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BitMEX Crypto Trader Digest Nov 02, 2017 android-chrome-512x512.png
From the Desk of Arthur Hayes
Co-Founder & CEO, BitMEX

From The BitMEX Research Desk

Non Empty Smaller Block Data By Mining Pool

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

Empty Block Data by Mining Pool

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

The Bitfinex Chain Split Tokens

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

The Miner Short Squeeze

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

XBTZ17 In Context

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

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

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68929985-7ed9-455f-8032-135354aebd39.png

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

 
 

Max % Premium PA

Max % Outright Discount

XBTM17

122.30%

-2.28%

XBTU17

32.38%

-5.62%

XBTZ17

42.47%

-7.17%



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

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

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

The Unwind

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

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

SHORT SQUEEEZZE

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

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

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

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

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

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

If I were a profit maximising miner here is what I would do:
  1. Buy Bitcoin Spot
  2. Buy XBTZ17 futures at a large discount.
  3. Shortly before the hard fork deadline, stop signalling for NYA.
  4. Bask in the glory of the annihilation of shorts on margin and futures.
If you believe this thought experiment might become reality here is what you should do:
  1. If you are short basis (short XBTZ17 vs. long spot), unwind that trade at a profit.
  2. Go long basis while it is negative (long XBTZ17 vs. short spot).
  3. If your risk appetite is large, go naked long XBTZ17 at a negative basis.

SegWit2x Bitcoin Is Not a Dividend

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

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

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

All Hail The CME

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Due to overbearing and counterproductive financial regulations, innovation is often rewarded with heavy fines and loss of licenses. An institution with billions of dollars of revenue at stake cannot take the regulatory and reputational risk dealing with Bitcoin unless someone else does it first.

Enter, LedgerX. For over four years, the firm pestered the CFTC to allow them to clear Bitcoin settled futures and options. The hard work paid off this fall when their markets launched. Less than two weeks later, the CME announced they too would join the club. The CBOE technically was the first legacy exchange to announce the impending launch of a USD settled Bitcoin futures contract; however, the CBOE will go live 2Q2018 and the CME plans to launch theirs by year end.

The only reason why some large financial institutions (FI) participate in the digital currency ecosystem is they cannot ignore an asset class that went from $0 to almost $200 billion in value in under a decade. Large FIs are severely constrained in their ability to deploy large amounts of capital due to counterparty risk on exchanges not compliant with their specific jurisdictional overseers. An exchange who they can already trade with, the CME, that offers Bitcoin trading products is exactly what they need to seriously get involved.

Custody Risk

A USD-settled Bitcoin futures contract is perfect for large traders who cannot or will not custody Bitcoin. This futures contract gives them exactly what they desire, a product that pays them fiat currency to speculate on a crypto currency.

From the CME’s perspective, they also absolve themselves of the risk of losing customer Bitcoin. This product requires almost zero technical innovation on their part.

Liquidity

The BitMEX XBTUSD swap is the most liquid Bitcoin / USD trading product globally. XBTUSD trades 5x - 10x more volume than the underlying index constituents, GDAX and Bitstamp, combined. XBTUSD’s daily trading turnover routinely exceeds $1 billion, and approaches $2 billion.

The CME index will include itbit and Kraken as well. For market makers who must hedge flow on the underlying exchanges, two seriously liquid derivative contracts will increase the volatility in the spot markets. It will also place immense strain on the spot exchanges’ infrastructure. Can these four exchanges stand up to the likes of Citadel submitting, amending, and cancelling thousands of orders per minute? Time will tell, but the CME is about to get a crash course in Bitcoin.

These issues probably influenced the way in which their index was constructed. The index methodology is overly complex in an attempt to deal with the forecasted liquidity and technological issues the leading spot exchanges face.

BitMEX takes a more laissez-faire attitude about the Bitcoin markets than the CME can afford. Every financial reporter will be watching for any misstep, and the headlines will come hard and fast highlighting any issues.

Market Fragmentation

The Bitcoin markets are highly fragmented due to different regulatory regimes and cultural differences between traders from different domiciles. The type of trader who can trade with the CME cannot trade with many of the exchanges where the reference pricing occurs.

This presents a trading opportunity of a lifetime for arbitrage funds who can straddle the regulated and unregulated exchanges, and who can trade across multiple jurisdictions. The divergences will become more acute as large positions are placed on CME and CBOE products.

Will the regulated derivatives follow or lead vs. the cowboy trading occurring in North Asia? From a market microstructure perspective, this will be a very interesting experiment.

ETF Anyone?

In the disapproval of the Winklevoss ETF COIN, the SEC stated that the absence of a liquid regulated derivatives market concerned them. If the CME doesn’t face plant, this will pave the way for the ETF. The SEC dances to the beat of large FIs. If the CME is reaping immense profits from a derivative, asset managers will want in on the racket via a listed ETF.

