Copy

View this email in a browser

BitMEX Crypto Trader Digest August 27, 2020

From The Desk of Arthur Hayes, Co-Founder & CEO, 100x Group

Dreams of a Peasant


(Source: The Grapes of Wrath - 1940)

I lack access to nightclubs and most other forms of revelry; therefore, I decided to become a crypto peasant. I’m farming the latest and greatest shitcoin DeFi projects. While I deride many of these projects as activity resulting in economic waste, there is an underlying proto-banking infrastructure that is being built on the rails of Ethereum and other protocols. Let this be my first treatise into the what drives demand and supply of crypto credit and the institutions that are being built to service these needs.
 
The Demand for Crypto Credit
 
There are only two use cases that I would lend against.

  1. Miners who borrow fiat (usually US dollars or Renminbi) to pay for electricity, rent, and salaries. They collateralise these loans with their mining machines and/or on balance sheet Bitcoin or Ether.
  2. Speculators that need fiat or crypto to trade with leverage. To short specs need to borrow the shitcoin itself, or to go yolo long they usually need dollars. These loans are usually not collateralised. The specs pay so much in fees, it behooves the trading platform to lend them capital. Even if many blow up, trading platforms with proper margin call protocols will be able to protect their capital.

Why can’t a small business or individual crowded out of the fixed income markets due to crony capitalism use the crypto capital markets instead?
 
Borrowing Crypto:

  1. Currently there are no industries where the entire value chain from producer to consumer pays entirely in Bitcoin. Imagine if you could only buy bottles of Dom P in Bitcoin. That would mean the French producer paid for their inputs in Bitcoin, the wholesaler paid the producer in Bitcoin, the nightclub paid its distributor in Bitcoin, and the end bubbly water consumer paid in Bitcoin as well. If your cost of production is not natively in Bitcoin, it is foolish to price your good in that currency. It also means that your cost of capital should not be in Bitcoin. When this becomes reality, then it will be possible to lend to actual businesses in Bitcoin.
  2. Personal loans are also not possible in Bitcoin. The proletariat (yeah that’s you, just because you wear business casual on your Zoom call from the waist up doesn’t mean you aren’t a replaceable cog in the service economy) earns fiat. There are many who would gladly take a Bitcoin loan at a low interest rate, but if the price of Bitcoin rises, they earn cheap but have to pay back expensive. That is a recipe for bankruptcy and NPLs.

 
Borrowing Fiat Stablecoin:

  1. It is absolutely feasible for an SME to borrow Tether or another near USD equivalent stable coin. However, outside of our little sandbox, not many vendors accept USDT for payment. Therefore, the borrower would borrow Tether, exchange it for USD (paying fees), then pay for the goods they need. At redemption, they would need to conduct the reverse, exchange USD revenue for Tether (paying fees), and then repay their Tether loans. While this is definitely doable, it isn’t easy. You might think it is, but that’s because you are in a crypto bubble. The bigger problem is that there are no proto-banks set up to conduct proper credit analysis on SMEs entirely over the internet across multiple legal jurisdictions. That is hard work, and risky. It’s what banks used to do, before central banks crushed the yield curve. Better to lend to people and companies whose debt is guaranteed by a central bank, than take actual risk lending to productive SMEs.
  2. If you are borrowing a stablecoin as an individual, you probably have exhausted all other options. Credit cards, personal loans, home equity loans etc. while expensive, are available. If you live in a place where the credit conduits are so broken, or your credit is so bad these products are not available to you, the person lending you a stablecoin is going to learn the meaning of adverse selection the hard way. 

For those of you whose brains have shrunk from too much TikTok, let me summarise.
 
I will lend fiat to miners because they have an asset that produces the most liquid and largest market cap cryptos Bitcoin and Ether. I would also lend them Bitcoin or Ether to purchase machines because the machines also produce Bitcoin and Ether.
 
I will lend to individual speculators of trading firms inside my own walled garden. I know they will generate fees by trading on leverage, and I know that I can call my loan back through the margin call process.
 
I will not lend to SMEs in either crypto or fiat stablecoin. SMEs’ revenue and expenses are in fiat, their cost of capital must also be in fiat lest the price of Bitcoin rises. I lack the ability to do proper credit scoring, nor is it easy to use a stablecoin outside of the crypto capital markets.
 
