“That’s Our Two Satoshis” — How The Crypto Derivatives Explosion Affects Markets

Jeff Dorman, CFA
Jul 8, 2019
What happened this week in the Crypto markets?

Not Much Actually
There are plenty of reasons why digital assets are advantageous over the legacy financial system, but one area that may not be as great as advertised is 24/7 trading.  The idea of 24/7 banking is certainly appealing, as there should be no restrictions on accessing, and transacting with your own capital. But trading is a bit different.  Crypto derivatives have a direct affect on cryptocurrency markets. There are times when the market just needs to pause, collect its breath, and reset. This of course is not possible in the globally-connected, unregulated digital asset ecosystem. But after a violent June rally followed by a widow-making levered unwind to end the month, it almost felt like crypto market participants implicitly agreed to take a much needed break last week.

Despite a slower week, volatility did not wane as Bitcoin alone moved between $9800 and $12,000 last week, with over 90% annualized volatility.  Prices ended largely unchanged week-over-week, as these large price swings were mostly quick and sharp, typically moving hundreds of dollars in minutes.  Volume was light, with virtually no significant news driving prices and a general lack of conviction. Away from the exchanges, OTC dealers reiterated that flow was nearly non-existent.  Notably, the higher quality “defensive” tokens that typically have high up-capture and low down-capture were generally better for sale last week -- which may be indicative of funds and traders still raising cash to meet margin calls after so many levered shorts and longs were liquidated at the end of June.   This price action is similar to when BB-rated, high quality HY bonds get sold aggressively when funds need to raise cash to meet redemptions. 

Where Does Crypto Go From Here?
Looking ahead, it’s anyone’s guess how the market will respond when flows pick up again.  While many crypto catalysts that fueled the 1st half rally are now in the rear-view mirror, the largest ongoing positive catalyst continues to be the deteriorating global macro backdrop.  Let’s start with the obvious, and most difficult to wrap our heads around:
Market Recap - Crypto Derivatives
A 10-year Central Bank-induced equity rally by itself, while potentially unsettling, is not necessarily a driver of flows into digital assets.  However, when you pull back the curtain further, the constant “riskless” equity gains may start to look less exciting when the government manipulation goes from implicit to outright explicit.  The ramifications of total loss of purchasing power from non-stop money pumps start to outweigh the idea of persistent financial gains.
Market Recap - Crypto Derivatives
Digging deeper, Raoul Pal succinctly captures the true “fear trade”, which continues to support digital assets, especially Bitcoin and to a lesser extent the innovative “decentralized finance” movement occurring on top of the Ethereum protocol.   In short, banking is getting very ugly in Europe, which may be impossible to slow down at this point. All of this is very bullish for non-sovereign money and banking.

Fear Trade - Crypto Derivatives

As we wrote a few months prior, we may be witnessing Bitcoin becoming a safe haven asset in real-time due to this government and political backdrop.  Our friends at DRW/Cumberland opined further with some stats from this past weekend:

“The most compelling theory has been that Bitcoin is increasing in response to geopolitical tensions and has been adopting the characteristics of “digital gold”. Positive daily correlation between gold futures and bitcoin have held an average value of 0.8 for the past nine days, reaching a YTD high of 0.89 on Tuesday. While cycles of positive correlation with gold futures is not notable in and of it itself, the duration and magnitude of this most recent cycle is unique. Numerous macro developments have spurred similar price patterns in both gold and bitcoin this week, further bolstering this thesis. For example, as trade tensions between the US and China eased following the G20 summit’s conclusion this weekend, gold dipped below $1,400 as BTC also began to have a more significant correction. We are hesitant to say that Bitcoin has fully adopted the characteristics of “digital gold” just yet, but we continue to track its responsiveness to broad macro disruptions and will continue to observe its longer term correlation.”
More on the Great Crypto Levered Unwind - An Addiction to Derivatives
Last week, we briefly touched on the cause of the late June Bitcoin surge, and subsequent 20% crash -- massive leverage.  The digital assets space is still so small relative to traditional asset classes that any levered losses can easily be absorbed and diluted by new money coming into the space, but we won’t be surprised if we’re still hearing about the aftermath of June’s final week of trading for many months to come.  In the past few days, some of this leverage declined, with funding rates coming back down to earth, but the crypto world is still abuzz with derivatives.
Below are just a few of the recent announcements involving the growth of crypto derivatives:

The growth in derivatives is universally viewed as a long-term positive, and for good reason.  In traditional markets, derivatives lead to more efficient pricing via spot/futures arbitrage, better cash/inventory controls, tighter risk management, hedging of forward production, higher ROI, and more efficient ways to express investment theses around specific catalysts.  However, in the still immature crypto world, we’re seeing how the rise of derivatives can lead to increased volatility and poor risk management, especially when the majority of participants are looking to derivatives simply to increase leverage, many of whom don’t always understand how margin works.  And perhaps most importantly, many of the non-Bitcoin “alt” coins that have been popular for the past few years were really just levered bets on crypto’s success -- so as the regulated Bitcoin futures and options market grows, real investors no longer have to look beyond Bitcoin and a few other select digital assets investments to get levered upside. 

