, that will change. As banks gin up their trading activities over the next 6 to 12 months, they will begin hand-holding their clients in their crypto baptism. If a bank is going to take the reputational risk by publicly announcing the creation of a trading desk, they will do whatever they can to generate business to justify the risk. The easiest product to trade is the one that doesn’t require anyone to actually touch the underlying asset.

An easy win for a newly minted trading desk is to provide risk pricing on CME and CBOE listed futures. A client wants to trade a chunky block immediately; the sell-side desk will quote a two-way and clear their risk on-exchange over the trading day. The client gets instant liquidity in excess of the screen, and the bank can take healthy bid-ask margins on meaningful flow.

As volumes and open interest grows, the interplay between the USD settled and Bitcoin settled derivatives markets will lead to profitable distortions in the market. Before that happens, interested traders should read the BitMEX vs. CME Futures Guide. The non-linear components of the BitMEX products complicates things, but ultimately means there will be profitable arbitrage and spread trades between the two universes.

Money Launderers Use Property, not Bitcoin

​For some, crypto-coins have a bad reputation: “it facilitates money laundering” is a common belief. Enlightened Hodlers retort that Bitcoin is a terrible way to launder money: it has a public ledger and relative illiquidity vs. the USD. While USD is the preferred method of account, which USD assets do money launderers favour? Pro-Tip: It ain’t Bitcoin.

In these modern times, washing $1 million of crisp cocaine-tainted Benjamins is no easy feat. If you walk up to a teller and attempt to deposit into a bank, they most likely will turn you away or call the police. You could call Saul in New York’s diamond district and attempt to wash it through precious stones; but, fencing those diamonds at close to par will prove difficult.

Governments always want more money parked in their jurisdictions. However, sometimes they have to play the coy mistress and profess their desire to stop terrorist financing (except for the Saudis). Below I will show that the property market is the preferred washing machine for the world’s unclean cash.

I will take a look at the real estate purchase and holding disclosures in Hong Kong, where China launders its money, and the United States where the world launders its money. I will look at both through the lens of the Common Reporting Standard (CRS). We will step into the shoes of our average USD millionaire Zhou from China. How would he clean his cash, and keep the eye Xi from knowing where his loot is?

Chinese people are under no illusion about the rapacious nature of their government. While many have benefited handsomely over the past 30 years, one wrong political misstep could send them back to the countryside penniless. The complete lack of financial freedom means that Beijing, if it wants to, can completely bankrupt you on a whim with no due process.

America, the home of the free, decided that it needed to know where all the financial assets of its tax donkeys globally reside. They required any financial institution to report on the assets of any American. China and many other countries also thought this was a great idea. Hence, the Common Reporting Standard was born. The CRS allows member countries to share financial data between themselves. Under the CRS, China can call up Hong Kong and request information on any Chinese national.

There were two very interesting developments in the history of the CRS:

  1. America failed to ratify the CRS. Which means, for example, that America is not obliged to share financial data on Chinese people with assets in America with China. Things that make you go ‘Hmmmm…’ for $200, Alex – America wants all countries to follow FACTA and inform on Americans, but it won’t return the favour. I wonder where all those assets held by non-Americans will end up?
  2. Hong Kong exempted property from the assets deemed reportable.

As this SCMP article notes, Chinese people rushed to convert bank deposits into property. Property is one of the best generators of economic activity. Many jobs are created on the back of a property boom. From a policy perspective, anything a government can do to encourage an increase in the property stock will make it look like it knows how to run a successful economy.

That’s the date the country falls in line with the Common Reporting Standards, or CRS – a Foreign Account Tax Compliance Act (FATCA)-type regime developed in response to a G20 request, aimed at combating cross-border tax evasion and protecting the integrity of the international tax system. The Chinese government pledged to join in with CRS in 2014.
Details on financial assets held by foreign individuals within mainland China will also start being collected.
The agreement means information will be exchanged with tax authorities in 100 countries and regions from next year, including Hong Kong.
The city has been considered a tax haven for many mainland investors, as there is no capital gains tax levied here. But now they are being forced to convert those financial investments into property, prior to the July deadline to avoid declaring any financial assets held abroad, to the Chinese authorities.

When it comes to the US, the National Association of Realtors is hell-bent on property purchases being exempt from KYC / AML regulations. FinCEN recognised that property became a blatant cash washing machine in certain hot markets, and imposed some disclosure requirements in August 2017.

Set to expire on February 23, 2017, FinCEN discovered that a significant portion of the reported covered transactions in the latest GTOs were linked to possible criminal activity by the individuals revealed to be the beneficial owners of the shell company purchasers. As a result, FinCEN is extending the current GTOs for an additional 180 days, until August 22, 2017, and may consider permanent data collection requirements later this year for more cities.

The GTOs require certain title companies to identify natural persons with a 25 percent or greater ownership interest in a legal entity purchasing residential real property without a bank loan or similar external financing in the following geographic areas meeting specific transaction thresholds:

  • $500k and above – Bexar County, Texas
  • $1m and above – Miami-Dade, Broward, and Palm Beach Counties, Florida
  • $1.5m and above – New York City Boroughs of Brooklyn, Queens, Bronx, and Staten Island
  • $2m and above – San Diego, Los Angeles, San Francisco, San Mateo, and Santa Clara Counties, California
  • $3m and above – New York City Borough of Manhattan

This is a step in the right direction to fight those evil money launders at the very high end of the market, but for your average Zhou with a few million big ones to stash, it is still business as usual.

America remains the favoured place to stash cash away from Beijing’s prying eyes, or, indeed, those of any other government bent on stemming capital flight. As long as someone stays below those investment limits, he or she can expect to have little difficulty obtaining a clean bank account and making a property purchase with cash.