I will not lend to individuals in either crypto or fiat stablecoin. Individuals who live in places with zero legal protections for foreign lenders, or have such shitty credit that none of the standard commercial banking credit products are offered to them are terrible debtors. 
 
The Supply of Crypto Credit
 
Bitcoin and Ether Hodlers
 
You know who you are. You ain’t selling no matter what the price. However, while you are chilling in the basement waiting for Bitcoin to hit $20,000 and Ether to hit $1,200, you would like to earn some yield. Your biggest worry when custodying your crypto with third parties is whether they can actually keep it secure. If you are a mETH head, you also worry about sloppy solidity code rendering the smart contract inaccessible, and your funds go poof!
 
You trust no one, just code. You don't trust much code either. You assume that anyone borrowing these funds from you is going to do a runner. If you have been playing in this sandbox long enough, you have seen and experienced all sorts of scams and transacted with all sorts of licentious rakes. As a result, you will only lend to very large and well-known platforms (large exchanges, large miners, large proto-banks).
 
Even if these platforms do not provide you collateral, they make so much money from their business activities that not paying you back would do immense damage to their reputation. A positive reputation in this ecosystem is essential. We don’t have a national government forcing its citizens to use our services even when we lie, cheat, and steal from them. Banking licenses are great things if you can get one. Bad behaviour occurs in crypto capital markets, but the scale is tiny, and you can’t behave that way too long before the word is out on social media and your customers flee.
 
Fiat Stablecoin Lenders
 
Back when I started trading Bitcoin in 2013, the 2nd best risk-adjusted, zero price delta trade was to lend USD at the FRR on Bitfinex. The rate sometimes approached 1% per day. I knew many people who wired their dollars in, deposited on the Bitfinex lending markets, and earned a phat yield.
 
What was number one? The number one best risk adjusted, zero price delta trade was cash and carry. The futures basis routinely was over 200% PA. I get hot and bothered with the basis jumps above 5% now.
 
These days for those seeking to earn more than 0% or negative in Europe and Japan, take their dollars, buy Tether or another fiat stablecoin, and stake it somewhere.
 
As much as we like to shit on the USD, the crypto capital markets like the rest of the world are intrinsically short the USD. Remember that the blockchains that support a multi-centa-Billion market cap use energy. Energy is priced in USD. Therefore, miners must find USD by selling mined crypto, or borrowing against their crypto. Speculators are usually net long. To get net long you need to borrow fiat to purchase more crypto.
 
A note on why speculators are net long. Bitcoin and other shitcoins can only fall to zero. But the upside is infinity. Cryptos are also insanely volatile. When you combine high volatility, unlimited upside, and limited downside you have an attractive call option. Therefore, as a speculator you should always look out for what to buy on margin, not sell. You aren’t guaranteed to make money, but you give yourself the best odds to succeed.
 
As savers buckle under zero and negative rates, they will become risk seeking with their capital. The crypto capital markets are the best place to earn serious positive yields if you are willing to take some modicum of risk.
 
The Intermediaries
 
We have demand, we have supply: let’s dance. What types of players stand in the middle and collect the crumbs?
 
Exchanges
 
The exchange business when done well at scale in crypto is very profitable. While traders pay low to zero fees to execute spot trades, they always pay for margin. Therefore, the more capital that can be funneled to risk-seeking speculators, the more trading volume, the more fee income. Exchange free cash flow (FCF) should be given to speculators at a price in order for them to trade more. At a certain point, the amount of capital desired by speculators will eclipse what the exchange can provide. At that point, the exchange will solicit capital from others.
 
Exchanges custody billions of dollars worth of crypto. As a depositor you trust that the exchange will secure it properly and not steal it. You implicitly trust the operators. Bad news spreads rapidly on social media. Any hint that the exchange is not a good credit, could metastasize into an exodus of depositors. Traders with zero balances don’t pay fees.
 
Exchange operators must maintain pristine reputations in the eyes of the community. The largest exchanges have the most to lose by stealing. Therefore, when they say I will pay you 1% a month to deposit USDT with me, you believe they can pay interest and principal. The exchange is the cheapest of all the intermediaries I will talk about because they have the most to lose by cheating.
 
