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BitMEX Crypto Trader Digest
January 13, 2020
From the desk of Arthur Hayes
Co-founder & CEO, BitMEX
From The BitMEX Research Desk
The Bitcoin Cash Hardfork – Three Interrelated Incidents
Abstract: The 15 May 2019 Bitcoin Cash hardfork appears to have suffered from three significant interrelated problems. A weakness exploited by an “attack transaction”, which caused miners to produce empty blocks. The uncertainty surrounding the empty blocks may have caused concern among some miners, who may have tried to mine on the original non-hardfork chain, causing a consensus chainsplit. There appears to have been a plan by developers and miners to recover funds accidentally sent to SegWit addresses and the above weakness may have scuppered this plan. This failure may have resulted in a deliberate and coordinated 2 block chain re-organisation. Based on our calculations, around 3,392 BCH may have been successfully double spent in an orchestrated transaction reversal. However, the only victim with respect to these double spent coins could have been the original “thief”.
Illustration of the Bitcoin Cash network splits on 15 May 2019
(Source: BitMEX Research)
(Notes: Graphical illustration of the split)
ForkMonitor: Unexpected Inflation Detection and Warning System
Abstract: ForkMonitor has now implemented unexpected inflation detection and warning systems for Bitcoin. The block reward is currently 12.5 bitcoin, which means that no more than 12.5 new bitcoin should be created each block. Some of the ForkMonitor nodes now calculate the total coin supply each block, using the gettxoutsetinfo RPC call. If the total coin supply increases by more than 12.5 bitcoin, warnings systems are initiated. This service potentially provides additional assurances to network participants about the supply of Bitcoin at any given time.
Bitcoin’s Block Timestamp Protection Rules
Abstract: We examine two of Bitcoin’s little-known rules, designed to stop nefarious miners from manipulating the block timestamps and achieving unfairly high mining rewards. We discuss why constants such as the two-hour MAX_FUTURE_BLOCK_TIME value may have been chosen and how this value may have particular implications for Bitcoin Cash. We conclude that Bitcoin’s time protection rules appear reasonably effective, an impressive feat, considering the lack of a functioning network when the rules were implemented.
Bitcoin Cash’s October 2019 Hashrate Volatility Increase
Abstract: We look at the recent elevated level of hashrate volatility on the Bitcoin Cash network. We note that the apparent cyclical nature of the oscillations may indicate a form of manipulation, although we found no direct evidence of such behavior. We conclude that there are no easy solutions to Bitcoin Cash’s hashrate volatility issue, on the other hand the negative impact on the usability of the coin has been marginal so far. The best course of action in the short term may be to be patient and research possible solutions, unless a particular cause becomes more apparent.
Bitcoin Cash Hashrate Estimate- (8 hour rolling average) – PH/s
(Source: BitMEX Research)
(Notes: Eight hour periods were chosen to maximise the visual impact of the apparent hashrate oscillations. Hashrate data calculated by using the difficulty and block timestamps)
Abstract: BitMEX Research and Coin Metrics are happy to announce the release of txstats.com, the successor to P2SH.info, an independent project created by Coin Metrics’ Lead Data Engineer, Antoine Le Calvez.
Bitcoin stored by P2SH address type(Screenshot from txstats.com)
Benford’s Law & Cryptocurrency Trading Data
Abstract: In this report we examine Benford’s law, a mathematical rule which describes the frequency of the leading digit in various real world sequences of numbers. We look at various datasets from the cryptocurrency ecosystem, such as coin prices and trading volume data. We explain that this mathematical concept should not be looked at in isolation and that a strong understanding of the underlying economics is necessary to draw strong conclusions. We note that for a minority of trading platforms, notably OKEX and HitBTC, the reported trading volume figures appear to result in a distribution which does not follow Benford’s law. However, this pattern does not imply inappropriate manipulation of the data and there are many potential legitimate explanations for the unexpected distributions.