Much like LedgerX, the Winklevii might be bested by a large ETF manager like Blackrock or Vanguard, who now has the regulatory cover to apply for their own Bitcoin ETF. Blackrock vs. the Winklevii; who has more capacity to provide push jobs for ex-SEC staffers?

While futures will allow wealthy individual traders and large FIs to comfortably trade Bitcoin, an ETF that appeals to retail investors globally will completely change the paradigm. Starting next year, expect more noise about an ETF approval emanating from the SEC.

Slow then Fast

I did not expect institutional take-up of Bitcoin to grow this quickly. There is too much money being made by startups in the space for large FIs not to get involved. As more and more of the regulatory and repetitional risk is removed, institutions will continue to increase their involvement and exposure. 

The Deutsche Bank Connection

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Bankers are flocking to the cryptocurrency industry as both principals and employees of related companies, fund managers, and as individual traders. Amid the rush towards this decade’s green financial pastures, one office of one bank stands out, Deutsche Bank Hong Kong.

Deutsche Bank’s foray into investment banking began with its acquisition of Bankers Trust. The firm then proceeded to ditch its conservative German roots, and import the biggest swingers in the industry. A clique of Merrill Lynch bankers were brought in. Their ring leader was Anshu Jain.

The culture was cowboy. My Hong Kong summer internship interviews in 2007 illustrates this point.

The first round of interviews was in Philadelphia. In my second 2-on-1 interview I met the man who’s team I would intern on that summer. I had just returned from my semester abroad in Hong Kong. He asked me why I loved Hong Kong, and I said I loved clubbing. I then rattled of a list of my favourite establishments. He would later tell me, that’s what sealed the deal for me in his mind.

That night I took the whole Deutsche contingent to my favorite dingy Philly late night EDM club. It got messy.

In 2007, financiers thought they were gods. Hong Kong has never regained the energy I felt that summer. I interned on the Equity Derivatives sales desk. HR nicknamed this desk the Snake Pit, because of the aggressive personalities that worked there.

The 2008 graduate training program in London featured similar aggressiveness. Deutsche offered an all expense paid trip to London for three months for all incoming graduates. The Japanese grads were the most intense. One grad got so drunk, and vomited so hard, he was hospitalised with a broken rib.

That is a taste of how the youngins were trained at Deutsche. The firm fostered an aggressive culture focused on partying hard, and making money. Unlike more demure banks, no one at Deutsche was shy as to why they were in the game. Making money was the goal, and no one was censured for being too flashy.

As the financial services industry entered a secular decline after the 2008 GFC, Deutsche people scattered to the wind. Deutsche lied to the German regulators about the value of its assets in an effort to avoid becoming recapitalised by the taxpayers. In hind side, that was the dumbest move ever. Their competing American banks gladly took TARP funds, paid huge bonus, and repaired their balance sheets. Deutsche limped along, and is one of the worst performing banks since the crisis.

The Deutsche Hong Kong reunion was ignited by Bitcoin. For some reason, this particular office is very well represented in the Bitcoin industry. The individuals I will list all went through the graduate training program, and our Deutsche stints all overlapped.

Arthur Hayes, CEO of BitMEX, member of the 2008 graduate class. I worked in Absolute Strategies Group, and then Global Prime Finance as a delta one ETF, futures, and swaps trader.

Greg Dwyer, Head of Business Development at BitMEX, member of the 2009 graduate class. He worked on the commodity structuring desk in Singapore, and then worked with me on the delta one ETF market making desk.

Nick Andrianov, Risk Management at BitMEX, member of the 2007 graduate class. He worked on the Flow and Exotic Index Volatility trading desk.

Andrew Rizkalla, Trading Lead at Paycase, member of the 2008 graduate class. He worked on the Program Trading and Facilitation desks.

Kayvon Pirestani, Director of Institutional Sales at Coinbase, member of the 2005 graduate class. He worked on the Equity Derivatives Sales desk.

Gavin Yeung, CEO of Cryptomover, member of the 2010 graduate class. He worked on the Program Trading and Facilitation desk.

Neelabh Dixit, co-founder of Cryptomover, member of the 2013 graduate class. He worked on the Portfolio Trading desk.

Donald Day, CTO Bletchy Park Asset Management, member of the 2009 graduate class. He worked as a quant strategist for the Absolute Strategy Group.

The are two other Deutsche Bank HK former employees who did not wish to be mentioned.

Risk Disclaimer

BitMEX is not a licensed financial advisor. The information presented in this newsletter is an opinion, and is not purported to be fact. Bitcoin is a volatile instrument and can move quickly in any direction. BitMEX is not responsible for any trading loss incurred by following this advice.

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