Let’s Try With Bitcoin

It is clearly easy to wash and hide a few million USD in the liquid property markets of Hong Kong and America. What about using the favourite monetary boogeyman, Bitcoin?

Assume you want to move $1 million in cash into Bitcoin.

There are two options: either you can open an account on an exchange, or trade over-the-counter (OTC) with a dealer.

Any exchange that can handle this sort of volume has a serious banking relationship. Their bank will require extensive KYC / AML checks on all accounts. If the purpose is to hide the flow of funds, this is suboptimal. Presented with a subpoena, the exchange will be obligated to present the customer details.

If you can’t use an exchange, perhaps an OTC dealer would trade with you. Unfortunately the large dealers also must follow KYC / AML regulations. They again have banking relationships to maintain.

The major liquidity sources are exchanges and compliant OTC dealers. There are dealers who will onboard a client without KYC checks; however, their spread vs. the market will be extremely aggressive. A 20%+ vig to clean your money, assuming they can handle your size, is to be expected.

Washing money through the crypto capital markets is very difficult if you are unwilling to provide KYC information. Property is much easier, and vested interests from the government to the real estate brokers want you involved. They will do all they can to alleviate KYC / AML reporting requirements. Satoshi ain’t the biggest illegal finance enabler: no, it’s Uncle Sam.

Bitcoin Economics – Deflationary Debt Spiral (Part 3)

Abstract

This report is the third in a three part piece on Bitcoin economics. In the first piece, we looked at common misconceptions with respect to how banks make loans and the implications this has on the ability of banks to expand the level of credit in the economy. We analysed the inherent properties of money which ensure that this is the case and evaluate the impact this could have on the business cycle. In part two, we considered why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money.  We explained the implications this could have on the ability of banks to engage in credit expansion. In this piece (part three), we examine the deflationary nature of Bitcoin and consider why this deflation may be necessary due to some of Bitcoin’s weaknesses. We also look at how Bitcoin could be more resilient to some of the traditional economic disadvantages of deflation than some of Bitcoin’s critics may think.

 

Click here to download the pdf version of this report

 

Bitcoin’s deflation problem

One of the most common critiques of Bitcoin and related crypto-coin systems, is the supply cap (in the case of Bitcoin 21 million) and the associated deflationary nature of the system, which could be damaging to the economy. Critics have argued that history has taught us that a finite monetary supply can be a poor economic policy, resulting in or exacerbating, economic crashes. Either because people are unwilling to spend appreciating money or because the real value of debt increases, resulting in a highly indebted economy. Bitcoin proponents are often called “economically naive”, for failing to have learnt these economic lessons of the past.

In this third piece on Bitcoin economics, we explain that the situation may be more complex than these critics think, as Bitcoin is fundamentally different to the types of money that came before it. There may be unique characteristics about Bitcoin, which make it more suited to a deflationary policy. Alternatively, limitations or weaknesses in Bitcoin could exist, which mean that too much inflation could have negative consequences not applicable to traditional forms of money. In our view, these issues are often overlooked by some of Bitcoin’s economic critics.

A selection of quotes about Bitcoin’s inflation problem

The supply of central bank notes can easily expand and contract. For  a  positive  demand  shock  to  bank  notes  (shifting  from  consumption/investment  to money: i.e. it is a  deflationary  shock),  the  central  bank increases money  supply  by  buying  securities and  foreign  currencies.    For  a  negative  demand  shock  to  bank  notes,  the  central  bank absorbs money in circulation by selling securities and other assets.  In case of [Bitcoin], the latter operation is not included in its protocol. That is  to  say,  the  cryptocurrency  protocol  usually  includes  the  currency  supply  rule,  but  does  not  have  a  currency  absorption  or  write-off  protocol. Can we reduce this irreversibility?

– Mitsuru Iwamura (“Can We Stabilize the Price of a Cryptocurrency?: Understanding the Design of Bitcoin and Its Potential to Compete with Central Bank Money”) – 2014

 

The point is that by not building in an inflation, of say 2% per annum in the global supply of Bitcoins, you almost doom it as a currency, because people will start hoarding it, knowing that it’s going to be worth more next year than it is this year

 –  David Webb (51 minutes into the video) – 2014

 

More broadly, a hard supply cap or built-in deflation is not an inherent strength for a would-be money. A money’s strength is in its ability to meet society’s needs. From my perspective, Bitcoin’s built-in deflation means that it does a poorer job than it might at meeting society’s needs. Maybe I will be proven wrong. We shall see.

 –  The Economist (“Bitcoin’s Deflation Problem”) – 2014

 

The currency’s “money supply” will eventually be capped at 21m units. To Bitcoin’s libertarian disciples, that is a neat way to preclude the inflationary central-bank meddling to which most currencies are prone. Yet modern central banks favour low but positive inflation for good reason. In the real world wages are “sticky”: firms find it difficult to cut their employees’ pay. A modicum of inflation greases the system by, in effect, cutting the wages of workers whose pay cheques fail to keep pace with inflation. If the money supply grows too slowly, then prices fall and workers with sticky wages become more costly. Unemployment tends to rise as a result. If employed workers hoard cash in expectation of further price reductions, the downturn gathers momentum.

 – The Economist (“Money from Nothing”) – 2014

 

Our current global system is pretty crap, but I submit that Bitcoin is worst.  For starters, BtC is inherently deflationary. There is an upper limit on the number of bitcoins that can ever be created (‘mined’, in the jargon: new bitcoins are created by carrying out mathematical operations which become progressively harder as the bitcoin space is explored—like calculating ever-larger prime numbers, they get further apart). This means the cost of generating new Bitcoins rises over time, so that the value of Bitcoins rise relative to the available goods and services in the market. Less money chasing stuff; less cash for everybody to spend (as the supply of stuff out-grows the supply of money).