(Ben Affleck explaining to Anna Kendrick the abnormally high occurrence of the digit 3, potentially indicating financial fraud, in the 2016 Hollywood movie “The Accountant”. Screen captured 41 minutes and 40 seconds into the film)
Bitcoin’s Initial Block Download
Abstract: We test the performance of Bitcoin Core by successfully conducting 35 initial block downloads (IBDs) and recording the amount of time the node takes to synchronize with the network. We used software releases in the period spanning from 2012 to 2019. The results show a considerable and consistent improvement in the performance of the software, but also a high degree of variance. Even with the latest computer hardware, older versions of Bitcoin struggled to get past the pickup in transaction volume which occured in the 2015 to 2016 period. Therefore we conclude that without the software enhancements, an initial synchronization today could be almost impossible.
Figure 1 – Bitcoin Initial Block Download Time (Days) – Average Of 3 Attempts
(Source: BitMEX Research)
(Notes: Synchronization up to block 602,707. Further details in the notes below)
Lightning Network (Part 5) – BitMEX Research Launches Penalty Transaction Alert System
Abstract: ForkMonitor has launched a Lightning Network penalty transaction alert system, available at https://forkmonitor.info/lightning. Unfortunately, it is possible the alerts could be manipulated, for instance by users artificially generating this transaction type on two nodes they control. On the other hand, our new alert system should capture every failed theft attempt on the Lightning Network, in real time. This may be a useful feature to those monitoring the health and development of the Lightning Network and additionally it could be useful to individual users concerned about their channels.
I CAN has IPO
Abstract: In contrast to the apparent management difficulties at Bitmain, in a shrewd piece of corporate finance, cryptocurrency ASIC manufacturer Canaan Creative successfully raised $90m in an IPO in November 2019, at a very attractive valuation from the company’s perspective. From Canaan’s point of view, the timing appears impeccable, right before the release of a set of financial results likely to show a loss in 2019, a Bitcoin price decline and the 2020 halvening which should reduce mining revenue. Quarterly disclosures in the prospectus illustrate extreme volatility in sales, which appear more volatile than both cryptocurrency prices and mining farm operation financials. The shares are down 43% since the listing, moving towards what we would consider a more attractive valuation for investors.
Canaan’s sharp share price decline since the IPO vs Bitcoin(Source: Bloomberg)
Build Systems & Security – Bitcoin Is Improving
Abstract: This piece is written by Bitcoin Core contributor and BitMEX Research guest writer, Michael Ford. Michael is the recipient of the HDR Global Trading Limited Bitcoin development grant of US$60,000 per annum. In this report, Michael explains recent Bitcoin Core build system improvements and how he has been involved in removing third party software dependencies, such as OpenSSL. The number of packages built in Bitcoin Core 0.19.99 is down 44% since Bitcoin Core 0.13.2 and the build time has fallen 42% since the peak, to 135 seconds, according to Michael’s tests. This work has improved the security of the software, by reducing the attack surface and improved software performance.
Bitcoin Core Dependencies – Build Time
(Source: Michael Ford’s analysis)
(Notes: Only requires packages, excludes downloading. Make -C depends -j8 NO_QT=1 NO_UPNP=1 etc, Conducted on MacOS)
Lightning Network (Part 6) – Over 60,000 Non-Cooperative Channel Closures
Abstract: In our sixth piece on the lightning network, we provide new data about its growth and size. We reveal statistics about private channels, often produced by mobile wallets, which are not normally included in traditional network metrics. We primarily focus on non-cooperative channel closures and a database we have constructed, which we believe contains all such transactions. Our database illustrates that non-cooperative channel closures are relatively common and that lightning network usage is higher than expected.
The number of lightning network non-cooperative channel closures in Bitcoin’s history is over 60,000.
Over 1,000 Bitcoin has been spent in non-cooperative channel closure transactions.
(Lightning strikes the city of New York. Source: Pexels)
From The Desk Of Arthur Hayes
When Options? Part 1
These are the three questions any self-respecting crypto punter asks themselves:
When liquid options?