The exchange will then take that 1% per month capital, and lend it to speculators at 10bps per day as an example. If the exchange gets 100% take-up, they make a spread of 2% (10bps * 30 days – 1%) per month. They also get to charge trading fees as speculators churn their books. The largest margin trading platforms all have schemes to raise assets with which to on-lend to speculators.
 
Lending Platforms
 
These platforms don’t own an exchange, and therefore do more traditional banking functions. They don’t have an intrinsic, profitable use case for the capital raised, so they match lender and borrower. Popular platforms such as BlockFi, Genesis, RenRenBit, Babel Finance, and MatrixPort conduct this business.
 
In the retail market, they offer very attractive rates for crypto and stablecoins. These are uncollateralised loans. In the OTC market, they will bid for size blocks of different coins depending on where they have massive demand and supply imbalances. These large trades tend to be collateralised. This market is very nascent and will be immensely important as the demand for credit in our ecosystem expands. This is the precursor to a well-functioning repo market where institutional lenders and borrowers can transact purely on trust.
 
The borrowers are the following:

  1. Miners who need to tender Bitcoin or Ether for fiat. The lending platform will demand over-collateralisation to protect their depositors. A typical structure is a borrower can borrow 50% of the USD value of their Bitcoin. If the price of Bitcoin drops 30%, a margin call is issued, if the price drops further without a collateral top-up, the Bitcoin collateral is liquidated. This flow is part of the reason why the March 13th sell-off was so vicious. Bitcoin and Ether collateral had to be liquidated to protect depositors.
  2. Hodlers who need fiat liquidity. Living the high life still requires a decent amount of fiat. Hodlers wishing to move out of the basement into better digs need to come up with statist ducats. These borrowers will also overcollateralise similar to miners.
  3. Exchanges need more deposits to lend to speculators. In a bull market, speculators will pay ridiculous rates because the assets they trade are appreciating so quickly. The exchanges will approach other intermediaries and borrow crypto or fiat to use on their platform. Because of the reasons mentioned above, exchanges are such good credits that they will usually not provide any collateral.
  4. Large trading houses are always on the lookout to use other people’s money to enhance returns. It is still very capital intensive to trade across all the major exchanges. Given the best shops also trade in the traditional markets, the crypto traders are always battling for more capital from the head office at reasonable rates. I know that some shops' traders get face ripped by their internal treasury desks. Some shops will provide USD as collateral to obtain crypto. Some shops, because of how established they are, can borrow without collateral.

These lending platforms are the closest thing our ecosystem has to banks. They bid for deposits by paying high rates of interest. They conduct credit analysis on borrowers, determine how much leverage to extend, and call loans to protect their depositors. For their efforts, they earn net interest margin (NIM).
 
Where these platforms differ from traditional commercial banks, is they cannot expand the money supply in the crypto capital markets. They conduct fully reserved banking. They can only loan funds equal to their deposits.

These platforms could create their own token and attempt to convince the market this token has a claim to income of the lender. This token could then be used as a cash equivalent on exchanges or to pay for crypto goods and services. If only someone was that audacious to mint currency out of thin air, and convince the market it was worth more than zero… I think you know where this is going.
 
I’m A Fucking Farmer – The DeFi Proto-Bank
 
Why not “decentralise” the functions of a lender? Why not create programmable finance? Why not have this borrowing and lending activity all live on blockchain and be completely transparent?
 
This is the dream. Various projects took up this challenge and created a whole ecosystem of dApps that attempt to perform the functions of a bank in a decentralised and trustless fashion.
 
Here is a very simple example of a DeFi lending project. There are so many more beautiful flavours, but let’s keep it simple:

  1. Select your protocol on which to build your DeFi bank. The most popular choice so far is Ethereum. That means the project using the ERC-20 standard.
  2. Create a smart contract where users can deposit a select number of ERC-20 tokens and earn yield. The most popular tokens are wrapped Bitcoin (e.g. WBTC, renBTC), ETH, DAI, USDT, USDC etc.
  3. Create a smart contract where the borrower can deposit collateral. E.g. I want to borrow ETH, so I will overcollateralise with WBTC. I deposit my collateral into a smart contract, and out the other side I receive ETH into my wallet. If the price of ETH/BTC rises (ETH is worth more Bitcoin), my WBTC collateral is liquidated on a decentralised exchange (Uniswap is all the rage right now) and ETH is returned to the lender. I can keep my ETH, but I have lost my WBTC collateral on the other side.
  4. The project either takes a fee in the form of a cut of the interest, or a fee for just arranging the trade.
     a.     The platform also issues their own native token and the only way to earn it is to participate on the platform as either a lender, borrower, or both.