 –  Charlie Stross (“Why I want Bitcoin to die in a fire”) – 2013

 

Nevertheless, there is still the 21m limit issue. If the limit is reached, the future of Bitcoin supply has to go down the path of fractional reserve banking, since only re-lending existing coin, or lending on the basis that settlement can one day be made in Bitcoin — a la conventional banking practice — can overcome the lack of supply

 Izabella Kaminska – Financial Times (“The problem with Bitcoin”) – 2013

 

 

So to the extent that the experiment [Bitcoin] tells us anything about monetary regimes, it reinforces the case against anything like a new gold standard – because it shows just how vulnerable such a standard would be to money-hoarding, deflation, and depression.

–  Paul Krugman (“Golden Cyberfetters”) – 2011

 

While Bitcoin has managed to bootstrap itself on a limited scale, it lacks any mechanism for dealing with fluctuations in demand. Increasing demand for Bitcoin will cause prices in terms of Bitcoin to drop (deflation), while decreasing demand will cause them to rise (inflation). What happens in each of these cases? Let’s start with deflation, because right now demand for Bitcoin is on the rise. What do people do when they think something’s value will be higher tomorrow than it is today? Well, they acquire and hold on to it! Who wants to give up money that’s constantly rising in value? In other words, rising demand causes demand to rise further. Irrational exuberance at its finest. Deflation begets deflation, ad infinitum, or at least until something breaks.

The Underground Economist (“Why Bitcoin can’t be a currency”) – 2010

 

Deflation and the deflationary debt spiral

Many economists have been debating the advantages and disadvantages of inflation for decades. Nevertheless, this primary point of contention is one of theory; economists, from differing schools of thought have a variety of views on the topic.  It is fair to say that the current economic consensus is that deflation is an undesirable economic phenomenon, while moderate inflation of around 2% per annum is desired. Those with Austrian school leanings, who oppose centrally managing inflation towards a certain positive target, tend disproportionality to support Bitcoin and gold’s somewhat deflationary nature.

One of the primary drivers for the negative view on deflation appears to be the 1929 great depression and the idea of a deflationary debt spiral. The theory is that during a period of economic recession and deflation, the real value of debt increases. Such an increase compounds the misfortunes of an already weak economy. Economist Irving Fisher is often credited with formulating this theory, as a response the financial crises of 1837, 1873 and the 1929 great depression.

Then we may deduce the following chain of consequences in nine links:

  1. Debt liquidation leads to distress setting and to
  2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
  3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
  4. A still greater fall in the net worths of business, precipitating bankruptcies and
  5. A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make
  6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to
  7. Pessimism and loss of confidence, which in turn lead to
  8. Hoarding and slowing down still more the velocity of circulation. The above eight changes cause
  9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way

 – Irving Fisher (1933)

 

Is deflation as bad as these critics claim?

To the extent that critics accuse Bitcoin supporters of being economically naive, they may not always be entirely correct or they could be missing some nuances. Firstly, one does not need to be an Austrian economist to question whether deflation (supply cap) is always undesirable. Deflation could be bad in some circumstances, but it may depend on the characteristics of the economy and the type of money used in society. The social sciences are not like maths or computer science, nobody really knows the right answer to a high degree of certainty and opinions in the academic community change over time. Furthermore, economic circumstances can change over time, which can result in a different set of dynamics, where different inflation policies are optimal. Therefore a hard rule, fixed for all time, such as “deflation is always bad”, may not be the correct philosophy. For example, maybe Fisher’s view on inflation was correct for the economy in the 20th century, however by 2150 technology may have fundamentally changed to such an extent, such that another inflation policy may be more appropriate for society.

Bitcoin has different characteristics and the deflationary debt spiral argument may be less relevant

As we explained in part 1 and part 2 of this piece, Bitcoin possesses properties which are fundamentally different to the traditional money used in the economy such as the US Dollar or gold backed systems. Traditional money, such as the US Dollar are based on debt, which is an inherent property of fiat money. Alternatively Bitcoin may have properties which make it resilient to credit expansionary forces, such that the money is not inherently linked to debt. Therefore in the event of an economic crash and deflation, in a Bitcoin based economy, the impact of increases in the real value of debt could be less significant than one may think. This could make the deflationary debt spiral argument less relevant in a Bitcoin based economy.  In our view, it is likely that many of the Bitcoin critics may have overlooked this point when evaluating the disadvantages of Bitcoin’s deflationary monetary policy.

Disadvantages of inflation unique to Bitcoin

In addition to Bitcoin having some potential advantages, which could make it more resilient to the disadvantages of deflation, Bitcoin’s critics may also have overlooked some of Bitcoin’s weaknesses, which may make it more vulnerable to inflation:

  • Arbitrary environmental damage – Another common criticism of Bitcoin is the environmental damage caused by the energy intensive mining process. Although as we explained in the second part in our series on mining incentives, this issue could be overestimated since miners have a uniquely high level of choice with respect to the geographic location of their mining operations. This flexibility could reduce environmental damage as miners may use failed energy projects rather than investing in new ones.  However, it is still important to note that, the negative environmental damage caused by Bitcoin does seem to be a significant negative externality.  Mining incentives are made up of transaction fees and the block reward (inflation). Therefore increasing inflation increases the level of environmental damage and increases the negative externality. If a 2% inflation policy is decided upon, this could mean at least 2% of the value of the system is spent “damaging” the environment per annum. The inflation policy decision is somewhat arbitrary and the more inflation is selected the greater the extent of environmental damage. There may even be parallels here with the existing financial system. The policy of central banks to stimulate the economy, to achieve their inflation targets, could also be said to cause an arbitrarily high level of environmental damage, at least in the eyes of some critics. Although the link between inflation and environmental damage in a Bitcoin based system is more direct and measurable.  Instead of continued inflation, in Bitcoin the block reward halves every four years until mining incentives are driven entirely by transaction fees. This means that the level of environmental damage will be driven by the market, in that it could represent the amount that users are willing to pay for security, rather than an arbitrarily high level of environmental damage which would be the result of an inflationary monetary policy.
  • Aligning the interests of miners and users – Miners are currently primarily incentivised by the block reward rather than transaction fees. This results in a number of potential problems in the ecosystem, for example perhaps the interests of miners and users are not well aligned. Miners could, for example, exclude transactions from blocks, against the interests of users. Miners may be less likely to take this kind of action if they are primarily incentivised by transaction fees, something Bitcoin’s deflationary policy ensures will eventually become reality.
  • Inability to generate coin value – The supply cap can be considered as a key selling point of Bitcoin for investors and is likely to have helped generate investor interest which may have been necessary to bootstrap the system. If a perpetual inflationary policy was chosen, Bitcoin may not have been able to succeed to the extent it has, even if the deflationary policy is inferior from an economic perspective.

