BitMEX Founder: Is the Cryptocurrency Problem Really Leverage
Originally written by Arthur Hayes
I Still Can't Draw a Line
Original text: 0x71, beat the Block Beats
A few days ago, Michael Burry, the original protagonist of the movie "The Big Short," said that all the hype and speculation was the cause of the crash, and that when cryptocurrencies fall from trillions of dollars, or Meme stocks fall from tens of billions of dollars, retail losses will approach the size of the country. As with most assets, the problem with cryptocurrencies is leverage. "If you don't know how much leverage there is in cryptocurrencies, you don't know anything about cryptocurrencies," he said.
In the financial world, "leverage" instruments magnify risk. Countless people have been lecturing traders on the power of leverage, and countless others have been ruining themselves in practice.
What role does leverage play as a financial instrument in the crypto world? Bitmex founder Arthur Hayes responded to Michael Burry's point of view in his article "I Still Can't Draw a Line" and shared his objective views on traditional finance, crypto finance and leverage.
(Any of the views expressed below are those of the author, which apply only to the financial system of the author's country, and should not be used as a basis for investment, nor do they represent the position of Blockchain.)
The rhythmic BlockBeats excerpts from the highlights, compiled as follows:
Many very smart economists pooh-pooh the crypto financial market because of the platforms that offer highly leveraged transactions in the crypto world. They are afraid of leverage, and they know that leverage will hurt the TradFi (traditional financial system) it supports. However, they do not fundamentally understand the difference between Tradfi and the crypto financial market. The paper will argue that the Tradfi system is inherently unstable, that the leverage used by the participants always ends up being paid by taxpayers and fiat users, and that the aid must be exaggerated to cover the banks' losses. Crypto financial markets, on the other hand, can withstand declines of up to 50% in a single trading day, and the underlying blockchain value delivery system does not require any assistance.
People who should know more about cryptocurrencies, based on economists' deep knowledge of the fractional-reserve-based legal credit financial system, often mock cryptocurrencies by making casual comments about highly leveraged transactions. More recently, I read in Grant's "Interest Rate Observer" (May 28, 2021) :
"As recently as two weeks ago on Wednesday, with the federal funds rate at zero, Just $9.4 billion in margin clearing could take cryptocurrency market value from $2 trillion to $1.4 trillion. Vijay Ayyar, head of cryptocurrency trading platform Luno Pte Asia Pacific, told Bloomberg that the crypto market is still a "Wild West" compared to other asset classes, On some trading platforms you can trade with as much as 50 to 100 times leverage."
An important point I want to make in this article is this: Yes, the crypto financial market is unstable, and this wild volatility is driven by leverage that affects the short-term prices of various tokens. However, I would also like to share some very simple indicators of how leverage works in the system and how the social loss model used by all the leading crypto centralized derivatives platforms ensures: 1. The Platform shall be protected at all times. 2. User's debts shall not exceed its initial margin. This is in direct contrast to the unlimited liability that users face for using intermediaries in Tradfi and the possibility of all trading halts on a volatile trading day. Can I play Can "t Stop, Won" t Stop, GameStop at your local AMC theater? (Here the author uses rhymes to satirize GameStop and Tradfi.)
For those crypto speculators sitting at the new cryptocurrency trading desk at Tradfi Bank, this is a must read if you want to understand how leverage works in the crypto financial markets. You're no longer in Kansas, and your year-end gains will be based on predicting short-term price movements. If you don't understand these concepts, you should immediately go back to Dallas and play the stock market.
Foundation of Monetary System & NBSP;
The monetary system can be roughly divided into three parts.
Unit of Money -- a unit of account used to store value and to pay for goods and services.
Value transfer mechanism - how the monetary unit is transferred between the participants in the monetary system.
Financial intermediation -- an entity that provides financial services to the system. The most important function of financial intermediation is to collect units of money from savers and funnel these savings to financial entities that wish to borrow money at interest rates.
The following simple table describes the difference between Tradfi and Crypto.
Currency unit:
TradFi: Official fiat currency, such as dollars, euros, etc.
Crypto: Crypto native tokens, such as BTC, ETH, etc.
