The Jolly Contrarian Life

Hello everyone

Following a sequence of minorly unfortunate but quite improbable incidents — at one point JC wondered whether he was in an episode of Game For A Laugh — there won’t be a fully thought-out newsletter this week.

But I offer a couple of thoughts about Bitcoin, seeing as I have been updating the JC’s prime brokerage section and Bitcoin has finally crossed that magical US$100,000 threshold.

It got me to thinking about the parallels between Bitcoin and our old friend Archegos.

What goes up?

There are plenty of theories about what Bitcoin is for — the fiendishly interested can see JC’s recent review of Bitcoin is Venice for truculent exploration of some of the better ones — but it does not seem to be in much use as a currency. You don’t buy things with it. You just buy it, hold it, and it goes up in value. Line Goes Up.

Seeing as — by quite deliberate design— there is no underlying fundamental at all to Bitcoin: it really is an abstract yardstick entirely divorced from the real economy — the only thing driving its valuation is collected opinion. As long as there are enough buyers in the market with the expectation it will continue going up and the means to continue buying, it will continue going up. Sellers will book their profits, and then watch in exasperation as it keeps going up.

It doesn’t matter why the market thinks it will keep going up. It is hardly news that markets become euphoric and, at their extremes, irrational.

Bitcoin has a logical conundrum, though. On the one hand, as the quintessential abstract token of value, it should hold a stable, immutable value, against which objective standard the rest of the economy can be measured — in a perfect world, Bitcoin would be as stable as metric metre, forever dispelling the vagaries of fiscal policy that propel fiat currencies in their frenetic dance — but if that were the case, the line would not go up. It would say flat, while the value of capital engaged in the productive economy, against that flat line, that would go up.

But “line stays flat” is nothing for HODLers to get excited about. If Bitcoin prices just stay put, why would anyone want to hold Bitcoin for any longer than absolutely necessary? In that case, Bitcoin would, waste away against real capital exactly the same way fiat currency does. We discussed the “wasting” nature of cash a bit in last week’s episode.

There would be no holding on for dear life: investing in Bitcoin would be like chasing parked cars.

Now, this is problematic for a crypto-currency and one of the central paradoxes at the heart of a permissionless distributed ledger. The problem goes like this:

* An ideal cryptocurrency would be an immutable, unchangable, perfectly stable store of value. That is what currencies are meant to do.

* A distributed ledger depends on “miners” deploying colossal amounts of processing power to solve problems to validate transactions on the blockchain. This involves expending resources (energy, processing power). Miners need some economic reason to be bothered doing that. Ideally, they would like to be paid.

* In a permissionless distributed ledger there is no central owner or administrator who can pay miners for this vital mining activity.

* This was Satoshi Nakamoto’s brilliant insight. He solved that problem by generating cryptographic tokens on the ledger itself. These could, by code, be minted and awarded to miners in return for proof of work.

* But, problem: these tokens don’t have any intrinsic value of their own —Satoshi Nakamoto just made them up — so miners will quickly want to exchange them into currencies which do have intrinsic value. To do that they must persuade someone else not just that these tokens have a value, but that they will rise over time. (If it did not, why would anyone buy them?) You need, in short, someone gullible. Enter HODLers.

* Such a belief in Bitcoin — that “line goes up”, “we’re all going to make it”, “we’re going to the moon”, “hold on for dear life” and so on — is now so pervasive in the market that, ironically, it seems to be more or less true. For now. But the market remains widely distributed, mostly unregulated and largely retail in nature. That is, gullible.

* The cryptocurrency “consensus” has quietly moved: Bitcoin is not a stable store of value and is almost never used as one. It is an appreciating asset. A paradox at the heart of the project: to be a viable product it has to go up, but to be a better currency, than what we already have, it has to stay stable.

Now if Bitcoin really were a reliable stable store of value, it would have achieved something no Fiat currency has managed.