The irony of this debate – economic criticisms are only relevant if Bitcoin is a tremendous success

Much of this discussion focuses on the economics of Bitcoin, assuming Bitcoin is widely adopted, such that the inflationary dynamics have an impact on society. In our view this is an unlikely outcome and perhaps should be considered even more unlikely by Bitcoin’s critics. In our view, Bitcoin may satisfy a useful niche, that of making both censorship resistant and digital payments, but it’s unlikely to become the main currency in the economy. Therefore the debate about Bitcoin’s deflationary nature should be considered as largely irrelevant anyway. Hence it is therefore somewhat odd that some critics use this as an argument against Bitcoin.

This point is similar to one Paul Krugman made in his 2013 “Bitcoin is Evil” piece. Although Mr Krugman is widely derided in the Bitcoin community, most notably for his 1998 comment that “by 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s”, we consider the distinction he draws in the quote below as both accurate and sensible:

So let’s talk both about whether BitCoin is a bubble and whether it’s a good thing — in part to make sure that we don’t confuse these questions with each other.

Paul Krugman – “Bitcoin is Evil” – 2013

 

Perhaps Satoshi thought that having a finite supply cap and a deflationary bias, may help the system succeed, even if from society’s point of view, moderate inflation would be more utilitarian. From a system design perspective, producing a working payment system should be the priority, since a system which does not succeed, even if it’s hypothetically beneficial to society, is ultimately useless.

Conclusion

We conclude that rather than being driven by economic naivety, some Bitcoin supporters may have had a more nuanced understanding of the relationship between debt, deflation, the properties of money and credit expansion than the critics think. In contrast one could argue it’s the economic mainstream’s lack of understanding of the relationship between money and debt, and the potential ability of Bitcoin to somewhat decouple the two, which is the most prevalent misunderstanding. Indeed to many, Bitcoin’s ability to decouple debt from money and thereby result in a deflationary climate without the deflationary debt spiral problem is the point, rather than a bug.

However, even if Bitcoin has solved this economic problem, perhaps it’s naive to think Bitcoin would result in a more prosperous economic system. Bitcoin is a new and unique system, which is likely to cause more economic problems, perhaps unexpected or new ones. After all there is no perfect money. It just may not be correct to apply the traditional economic problems of the past, to this new type of money. Although it may be more difficult, identifying Bitcoin’s potential economic problems may require more analysis and a stronger understanding of the underlying technology.

Ironically, if one thinks these economic problems associated with deflation have a remote chance of being relevant, like the critics indirectly imply, that would mean Bitcoin has a significant chance of becoming widely adopted and hugely successful. In that case, perhaps the sensible thing to do is buy and “HODL”.

 

List of 44 Bitcoin fork tokens since Bitcoin Cash

Abstract: Although in 2018 Bitcoin may have somewhat moved on beyond this issue, in this sixth piece on consensus forks and chainsplits, we provide a list of 44 tokens which seem to have forked away from Bitcoin since the Bitcoin Cash split.

(Source: gryb25)

From late 2015 to the end of 2017, there was significant focus and analysis in the Bitcoin community about a chainsplits, finally resulting in the launch of Bitcoin Cash and then a plethora of other tokens. We have already covered some of topics related to these splits, in the five articles below:

In this sixth piece we list 44 Bitcoin forked tokens.

List of Bitcoin forked coins since Bitcoin Cash

Name URL/Source Fork Height
Bitcoin Cash https://www.bitcoincash.org 478,558
       Bitcoin Clashic http://bitcoinclashic.org (Forked from Bitcoin Cash)
       Bitcoin Candy http://cdy.one (Forked from Bitcoin Cash)
Bitcoin Gold https://bitcoingold.org 491,407
Bitcore https://bitcore.cc 492,820
Bitcoin Diamond http://btcd.io 495,866
Bitcoin Platinum Bitcointalk 498,533
Bitcoin Hot https://bithot.org 498,777
United Bitcoin https://www.ub.com 498,777
BitcoinX https://bcx.org 498,888
Super Bitcoin http://supersmartbitcoin.com 498,888
Oil Bitcoin http://oilbtc.io 498,888
Bitcoin Pay http://www.btceasypay.com 499,345
Bitcoin World https://btw.one 499,777
Bitclassic Coin http://bicc.io 499,888
Lightning Bitcoin https://lightningbitcoin.io 499,999
Bitcoin Stake https://bitcoinstake.net 499,999
Bitcoin Faith http://bitcoinfaith.org 500,000
Bitcoin Eco http://biteco.io 500,000
Bitcoin New https://www.btn.org 500,100
Bitcoin Top https://www.bitcointop.org 501,118
Bitcoin God https://www.bitcoingod.org 501,225
Fast Bitcoin https://fbtc.pro 501,225
Bitcoin File https://www.bitcoinfile.org 501,225
Bitcoin Cash Plus https://www.bitcoincashplus.org 501,407
Bitcoin Segwit2x https://b2x-segwit.io 501,451
Bitcoin Pizza http://p.top 501,888
Bitcoin Ore http://www.bitcoinore.org 501,949
World Bitcoin http://www.wbtcteam.org 503,888
Bitcoin Smart https://bcs.info 505,050
BitVote https://bitvote.one 505,050
Bitcoin Interest https://bitcoininterest.io 505,083
Bitcoin Atom https://bitcoinatom.io 505,888
Bitcoin Community http://btsq.top/ 506,066
Big Bitcoin http://bigbitcoins.org 508,888
Bitcoin Private https://btcprivate.org 511,346
Classic Bitcoin https://https://bitclassic.info 516,095
Bitcoin Clean https://www.bitcoinclean.org 518,800
Bitcoin Hush https://btchush.org 1st February 2018
Bitcoin Rhodium https://www.bitcoinrh.org Unknown
Bitcoin LITE https://www.bitcoinlite.net Unknown
Bitcoin Lunar https://www.bitcoinlunar.org Unknown
Bitcoin Green https://www.savebitcoin.io Unknown
Bitcoin Hex http://bitcoinhex.com Unknown