Value Transfer Mechanism: & NBSP;
Tradfi: Cash and Bank Transfer & NBSP;
Crypto: public chain & NBSP;
Financial intermediation:
Tradfi: Bank & NBSP;
Crypto: Centralized and decentralized trading platform, digital wallet, mortgage lending business & NBSP;
There are some fundamental differences between Tradfi and Crypto, and using leverage within the system can lead to different results.
Monetary unit & NBSP;
TradFi
The authorities issue a unit of money, and they determine the amount of money to be issued, which we call fiat money. A central bank is an official branch usually responsible for maintaining the financial system. The central bank supervises commercial banks, which issue money by making loans. Both central banks and commercial banks can expand the money supply by issuing credit.
Crypto
If a participant chooses to run some crypto open source software, there are a set of rules in the network that all participants must agree to, and native tokens are issued and managed by those rules. The total number of tokens in circulation can be changed, but this requires the consent of at least 51% of participants. In the case of Bitcoin, network participants agreed that only 21 million Bitcoins would be mined, and that no individual or institution could unilaterally change the supply.
To highlight
In Tradfi, if the money supply needs to expand or contract, the authorities can change the supply without the consent of other participants. In the crypto world, you can't change your currency issuance plan unless you have the consent of the majority of the network. The more people who contribute resources to the network, the harder it is to reach agreement. So the more successful an encrypted network is, the harder it is to change.
Value Transfer Mechanism & NBSP;
TradFi
用户可以持有钞票或者活期存款。基于 TradFi 系统的复杂性和全球性，除非用户在当地购买商品和服务的情况，否则不会使用现金。绝大多数资金都存放在银行，银行从官方获得执照，其本质是一张印钞许可证，因为银行被允许发行信贷，尽管他们是私人实体（仅限国外）。 没有银行，价值就无法在各方之间转移。换句话说，如果银行出于某种原因倒闭，价值将停止在经济参与者之间流动。我们将稍后再次讨论这个潜在的可怕假设。
Crypto
在加密世界，任何有计算能力和网络的实体都可以验证和发布区块。对于像工作量证明（Proof-of-Work）等共识算法，实体规模越大，出块就越高效。在 2021 年，个人使用家用电脑来挖比特币已经几乎不可能。然而，如果所有大型矿场都下线，比特币网络将自行调整出块难度，业余矿工将有机会再次挖掘和发布区块。 在区块链网络中，整条链开放平等，任何人都可以向网络贡献算力，不需要权威第三方进行授权。这就是公有链反脆弱的关键原则，大玩家被淘汰并不会导致整个系统的崩溃。
To highlight & have spent
If all the banks fail, the Tradfi system will cease to function effectively. But if all the big miners are eliminated, the Crypto system will adjust to block difficulty and value can still be transferred between parties.
Financial intermediation & NBSP;
TradFi
In the traditional financial system, the most important and largest intermediary is the bank. Banks are officially licensed to accept deposits. They could double those deposits by lending to high-net-worth borrowers (printing money), and they could use the bank's equity and deposits as collateral for the loans. The central bank dictates how much leverage banks can use, but if all customers want to withdraw their deposits at the same time, banks cannot meet all requirements. In fact, the authorities can print enough money to help the banks repay their debts. As a result, when a bank faces a crisis, it becomes a matter of political choice which part of the population's deposits will lose value.
Crypto
In a blockchain network, you don't need to go through any entity to interact with the public network. You are your own financial institution. So there are benefits to centralisation, as a range of private intermediaries can provide depositing, lending, trading and so on, and these firms can also provide a lot of leveraged trading. But because neither entity can issue tokens on the chain again, no one can refund users' lost money in the event of a crisis for the intermediary.
To highlight & have spent
In a traditional financial system, when a bank faces a crisis, the authorities can issue enough fiat money to cover the bank's debts. For the crypto intermediary, if the company fails to live up to its promises, the user is bound to lose some or all of their money.