If I knew the answers to questions 1 and 2, HDR Long Term Capital Management would not be a figment of my imagination, but a fee guzzling hedge fund posting returns that rival Renaissance Technologies. By the way, I recently read somewhere that since its inception, Ren Tech earned over $100 billion in net gains AFTER fees of 4 and 40. Jim Simons is the Samuel L Jackson of investing; he is one bad ass mother fucker.
As the CEO of the largest crypto derivatives trading platform, I do however have a somewhat informed opinion on the third question. For those of you ringing in 2020 with a resolve to read even less text and more Instagram, here is the summary:
The liquid crypto delta one trading products obviate the need for traders to rush into traditional screen options trading platforms like in traditional asset classes. That does not mean that volatility products will not pick up liquidity. As more participants rediscover the need to smooth out volatile cash flows and earn yield on their Bitcoin, both insurance and yield products with embedded options will become popular. These structured products will lead the way towards a more mature crypto derivatives market, and that liquidity will leak into vanilla options traded by sophisticated traders. BitMEX will be present in the areas of the market where we can add value.
Delta One Dominance
Traders use delta one products to obtain leveraged directional exposure to an asset. Traders always want more leverage when they are prescient; that’s how you earn more ducats. Traditional trading platforms and exchanges, baring shady CFD brokers / bucket shops, offer limited leverage.
Unless you are a very large hedge fund, bank, or financial institution, you will not have access to a large amount of leverage. Exchanges endeavor to protect their seat holders who are on the hook for bankrupt traders by limiting leverage. The most liquid equity futures contract globally is the CME’s Globex S&P E-mini contract. I believe the maintenance margin offered by the exchange equates to max 5x leverage. 5x leverage ain’t the nuts when a large daily move in the underlying is considered 1%.
Brokers may offer higher leverage trading FX pairs, but obtaining 100x or greater leverage is getting increasingly difficult. Even if you can obtain high leverage, these exchanges or brokers do not limit your liability. When the Swiss National Bank removed the CHF/EUR peg in January 2015, a few shops sued customers for large losses. That’s not a good look.
Since the options are either low leverage offered at the exchange level, or high leverage offered by a broker, with the risk of total financial ruin, traders in search of safe leverage must resort to options. By purchasing out of the money (OTM) call and put options, traders can enjoy much higher leverage and limited liability.
The OTM options will trade cheap because the strike price is far enough away from the current spot price to dampen the premium. You pay less for an outcome that is less likely to happen. If the trader is wrong, he only loses the premium. This way, traders construct leveraged positive convexity trades.
The other, and arguably more important facet which will reduce the premium is low observed volatility levels for equities, fixed income, and currencies. If the asset price moves very little and is OTM, the premium will be cheaper, which offers larger gearing.
As a result of this market structure, options appeal to speculators. In turn, speculators bring the gift of liquidity on both sides of a market. Life is all about discovering cheap convexity. Traditional asset class options markets offer convexity, leverage, and safety to speculators. Delta one products offer none of these characteristics, therefore, speculators add a significant amount of liquidity and open interest to the options markets.
Crypto derivatives feature a completely different market structure.
Suing your customers is bad business and almost impossible when the margin currency, Bitcoin, is barely recognised as real money. As a result, all platforms adopted a limited liability stance from the outset. You can only lose your initial margin on BitMEX, no matter how big your position is.
Nothing in life is free, unless you are a politician running for election. If traders can only lose what they put in, then in volatile and jumpy markets, winners cannot enjoy their full unrealised profit. There will be situations where the market gaps up or down and the platform does not possess enough equity to pay out winners in full. That is where the socialised loss system plays a role.
The socialised loss system ensures the platform is solvent under all market conditions. Crypto trading platforms did not start by selling seats to well-heeled institutions willing to put their balance sheets on the line so punters can go 100x on one of the most volatile assets in human history.
I can only speak for BitMEX, but if Bitcoin goes to zero or infinity in one tick, we will be solvent. That is how much safety our socialised loss system provides.
A limited liability and socialised loss margin system sounds attractive in theory, but without the third piece, the insurance fund, it is still deficient. In a two-trader system where one person is long and other side short, the maximum return on equity (ROE) is 100%. That is because you can only win what the other side has placed as margin. This platform could offer 1,000x leverage and it would still be a nothing burger. The leverage is irrelevant if you can’t raise your ROE substantially above 100%.