(Source: BitMEX Research, Forked coin websites, findmycoins.ninja)

Please note it is very important to handle these new fork tokens with caution. In particular, we would strongly advise you not to import your Bitcoin private key into any new fork token wallets without first spending the Bitcoin to a new output associated with a different private key after the token snapshot point, so that your Bitcoin is not at risk.

 

 

BitMEX Downtime, May 17 2018

Today, May 17, 2018, the BitMEX trading engine encountered several separate and heretofore unpredictable problems, causing feed latency and downtime in spurts throughout the day.

Disks mounted to the main trading engine hardware degraded sharply in performance at roughly 10:00 UTC. This degradation caused feed latency during scheduled archive and reindex jobs, which caused significant backpressure. Disk I/O operations were running at roughly 1/20 of their expected rate.

BitMEX runs redundant drives, but in this case, both drives were simultaneously exhibiting this degraded behavior. We had no choice but to schedule a maintenance downtime to replace them. Unfortunately, backpressure reached critical levels faster than we expected and we moved up our timetable.

At no point was data integrity compromised by this problem, but restoring the machine to a functional state with nominal disk performance took longer than expected to execute and verify.

After this action was complete, we restarted trading. Unfortunately, another problem was uncovered during the next archive, where a reindex job combined with a previously rare request pattern led to unexpected index regeneration and symbol revalidation on specific tables. This led to another backpressure scenario, with similar symptoms.

We have identified and fixed multiple contributing factors to the above behavior. The trading engine team will be closely monitoring engine performance throughout the day while continuing root cause analysis for the slowdowns.

Why UPs?

BitMEX is proud to launch its first optionality products: UPs and DOWNs. This marks a very significant milestone in the product development history of the platform. With futures, swaps, and now options, BitMEX is inching closer to the goal of offering all manner of derivative products for the crypto-coin industry.

Why UPs and DOWNs?

UPs or Upside Profit Contracts, and DOWNs or Downside Profit Contracts are similar to call and put options. One of our biggest strengths at BitMEX is in engaging with the community and listening to our customers, and we have heard the roar for such products as the level of sophistication grows in this industry.

Why Now?

The liquidity profile of Bitcoin derivatives trading has changed dramatically over the past 12 months. The BitMEX XBTUSD Perpetual Swap is now the most heavily traded instrument in the entire crypto trading industry. Average daily trading volumes are in the billions of USD notional.

Before non-linear products like options are viable, linear products (Perpetual Swaps and Futures) must be sufficiently liquid. Given the liquidity profile of XBTUSD and the quarterly Bitcoin / USD futures contracts, we now believe there is sufficient liquidity in order to launch a successful options product.

What’s the Use Case?

Imagine Bitcoin is currently trading at $10,000 and you believe that by the end of the week, it will move 10% higher to $11,000. However, you don’t want any exposure to the price unless it hits your target. Also, you do not want your position to be liquidated before your target is reached, irregardless of the intra-week spot movements. For example, if the price drops to $5,000 but recovers to $12,000 by the settlement date, you will still profit and will not be liquidated.

Hence, you want the ability to participate above your target of $11,000 on the long side. The UPs product allows you to express this view, however this “optionality” comes at a cost which is the premium you pay to the seller of the option.

Why Can You Only Buy?

Selling naked (i.e. unhedged) options is one of the fastest and easiest ways to financial ruin given the potential for unlimited losses. On BitMEX, traders are limited to the margin they deposit on the platform, hence if the seller of the option cannot make good on potential losses, then socialised loss systems will need to be put in place which we want to avoid. As a result, we require sellers of the options to post the full notional value of the UP or DOWN contract.

Because no leverage is offered to sellers, it is very expensive from a capital perspective to make a market. In order to guarantee tight spreads at sufficient size, the BitMEX affiliated anchor market maker will be the only entity allowed to sell options initially.