This business model is that of a proto-bank engaged in fully reserved lending. Loans Outstanding <= Deposits. The part that makes this interesting is that it is programmable finance, where the owners are those who actually use the service. Contrast this with a typical bank where common stockholders are governments, large asset managers, and some retail investors. Ownership of equity is conferred through purchase of shares, rather than by usage of the service.
 
Tokenomics (you know, "The Economics of Tokens", it’s going to be a new major at Wharton taught by Dan Larimer) is fascinating, and where the activity known as yield farming originated. Using the above example, I create a fixed supply of tokens and the only way to earn these tokens is to engage in borrowing or lending. You can of course purchase them in the open market from holders who wish to sell.
 
The token has the following attributes:

  1. All fee income to the project is passed onto the token holders net of OPEX costs.
  2. Token holders can vote by submitting improvement proposals and vote via staking their token. Here are some things that holders can vote on:
     a.     OPEX costs - the biggest cost for an ERC-20 token is the Ethereum network’s gas fees.
     b.     A list of approved uncollateralised borrowers. E.g. Token holders could vote to allow an exchange the ability to borrow against depositors at the market clearing rate without collateral.
     c.     Leverage ratios for collateralised lending.
     d.     Fees charged by the platform.

The next question is how do you value such a token in the open market? As a holder of the token, I earn a yield denoted by the following formulas:
 
My Yearly Token Income = # of Tokens I hold * [Fee Income / Total Supply of Tokens]
 
My Token Yearly Yield = My Token Yearly Income / [Price Paid per Token * # of Tokens]
 
Let’s say that yield was 5%. Ignoring the risk that the smart contract is constructed poorly, I must evaluate this investment against something similar. If all loans are at least fully collateralised I don’t have to worry about the credit quality of the loan book. I am also assuming I can sell collateral in the event of a margin call with no market slippage. That means the security I should evaluate my earnings against are US Treasuries. The US Government can print money at will, so in USD terms it is risk free. There is political risk that they decide not to print money to payback holders, but barring that, it is risk free in nominal USD terms. We are not talking about the purchasing power of the USD after rampant M2 inflation, just the fact that if you lent $100, you get back $100.
 
Short term (<2 years) US Treasury securities yield slightly more than 0%. Therefore, investing in a token that yields >0% is a better use of your capital.
 
The risks to your investment in this DeFi proto-bank are the following:

  1. The lower the amount of assets locked in smart contracts, the lower the potential fee revenue. Therefore, if after you purchase the token, the AUC declines, your anticipated yearly fee income will be insufficient to generate enough yield.
  2. The loan book takes impairment. If all loans are at least 100% collateralised, that would mean that when attempting to liquidate collateral, market liquidity did not allow the protocol to recover all the value of the lent currency. E.g. You borrow $100 USDT against $110 worth of WBTC, the price of WBTC falls 10%, the protocol liquidates WBTC against USDT and is only able to recover 90 USDT. Now the loss of 10 USDT must be taken from the pool of retained earnings, or depositors must receive a haircut proportional to their % in the total deposit asset pool.
  3. If the loan book lends to certain perceived high-quality credits like exchanges with less than 100% collateral, that borrower could default. A similar sort of income or principle impairment would occur similar to point 2.
  4. A crypto bank robbery happens. That is the result of an intentional or unintentional bug in the smart contract code that syphons assets out of the project, or they become inaccessible.

This is the bull case for your yield to rise in the future:

  1. The protocol is able to gather more and more AUC, thus increasing the potential fees earned.
  2. The token holders vote on appropriate credit policies that allow for the extension of credit that is not 100% collateralised at an acceptable risk level. That means that the default impairment cost is less than the interest income earned from these riskier activities.

The majority of DeFi projects require staking and some sort of uneconomical activity. As a reward for your participation you are able to farm a token created out of thin air with dubious ownership claims to any potential income stream of the project. The memes are hilarious (YAM, BASED, etc.), and the fact that these tokens are worth more than zero is a testament to the financial repression hoisted upon savers by the all-powerful central bankers.
 
