BitMEX founder’s latest long article: Chaos

author   | Arthur Hayes, Founder of BitMEX

translate   | Wu talks about blockchain Wu Zhuocheng

(Note: Since Arthur Hayes's article is difficult to translate, please understand. You can make corrections in the comment section. Reprinting without authorization is prohibited .)

Original title: Maelstrom

The most psychologically powerful measure of your portfolio's health is annualized return. As always, the goal is to maintain or increase the purchasing power of your assets relative to energy costs. The essence of human civilization is to convert the potential energy of the sun and the earth into kinetic energy to support our bodily functions and modern lifestyles. Making money is not the goal, because money is just an abstract concept of energy. The right way to measure your financial success is to determine how much energy your lifestyle currently costs (using oil as an example below) and how much it will cost in the future (of course, this is difficult to measure). Then, you must ensure that your financial savings grow faster than your expected energy consumption rate.

Markets don’t stop at the sound of 12:01am on January 1, 2022. Returns are compounded and path-dependent in nature. Unfortunately, only a few trading days really matter. A simple example can illustrate this.

Back on January 1, 2020, when the world was simpler and the global coronavirus madness hadn’t taken hold, Bitcoin was priced at $7,216. On the last day of that wonderful year, Bitcoin was priced at $28,996, an average annual return of 302%. Who made more money, Bitcoin investors or Pfizer?

While this is an impressive annual return, it masks the dramatic turbulence the market experienced in mid-March. Let’s focus on March 2020.

On March 16th, Bitcoin experienced a correlation moment, as it, along with every other risk asset in the world, was hammered as the world (except China) discovered that the COVID-19 pandemic was real and extremely destructive. A correlation moment is when all risk assets fall at the same time, and investors on margin rush to sell everything to increase the world’s reserve currency (currently the US dollar) so they can pay back their loans. No asset is spared. Only when the dust settles and the fear dissipates, will asset prices start moving in more idiosyncratic ways again.

From January 1 to March 16, the price of Bitcoin plummeted 38%. Many people were stopped out, either psychologically or forcefully (a psychological stop is when the price of an asset reaches some kind of built-in pain point that forces you to hit the “sell” button. A forceful stop is when your leverage provider closes your position to preserve some collateral value).

The above chart illustrates both good and bad results of path dependence. The most important lesson is that trading action on March 16th was by far the most important day of the year. The very best traders who got on board had the opportunity to significantly increase their portfolio returns, with returns from the low on the 16th to the end of the year being 250 percentage points higher than if they had invested starting on January 1st.

If you are unfortunate enough to exit on the 16th, but have the energy and financial resources to buy back into the market, the date you re-enter your position is extremely important. Bitcoin did not recover to its January 1st level until April 21st. The longer you wait, the lower your 2020 compound return will be.

An active trader would have to be present on any day like March 16th and sell a position and buy it back shortly after selling it to create a constant compound return.

For investors who don’t want to watch Bitcoin 24/7, you must construct a portfolio that is convex on a catastrophic day like March 16. The most important psychological hurdle to overcome is to abandon the concept of year-over-year arithmetic returns and move to compound returns. The above example illustrates the negative impact of compounding, if you don’t protect your position on the downside, you won’t be able to participate in the upside rally.

To do all of the above, you have to remove emotion from your investment decisions and use a reasonable amount of leverage. The former requires more skill than the latter, because it is very difficult to completely change your investment philosophy (especially given that most investment literature focuses on arithmetic returns). To make matters worse, all fiduciaries (i.e., fund managers) are paid bonuses on an annual basis. If your fund manager loses all of your assets, the worst that can happen to them is that they are temporarily unemployed, while if the market goes their way, you will still be paying them a percentage point of your return every year, which will destroy your compounding over time. I don't have a solution to the trusteeship problem, but just remember that it exists and adjust your behavior accordingly.

The point of this Bitcoin price history lesson is to start a discussion about how I should position my portfolio this year before I think there will be a string of disastrous trading days like March 16, 2020. As usual, this is related to the Federal Reserve reducing the growth of its balance sheet to 0% and subsequently raising interest rates one to three times in 2022.

I will start the discussion by discussing why interest rates are so important and then discuss how aggressive short-term policy rates set by central banks will inflict the most pain on global risk assets over a three to six month timeframe. I believe that the Fed and other lemming central banks around the world will eventually have no choice but to continue printing money. But at some point soon, domestic politics in many countries may require tightening the money supply to quell dissent from the populace whose food, housing and transportation costs are rising, and rising dramatically!

Listen carefully

When it comes to central banks, it is fashionable to be as transparent as possible about future actions. Yet in the face of obvious data, the top brass refuse to admit that money printing is the cause of the inflation that is tearing society apart. Those who do what they are told have accumulated a lot of fiat currency since the Great Recession of 2008. Those who care about fundamentals and other such nonsense have underperformed, don't be stupid, buy the damn market now!