The problem & have spent
The fundamental problem with Tradfi is that banks operate the value transmission system and are the biggest intermediaries. The authorities are concerned with the stability of the wider financial system, so if the banking system becomes over-leveraged and suffers catastrophic losses, the authorities must bail it out. In fact, the authorities could issue enough money to cover all the banks' losses. This means that every time a bank suffers a crisis, the authorities will do so, especially as the global economy becomes more complex and interconnected. The only mechanism that might dissuade the authorities from helping the banks is the inflation in the prices of goods and services that would result from excessive money printing.
Banks, as private institutions, will take as many risks as they can within the rules once they understand that the authorities will bail them out for the sake of wider financial stability. Banks don't need to use common sense to judge whether the rules are reasonable, they just need to follow them! The complexity and size of the current global economy also require banks to be publicly financed companies listed on national stock markets so that they can be real players at the poker table.
Bank executives receive annual bonuses for taking risks and are encouraged to take as many risks as possible. These risks could be trading stocks, or borrowing money from a particular sector of the economy. If the outcome is not satisfactory, mass shareholders will suffer losses and may even be wiped out. But bank managers are likely to keep their jobs because they are needed to keep running the bank and deliver value. If the result is ideal, they will get a big bonus. Matt Levine of Bloomberg Money Stuff always quips that investment banks are socialist havens run for the sole purpose of providing welfare to their employees.
That's why "leverage" is a dirty word. Everyone knows that leverage will destroy the banking system, and if it does, the authorities will step in, print money and possibly create inflation. What they fail to see is that the solution to this problem should be to ensure that the transmission of value is not managed by for-profit financial intermediaries.
Bitcoin is a pioneer of distributed ledger technology, which allows central bank digital currency (CDBC) to run on private chains. The central bank could nationalise the value transmission mechanism by offering all citizens direct access to official digital bank accounts. The problem is that it would radically change the way "too big to fail" commercial banks operate. In essence, the central bank will compete with the commercial banks it supervises.
Why would customers hold dollars from commercial banks if there were Federal Money issued by the Federal Reserve? Users may hold currencies other than Federal dollars only if the interest rate is attractive enough. Interest rates are attractive only when third-party financial intermediaries borrow from competent entities. Because these businesses can pay the right interest rates, there is less risk to the public. That, my friend, is what banks are supposed to do. But because banks have a licence to print money and are officially strict about what they can do, they bet on risky assets and go bust, with a Christmas bonus.
Lazy economists and macroeconomists mistakenly believe that crypto markets work in a similar way to Tradfi. It's not. In crypto markets, the mechanism of value transmission is out of the control of financial intermediaries. Therefore, financial intermediaries in the crypto market live and die by their business models and risk management systems. If they go bankrupt, there is no savior. Unfortunately, the user loses money, but the network continues to operate as the code dictates.
Leveraging in the crypto world will not cause the ecosystem to collapse, and any losses will remain local, limited to the holder of an intermediary's IOU or the individual's crypto assets.
How Leverage Works in the Crypto World
What exactly is Bitcoin? Is it an asset, a currency, a commodity, data, or a network? It is part of all of these things at the same time, and it is difficult to legally define Bitcoin, which has led to different judicial definitions in different jurisdictions.
The foundation of a well-functioning financial system is a clearly codified contract law. The enforceability of the contract gives participants the confidence to trade fairly with people and entities they would never have met in real life. The result is trust.
When Bitcoin emerged, there was no clear definition or concept to draw on. If someone owes you bitcoin, how should he pay it back? This is not an easy question and is beyond the scope of this article. The ambiguous nature of the definition of Bitcoin determines that "not your key, not your coin" is the only law in the meta-universe.
From the perspective of a centralized cryptographic platform, the only assets owned by the user reside in the platform-controlled wallet. From the user's perspective, this means that their financial obligations to the platform are limited. No matter how badly they trade, they will never owe more than their original margin.
If the user deposits a margin of 1 bitcoin and leverages it 100 times to the size of 100 bitcoins, the contract price drops 10%, and the total loss is 10 bitcoins. The user only put one Bitcoin on the platform, so the user only loses one of his Bitcoins. The gainer of the contract is owed 9 bitcoins. Loss of 10 BTC - 1 BTC margin =9 BTC deficit.