When faced with severe income inequality, and free money (for the fortunate), financial speculation will surge. Would you rather work for 30 years for stagnant to negative real income gains in service to a mega-corporation, or would you rather come play in the intellectual casinos that are the financial markets? At least at the casino you can visualise yourself hitting it big quickly. I imagine many “essential” workers are just so happy they can serve humanity for below average wages.
 
Against this potentially dystopian backdrop where greater than 50% of the population is on some sort of basic income, trading worthless memes under the guise of innovative technology ceases to be so daft.
 
The Holy Grail of Bitcoin
 
For Bitcoin to be true money, the cost of capital for certain businesses and individuals must be priced natively in Bitcoin. Any linkage to a fiat currency relegates the Bitcoin capital markets to be perennially short US dollars. All points in the value-added chain of goods production must be able to borrow cheaply in Bitcoin.
 
The current miner and speculator use case for crypto and stablecoin fixed income products is a great first step. This demand laid the groundwork for the rise of DeFi yield farming. While the majority of activity is economically wasteful, the underlying ability to build an ecosystem of dApps enabling programmable finance is a big improvement over the slow analogue expensive legacy financial system. The rise of the DeFi proto-bank where users own the rights to the NIM earned, will usher in a wave of inclusive banking services for the businesses and individuals crowded out of the capital markets by corporate socialism.
 
That is the dream of the DeFi proto-bank. It will almost certainly not materialise during this bull market. But that narrative will attract, hopefully, hundreds of billions of USD capital into the ecosystem. A sustained pump needs a powerful narrative. I believe this can serve that purpose.
 
I am laser-focused on how 100x can be a cornerstone in the fixed income scaffolding of the crypto capital markets. Watch this space, we are working on some cool shit.
 
A Note on my DeFi Shitcoin Trading
 
I, like many other punters, am enjoying yield farming meme tokens. To put this degenerate behaviour into context:

  1. I fully expect to lose most of all of the money I “invest” into any of these projects. In my head I like to believe I can read market sentiment and get out at the top of the bull market. But in reality, like most other traders, I will buy high, hold, hold, hold, and sell well after the top.
  2. I view the destruction of my capital as the only way to learn what the next wave of products and services should be built in this space by 100x. You can never find a truffle if you aren’t willing to wallow in the dirt.
  3. The size of my positions are tiny. My core investments of gold and silver miners, physical gold, and my interest in 100x dwarf any investment in YAM, YFI, DOT, or any other piece of shit token I decide to buy.
  4. There are no nightclubs. I am replacing bubbly water spend, with shitcoins. At least I’m learning something.

 
Global Macro
 
I, like many other pseudo intellectual keyboard warriors, have a massive upside price target for Bitcoin. I will get to that in the next digest. But Q4 is going to be a humdinger.
 
The first title fight of 2020 is Trump vs. Not Trump. The Not Trump camp doesn’t deserve to be mentioned by name as they are so uninspiring and status quo, they do disservice to the so-called progressive party of American politics. I am excited for a few months of dank memes, pithy one-liners, and a gross oversimplification of the ills of the American empire.

The financial markets are going to whipsaw as politicians contort themselves to continue feeding at the trough. This unfortunately will have lasting effects on everyone’s lives across the globe. Out of the chaos, more people will mistrust centralised authority and look for ways to protect their physical persons and capital from the wanton destruction waged upon them by their rulers.
 
My pocket rockets are primed and ready. 加油 Gold and Bitcoin.
 

From The BitMEX Research Desk

The Crisis Happened: What’s Next?

Abstract: Due to numerous requests, we provide a follow up to our February 2019 piece, “Anatomy Of The Next Global Financial Crisis”. We update our thinking following the pandemic driven crash and liquidity driven recovery in financial markets. We no longer think long dated volatility related bets are an effective way to protect portfolios because they are now too expensive. We believe that inflation linked government bonds could be the main pillar going forwards as part of one’s protection strategies, as more of a tactical position. While gold, Bitcoin and to a lesser extent the yen, could be the other main pillars.