While policy changes frequently, the Fed is very clear about what they intend to do. “Temporary” inflation has now been put on hold, and the Fed has signaled that they think it’s time to curb inflation in food, energy, and transportation at the expense of financial asset prices. To this end, they have decided to stop buying bonds by March of this year, and if their “dot plot” holds true, the first rate hike will occur between March and June.

Most market participants believe that Democrats will instruct the Fed to raise interest rates, and the Fed will do so. Democrats must demonstrate their hawkish stance on inflation to avoid being completely defeated in the November congressional elections. But there is no consensus on how short-term rate hikes will affect financial assets - that is, whether they will weather the storm or buckle under pressure.

Forgetting the views of non-crypto investors, my reading of crypto investor sentiment is that they naively believe that the fundamentals of overall network and user growth will allow crypto assets to continue their unabated rise.

In my opinion, this portends a serious crash, as the harmful effects of rising interest rates on future cash flows could prompt speculators and margin traders to sell or significantly reduce their holdings of crypto assets. I do not deny that loyal diamond hands are constantly adding positions after the price crash, but in the short term, this "iron fan" cannot prevent a catastrophic drop in prices. Remember, as long as there is 1 Bitcoin trading at $20,000, then the final price will be $20,000, even if there are 19 million Bitcoins in the world that are not traded in the market. The final trading price is caused by the abandonment of marginal sellers, although the transaction scale is small.

The most damaging effect of the last traded price is the psychological shock to weak traders, and it affects the liquidation of underwater positions on leveraged trading platforms. So don't tell me all the crypto market OGs are busy buying the limit down; none of this matters when the fund managers are destroying your positions.

For more than a decade, cryptoasset investors have been salivating at the prospect of “institutional” investors entering the space. Now, they are finally here, as the Bloomberg headline below indicates. While the asset allocations are small, there are enough believers from the world of TradFi to make a difference.

"Billionaires Are Embracing Crypto in Case Money 'Goes to Hell'"

https://www.bloomberg.com/news/articles/2022-01-01/billionaires-dalio-peterffy-embrace-bitcoin-ethereum-as-inflation-hedge?sref=vvpMCnMg

The article discusses how high-profile CEOs and investors like Tom Peterffy (InteractiveBrokers) and Ray Dalio (Bridgewater) hold Bitcoin and other crypto assets as a hedge against a decline in fiat currencies.

While the wealthy who run the big TradFi firms can withstand severe price drops, the lemmings who follow them cannot. The asset management industry is more than happy to invest in crypto assets, as long as these overpaid imitation chefs don’t lose their well-paid jobs when prices fall. They have no faith in, and no allegiance to, Satoshi. Therefore, if external conditions warrant reducing their crypto asset allocations, they won’t hesitate to liquidate their positions — no matter how large the loss.

Institutional investors are subject to the power of Eurodollars (holding dollars outside the domestic U.S. banking system). Essentially, the entire world is shorting the dollar. When the dollar price falls, credit expands and financial assets are happy. When the dollar price rises, credit contracts and financial assets are sad. Read the Alhambra Investments blog for a more in-depth discussion of how this market works.

The rate of change of money supply growth, i.e. its first derivative, is the most important factor in determining whether institutional investors are bullish or pessimistic.

The white line is the US M2 growth rate, which gradually grew in 2019. In March 2020, the Fed used its magic money printing machine to nationalize the corporate bond market and save the US Treasury market by bailing out a group of over-leveraged macro hedge funds. This caused a leap in M2 growth. The Fed's balance sheet grew, and as a result, the larger the M2, the slower it grew (the law of large numbers), and the US government did not make enough fiscal spending to continue to accelerate the printing of money.

Currently, the Fed is forecasting that the growth of their balance sheet will slow to zero. If they do not reinvest the maturing bonds in their portfolio, their balance sheet will actually shrink. The ugly white arrow in the chart above shows the effect this is likely to have on the money supply.

The yellow line is the price of Bitcoin/USD. Easy monetary conditions in the US have certainly influenced the meteoric rise in price (albeit with a delay of several months). Bitcoin has been moving sideways since M2 growth stagnated. If M2 growth were to reach 0% or even negative values ​​in the short term, the natural conclusion is that Bitcoin (in the absence of any incremental growth in the number of users or transactions processed through the network) would likely also be lower.

I could post more charts depicting the credit impulse in different countries, but they all paint the same picture. Villagers are waking up because the prices of meat, vegetables, taxis, rent, and other necessities are rising faster than their wages. Now their public enemy number one is inflation. If domestic politicians around the world want to continue to enjoy the fruits of their labor, they will have to pretend to do something. So it's time for some song and dance from central banks, who are willing, at least for a short time, to unwind their balance sheets and return to positive interest rates that reflect various domestic economic realities.

