Original title: Persistent Weak Layer

Author: Arthur Hayes, Founder of BitMEX; Translated by: Deng Tong, Golden Finance

I spent the first two weeks of October skiing in the South Island of New Zealand. I had spent the previous season in Hokkaido, and my guide assured me that New Zealand was one of the best places in the world for backcountry skiing. I took his word for it and spent two weeks with him, chasing powder and big lines from Wanaka. The weather was great, and I was able to ski over some spectacular peaks and across huge glaciers. As an added bonus, I also improved my alpine climbing knowledge.

Storms in the South Island are ferocious. When there is bad weather, you sit at home or in a mountain cabin. To kill time, one afternoon my guide gave me a course in avalanche science to pass the time. I have done many avi trainings since I first went into the backcountry of British Columbia as a teenager, but I have never taken a proper certification course.

This information is fascinating and thought-provoking because the more you learn, the more you realize that when you ski in avalanche terrain, there is always a chance that you will be caught in an avalanche. Therefore, the goal is to reduce the risk to an acceptable level.

This course introduces you to different types of snowpack and how they can cause avalanches. One of the most terrifying scenarios is a persistent weak layer (PWL), which when stressed can trigger a sustained slab avalanche.

In avalanche science, a PWL refers to a specific layer of snow in the snowpack that is structurally weak over an extended period of time, significantly increasing the risk of avalanches. These layers are particularly dangerous because they can lie deep within the snowpack, dormant and unstable for weeks or even months until they are finally triggered by additional stress, such as skiers or more snowfall. Knowing that PWLs exist is critical to avalanche forecasting, as these layers are often responsible for large, deep, and deadly avalanches.

The geopolitical situation in the post-World War II Middle East is fundamental to our modern global order. The trigger is usually related to Israel. From a financial market perspective, we are concerned about how energy prices will react, how global supply chains will be affected, and whether a nuclear weapons exchange will occur if hostilities escalate between Israel and another Middle Eastern country, especially Iran or its proxies.

As investors and traders, we are on a precarious but exciting slope. On one hand, major countries or economic blocs are reducing prices and increasing the quantity of money as China officially kicks off its money printing reflation. Now is the time to take the biggest long-term risk, and I am obviously referring to cryptocurrencies. However, if the Israel/Iran situation continues to escalate and results in the destruction of Persian Gulf oil fields, the closure of the Strait of Hormuz, or the detonation of a nuclear bomb or device, the crypto market could suffer a massive sell-off. As they say, you can't invest in war.

I face a choice: do I continue to sell fiat to buy crypto, or do I reduce my crypto exposure and hold cash or Treasuries? If this is indeed the start of the next leg higher in the crypto bull market, I don’t want to be underallocated. Still, I don’t want to burn capital if Bitcoin drops 50% in a day because Israel/Iran sparked an ongoing financial market avalanche. Forget Bitcoin; it will always bounce back; I’m more worried about some shit in my portfolio… memecoins.

As I think about how to allocate Maelstrom’s portfolio, I want to walk readers through the simple scenario analysis I’m using.

Scenario

Scenario One: The Israel/Iran conflict devolves into tit-for-tat, small-scale military operations. Israel continues to assassinate civilians and behead people, while Iran responds with telegraphed, non-threatening missile strikes. No critical infrastructure is destroyed, and no nuclear strike occurs.

Scenario 2: An escalation of the Israel/Iran conflict culminates in the destruction of some or all of the Middle East oil infrastructure, the closure of the Strait of Hormuz, and/or a nuclear attack.

The persistent vulnerability layer holds true in Scenario 1, but fails in Scenario 2, leading to an avalanche in financial markets. Let’s focus on the second outcome, which would endanger my portfolio.

I will evaluate the impact of the second scenario as it specifically affects the cryptocurrency market, but primarily Bitcoin. Bitcoin is the crypto reserve asset and the entire crypto capital market will follow its lead.

