Author:Arthur Hayes
Compiled by: Mary Ma Wu Talks about Blockchain
The question at hand is whether Bitcoin has hit a "bottom" at its current price. Bitcoin is the purest and most proven form of cryptocurrency, and while it may not be the worst-performing cryptocurrency, its role as a reserve asset will ensure that Bitcoin leads us out of the dark shadows. Therefore, we must watch Bitcoin's price action to determine if this market has hit a bottom.
There are three groups that are forced to dump their Bitcoin into the hands of true believers: centralized lending exchanges, Bitcoin mining companies, and ordinary speculators. In each case, the misuse of leverage, whether in their business operating model or their use of leverage to finance transactions, was the cause of the liquidation. With U.S. short-term Treasury yields rising from 0% in the third quarter of 2021 to 5% currently, everyone has suffered huge losses on their ultra-bullish beliefs.
After reviewing how leverage destroys each group’s positions as rates rise, I’ll explain why I think they have no more Bitcoin to sell, and why, long term, we may have already hit the low of this cycle with the recent FTX/Alameda debacle.
In the last part of this post I will list the ways I plan to trade on this possible bottom. To this end, I recently attended a webinar by my macro idol Felix Zulauf. At the end of the broadcast, he said something that stuck with me. He said that investors and traders need to pay attention to identifying tops and bottoms, but most people focus on the noise in the middle, and judging the bottom is usually in vain. Now that I'm on this fool's errand, I'm going to try to call it in a way that protects my portfolio to maximize my cushion against errors in price and/or timing.
With this in mind, let’s take a deeper look.
Most of us are probably not as gifted as the Alameda CEO, so we have to learn math the hard way. Do you remember PEMDAS? It is an acronym that describes the order of operations when solving equations.
P — Parentheses
●E — Exponents index
M — Multiplication
●D — Division division
●A — Addition addition
S — Subtraction
The fact that I still remember the acronym decades after first learning it speaks to its stickiness.
But equations aren’t the only things with a static order of operations: bankruptcies (and the contagion that follows) also occur in a very specific order. Let me first explain what that order looks like, and why it occurs.
But before I do that, let me acknowledge that no one wants or intends to go broke. So I apologize in advance if I offend anyone who has lost money due to SBF's evil deeds. But this scammer just keeps opening his mouth and saying stupid things that need to be called out on him. So the rest of this post will be peppered with sad melodrama about SBF and the people he is responsible for. Now, let's get back to the point.
Centralized lending companies (CELs) often go bankrupt because they either loan money to entities that cannot repay it or have maturity mismatches on their loan books. The reason for the duration mismatch is that banks receive deposits that can be called back by depositors within a short period of time, but they use these deposits to issue loans over a longer period of time. If depositors wanted their money back, or demanded higher interest rates due to changes in market conditions, CEL would be insolvent without an injection from some white knight company and would soon go bankrupt.
Before CEL becomes insolvent or bankrupt, they will attempt to raise funds to improve the situation. The first thing they have to do is collect as much of the loan as they can. This mainly affects those who borrow money from them in the short term.
Imagine you are a trading firm that borrowed money from Celsius, but within a week, Celsius demands the return of those funds and you oblige. As a trading firm, getting called in a bull market is not a big deal. There are plenty of other CELs that will lend you funds so that you don’t have to liquidate your existing positions. However, when the bull market fades and there is a market-wide credit crunch, all CELs will typically call in their loans at the same time. With no one to turn to for additional credit, trading firms are forced to liquidate their positions to meet capital requirements. They will liquidate their most liquid assets first (i.e. BTC and ETH), hoping that their portfolio does not contain too many illiquid junk coins like Serum, MAPS, and Oxygen (like Alameda and 3AC do).
After CEL recovers all the short-term loans it can, it will start liquidating the collateral backing its loans (assuming it actually requires collateral, note: irony that Voyager can have unsecured credit). In the cryptocurrency market, before the recent implosion, the largest category of collateral was loans secured by Bitcoin and Bitcoin mining machines. So once things started to go bad, CEL started selling Bitcoin because it is the most commonly used asset for collateral and the most liquid cryptocurrency. They also turned to the mining companies they lent money to, asking them to provide Bitcoin or their mining machines, but if these CELs don't operate a data center with cheap electricity, mining machines are as useful as SBF's accounting skills (note: irony).
As a result, despite the ongoing credit crunch, we are seeing massive spot sales of Bitcoin hitting both centralized and decentralized exchanges:
1. CELs try to avoid bankruptcy by selling Bitcoin as collateral
2. Trading firms see their loans called and have to close their positions. This is why the price of Bitcoin plummets before the CELs go bankrupt. This is a big move. The second drop (if there is one) is driven by the fear that firms once thought to be untouchable are suddenly starting to act like zombies, about to liquidate assets. This tends to be a smaller move, as any firm at risk of bankruptcy is already busy liquidating Bitcoin to survive the crash.
The above chart of Binance’s BTC/BUSD trading volume illustrates that there was a surge in trading volume during the two credit crises in 2022. It was during this time span that all of these once legendary companies gnashed their teeth.