Benchmark Assets

Bitcoin is a cryptographic representation of money/energy.

Ethereum is the decentralized computer of the internet.

For the most part, every other major crypto asset can be categorized in the following manner.

1. Tokens bound to Layer 1 protocols are expected to become the "next Bitcoin or Ethereum". These networks have greater scalability, can process more transactions per second, or are anonymous. For example, Monero is to Bitcoin, or Solana is to Ethereum.

2. The other category is to use existing Layer 1 protocols as tokens to complete certain intended functions, such as Axie Infinity, a token-based game that uses NFT assets residing on the Ethereum blockchain to make money.

A token is either trying to be a better version of Bitcoin or Ethereum, or it leverages the capabilities of both networks to create a new product or service.

Both Bitcoin and Ethereum have some fairly significant shortcomings, and if another crypto asset were to replace either one, its value would naturally explode. Anyone who discovers the above tokens ahead of time will become rich in crypto assets. There are many Layer 1s with high and rising expectation premiums, but these protocols are traded based on expectations because the fundamentals of these protocols (such as the number of wallet addresses or the amount of actual transaction fees paid in the native token) pale in comparison to Bitcoin or Ethereum. This does not mean that over a long enough period of time, a particular coin cannot be a winner. However, we don't care about the long term, we care about the next 3 to 6 months and protecting the downside of our portfolio.

Regarding tokens that rely on the Bitcoin or Ethereum blockchain to achieve their functions, these tokens should not be worth more than the protocols they are built on (in theory). This is the difference between investing in general applications and specific applications of a technology - general applications are more likely to provide iterative power for multiple successful specific applications, so general applications should be valued higher. Although there is a big gap between the market capitalization of Ethereum and ERC-20 dAPPs, the price of dAPPs will rise faster than Ethereum in a specific time frame. Of course, during the decline, the above dAPPs will lose value faster than Ethereum.

That's how I see the world. Therefore, I benchmark all returns in my crypto portfolio to Bitcoin or Ethereum. I enter the crypto world by exchanging fiat for Bitcoin and Ethereum, and these tokens always lead a rally, and then it's time to buy low and sell high. In the process, my Bitcoin and Ethereum holdings may increase.

If I believed that in three to six months, Bitcoin and Ethereum would trade below $30,000 and $2,000, I would sell all my shitcoins. This is because Bitcoin and Ethereum are the highest quality tokens and they will fall less than all of their unproven competitors. Any specific application using Bitcoin or Ethereum will also experience a free fall greater than 9.8m/s, and in a true crypto asset risk-off environment, these shitcoins could fall 75% to 90%.

The movement of the TradFi system is based on the fluctuations of the Eurodollar cost, while the crypto market is likely based on Bitcoin and Ethereum. I don't have hard data on this, but my hunch is that there are billions of dollars worth of Bitcoin and Ethereum being used as collateral, with holders depositing Bitcoin/ETH and receiving USD in return. These USD are used to buy assets such as cars or houses, as well as gold mining altcoins. If you think we are in a bull market and you already have a base, it makes sense as a trader to leverage and buy an altcoin to get a 10x gain if Bitcoin goes up another 10%.

Whether you buy shitcoins or more SHIB, if Bitcoin or Ethereum drops 20% to 30%, you will be forced to sell assets and raise Bitcoin or Ethereum to avoid liquidation. The contraction of the fiat price of the base asset will cause some margin traders to sell their altcoin positions desperately, regardless of whether they are making money. This is the reason for the last price being affected by marginal weak-hand sellers.

It doesn't take much marginal selling pressure to puncture this bubble. CTMD Those high Farming APYs, once the shitcoins start to shit, everyone will exit to take profits. Even if only a small number of traders get a lot of altcoins in a leveraged manner, due to the lack of liquidity of these coins, it will be difficult to find large-scale buying on the way down. Remember, big in, small out.

Timeline

What if I'm wrong? If the crypto market bull run continues without a big drop, how will my portfolio be hurt?

1. March to June

During this time, the Fed either raises rates or it doesn’t. The market expects the Fed to raise rates, and they will be disappointed if one of three things happens.

1. The Consumer Price Index (CPI) growth rate falls below 2%. This is unlikely to happen, given that the index is “managed” by government statisticians. But if the CPI trend falls sharply, the political pressure from voters will dissipate, and the Fed may be able to publicly reverse the trend.

2. The extremely complex and opaque money and Treasury markets will collapse in certain parts. You’ll know it when you see it — this is the one thing the Fed fears most. Given that all of TradFi’s assets are valued based on prices in the U.S. money market, the Fed must do whatever it takes to ensure that this market functions in an orderly manner. Normally, restoring order requires massive amounts of money printing.

