Crypto Trader Digest – Nov 30

Welcome To BlockMEX

 

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Arthur: Hi Garry (VC), I want to tell you about a pivot we just made. BitMEX is now BlockMEX, we allow trading of Blockchain Derivatives.

VC: Oh that’s great. You know we are not that interested in Bitcoin, but very positive about the Blockchain. Please tell me more.

Arthur: Clients use Blockshares to trade on BlockMEX. And we allow the trading of financial derivatives using the Blockchain.

VC: Wow that’s awesome. So you no longer use Bitcoin? You were previously called BitMEX right?

Arthur: We never were a Bitcoin company. The “Bit” merely stood for digital information, you know like Bits and Bytes.

VC: Gotcha. So what kind of Blockchain do you use for your derivatives, do you touch Bitcoin in any way?

Arthur: Touch Bitcoin, oh heavens no. We created our own Blockchain that uses Blockshares. It is proprietary to BlockMEX.

VC: Wow, you created your own Blockchain? I’m really impressed. So if anyone can trade anything using the BlockMEX Blockchain, how do regulations work?

Arthur: Regulations are irrelevant with the Blockchain. It’s all decentralised, so no legacy regulations apply to BlockMEX.

VC: Man, the Blockchain is so amazing. So what about trading volumes?

Arthur: We have not done a single trade on BlockMEX yet. That’s okay, we’re just pre-revenue. Our technology is meant for large financial institutions. We are going to revolutionise how they trade derivatives.

VC: I totally agree that legacy finance needs services like yours. What about your team? Finding good Blockchain engineers is getting harder and harder.

Arthur: Our team is top notch. We have expert MySQL and PHP developers straight from Tokyo. They have been involved with the Blockchain since 2010.

VC: I really think you guys are onto something. How can our firm, FOMO Capital, get involved?

Arthur: On the back of our strong traction, we are raising $116 million at a $500 million valuation.

VC: That sounds very reasonable. FOMO Capital typically writes checks for $50 to $100 million. We are interested in leading your round.

Chinese Exchanges: Bitcoin Shadow Banks

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How do Chinese Bitcoin exchanges make money when they charge no fees to trade spot? When asked, management of the big three (OKCoin, Huobi, and BTCC) assure us that they do indeed make money. In this post, I will conduct a thought experiment as to how I would monetise a spot business that charges zero fees in China. I have no concrete evidence to back up any of my claims other than deductive logic.

China accounts for the vast majority of all on-exchange Bitcoin trading. Exchanges must therefore have a large balance of customer CNY and Bitcoin. I believe that Chinese exchanges act as shadow banks. They borrow at 0% from clients who wish to trade Bitcoin, and lend out customer funds by purchasing China debt instruments.

When the product is free, you are the product. Chinese Bitcoin exchanges use the captive CNY held to trade Bitcoin to earn interest income. How much does it cost to operate the exchange? I have no hard data, but the big three generally have around 150 staff. Assume an average salary of 10,000 CNY per month. Demand deposits yield between 3% to 5%; this is the least risky form of lending as it can be redeemed at any moment from the bank to satisfy withdrawals. The yearly salary costs alone are CNY 18 million. To earn that amount in interest income at 5% requires CNY 360 million or $56 million of stable customer funds. Given the reported trading volumes, it is reasonable to assume that the big three could each possibly hold this amount of capital.

Unfortunately only investing using demand deposits just barely covers salaries. If the exchange is to turn a profit, they must step out on the risk and maturity curve. Private companies cannot obtain credit from banks. All bank credit is reserved for State Owned Enterprises (SOE). In the last decade, high interest rate Wealth Management Products (WMP) have emerged to provide credit to SMEs. The banks underwrite these WMPs off balance sheet which are secured on a company’s assets. WMP yields range from 10% to 20% and have various maturities. Investors believe there is an implicit guarantee provided by the issuing bank. The belief is the government would not let WMPs fail because of the catastrophic losses retail investors would suffer. Therefore, in the few cases where it appeared a company would default on a WMP product, the banks have stepped up and rolled the debt.

Like any bank, a Chinese exchange must keep a portion of the float liquid so they can’t lend the entire balance out via WMPs. The below table assumes that the Demand Deposit rate is 5% and the WMP rate is 20% per annum. NIM is the Net Interest Margin, which in this case is the full interest rate since customers are paid nothing on CNY they hold with the exchange.

% Liquid % WMP Yearly NIM Costs Profit
50% 50% $7,031,250 $2,812,500 $4,218,750
40% 60% $7,875,000 $2,812,500 $5,062,500
30% 70% $8,718,750 $2,812,500 $5,906,250
20% 80% $9,562,500 $2,812,500 $6,750,000
10% 90% $10,406,250 $2,812,500 $7,593,750

As the table shows, the more credit and maturity risk management is willing to take the more money they make. Given there is no regulation as to how the exchange holds customer funds, management can invest in whatever they like to generate a positive NIM. It is not a far stretch to imagine the CEO’s punting the A share market in their spare to time to generate enhanced returns.