image4-15Source: CME
Notable Movers and Shakers
In a week where Bitcoin dominated the market despite volatility (+6%), only a select few projects in the digital asset space had price action driven by specific catalysts:

  • Tezos (XTZ) was the benefactor of a midweek surge, finishing the week up 30% after a press release Wednesday announced that BTG Pactual, along with Dalma Capital, will be utilizing Tezos to tokenize a variety of traditional and alternative investments (aka Security Token Offerings). BTG Pactual was the first investment bank to officially launch an STO on the Ethereum blockchain, but noted that Tezos aligns better with their vision of global asset tokenization.
  • Waltonchain (WTC) released multiple updates following their successful mainnet upgrade on June 29th, resulting in a very strong showing last week (+80%). On Tuesday, the team announced a restructuring of the Waltonchain mining pools, as well as an incentive plan for miners to hold more WTC in their wallets (leading to reduced mining difficulty). On Thursday, the team announced that the token lock-up for team members was extended for another 6 months to January 2020. On Saturday, the Waltonchain Foundation shared a transparent expense report for Q2 2019. Market confidence seems to be trending up for the project, as the team has made it evident that communication is at the forefront of their plans for Q3.
  • Dogecoin (DOGE) was on the receiving end of a Binance listing last week, causing an intraday price increase of 50% on the largest volume seen since September 2018. The hype faded, and DOGE finished the week +10%, but it’s worth mentioning that the effects of liquidity events (namely, exchange listings) is not a dead art. Even a technically dead project (with an impressive community) stands to benefit from an exchange, such as Binance, offering a market. 
What We’re Reading this Week
In this Forbes piece, Caitlin Long details the different stability features among cryptocurrencies. She explains the distinction between systemic stability (found in Bitcoin) and price stability (found in Libra and other stablecoins), which each serve different purposes. Individuals should therefore understand that Libra will only be offering exposure to a basket of fiat-backed price-stable currencies, whereas Bitcoin is an asset completely outside the traditional fiat-based financial system.
The Bank of International Settlements (BIS) last week announced it would be creating an innovation hub for financial technology, with the aim of better understanding digital currencies and potentially creating Central Bank Digital Currencies (CBDC). BIS’s manager, Agustin Carstens, has previously spoken firmly against digital assets such as Bitcoin, arguing they are not functional payments systems. BIS’s reversal is unsurprising given the increased interest in digital assets but time will tell if they can produce anything close to current cryptocurrency systems. 
BNY details the recent investment opportunities and progress in the digital assets market over the last year, including hurdles for allocators such as lack of infrastructure, regulations, and custody options. They also discussed their Digital Asset Strategy fund which invests in blockchain businesses focused on enterprise. BNY has been quiet on the topic of digital assets so this recent report indicates they may become more active in the near future.
One of the biggest problems in digital assets is properly auditing transactions to the same level of traditional financial transactions.  PwC released a feature last week as part of its Halo data auditing suite, which allows users to better pair cryptocurrency transactions and prove ownership.The tool works on BTC and several of its forks, LTC, ETH, OAX and XRP and will be offered to non-PwC clients. PwC notes that “It is important as companies continue to digitize we, as auditors, keep up with technology changes in the market, continue to develop audit tools that meet the needs of emerging technologies and serve the changing and developing demands of our stakeholders”. 
DocuSign is a company that really benefit from blockchain technology, offering a way to further authenticate signatures and streamline paperwork-based industries. Indeed they have been exploring blockchain for quite some time, beginning in 2015 with a joint demo with Visa using Bitcoin followed by a second pilot in 2018 using Ethereum. Both proved to be non-starters, however DocuSign’s recent investment in a smart contract technology provider, Clause, could lead to advancing its ambitions. 
In a bid to court investment dollars from the Middle East, the Ethereum Foundation is working to show that Ethereum is Sharia Law compatible.  Such a move would open the door to fresh capital by allowing groups such as Saudi Arabia’s Public Investment Fund, which manages $300b in AUM, to invest in Ethereum projects. In addition to this effort, ConsenSys, the venture group focused on growing the Ethereum ecosystem, has been making “connections with governments in the Persian Gulf”. 
In partnership with the charity Oxfam and insurance company Aon, insuratech firm Etherisc has  launched a blockchain-based insurance platform for farmers in Sri Lanka. Farmers in Sri Lanka comprise 30% of the population yet very few have insurance making it a perfect market for a decentralized insurance project. The platform, which already has 200 farmers signed up, provides micro-insurance to farmers who may lose crops due to damaging weather conditions. Insurance is one of the major markets set to be disrupted by blockchain technology and its implementation in places like Sri Lanka show how it can also be a force for social good.
And That’s Our Two Satoshis! 
Thanks for reading everyone!   
Questions or comments, just let us know.  
The Arca Portfolio Management Team
Jeff Dorman, CFA - Chief Investment Officer
Katie Talati - Head of Research
Hassan Bassiri, CFA - PM / Analyst
Sasha Fleyshman -  Trader  
Wes Hansen -  Director of Trading & Operations
To learn more or talk to us about investing in digital assets and cryptocurrency
call us now at (424) 289-8068.




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