In summary, as CELs transitioned from solvent to insolvent to bankrupt, these other ecosystem players were also impacted:
1. Trading firms that borrowed short-term funds from CEL saw their loans called back.
2. Bitcoin mining companies, which typically use Bitcoin on their balance sheet, future Bitcoin and/or Bitcoin mining machines as collateral.
Two of the most ignorant crypto trading firms, Alameda and 3AC, both grew to such massive size because of cheap borrowing. In Alameda’s case, the polite way to put it is that they “borrowed” it from FTX customers, though others might call it theft. In 3AC’s case, they duped gullible and desperate CELs into lending them money with little to no collateral. In both cases, the banks believed that these firms and other trading firms were engaging in super-smart arbitrage trades that insulated these firms from market shifts. However, we now know that these firms were just a bunch of degenerate, long-only gamblers. The only difference between them and the masses was that they had billions of dollars to play with.
What did we see when these two companies were in trouble? We are seeing massive moves of the most liquid cryptocurrencies Bitcoin (WBTC in DeFi) and Ethereum (WETH in DeFi) to centralized and decentralized exchanges, where they are then sold. This happens during big declines. When the dust settles and neither company is able to lift the asset portion of their balance sheet above the liability portion, what they are left with is almost entirely the most illiquid crapcoins. Looking at the bankruptcy filings of centralized lenders and exchanges, it’s not entirely clear what crypto assets are left. The files hold everything together. Therefore, I cannot prove that all the Bitcoin held by these bankrupt institutions was sold off in multiple crashes, but it does appear that they did their best to liquidate the most liquid crypto collateral before going bankrupt.
CELs and all the big trading firms have sold most of their Bitcoin. Now all that’s left are illiquid shitcoins, private equity in crypto companies, and locked pre-sale tokens. How the bankruptcy courts ultimately deal with these assets is irrelevant to the development of the crypto bear market. I am relieved that these entities have almost no excess Bitcoin to sell. Next, let’s look at Bitcoin miners.
Bitcoin Mining Company
Electricity is priced and sold in fiat currency, and it is a key input to any Bitcoin mining operation. Therefore, if a mining company wants to scale up, they either need to borrow fiat currency or sell Bitcoin on their balance sheet in exchange for fiat currency in order to pay for electricity. Most miners want to avoid selling Bitcoin at all costs, so they take out fiat loans against Bitcoin on their balance sheet, Bitcoin that has not yet been produced, or Bitcoin mining machines.
As the price of Bitcoin rises, lenders feel emboldened and lend more and more fiat currency to mining companies. Miners are profitable and have hard assets to lend against. However, the continued quality of loans is directly related to Bitcoin’s price level. If the price of Bitcoin falls rapidly, the loans will breach the minimum margin level before mining companies can earn enough revenue to repay the loans. And if that happens, lenders will step in and liquidate miners’ collateral (as I explained in the previous section).
As far as we know, this happened because a massive decline in asset prices, especially in the crypto bear market, combined with rising energy prices squeezed miners across the industry. Iris Energy is facing default claims from creditors on a $103 million equipment loan. In September, Compute North was the first major player to file for bankruptcy protection, and other large companies, including Argo Blockchain (ARBK), also appear to be teetering on the brink of solvency.
But let’s take a look at some charts to see how these waves of cryptocurrency credit crunch are affecting miners and how they’re reacting.
Glassnode published a great chart showing the 30-day net change in Bitcoin held by miners.
We can see that miners have been net selling large amounts of Bitcoin since the first credit crunch in the summer. They have to do this to try to keep their large fiat debt loads in check. If they had no debt, they would still have to pay their electricity bills, and with the price of Bitcoin so low, they have to sell more Bitcoin to keep their facilities running.
While we don’t know, and will never know, whether the maximum amount of net selling has been reached, at least we can see that mining companies are behaving as we would expect under the circumstances.
Some miners were not successful or they had to scale back their operations. This is evident in the changes in hashrate. I took the hashrate and first calculated a rolling 30-day average. Then, I took this rolling average and looked at the 30-day change. I did this because hashrate is quite volatile and it needs some smoothing.
Generally speaking, hashrate has been trending upward over time. However, there have been periods where 30-day growth has been negative. Hashrate was down after the summer crash, and then recently plummeted due to the FTX/Alameda fallout. This reaffirms our theory that miners scale down operations when there is no more credit available to finance their electricity bills.
We also know that some high-cost miners have had to stop operating because they defaulted on their loans. Any lenders that took mining machines as collateral may find it difficult to use them because they are not businesses that operate data centers. And because they can't use the machines, lenders have to sell them on the secondary market, and this process takes time. This is also what causes the hash rate to drop for a period of time.
Here is a price chart for a Bitmain S19 or other similar miner with an efficiency of less than 38 Joules (J) / Terahash (TH). As we can see, S19’s collateral value plummeted along with the price of Bitcoin. Imagine you use these miners as collateral to lend out dollars. The miner you loaned to tries to sell Bitcoin to provide more fiat to repay your loan, but is ultimately unable to do so because the profit margin decreases. The miners subsequently defaulted on their loans and handed over their mining machines in repayment, which are now worth almost 80% less than when they took out the loans. We can guess that the most frenetic loan origination point is near the top of the market. Ignorant lenders always buy the top and sell the bottom, every time!