3. Inflation is no longer the number one concern for American voters ahead of the November election.

Of the three scenarios, I think the second is the most likely. No one can predict what will happen to the currency/Treasury markets when the Fed stops providing money. There is so much leverage built into the system that it is impossible to know if methadone will kill an addict.

Given the law of large numbers, simply resuming the previous trend of asset purchases will not lead to a sudden and sharp acceleration in the growth of the money supply. Therefore, while risk assets will rejoice, including crypto assets, the best case scenario is that asset purchases slowly climb back toward previous all-time highs. Even if this happens, the only way for the crypto market to rise is if the Fed publicly opens the tap and fiat flows into crypto.

If this starts to happen, there will be plenty of time to sell fiat, increase your total crypto holdings, or move up the crypto risk curve by increasing your altcoin holdings. You always go up the stairs and down the elevator.

If I'm wrong, I won't suffer a major loss as the crypto market resumes its upward trajectory. It won't cost much to be patient.

2. From June

Assuming I'm right and the Fed raises rates at least once before its June meeting, if any of the following scenarios occur, the Fed will suddenly slash rates to zero and start printing money faster than Usain Bolt.

1. The S&P falls 20% to 30% from its all-time high (reached in the first half of 2022). Whether you are a net exporter in Asia or Europe, or a wealthy American, you probably own a huge amount of U.S. stocks. The U.S. stock market is the best performing stock market in the developed world, and it is also the largest and most liquid. There are too many wealthy people paying taxes and spending recklessly, and the Fed will not let them down if there is serious turmoil in the stock market.

Another interesting reflex is that the conventional wisdom of maintaining a 60/40 mix of stocks and bonds means that if 60% of stocks fall, fund managers with trillions of dollars must sell bonds to maintain that ratio, which is written in their books. So if the Fed allows stock prices to fall, it will increase the federal government's borrowing costs - because as bond prices fall, yields rise - at a time when the government is facing record deficits.

2. Certain parts of the extremely complex and opaque currency and U.S. Treasury markets would collapse.

3. The November 2022 election is over.

Worst case scenario, the parties are back on track after November. Neither of the two political parties in the US actually wants to stop the rise in asset prices. Both parties prove their worth by shouting to the world: "I'm in power, the S&P 500 is up!" This makes everyone rich and makes your wealthy donors happy. After the common people go through the drama of voting and expressing their dissatisfaction with the soaring cost of living, they can be forgotten until the next election. The government will then continue to inflate financial asset prices by printing money. This is the US business model, and it must be maintained because of the structure of the global economy.

confusion

I don’t actively trade around my positions. My goal is to construct a portfolio that I believe will be able to participate in the upside while limiting losses on the downside. As I mentioned before, if the return curve of my portfolio is convex, I’m doing well. While I’ve spent most of this post talking about the crypto side of my portfolio, I expect my portfolio of long interest rates and FX options — through my investments in volatility hedge funds — to make up for any losses on the crypto side. However, if I’m honest with myself, I may need to add more so that I have enough vega to take advantage of the downside.

I don't want to sit in front of a screen for hours on end, staring at my Bitcoin day after day, I don't like it. Some traders do this and are successful short-term traders, but these traders have to be very focused. If you can't or don't want to be on call 24 hours a day, watching your crypto portfolio, don't try to do short-term trading.

As these thoughts brewed in my head over the past few weeks, I resolved to take action. I went through my entire crypto portfolio. Any shitcoin I wasn't willing to add to my position after a 75% drop from current levels, I dumped. That left me with Bitcoin, Ethereum, and a few other metaverse and algorithmic stablecoins. Position size is not determined by the notional amounts you hold, but rather what percentage of your total assets they represent. A 100 BTC position is large for some, and too small for others. Everything is relative.

For now, I'm waiting. I remain fully invested in my benchmark crypto assets. Your crypto benchmark may or may not be similar to mine. I gave you my reasons, and you should think clearly about why you think your benchmark is valid in the context of your energy goals.

If Bitcoin hits $20k, or Ethereum hits $1,400, then I’ll start to question whether these crypto assets have energy value. Both prices were all-time highs during the previous 2017 bull run, but those were fiat prices, and if oil goes negative again, who cares if the fiat price of the benchmark crypto asset decreases.

I held my fiat currency, ready for the vertical candle. I had been trading this market long enough to spot the final blow that broke the soul of the speculative bull market. Although I was confident in my ability to spot the bottom, I also learned not to try to catch a falling knife. If you didn't bottom the market, so what? Let the market heal, then buy at a higher level as the marginal trades of the sellers are over.

He who sells first, sells best. Now is the time to evaluate whether positive interest rates will hurt your portfolio enough to buy more energy. No matter how hard governments try to suppress the volatility of the universe, the normal state is chaos. We are entropy!