I am more concerned that now that the United States has committed to deploying the THAAD system in Israel, Israel will up the ante. Israel is definitely planning a large-scale attack, to which they expect Iran to respond strongly. Moreover, the more Israel publicly states that it will not attack Iran's oil or nuclear facilities, the more I believe that this is exactly what they are planning.

The United States said on Sunday it was sending U.S. troops and an advanced American anti-missile system to Israel, a highly unusual deployment aimed at bolstering the country’s air defenses following Iranian missile attacks.

Source: Reuters

Risk 1: Physical destruction of Bitcoin mining machines

War is physically destructive. Bitcoin mining rigs are the most valuable and important physical manifestation of the cryptocurrency. What will happen to them?

The main assumption of this analysis is which part of the world the conflict dynamic will spread to. While the Israel/Iran war is just a proxy war between the US/EU and China/Russia, I don’t think either side wants to attack the other directly. Furthermore, the final belligerents are all nuclear powers. The US is the most aggressive militaristic power in the world and has never directly attacked another nuclear power. This is telling because the US is the only country to deploy nuclear weapons (at the time, they scared Japan into surrendering by nuking two cities in order to end World War II).

The next question is, is there a significant amount of Bitcoin mining activity in Middle Eastern countries? According to some media reports, Iran is the only country where Bitcoin mining is thriving. According to sources, Iranian Bitcoin miners account for up to 7% of the global hash rate. What would happen if Iran's hash rate dropped to 0% due to internal energy shortages or missile attacks on facilities? Nothing.

Here is a chart of the Bitcoin network hash rate from January 2021 to March 2022.

Remember when China banned Bitcoin mining in mid-2021, the hash rate quickly dropped by 63%?1 The hash rate recovered to its May 2021 high in just eight months. Miners moved out of China, or other global players were able to increase their hash rate due to more favorable economic conditions. On top of that, Bitcoin hit a new all-time high in November 2021. The severe drop in network hash rate did not have a noticeable impact on the price. Therefore, even if Iran were completely wiped out by Israel or the United States, which would result in a 7% drop in global hash rate, it would not have any impact on Bitcoin.

Risk 2: A sharp rise in energy prices

The next consideration is what would happen if Iran destroyed major oil and gas fields in retaliation. The Achilles’ heel of the over-leveraged Western financial system is the shortage of cheap hydrocarbons. Even if Iran could destroy the Israeli state, it would do nothing to prevent war. Israel is merely a useful but expendable appendage of Pax Americana. If Iran wants to strike a blow against the West, it must destroy hydrocarbon production and prevent the transit of laden recipients of oil through the Strait of Hormuz.

As oil-scarce countries will use other energy alternatives to power their economies, oil prices will soar, dragging all other energy prices higher. What will happen to the fiat price of Bitcoin?

Bitcoin is energy stored in digital form. Therefore, if energy prices rise, Bitcoin will be worth more relative to fiat currencies. Bitcoin mining profitability will remain the same, as all miners face a parallel rise in energy prices. Ensuring energy security may be more challenging for some large industrial miners, as utility companies invoke force majeure clauses and cancel contracts at the request of governments. But if hashrate drops, mining difficulty will also drop, making it easier for new entrants to mine Bitcoin profitably at higher energy prices. The beauty of our Satoshi-sama’s creation will be on full display.

If you want a historical example of hard currency’s resilience to energy shocks, consider how gold traded from 1973 to 1982. In October 1973, the Arab oil embargo began as retaliation for U.S. support for Israel in the Yom Kippur War. In 1979, Iranian oil supplies were removed from global markets following the revolution that overthrew the Western-backed shah and established the current theocratic regime of Ayotollah.

Spot oil (white) and gold (yellow) prices against the US dollar index of 100. Oil is up 412% and gold is almost following it with a 380% gain.

This is the price of gold (gold) versus the S&P 500 (red) divided by the price of oil, with the index being 100. Gold bought only 7% less oil, while stocks bought 80% less oil.