Bitcoin trading has become a side show, and these entrepreneurs have created very profitable banking institutions. Because they have excess cash, they are able to pledge customer CNY to fund whatever assets will generate a positive risk adjusted NIM. The Chinese Bitcoin exchange model will be copied in other emerging markets with broken credit intermediation and high nominal rates of interest. If I was opening a spot Bitcoin exchange in India, this is the model I would choose. Private credit in India is hard to come by, and nominal rates are sky high.

The Magic Number Is 6.40

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The IMF is set to announce the CNY’s inclusion into the SDR basket today. Analysts expect that after the inclusion, the PBOC will intervene less in the FX markets and allow the CNY to depreciate further. 6.4 is the highest level USDCNY reached this summer after the shock devaluation.

If USDCNY rises above 6.4, the dominoes may begin to fall. The expectation of future weakness will become more acute. Ordinary citizens will search for any means to preserve their purchasing power. The Bitcoin meme is gaining ground in the financial media. Zerohedge mentions Bitcoin daily when talking about the Chinese financial markets. Once the mainstream pundits at Bloomberg, FT, and WSJ discover Bitcoin, make sure you have your moon boots ready.

Apart from the Federal Reserve meeting December 16th, nothing else will have more impact on Bitcoin than the USDCNY exchange rate. The above chart shows the Bitcoin premium expansion as CNY has depreciated (as USDCNY rises, CNY is worth less USD). To check the PBOC’s daily USDCNY interbank rate click here. If you are lucky enough to have access to Bloomberg or Reuters, search for the USDCNY daily fix. It is announced each day at 9:15am Beijing Time GMT + 8.

Don’t fight the Fed. In Bitcoin, don’t fight the PBOC.

XBT Spot

 

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$400, here we come. Global macro is providing so many positive catalysts for Bitcoin it is hard to keep them all straight. Argentina has descended into currency chaos. The CNY depreciation continues. The Fed is expected to lift rates and torpedo asset markets globally.

Yet – $400 won’t be taken as easily as it was one month ago. The retrace from the graces of $500 has been slow and steady. However, the recent price action contains the wiff of FOMO, and the upward pressure is likely to accelerate if the CNY devaluation continues.

Trade Recommendation:

Daily 100x Futures, XBT24H: Buy XBT24H while spot is $375 to $380 with an upside target price of $385.

Weekly 50x Futures, XBT7D: Buy XBT7D while spot is $375 to $385 with an upside target price of $400.

Crypto Trader Digest – Nov 3

It’s China Stupid

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As China goes, Bitcoin goes. This Halloween weekend, Bitoiners were either drinking in celebration, or fixated on their charts as China ripped and roared higher. XBTCNY reached a high of 2316 CNY or $364 this past Friday. I will devote the entirety of this week’s newsletter to questions surrounding China’s impact on Bitcoin.

Is China Using Bitcoin To Get USD?

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The PBOC is attempting to halt the hot money fleeing China. Since the 4% devaluation in late August, the authorities began actually enforcing capital controls. Bitcoin is legal in China, and individuals can wire RMB to one of several large Bitcoin exchanges to exchange RMB for Bitcoin. Once they have Bitcoin, they are free to transfer it anywhere in the world to buy goods or services, or convert into another fiat currency.

Further devaluation is forthcoming for the RMB. The Chinese citizens know this, and are searching for ways to protect their wealth. One popular theory is that through Bitcoin, Chinese households will get access to USD. The Bitcoin corridor is very narrow, and even a slight uptick in this sort of activity would cause trading volumes and the price to skyrocket.

The above chart shows the ratio of XBTCNY volume on OKCoin.cn, Huobi, and BTCC vs. XBTUSD volume on Bitfinex, Bitstamp, Coinbase, itBit, and OKCoin.com. Each was indexed at 100 on October 1st. Each subsequent day’s index looked at the change in volume vs. October 1st. If Chinese households were using Bitcoin as a USD conduit, then XBTCNY and XBTUSD volumes would have the same magnitude of increase.

The chart clearly shows that there were actual inflows into Bitcoin that didn’t fully leak into USD. This is very price positive. There is actual organic demand from China for wealth preservation or pure upward price speculation using Bitcoin. As the rest of the world piggybacks on the surge in Chinese demand, that ratio will fall further.

USDCNY vs. USDCNH: The Bitcoin Angle

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Currency trading in China is a complicated and fickle beast. There are three currency pairs to know about. The interbank USDCNY rate is set each morning at 9:15am by the PBOC. This is the rate at which member banks can trade USDCNY against the PBOC. USDCNY floats in a PBOC set band around the interbank USDCNY rate. USDCNY can only be traded onshore in China and is subject to capital controls. USDCNH is the offshore version of USDCNY. This pair floats in a band around the USDCNY rate. USDCNH cannot be imported onshore accept in a few circumstances that are irrelevant for this discussion.