Many of you may have concerns that the BitMEX affiliated entity is the sole market maker, however here are some points to consider:

  1. As further discussed below, one cause of the engine overload issue is that we have many market makers constantly updating quotes on currently listed products. This consumes a vast amount of precious engine capacity. Until our engine performance is fixed, we refrain from listing any new product that exacerbates the issue. (E.g. this is one of the reasons why we delisted a number of our quarterly altcoin futures contracts, since the volumes they generated did not justify the engine resources consumed.) Hence, if only one market maker quotes on the UPs and DOWNs product, then the impact will not be meaningful on the engine.
  2. The UPs and DOWNs products need to be fully margined. That is, buyers must pay the premium in full and sellers must post the full notional of the option in margin. That means that irregardless of where the price settles, neither buyers nor sellers will ever be liquidated. If the contract settles in the money, buyers are assured they will always receive their profit. Furthermore, this means that the anchor market maker cannot manipulate the UP or DOWN market in any way to liquidate any customer. 
  3. The anchor market maker is tasked with keeping a tight market so that buyers can enter and exit trades as they wish throughout the contract’s length. We want to increase liquidity, having wide markets or an empty order book is not in BitMEX’s interest.
  4. As we respond to customers’ feedback about the products, changes will be made to the UPs and DOWNs contracts. The anchor market maker will be able to adjust to the new product structure faster than any third party. That means that we can fail fast, and relaunch the product quickly with guaranteed liquidity.

What Are We Doing About Engine Performance?

At BitMEX, our top priority is improving the performance of our engine. In a detailed blog post, BitMEX Technology Scaling: Part 1, our CTO Samuel Reed explains in detail the issues we face and what we are doing to resolve these issues. However I will reiterate some points here.

The solution is not as simple as adding more servers or more engineers. The engine has a maximum throughput that is constrained by risk checks and calculations which are performed on each order, position, trade or price change so that we can maintain mathematical consistency on a platform that allows for 100x leverage. We have a two-pronged strategy to solve for this unique problem that BitMEX experiences:

  1. Optimise as many existing functions as possible to obtain efficiency gains. We have been rolling out improvements weekly; however, that extra capacity is consumed very quickly as the demand increases to match engine performance improvements.
  2. Re-architect the engine from the ground up so that the aforementioned issues can be scaled horizontally which will allow for more products and more users without overload issues. This work is ongoing, it won’t be solved overnight, but we are working towards this goal.

I want to emphasise that we will not list any products that worsen engine performance until we increase capacity sufficiently.

Additionally, we are scrutinizing which API users cost us the most in resources. Further API rate limits on traders with non-optimal Quote / Trade ratios are forthcoming. I remember how hard I fought as a CEO to convince traders to provide liquidity on our platform. This action pains me deeply and further sharpens my focus on finding a solution to this problem so that anyone who desires to provide liquidity may do so.

Launching the UPs and DOWNs products does not mean that BitMEX has forgotten or ignored the overload issue. Rather, we must continue to launch and test new products within reason so that in a year’s time we have another wildly successful product like XBTUSD.

If you are a talented engineer who believes he or she has a solution to this problem, we want to hear from you / hire you. Please reach out to us via the careers page or email, and a senior member of staff will review your qualifications or suggestions.

– Arthur Hayes, CEO and co-founder

BitMEX Market Making Desk

We have recently updated our Terms of Service to explicitly clarify the relationship between BitMEX the trading platform, and an affiliated entity that engages in market making.

ToS Update

BitMEX has a for-profit trading business that, among other things, transacts in products traded on the BitMEX platform.  The trading business primarily trades as a market maker. The trading business is organised to be separate and distinct from the platform business. Specifically, no front office personnel are shared between the trading business and the platform, the trading business operates from a separate physical location, and the trading business does not have access to any platform order flow, execution, customer or other information on terms that are not otherwise available to any other platform user. In addition, unless otherwise set forth in the terms of a specific BitMEX product, the trading business receives access and trading privileges only on the same terms as are available to any other user.

Why Market Make?

Early on we discovered that market makers are very fickle. They only want to invest the time connecting to a trading platform that already has flow. What they don’t want to do is try out a new exchange where they must expend resources connecting only to have no takers. Given trades must be collateralised, this reduces their returns.

In order to entice others to provide liquidity, we funded an entity that would quote as soon as a new product listed. As the product became more liquid, this entity would scale back it’s quotes and focus on another product with lower liquidity on the BitMEX platform.

Right now the activity of this affiliated entity is concentrated on the altcoin contracts. XBTUSD and the quarterly Bitcoin / USD futures contracts have plenty of liquidity, and new market makers join every day to beef up those orderbooks. Mission accomplished … for now.

Being able to immediately support a new and illiquid product allows us to experiment with products that other platforms without an anchor market maker cannot. It also speeds up the process to obtaining other 3rd party liquidity providers.

How Do We Align Incentives?

The trading entity is a for-profit operation. However, their earnings are comprised of a service fee paid by the business, that is the BitMEX trading platform. In terms of trading PNL, the market making desk’s goal is to be breakeven.

If the desk is making too much trading PNL, the business will instruct them to tighten spreads and increase size. As a franchise, BitMEX succeeds because of greater trading volumes, not because of the market making desk’s trading PNL.

The market making desk earns the most if the exchange earns the most. That also means that dishonest and manipulative behaviour on the part of the market making desk is not tolerated. As you saw mentioned, the desk sits in a separate physical location. They also have no better information or access than any other trader on BitMEX. If traders feel that the platform is not fair, they will leave, and no one will get paid.

Our lead outside counsel is fully aware of the operation and advises us on best practices to ensure that we place the interests of BitMEX customers first.

What Activities Does The Desk Engage In?

The primary trading activity is providing two-sided liquidity on selected BitMEX products. The desk’s current focus is on increasing the liquidity on the altcoin contracts. The desk will also be the anchor market maker for the UPs and DOWNs products.

The desk also trades OTC with various counterparties globally.

As mentioned earlier, the desk does not engage in manipulative behaviour. The desk does not front-run customers. The desk does not manipulate either the market on BitMEX or the underlying exchanges for the purposes of stop loss hunting, or causing cascading margin calls.

None of this behaviour has occurred in the past, and if such behaviour is discovered, those responsible will be terminated immediately for cause.

Who Runs The Desk?

The head trader is Nick Andrianov. He is a former Deutsche Bank equity flow and exotics options trader. Nick and I have known each other for over ten years. His integrity is unquestionable.