An additional pot of funds which pays out winners when the losers go bankrupt is needed to raise ROE above 100%. Traditional exchanges partner with a clearinghouse which provides such a backstop from guarantee bonds. Usually seat holders must purchase these bonds; in return they receive a fee on every trade.
However, if I came to you in 2015 and asked you to give me some Bitcoin to help traders use 100x leverage, you probably would have suffered a myocardial infarction laughing at my expense. Therefore, BitMEX and other platforms had to find another source of funds to backstop the market. The insurance fund is that pool of money. The BitMEX insurance fund currently holds approximately 33,500 Bitcoin.
Pop goes the weasel, with an insurance fund the potential ROE in a socialised system rises above 100%. Mathematically the larger the insurance fund the larger the potential ROE of a new trade becomes. The other factor that influences the potential ROE is the number of traders on a platform who have different price expectations on the long and short side. The more punters, the greater chance that a liquidation order will be cleared in the market at better than bankruptcy price. As a result, the insurance fund will grow.
Assume that all crypto derivatives platforms have the same number of active users. (I could posit that BitMEX has the most, but I can’t verify that without knowing the active user base of all competitors. And alas I don’t have that information.) The only public data which all socialised loss platforms post is their insurance fund. BitMEX has the largest fund. Therefore, on BitMEX a trader will have the highest pre-trade potential ROE.
If we assume a non-zero insurance fund balance, then the crypto delta one markets begin to confer some juicy convexity for traders. Consider this:
Traders can only lose what they put in. That means their downside loss is capped.
Traders can make more when they are right than when they are wrong, regardless of going long or short. That means their return profile is always positively convex.
Traders can use high leverage.
In essence, the crypto capital market structure has wrapped options into a delta one product. The return profile of a crypto future or swap hasn’t changed. On the leveraged notional, a 1% rise in price equals a 1% rise in the contract. However, on an ROE basis the trader has purchased an option with the premium as the initial margin.
Various crypto platforms have over the years offered options markets. While the liquidity is definitely better than five years ago when I entered the space, it still is pretty illiquid. Many traders lament the lack of “proper” liquid screen market of calls and puts of various strikes.
Traders who cut their teeth trading equity and fx options want the same trading weapons in crypto. However, the crypto option is a breech loaded musket compared to the crypto perpetual swap Gatling gun. Charge that hill if you dare.
Trading options is orders of magnitude more complicated than trading futures and swaps. Delta, Vega, Theta, Rho, Gamma, dVega / dVol, I could go on with the alphabet letter soup of the option greeks. I still remember the weekly quizzes on options math and the greeks the MD would give me during my internship on the derivatives sales desk at Deutsche Bank. Given volatility sales and trading desks employ tens of thousands but not millions, most traders of all stripes barely understand how these markets are priced.
Case in point, one day I was sitting with a trader who traded Variance Swaps. A Variance Swap allows the trader to have constant vega across all strikes. If you don’t know what that means, this story will be comforting. The trader had a fancy spreadsheet which calculated all the option greeks and told him his daily PNL. All he had to do was vigorously press F9 to generate quotes. I asked him how those were calculated. He responded that he didn’t know, the quants made the spreadsheet and he just followed it blindly.
Moral of the story, this shit is complicated.
Strike one! Traders will always do what is easiest if they can generate the same return profile.
Crypto volatility is very high. We are currently in a low volatility regime and 30 day realised volatility is around 40%. When pricing an option, the higher the volatility the more expensive the call or put. Therefore, option buyers, the speculators, must post high amounts of capital to obtain convex trades. In order to be cheaper than the BitMEX XBTUSD perpetual swap, the most liquid crypto derivatives product, the premium must be less than 1%. That is not possible when the underlying asset has such a high realised volatility.
Strike two! Traders will always gravitate to the product with the most leverage.