To deal with such trading losses in excess of margin, crypto trading platforms impose a tax on profits or liquidate positions early. In the above case, to deal with a nine-bitcoin funding gap, the head crypto derivatives platform would have liquidated the position of the winning trader at the bankruptcy price of the losing trader. Thus, in the case of limited trading liability, the margin that the winner can earn is the margin that the loser can provide. In other words, if the long has only 1 bitcoin margin and the price drops, the short can only make a profit of 1 bitcoin. Each platform has slightly modified the process of prematurely liquidating the winners' positions and, in general, has followed the blueprint described above.
The net result is that these losses do not spread beyond a single platform, no matter how severe the traders' liquidations. No platform would be considered an important financial institution (SIFI) for crypto systems, because even if all traders were liquidated (a highly unlikely scenario), their losses would be limited based on the principle of limited liability for trading. Fortunately, when the world of crypto finance was first formed, no one was willing to buy an entry seat, which would have hindered the development of today's more resilient anti-fragile system.
This is in direct contrast to the typical margin or leverage agreements at traditional financial institutions and the way Tradfi intermediaries handle losses in excess of margin. For the Tradfi intermediary, the user needs to use all the financial net worth to offset the arrears. If the transaction goes against the intermediary, the Tradfi intermediary can and will Sue the user, thereby putting the user into negative equity.
A typical Tradfi trading platform/clearing house also requires member institutions to post collateral to cover trading losses that exceed margins. Members have a responsibility to the clearing house, which also links them to the financial performance of every contract in the market. In the esoteric corners of the financial market, if the losses are large enough, they can lead to huge capital losses for unrelated financial institutions, which are members of trading platforms/clearinghouses.
The risk passability caused by the underlying structure of the Tradfi trading platform/clearing house model is the reason why many supranational financial regulators regard large Tradfi trading platforms as SIFIs. If an institution is designated a SIFI, extra oversight will follow. But the point is that if the institution is on the brink of failure, it can be bailed out because it must survive for the health and stability of the "system".
Open Interest (OI) contracts, which roughly represent the number of leveraged positions on head-centered derivatives platforms.
Suppose you have three traders, A, B, and C, all of whom currently hold zero contracts.
A buys 1 contract, B sells 1 contract, OI goes from 0 to 1.
A = 1 multiple single
B = 1 empty single
C = No contract.
A buys one more contract, C sells one more contract, OI goes from one to two.
A = 2 multi single
B = 1 empty single
C = 1 empty single
B buys 1 contract, C sells 1 contract, OI is still 2.
A = 2 multi single
B = No contract.
C = 2 empty single
A sells 2 contracts, C buys 2 contracts, OI goes from 2 to 0.
A = No contract & NBSP;
B = No contract.
C = No contract.
OI can tell us how many leveraged long and short positions we have on a particular platform. While we don't know how much leverage traders use on a weighted average, we do know that a certain amount of leverage is used.
我通过 Glassnode 的数据，得出了目前比特币市场上存在的假定杠杆量的近似值。
有趣的一点是，尽管衍生品平台上的交易量比现货平台大几个数量级，但与市场的整体规模相比，未平仓合约仍非常小。我相信一些黄金爱好者可以找到一些令人震惊的图表，显示 COMEX 黄金合约的未平仓合约大大超过了可结算的实物黄金数量。这些事不由地让你陷入沉思。
If all crypto derivatives platforms collapse at this point, the short-term impact will undoubtedly be negative, but in the long term, leveraged positions will not be a significant part of the market. This proportion will undoubtedly increase as the ecology matures. But the vast majority of leveraged trades take place on platforms that do not allow losses to spread outside. But in the Tradfi system, the inherent links between trading platforms, clearing houses and member institutions magnify losses and lead to systemic problems that always end up bailing them out by issuing extra money.
The problem has never been leverage per se, but who has to pay for the inevitable losses. In the crypto world, the user takes the initial margin and the platform takes care of the rest -- and while there may be a discount along the way, the larger external systems are unaffected beyond the short-term price impact. In Tradfi, the bank is never damaged. Because of their role in international payments, they cannot be harmed, but we global citizens pay for the losses through inflation.
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