USDCNY and USDCNH both have different forward curves, which represent the supply / demand dynamics of onshore and offshore CNY. Only domestic Chinese banks can participate in the deliverable USDCNY forward market, and this market is heavily regulated and monitored by the PBOC. Any bank globally can participate in the deliverable USDCNH forward market; the PBOC have very strong regulatory control over this market. Because of this, the USDCNH is a leading indicator of where the PBOC will set the interbank USDCNY, as banks can effectively use the offshore forward market to speculate. Recently USDCNH has traded at a higher price than USDCNY, which signals the market believes further CNY devaluation will occur.

The chart above shows the USDCNH premium (read: the market thinks CNY will be devalued) vs. the premium of Bitcoin in China. There is no clear correlation between the two metrics. The complicating factor is that the PBOC actively intervenes in the USDCNH forward market to narrow the differential. The PBOC does not want clear market signals of the impending devaluation. I still believe that a major motivating factor for China’s shift to Bitcoin is a real fear of currency devaluation.

How To Play The China Bitcoin Premium

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The China Bitcoin Premium chart as the most important chart in Bitcoin. The premium rose substantially during the recent run up in price. The 5%-10% region is very important. If the premium breaks out of this range, it means the usual avenues of arbitrage are broken. Arbitrageurs provide a price dampening effect in China. If they are unable to effectively move money between China and Hong Kong, then Bitcoin and China will soar farther and faster than in November 2013.

The premium is close to the 10% level. Let’s examine how to properly arbitrage this premium.

  1. Set up a Bitcoin account offshore (Bitstamp and Bitfinex are my top choices), and a Bitcoin account onshore (OKCoin.cn, Huobi, or BTCC are my top choices).
  2. Set up a mainland Chinese bank account. If you live in Hong Kong, take the bus to Shenzhen and you can open a bank account with just your passport. The Chinese banking system is very easy to enter, but hell to exit.
  3. Wire USD to your offshore exchange, then buy Bitcoin.
  4. Send the Bitcoin to your onshore exchange, sell it to realise CNY, then withdraw the CNY to your onshore bank account.
  5. Now comes the tricky part of converting CNY into USD or HKD. Every person is given a $50,000 equivalent FX limit each year in China. Assume that you have exhausted your limit. You can travel to China and withdraw 20,000 CNY and walk it across the border. If you want to do size, then you need a few friends to come with you each day. Or you can use a shadow bank to move the money from CNY to HKD. Unfortunately Beijing has begun cracking down on these bankers, and your money may or may not appear in Hong Kong.

With $10,000, you could make $800 per day in profit. However moving even $10,000 between China and Hong Kong on a daily basis is quite difficult. Therefore, I expect the premium to continue its upward ascent as the fear of continued CNY devaluation grows. Also remember that as the PBOC lowers the benchmark interest rates, it becomes less attractive to store savings with a bank, and more attractive to speculate on risky assets like Bitcoin.

Conclusion: Long And Strong

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Unlike 2013, there are real concrete macro factors affecting the flow of CNY into Bitcoin. Bitcoin has passed through many trials and tribulations over the past two years. Many exchanges have fallen, but Bitcoin and the blockchain are still here. China and the rest of the world tackled the 2008 GFC by engaging in a money printing orgy. The effects of which are only starting to be felt. The volume of world trade is declining and the only method left for nominal growth is money printing. Nominal not real growth is all that matters so that banks can extinguish their pouch of non performing loans. The high priests of central banks will provide this growth at whatever social and or economic cost.

China “rescued” the world in 2008 by going on a massive credit fueled infrastructure spending spree. The PBOC now must fight the spectre of deflation. The tools at its disposal are rate cuts and currency debasement. Bitcoin and other non-standard risk assets will gain favor with a desperate populace trying to escape the jaws of inflation. Short this rally if you must, but cover before you bust.

XBT Spot

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$330 dusted, $320 is history, $340 we are almost there. That statement is filled with hubris. As a speculator, I would like to see $300 put to the test and pass before I marched towards $400.

The volumes on non-Chinese exchanges have not increased enough at these levels. This week will be a true test. Will the $300 prices bring out the closet buyers. A good indicator will be premiums paid in America on LocalBitcoins. The volume on Coinbase will also be an important barometer. Coinbase operates the largest American Bitcoin brokerage service, and all that volume is passed onto their exchange. The largest trading market for Bitcoin has spoken, but we still need follow on support from the second fiddle, America.

Shorting this rally has proved fatal. If you want to express your bearishness, earn the carry by shorting the BitMEX daily 100x leveraged Bitcoin / USD futures contract, XBT24H, vs. buying spot.

Trade Recommendation:

If you are bearish, sell XBT24H vs. buy spot for a cash and carry arbitrage trade.

If you are bullish, buy weekly 50x leveraged Bitcoin / USD futures, XBT7D, while spot is $325 to $330.