But the market has had other ideas. Bitcoin’s price trajectory has been markedly more volatile than any other currency (or asset) in the nearly fifteen years it has been around. Bitcoin is still valued in U.S. dollars.

Are we off to the moon then? Only a fool would predict where and when — but we should not expect Bitcoin to be immune to the same price pressures as other assets. It is driven by supply and demand.

The Archegos example

The Archegos comparison is sobering:

Vipshop, Tencent and Baidu — illiquid, thinly traded stocks — rose irrepressibly in the dog days of March 2021.

We know now there was only one buyer in the market: Archegos’s Bill Huang. He was trading “on margin” at extremely tight “haircuts”: as low as fifteen or ten per cent, meaning he was borrowing up to ninety per cent of the purchase price of the stocks from his prime brokers. Being illiquid, the more stocks Huang bought, the higher their prices went.

This created “equity” in Archegos’ portfolio. For reasons explained elsewhere — but in JC’s view they are not good reasons — swap dealers must pay unrealised gains out to customers in cash variation margin.

Huang used the cash to double down on the same companies.

It was only when ViacomCBS went to raise capital on the back of its “spectacular” stock market performance that all hell broke loose: no one — not even Archegos, which by now was completely tapped out of credit with its brokers — expressed interest in the shares, and suddenly existing holders sprinted for the exits. The result was — ouch:

Now, when you are five times levered, a drop like that can wipe you — and sometimes, your prime broker — out.

Is the Bitcoin increase the same?

The chart looks familiar, but the scenario is a bit different: firstly, Bitcoin is hardly an illiquid market: it is a widely traded retail investment. There are a lot of people in it, and a lot of people invested in it. No one is cornering the market.

Secondly, we don’t know how many people are investing “on margin”, although there’s reason to believe there are some. Most trad-fi institutions stopped financing cryptocurrency after FTX blew up in 2022, but crypto platforms like Binance and Coinbase offer margin trading.

Nonetheless, the pool of margin finance investors is significantly wider: whereas Archegos was more or less the only investor in its markets, Bitcoin is widely held by retail investors and margin financing is readily available, at least from crypto platforms, some of whom will accept crypto assets as collateral.

A key feature of the Archegos situation was the unvirtuous circle of Archegos drawing down equity on its profitable positions and ploughing that equity back into the same positions, forcing them upward and generating yet “phantom equity”. This was a cavalier strategy for a single fund in a thinly traded corner of the market.

Since Bitcoin is so widely traded, the concentration effect might seem unlikely, but networked retail investors can behave as a herd, and that may create a similar amplifying effect. There is an element of “membership” to cryptocurrency trading: investors are engaged in discussion forums and on social media, and there is an element of dissociation from “no-coiner” outsiders. In fair times, this fortifies the currency against “ignorant” criticisms from without: should there be significant market corrections that sentiment might quickly turn (though it has been remarkably resilient to date!

It remains trivially true that an investment in Bitcoin at $10 was a better trade than an investment at $100,000. Perhaps the line can continue inexorably up, but no one has managed to explain why that is necessarily so. If it does continue its upward trend, a “present investment” becomes a progressively worse “buy” investment, and a progressively better “sell”.

At some point, investors will want to liquidate their investments and enjoy the wealth it brings them: a line that goes ever upward is great, but at some point, investors will want to convert their investments into the proverbial condo in Miami. That should put some downward pressure on prices unless other investors come in who are still prepared to ride the train. This depends on a geometrically increasing class of new investors. Populations are stabilising: there does not seem to be such a thing. This is the basic mechanism of a Ponzi scheme.

The market can of course remain irrational longer than JC’s hot takes can remain plausible so we’ll have to see, but few exuberant market pile-ons like this end well.

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Playlist

On that uplifting note, I’ll wish you a happy Christmas and set you off on your way with the JC’s “So Uncool it is Cool” playlist for you to put on when you are stuffing the bird.

Faith No More covering the Commodores is just — perfect.