Since CELs have a lot of mining equipment that they can't easily sell and operate, they can try to sell the equipment and recoup some of their funds, but it will be in the single digits because new mining machines are trading at 80% lower than a year ago. They can't operate a mine because they lack a data center with cheap electricity. This is why the hashrate disappears because there is no way to restart the mining machine.
Looking forward, if we assume that most mining loans have disappeared and there is no new capital to lend to miners, then we can expect miners to sell most of the block rewards they receive.
As shown in the table above, if miners sold all the Bitcoin they produce every day, it would have almost no impact on the market. Therefore, we can ignore this continuous selling pressure as it is easily absorbed by the market.
I believe that the situation of CEL and miners being forced to sell Bitcoin is over. If you had to sell, you would have already done so. If you have a pressing need for fiat, there is no reason to hold to keep going. Given that almost every major CEL has stopped withdrawals or gone bankrupt, there are no more miner loans or collateral to liquidate.
small scale speculator
These gamblers are ordinary traders. While many of these individuals and companies will certainly collapse, the failure of these entities is not expected to have large-scale negative impacts throughout the ecosystem. Having said that, their behavior can still help us guess where the bottom is.
The Bitcoin/USD perpetual contract (invented by BitMEX) has the highest trading volume of any crypto instrument. The number of open long and short contracts is called open interest (OI) and tells us how speculative the market is. The higher the level of speculation, the more leverage is used. As we know, when prices change rapidly, it can lead to large amounts of liquidation. In this case, OI’s all-time high coincides with Bitcoin’s all-time high. As the market falls, margin longs are unwound or liquidated, which also causes OI to fall.
Looking at the sum of OI across all major centralized cryptocurrency derivatives exchanges, we can see that the local low in OI also coincided with Bitcoin’s sub-$16,000 needle on Monday, November 14th. Now, OI is back to where it has been since early 2021.
The timing and magnitude of the OI reduction leads me to believe that most of the over-leveraged long positions have been extinguished. The ones left are traders using derivatives as a hedge, and those using very low leverage. This gives us a base to move higher.
Is it possible that OI could drop further as we enter the sideways, non-volatile portion of the bear market? sure. However, the pace of change in OI will slow down, meaning chaotic trading periods characterized by massive liquidations, especially on the long side, are unlikely to occur.
Timing of re-entry
what i don't know
I don't know if $15,900 is the bottom of this cycle, but I do know that the forced selling due to the credit crunch has stopped.
I don't know when or if the Fed will start printing money again. However, I think the Treasury market will become dysfunctional sometime in 2023 as a result of the Fed tightening monetary policy. At that point, I expect the Fed to start printing money again, and boom, boom, Bitcoin and all other risk assets will soar.
all that I know
Everything is cyclical. What goes down, comes up again.
I like to earn close to 5% by investing in US Treasuries with maturities less than 12 months, so I hope to earn some income while I wait for the crypto bull run to return.
What to do?
My ideal crypto asset must outperform Bitcoin and, to a lesser extent, Ethereum. These are the reserve assets of cryptocurrencies. If they are going up, my asset should go up by at least the same amount, which is called crypto beta. The asset must generate a yield that I can claim as a token holder. This yield is certainly much higher than the 5% I can get by buying a 6-month or 12-month treasury bill.
I have some super strong assets in my portfolio like GMX and LOOKS. In this article, I will not explain why I will opportunistically sell my Treasuries and buy them during a sideways bear market in the coming months. But if you want to start looking for the right assets to participate in the rise and earn income while waiting for the bull market to return, then open a site like Token Terminal and see which protocols generate real income. It is then up to you to research which protocols have attractive token economics. Some may earn a lot of revenue, but it will be difficult for token holders to withdraw their share of the revenue to their own wallets. Some protocols pay most of their revenue directly to token holders on an ongoing basis.
The best part about some of these projects is that DeFi got hammered during the two downward waves of the 2022 crypto credit crisis. Investors throw away good projects along with bad ones because they are eager to raise legal funds to repay loans. So the price-to-fee ratio (P/F) of many of these projects is really screwed up.
If I can get 5% on a treasury bond, then when I buy these tokens I should at least get 4x that, or 20%. A 20% annual rate of return means I should only invest in projects with a P/F ratio of 5x or less. Everyone has a different expected rate, but this is mine.
I could buy Bitcoin or Ethereum, but neither cryptocurrency would make me enough money. If I don't make enough, I expect that when the market turns, the price in fiat terms will rise significantly. While I believe this is going to happen, if there were a cheap protocol where I could get rewards in Bitcoin and Ethereum, plus benefits from actually using the service, that would be great!
Investing when you think the bottom is definitely risky. Do not be afraid, O brave and upright warrior, for the spoils of war shall go to the faithful.