Market makers, I haven’t forgotten about you. For every buyer there is a seller. Writing options is a tough business. If the volatility is high, margin requirements for writers of options will be very expensive. Market makers must be able to write naked options while quoting. Writing naked call options on an asset that popped 40% in a few hours when Xi Jinping mentioned the word “blockchain” is risky. As a result, the margining systems employed by various platforms are extremely conservative.
The same set of crypto market makers quote crypto delta one and options products. They must decide how to allocate their capital. If the option requires more capital due to margin requirements and has less flow because it’s less understood and offers less leverage, they will provide less liquidity. If the brave speculator turns up to trade an option and you can drive a Tesla pickup truck through the spread, she will hightail it back to XBTUSD.
Strike three, and you are out! Traders prefer the liquid to the illiquid derivative.
I hope you enjoyed a nice primer on the crypto derivatives market structure and why delta one products will be preferred to options by speculators.
Limited liability which translates into a max loss of 100% of initial margin, but a max upside that vastly exceeds 100%. Also known as positive convexity.
High premiums because of high implied volatility, which translates into low leverage or gearing.
Limited liability as you can only lose your premium.
After laying out what won’t work, in the next voluminous installment I will get into my views on what sort of option / volatility products will become popular in 2020.
Glossary of Terms
For those of you who didn’t get any of what I just said, here’s a glossary.
Delta – The change in the value of a derivative contract with respect to the price of the underlying asset.
Delta One – Derivatives where delta equals one. This term will be used to refer to futures and swaps products of the crypto space. I was a practicing delta one trader during my time working for the man.
Socialised Loss System – This is the dominant margining system used by all liquid crypto derivatives platforms. In this system, if there is not enough money to pay out winners due to bankrupt losers, the winners’ unrealized profit is reduced, or their position is closed early.
Initial Margin / Limited Liability – A complement to the socialised loss system. Traders can only lose a position’s initial margin. The trading platform cannot go after other financial assets held outside of its system. This is different than most brokers offering any sort of derivatives / leveraged trading, they can and will go after the entirety of a traders’ financial net worth if losses exceed the initial margin.
Insurance Fund – This is the guarantee fund attached to a socialised loss system. On BitMEX, if you are liquidated, the system takes over your position and closes it in the market. If there is equity left over after closure, those funds are deposited into the insurance fund. The losers pay into the fund with their leftover equity. The fund is tapped when a liquidation order cannot be closed at a price which is above its bankruptcy price.
Volatility Products – Derivatives where the delta is greater than one. This term will be used to refer to options products of all stripes. When trading options, you are not just trading directionally but also for convexity and yield.
Convexity – This is the asymmetric nature of a payoff curve. A positively convex trade is one where you make more money when you are right than when you are wrong, assuming the same asset price movement on the up or downside. Buying an option is a positively convex trade. A negatively convex trade is one where you lose more money when you are wrong than when you are right, assuming the same asset price movement on the up or downside. Selling or writing an option is a negatively convex trade. Convexity is not free, the price for this return profile is the premium attached to any option.
Yield – A trade that yields a fixed known payoff by expiry. Selling a covered call option is a yield trade. E.g. A miner expects to produce 100 Bitcoin in one year sells 100 $10,000 Strike December 2020 Bitcoin / USD Call Options and receives 20 Bitcoin premium from the buyer. The miner knows a priori that this trade will yield 20 Bitcoin of income regardless of where the price of Bitcoin settles in one year.
I am doing these concepts a disservice via these curt descriptions, but I am cognizant of a burning desire on behalf of punters to read as little as possible while still trading profitably.
This article should not be copied or reproduced in whole or in part. The information contained in this article does not constitute research or a recommendation.
Neither BitMEX nor any of its affiliates make any representation or warranty, as to the accuracy or completeness of the statements or any information contained in this article and any liability therefor (including in respect of direct, indirect or consequential loss or damage) is expressly disclaimed. This is not providing any financial, economic, legal, accounting or tax advice or recommendations. In addition, the receipt of this article is not to be taken as constituting the giving of investment advice nor to constitute such person a client of BitMEX.