Nick receives the business objectives from various senior members of BitMEX. The business and the market making desk work closely with the express goal to make every single BitMEX product as liquid as possible.

Financial Risks

Trading losses incurred by the market making desk will not affect the solvency of the BitMEX trading platform.

As stated above, the market making desk sits within a separate entity. Their goal is to provide liquidity to BitMEX and the wider crypto capital markets.

– Arthur Hayes, CEO and co-founder

BitMEX Technology Scaling: Part 1

Hi there – I’m Samuel Reed, CTO of BitMEX.

It’s been an incredible journey over the last four years building BitMEX. When we started, I don’t think any of us could have imagined the success this platform would achieve or how it would come to dominate Bitcoin/USD trading in 2018.

From 2014 to today, the BitMEX platform has grown from zero to an average of $3B of trading volume per day. Our flagship product, XBTUSD, trades more than any crypto product in the world. We serve customers all over the world, in five languages, and have become the premier platform for Bitcoin price discovery and liquidity.

The BitMEX team has been hard at work improving capacity, building a solid mobile offering, and creating a tech team that is truly best-in-class. We are not resting on our laurels, enjoying this success for the sake of it. Quite the opposite: we’ve been busier than ever.

We’d like to let the community in on how we formed and how we’re moving forward. As was wisely said: “In order to defeat the bug, we must understand the bug.”1


Origins

I’ll begin with a true story.

Source: russellfreeman.com

In 2014, I was speaking at a web development panel in Hong Kong for General Assembly, a coding bootcamp. They wanted to give their soon-to-graduate students a taste of what it was like to work professionally. I took the opportunity to talk about my history: a career made of positions in several small businesses, startups, and government – with an emphasis on how incredibly in-demand software engineers are.

A rather loud personality in the back asked a question: “How do cash-poor startups looking for a CTO make a case? How do you attract great talent in such a competitive atmosphere?”

“Well, that’s a good question, and a tough answer,” I said. “Without funding, you have the challenge of a serious risk versus a sure thing. Why should any experienced developer forgo $200,000 or more at a large tech company, in a comfortable, resource-rich environment, to work 80 or more hours a week? You essentially have to find some bozo” – I really said this – “who believes in your idea so much he’s willing to take the risk despite so many better options.” I wished him good luck and we continued the panel.

He came up to me after the panel and told me he wanted to do a Bitcoin derivatives exchange. I knew then: I was that bozo, and Arthur Hayes and I were to become business partners.

Without any major funding, we brought an alpha online within six months and started with the BitMEX Trading Challenge, an no-rules trading competition where we put the exchange through its paces. And it really was no-rules (aside from multiple accounts) – hacking the site would win you the prize. We paid out a few Bitcoin in bug bounties in those days but we didn’t have any major failures.

Much to the annoyance of my wife, we launched BitMEX on during our honeymoon in Croatia, on November 24, 2014. Ben and Arthur celebrated separately, in Hong Kong. Notice the original trading interface in both photos. You can still read the original Trollbox messages from that day.

November 24, 2014, Dubrovnik, Croatia.
November 24, 2014, Hong Kong.

 


Building BitMEX, 2014

All projects are a product of the time in which they are built. In early 2014, the crypto ecosystem was reeling from the vacuum Mt.Gox left behind. The focus at the time was not “proof of work” vs. “proof of stake”, as it is today, but a forgotten term called “proof of reserves” – just Google it and look at the timestamps of all the popular posts. In fact, a question about this was the top-voted comment on our Reddit launch announcement.

The first rule of running a Bitcoin exchange is, and always has been, “Don’t lose the Bitcoin.”

This rule pervades everything we do at BitMEX. It permeates our policy, even today: we still use a 100% cold wallet where every transaction is multisig. Look up a 3BMEX transaction on the blockchain, and you’ll see it. For 1,250 straight days (!), at least two out of the three of us have gotten up, read the day’s withdrawals, done our risk checks, and signed, to be passed onto the next partner for signing and eventual broadcast.

At the time, I thought users would resist this. Yes, Bitcoin is better in so many ways than any monetary system that has come before it. But it is weaker too. Custodianship is an unsolved problem that requires constant vigilance. I think our customers know this and appreciate it. In our early days, we received a large number of complaints about withdrawal times. Today, where we are the largest exchange by volume in the world, we receive barely any. People get it – caring for your deposits this way is not easy. We do it not because it is convenient, but because it is safe.

BitMEX in 2014.

The atmosphere in 2014 influenced how we built BitMEX. My frontend experience lead me to adopt ReactJS for the frontend. BitMEX was the first exchange to launch with it, a choice that has paid dividends well into 2018.

We were also the first – and likely still the only – exchange to build our matching and margining engine on kdb+/q, a technology traditionally used for querying of large-scale time-series data. It’s a natural fit. It’s fast (bear with me), using SIMD instructions to greatly boost throughput, it’s flexible, and it’s accurate. Kdb+’s flexibility and speed allowed us to pivot our product offerings twice: from low-leverage inverse and quanto futures to high-leverage ones, and from high-leverage futures to our flagship product, the XBTUSD Perpetual. We also pivoted loss-recovery mechanisms twice, from guaranteed settlement, to Dynamic Profit Equalization, to ADL.

BitMEX is a company known for listening to its customers and adapting. This required flexibility, innovation, and a lot of sweat equity from everyone on the team, and we’re so proud of how far it’s come.


Now, it wouldn’t be fair to come this far without addressing the title of this post. BitMEX now trades as much as US$6.5 billion per day. Our most recent 1-minute record was US$35 million, a number that is higher than the entire month of April 2016.

The highlighted month, March 2016, had 16M of volume on XBTUSD. XBTUSD now peaks at double that in just one minute.

