The Bezzle and FTX

 

It is hard to get a full handle on what happened to the FTX exchange and the crypto market in the last week. We know that FTX filed for bankruptcy. We know from filings that the liabilities exceed assets which may be at inflated levels. We know that customer funds are frozen, and they were used to support the FTX trading arm. We know that FTX is both a cause and casualty of a crypto-bubble popping. 

We should not be surprised by this story. We have seen it before. It has occurred during other periods of market excess. The bezzle is the period when an embezzler has his gain, and the victim has no loss. Charlie Munger would refer to this financial illusion as the febezzle or functional equivalent of the bezzle when psychic wealth is created even without illegality by mistake or self-delusions. This was the period before the FTX failure. 

We have moved from Galbraith's bezzle to bankruptcy. As Buffet would say, the tide has moved out, and we will find out who is wearing swim trunks. There was Ponzi, the Match King, Madoff, and assorted other characters during bubble who made wild promises only to generate a house of cards. Sam Bankman-Fried may be added to this list, a persona based on a flim-flam mixed with hubris, poor management, and hucksterism.

We will now have an investigation. There will be more regulation which is late to solving the problem. Participants of the exchange who had funds at FTX will take losses as general creditors, investors in the company will write-down investments, and we will ask how this happened and tell tales of greed and excess which will serve as a warning for future investors. It will happen again. 

Once again - greed, FOMO, and ignorance play a key role with investors parting with their money. The big tale of crypto taking over finance is over. The only story will be about a bubble and its aftermath.

Cryptocurrencies - What are factors are they related to?

Determining what are the factors that are related to cryptocurrencies is not easy because most of the evidence suggest that cryptos are independent of other assets, risk factors, and macro-variables. This asset class has a mind of its own. The most exhaustive study shows very little relationship with independent variables that impact other asset classes, see "Risks and Returns of Cryptocurrency"

The table below summarizes the research. Perhaps some of the results are related to the high crypto volatility and will change as the market matures. One year in the life of crypto currencies may match years for other asset classes; nevertheless, there is little evidence supporting the idea that traditional risk factors can explain crypto behavior.

The complex ecosystem for gaining crypto exposure

The landscape for cryptocurrencies is getting more complex not simpler. Complexity comes from the process of experimentation with how to employ blockchains and the development of new ways to enhance the usage of cryptocurrencies as a store of value and medium of change. Like many industries, growth will lead to winners and loser. There have been significant failures, hacking, and fraud. There has been significant adoption my many major corporations and new payments experimentation. There will be creative destruction as users and usage sort out how to best exploit this technology. 

However, growth and maturity also lead to financial innovation and complexity on how to access, finance, and trade cryptocurrencies. Innovation will attempt to reduce the cost of trading and gaining exposure. Some of these developments are related to the regulatory environment. Innovation will also occur in an effort to reduce the cost of regulation and avoid market impediments for usage. At the same time, regulators will attempt to serve in a role of facilitating the common good through helping to form standards for usage to protect investors. The goals between investors and regulators should be aligned; however, in a rapidly changing market, regulator may be perceived as slow moving versus the crypto innovation crowd.

A simple financial map (from CAIA blog) for accessing crypto exposure shows the market broadening. There is direct, traditional, and futures markets available for investors; however, not all are the same and there exists inefficiencies in pricing across these marketplaces. Investors must focus on these cost and pricing differences. 

Is Bitcoin (BTC) "digital gold"? Ethereum (ETH) "digital oil"?

Bitcoin is beginning to be referred to as "digital gold" while Ethereum (Ether) is referred to as "digital oil". These are strong commodity metaphors that can be useful for investors. These turns of the phrase are based on their fundamental use and provides a framework for where their growth may be headed. Of course, metaphors are not perfect, but they do provide a point for discussion.

Bitcoin is mainly a store of value and has taken on the features of gold for many investors. Gold has been the alternative to fiat currencies. For many, the limited supply relative to fiat currencies make bitcoin a worthy substitute. It also has the characteristics of gold in that it is not easy and cheap to use as a medium of exchange. It can fill this exchange role given its dominance in the marketplace; however, other cryptocurrencies may do it better. The metaphor breaks down when the volatility of Bitcoin is compared with gold. A chart of the differences makes gold look like it has flat-lined over the last few years.

Ethereum is general purpose blockchain developed for smart contracts and Decentralized apps. As a network and platform, it allows for innovation and other alternative uses within the crypto ecosystem, smart coins; consequently, it has characteristics of a "fuel". The platform allows for conversions at low cost. This ability to be used as a platform for other medium of exchange activities suggest that it may surpass BTC as tool for crypto growth. 