Assuming that either party removes Middle Eastern hydrocarbons from the market, the Bitcoin blockchain will continue to function and the price will at least maintain its value. Energy, and energy in fiat currency terms, will certainly rise.

Let's move on to the final monetary issue.

Risk 3: Currency Risk

The key question is how the United States will respond to this conflict. Both political parties firmly support Israel. The United States supports Israel by providing weapons. Since Israel cannot afford to buy the weapons needed to wage war against Iran and its proxies, the US government borrows money to pay American arms dealers such as Lockheed Martin to provide ammunition to Israel. Since October 7, 2023, Israel has received $17.9 billion in military aid.

The US government buys goods with credit, not savings. This is what the above graph conveys. In order to provide free weapons to Israel, the bankrupt US government needs to borrow more. The question is, who will buy this debt if national savings are negative? The green arrows show a situation where the US has negative net national savings. Luke Gromen correctly points out that these arrows correspond to the following:

The arrow in the above chart corresponds to a sharp increase in the size of the Fed's balance sheet. As the United States plays the role of warlord by supporting Israel's military actions, it must borrow more money. Just like after the 2008 Global Financial Crisis (GFC) and the COVID-19 lockdown, the balance sheet of the Federal Reserve or the commercial banking system will asymptotically rise to buy this increased debt issuance.

How Would Bitcoin React to Another Major Increase in the Fed’s Balance Sheet?

This is the price of Bitcoin divided by the price of the Federal Reserve's balance sheet, with the Fed's balance sheet index being 100. Since its inception, Bitcoin has outperformed the Fed's balance sheet by 25,000%.

We know that war causes inflation. We know that the U.S. government must borrow money to sell bombs to Israel. We know that the Federal Reserve and the U.S. commercial banking system will buy up this debt by printing money and expanding their balance sheets. Therefore, we know that Bitcoin will rise sharply in fiat currency terms as the war intensifies.

What about Iran's military spending? Will China/Russia help Iran's war effort in some way? China is perfectly willing to buy Iran's hydrocarbons, and China and Russia sell Iran's goods; however, none of these deals are on credit. From a cynical perspective, I believe China and Russia will act like cleanup crews. They will publicly condemn the war, but will not do anything noteworthy to prevent Iran's destruction.

Israel is not interested in nation building. On the contrary, they would be happy if the Iranian regime collapsed due to popular unrest as a result of their attacks.

China and Russia’s support will not expand the global fiat money supply, if you want to call it that. Therefore, it will not have a noticeable impact on the fiat price of Bitcoin.

Intensifying conflict in the Middle East will not destroy any of the critical physical infrastructure that supports cryptocurrencies. As energy prices soar, Bitcoin and cryptocurrencies will rise. Hundreds or trillions of newly printed dollars will re-energize the Bitcoin bull market.

Trade with caution

Just because Bitcoin will go up over time doesn’t mean the price won’t fluctuate wildly, or that all shitcoins will share the glory. The name of the game is to position yourself appropriately.

I was prepared for a wild mark-to-market pullback in any position I held. I cut those positions drastically when Iran launched its latest wave of missiles at Israel. Given the unpredictability of how crypto assets would react to heightened hostilities in the short term, my exposure was too large.

I have not yet instructed Akshat, Maelstrom's head of investment, to slow down or stop our pace of deploying funds into pre-sale token exchanges. With the idle fiat currency held by Maelstrom, I will stake it on Ethena and earn some huge gains while waiting for good entry points into various liquid shitcoins.

The worst thing I can do as a trader is to trade based on who I think is the "right" side in this war. This will lead to you going bankrupt as both sides of the war will experience financial repression, complete asset confiscation, and destruction. The best thing to do is to get yourself and your family out of harm's way and then put your money into instruments that can outlast the depreciation of fiat currencies and maintain their energy purchasing power.

Notes

1 - I say this because when looking at the IP addresses of miners submitting blocks, China is still one of the largest places for Bitcoin mining.