The following charts show monthly turnover in increasingly large timescales, to highlight detail completely lost in the overall view:

To understand why BitMEX is experiencing slowdowns, despite using a solid technology like kdb+, it’s important to understand what BitMEX does differently than other exchanges.

100x is a number that elicits a large number of reactions, ranging from “are you crazy?” to “how is this possible?” It is only possible due to incredible financial engineering from our co-founder and CSO Ben Delo. Ben is a diligent and brilliant mathematician. He built a perfect mathematical model for trading, a constantly-coherent system that continuously audits all trades and always sums to zero. Transactions don’t get lost in the BitMEX engine. A user’s balance never goes negative. There are entire classes of bugs that are common on other platforms that never occur on BitMEX, and it is that attention to detail that makes all the difference. Mark/Fair Pricing, the weighted ADL system, perpetual contract funding rates, and live isolated/cross remargining are all new, novel concepts that did not exist before BitMEX.

This consistent coherency inside the BitMEX engine makes 100x possible. Kdb+ has historically been fast enough that we can continuously remargin all positions upon each and every price change. This provides the safety and speed necessary to not only survive within the razor-thin requirements of 0.5% maintenance margin, but thrive. The BitMEX Insurance Fund, a fund that guarantees settlement of BitMEX contracts, contains (at the time of writing) an incredible 6,149 XBT, over US$50M. Competing firms have insurance funds in the single digits of Bitcoin, despite offering as low as only 20x leverage.

BitMEX won’t sacrifice safety for speed. The security of our users’ funds and confidence in their trades is paramount. But we hear all of you: you want to trade faster, you want freedom from “System Overload” messages, and we will give that to you.

Since late 2017, the BitMEX team has refocused on engine performance as our highest priority. We have built, and are continuing to build, a team full of the top professionals in the space. This team works hard, building capacity for the next 100x increase in trading volume.


In the second part of this series, I’ll explain in-depth:

  • How the BitMEX engine processes orders and remargining
  • How real-time messages flow through our system to your browser
  • How BitMEX uses API-first design to provide the most powerful API in the business
  • Performance charts showing hot-spots, peak versus baseline load, and corner-cases
  • A breakdown of the dreaded “System Overload” message, and how it is generated

In the third part, I’ll also explain:

  • Performance numbers showing how capacity has increased since 2017
    • We have made large strides in the past months – but demand has increased to match
  • Roadmaps and pending work for Q2
  • BitMEX’s vision for the future of online derivatives trading

Thank you to all of you for being a part of BitMEX’s success. Ben, Arthur and I feel fortunate than to be a part of such a great company: our customers, team, and market opportunity are simply best-in-class.

Reach out to me directly on Twitter at @STRML_ and on Telegram at STRML. I also occasionally talk with traders on the Whalepool TeamSpeak, a fun community of traders that have given great feedback and encouragement to BitMEX for years.


A common sight from the window of the Dubrovnik apartment where BitMEX was launched.

1 – Starship Troopers was ahead of its time with its views on software development.

Funding Mean Reversions 2018

One of the most powerful and simple trading strategies is mean reversion. The XBTUSD swap features a funding rate that is exchanged between longs and shorts every 8 hours. The rate is calculated based the observed premium or discount of the swap over the spot index from the previous 8 hours. The lag between observation, announcement, and payment of funding gives this rate predictive power.

The intent of the funding rate is to entice traders to take the counter-trend position. If the market is falling, those trading with the trend will pay funding (shorts). If the market is rising, those trading with the trend will pay funding (longs). The trend is your friend until it ain’t. Anecdotally traders notice that the funding is elevated in absolute terms directly preceding a turn in the market’s direction.

Last September I presented a simple mean reversion funding strategy. If funding is high in positive terms, short XBTUSD right before funding is charged. Receive the funding payment, then cover the short position 8 hours later. If the funding is high in negative terms, go long XBTUSD right before funding is charged. Receive the funding payment, then close the long position 8 hours later. Depending on your criteria for when you put on this trade, there is a historically positive profit.

Armed with slightly longer than one year’s worth of data (March 2017 to April 2018), I have calculated the historical returns for this strategy. The trading triggers happen at one and two standard deviations away from the mean on the positive and negative side. The below are the results:

Sigma – This is the number of standard deviations away from the mean.

Count – For negative funding, this is the number of observations where the funding rate is below or above the Sigma for negative and positive funding rates respectively.

% Passes – This is the percentage of observations in the Count sample set where if the Sigma is negative, the next log 8-hour return is positive; or if the Sigma is positive, the next log 8-hour return is negative.

Cumulative Funding – This is the total amount of funding received from the observations in the Count sample set. If the Sigma is negative you will be going long XBTUSD and receiving funding. Therefore, even though the Cumulative Funding is listed as negative, you will receive this as income.

Cumulative XBTUSD Return – This is the sum of the next log 8-hour return of observations in the Count sample set.

Cumulative Return – This is how much you will earn from this mean reversion strategy. That is the funding income net of the return from the XBTUSD trades.

% of Total Observations – [Count / Total Number of Observations]

The most profitable range in this simplistic study is between the one and two Sigma absolute ranges. That fundamentally makes sense. If the funding is at the maximum, the counter-trend trade will very likely blow up in your face as the trend continues. Bitcoin, as readers know, is a very emotional market. The highs go higher and lows lower.

As the funding moderates during an extended rally or dump, that is when the tide is most likely to change. And that is when placing a counter-trend trade which receives the funding and direction change is the most profitable.

The more sophisticated statisticians amongst us can concoct much more advanced and nuanced mean reversion strategies centred around the XBTUSD funding rate. The data for the analysis I conducted are all freely available via our public API. This study is yet another proof that plenty of juice remains in the Bitcoin market for cool-headed analytical traders.