To further push this metaphor, holding BTC and ETH is like holding a basket of commodities. Both have unique value. 

Crypto correlation - no clear relationship with hedge funds and equities

 

Cryptocurrencies and crypto hedge funds have a return performance life independent of other asset classes and strategies. This is one of their clear benefits but also the reason for why many investors have a problem with crypto. It is not clear what are the drivers for return. Certainly, crypto has moved higher with the stock market and has gained from the excess liquidity across global markets; however, finding independent drivers for price has not been easy.  Some simple analysis from FactorResearch tells the story. 

The correlation between crypto hedge funds, the S&P 500 and the top 50 hedge fund index shows both negative and positive correlation over the last six years. The correlation has ranged between -.6 and .8 with more recent numbers again closing in on zero. 

However, the returns for crypto hedge funds seem to be driven by Bitcoin beta. These hedge funds have the feel of long-only investments with limited downside protection. 

Applying known investment strategies to crypto asset makes sense, but it cannot be expected to have the same return patterns.

Holding bitcoin ETFs given the futures contango - A difficult game

 

Bitcoin futures ETFs have started to be traded with the excitement associated with an easy method for investors to access bitcoin price activity; however, these instruments are not linked to the cash market but rather to bitcoin futures. This feature has significant implications for investors because these ETFs will be subject to roll risk. If the underlying futures market is in backwardation, long trades will gain from the roll-up the futures curve, but if the market is in contango, there is a negative cost from holding the long futures. 

So, what is the cost from holding bitcoin futures ETFs? The bitcoin futures market is in contango which creates a return drag. If the cash price does not move, the investor will lose on the roll cost.  

The cost of this contango effect is significant. The drop from second to first month bitcoin futures is over 11% on an annual basis on November 22. The futures are listed monthly. The cost is over 7% for third to second futures and 6% for fourth to third futures. Unfortunately, the liquidity for the back months is significantly lower than the front month, so trading is concentrated in the front two contracts. Volume in the front month is averaging a few thousand contracts while five months out the volume is less than 30 contracts. 

To make money, the ETF investor has to overcome management fees that are close to 100 basis points, pay the transaction costs associated with the trading, pay brokerage on their transaction, and pay the roll costs which means that the hurdle necessary to make a positive return is well over 10% for trading the most liquid futures. 

There have been similar high costs associated with trading crude oil ETFs associated with the futures contract when the market is in contango; however, more liquid back months have allowed trading along the crude oil futures curve. Investors need to be aware of the market's structural costs before entering into these investments. 

Fidelity survey - Digital asset interest increasing - What are you going to do with digital assets in 2021?

 

Fidelity Digital Assets generated the Institutional Investor Digital Asset Survey earlier this year that will have implications for investment research and asset allocations next year. More than 25% of US investors now have allocations to digital assets. Over 50% of US investors have direct investments in digital assets and one in five investors have  digital asset exposure via futures. The survey was quite extensive with close to 800 investors participating and was conducted by Greenwich Associates.

There is no question that central banks are taking a close look at digital assets and they will play an important role as a medium of exchange. Investors will have to watch these developments and have a view on how to play it for their portfolios.  

It has helped that digital assets have shown strong performance in 2020, but there are a number of reasons for the strong investor interest this year. There is a growing interest in digital assets as an alternative currency and as a substitute for holding gold. What to do with digital assets is another key question for 2021. 

Bitcoin price moves and networking effects - The difference between social and financial networks is important

Crypto-currencies are in strong market downturn with a 40% decline in the last month and more than 20% in a single day earlier in the week only to be followed by  strong gain of more than 30%. There has been a wide amount of buzz about bitcoins, yet this decline has not really impacted other financial markets. What is clear is that bitcoins are not integrated at this time with other financial markets so there are limited network effects.

It is important to start to think about network effects and  social networking is not the same as networking of financial markets. What separated the Great Financial Crisis was the networking of leverage, financial institutions, and product distribution. When networking of financial markets is high, there will be spill-over effects that impact multiple markets. A bank that is stressed can impact a broad range of financial markets based on their lending arrangements. A shock in one commodity can affect lending and risk-taking across all commodity markets.

A financial shock that is not networked across markets will have limited impact outside of the immediate participants. In the case of crypto-currencies, there are strong social networks with talk on social media, but there is limited leverage and connection to financial institutions. Hence, a bitcoin shock will make news but will not impact the financial wealth process. 

This is important because I believe the "new global macro" thinking is more focused on understanding network effects and how they may affect cross-market price relationships. Understand the networks and you can exploit changes in correlation.