(Source: Bloomberg; US consumer price index since 1914)
 

Subtleties and Security

Abstract: This piece is written by Bitcoin Core maintainer and BitMEX guest writer, Michael Ford. Michael is the first recipient of the expanding 100x Group Bitcoin Developer Grant Program, formerly the HDR Global Trading Bitcoin Developer Grant Program. This follows on from Michael’s first piece for us: Build Systems & Security – Bitcoin Is Improving. In this new piece, Michael explains four security improvements to Bitcoin Core that he has been working on. This work illustrates the importance of testing on multiple platforms.


 

Battle For ASIC Supremacy

Abstract: We look at the history of Bitcoin mining ASIC manufacturers, in particular the reported energy efficiency of the mining machines. We analyse the five main players in the market today, with a focus on Canaan and its profit warning right after its IPO. We then evaluate Ebang’s recent IPO prospectus and comment on the challenges the group faces with respect to its market positioning, profitability and geo-politics. We assess MicroBT, who are gaining significant traction in the market, obtaining share from Bitmain, who appear to be facing an almost comically abysmal corporate governance situation. In conclusion we think that post the 2020 Bitcoin halving, further industry consolidation is likely in both the ASIC manufacturing sector and mining farm operating sector.


(Source: Manufacturer websites, BitMEX Research; Reported Miner Efficiency (J/TH) vs product launch date)
 

Call to Action: Testing and Improving asmap

Abstract: This piece is written by Bitcoin Core contributor and researcher, Gleb Naumenko. Gleb is a recipient of 100x Group’s Bitcoin Developer Grant Program. In this article Gleb writes about how Bitcoin Core connects to other nodes on the network. He first provides some background about the latest default connection policy in Bitcoin Core 0.20.0, before explaining why there may be weaknesses in the current system which could make it easier for malicious actors to initiate an eclipse attack. Gleb goes on to talk about a potential more robust experimental peer selection methodology called “asmap”. Gleb then provides instructions for testing this new feature. Testing would help in ensuring the best security practices become more accessible.


(Illustration of Bitcoin Core’s new peer selection methodology)

 

Bitcoin Softfork Activation Methodology

Abstract: Bitcoin’s Taproot softfork upgrade looks almost ready and the Bitcoin community has started to seriously discuss the potential activation methodologies. In this piece, we summarise the main choices when it comes to the activation and discuss the most significant points of contention. We conclude by postulating that there is no perfect activating methodology. Any activation approach could set a bad precedent, which could be exploited at some future date. However, although there is a lot of “bikeshedding” occurring, due to the lack of contention about this particular upgrade, the exact activating path taken at this point may not be particularly critical. A potential partial solution to some of the dilemmas present and possible way forward could be for Bitcoin Core to release a client with a relatively passive activation logic and for other community members to follow on from this by releasing clients that force the same activation in a slightly more assertive manner.


 

Antminer S19 Pro vs Whatsminer M30S+

Abstract: We compare and measure various performance metrics for two of the latest and most energy efficient Bitcoin mining products, MicroBT’s Whatsminer M30S+ and Bitmain’s Antminer S19 Pro. Obviously the more expensive 7nm Bitmain product is more powerful, however the miners are pretty similar in terms of output. Our data over a short three day period shows that the Bitmain miner has slightly stronger performance than the Whatsminer, however the Whatsminer appears to have superior stability. In general, both machines are impressive and we predict the two companies will be in neck and neck competition over the next few years.


 

Antminer S19 Pro vs Whatsminer M30S+ (Part 2) – Thermal Image Analysis

Abstract: We provide a follow up to our previous piece, a comparison between the Antminer S19 Pro and the Whatsminer M30S+. We focus on the thermal characteristics of the miners and provide thermal images. The thermal images indicate more clearly that the Whatsminer has a higher operating temperature than the Antminer (perhaps by design), while both devices have a similar impact heating the external environment.


(Thermal image of the Whatsminer M30S+)
 

Risk Disclaimer

No articles in this email should be copied or reproduced in whole or in part. The information contained does not constitute research or a recommendation. 

Neither HDR Global Trading Limited nor any of its affiliates make any representation or warranty as to the accuracy or completeness of the statements or any information contained in these articles 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 email is not to be taken as constituting the giving of investment advice nor to constitute such person a client of the BitMEX trading platform.