BitMEX founder writes: The market is heading towards chaos, having sold off most altcoins

Author: Arthur Hayes, Founder of BitMEX

Original Title: “Maelstrom”

Translation: Wu Zhuocheng, Wu Says Blockchain

The most psychologically impactful metric for the health of your investment portfolio is the annual return. As always, our goal is to maintain or improve the purchasing power of assets relative to energy costs. The essence of human civilization is to convert the potential energy of the sun and the earth into kinetic energy, supporting our bodily functions and modern lifestyles. Making money is not the goal, as money is merely an abstract concept of energy. The correct way to measure your financial success is to determine how much energy your current lifestyle consumes (using oil as an example later) and how much it will consume in the future (which is, of course, difficult to measure). Then, you must ensure that the growth rate of your financial savings exceeds your expected energy consumption rate.

The market does not stop because of the clock striking 12:01 AM on January 1, 2022; returns are inherently compounded and path-dependent. Unfortunately, only a few trading days are truly important. A simple example can illustrate this.

Back to January 1, 2020, when the world was still simple and the madness of the global coronavirus had not yet formed. At that time, the price of Bitcoin was $7,216. By the last day of that wonderful year, the price of Bitcoin was $28,996, with an annual return of 302%. Who made more money, Bitcoin investors or Pfizer?

While this is an impressive annual return, it obscures the severe turbulence the market experienced in mid-March. Let’s focus on March 2020.

On March 16, Bitcoin experienced a correlated moment as the world (excluding China) discovered that the COVID-19 pandemic was real and extremely destructive, and Bitcoin, along with all other global risk assets, was severely impacted. A correlated moment occurs when all risk assets fall simultaneously, and investors rush to sell all assets in margin trading to increase global reserve currency (currently the US dollar) so they can repay loans. All assets, without exception. Only when the dust settles and fear dissipates do asset prices begin to move again in a more specific manner.

From January 1 to March 16, the price of Bitcoin plummeted by 38%. Many were stopped out, whether psychologically or forcibly (psychological stop-loss refers to when the price of an asset reaches a certain intrinsic pain point, forcing you to hit the "sell" button. Forced stop-loss refers to when your leverage provider closes your position to retain some collateral value).

The table above illustrates the good and bad of path-dependent outcomes. The most important lesson is that the trading behavior on March 16 was the most important day of the year so far. Those very skilled traders who were tied to the trading ship had the opportunity to significantly increase their portfolio returns, with returns from the low on the 16th to the end of the year being 250 percentage points higher than returns from investing starting January 1.

If you were unfortunate enough to exit on the 16th but had the energy and financial capacity to re-enter the market, the date you resumed your position becomes extremely important. Bitcoin did not return to its January 1 level until April 21. The longer you waited, the lower your compound return for 2020 would be.

Active traders must appear on any day like March 16, selling positions and then quickly buying back to create a constant compound return.

For those investors unwilling to monitor Bitcoin around the clock, you must build a portfolio that exhibits convexity on catastrophic days like March 16. The most important psychological barrier to overcome is to abandon the concept of annual arithmetic returns and shift to compound returns. The above example illustrates the negative impact of compounding; if you do not protect your chips during a downturn, you cannot participate in the subsequent rebound.

To achieve the above, you must eliminate emotional factors when making investment decisions and wisely use a certain amount of leverage. The former requires more skill than the latter, as completely changing your investment philosophy is very difficult (especially considering that most investment literature focuses on arithmetic returns). Worse, all trustees (i.e., fund managers) are paid bonuses annually. If your fund manager loses all your assets, the worst-case scenario for them is temporary unemployment, while if the market moves in their favor, you still have to pay them a percentage of your returns each year, which over time can destroy your compound returns. I do not have a solution to the trustee problem, but remember that it exists and adjust your behavior accordingly.

The significance of this Bitcoin price history lesson is that I believe there will be a series of catastrophic trading days like March 16 before discussing how I will allocate my portfolio this year. As always, this relates to the Federal Reserve reducing the growth of its balance sheet to 0% and subsequently raising interest rates one to three times in 2022.

I will start by discussing why interest rates are so important, then discuss how the aggressive short-term policy rates set by central banks will cause the most pain to global risk assets within a three to six-month timeframe. I believe the Federal Reserve and other central banks around the world will ultimately have no choice but to continue printing money. However, at some point, domestic political pressures in many countries may require tightening the money supply to quell public dissent as their costs of food, housing, and transportation are rising significantly!

Listen up

When it comes to central banks, being as transparent as possible about future actions is in vogue. However, in the face of obvious data, the higher-ups refuse to acknowledge that printing money is the cause of the inflation tearing society apart. Since the Great Recession of 2008, those who have followed orders have accumulated a massive amount of fiat currency. Those who care about fundamentals and other similar nonsense have underperformed; don’t be foolish, buy that damn market quickly!

While policies often change, the Federal Reserve is very clear about what they intend to do. "Transitory" inflation has now been shelved, and the Fed has hinted that they believe it is time to curb inflation in food, energy, and transportation at the expense of financial asset prices. To this end, they have decided to stop purchasing bonds before March this year, and if their "dot plot" holds, the first rate hike will occur between March and June.

Most market participants believe that Democrats will instruct the Federal Reserve to raise interest rates, and the Fed will comply. Democrats must prove their tough stance on inflation to avoid being completely defeated in the congressional elections in November. However, there is no consensus on how short-term rate hikes will affect financial assets—whether they will withstand the storm or yield under pressure.

Let’s forget the views of non-crypto asset investors; my interpretation of the sentiment among crypto asset investors is that they naively believe that the growth of the entire network and its users will lead to a continuous rise in crypto assets.

In my view, this foreshadows a severe crash, as rising interest rates' detrimental impact on future cash flows may prompt speculators and margin investors to sell or significantly reduce their holdings in crypto assets. I do not deny that loyal diamond hands are continuously adding to their positions after price crashes; however, in the short term, this "iron powder" cannot prevent a catastrophic price drop. Remember, as long as there is one Bitcoin trading at $20,000, the ultimate price will be $20,000, regardless of whether there are 19 million Bitcoins not traded in the market. The final trading price is determined by the abandonment of marginal sellers, even if the trading volume is small.

The most destructive impact of the final trading price is the psychological shock to weak traders, which affects the liquidation of underwater positions on leveraged trading platforms. Therefore, don’t tell me that all crypto market OGs are busy buying the dip; it doesn’t matter when fund managers destroy your positions.

For over a decade, crypto asset investors have been drooling over the entry of "institutional" investors into the space. Now, they have finally arrived, as indicated by the Bloomberg headline below. Although the allocation of assets is small, there are enough believers from the TradFi world to change the situation.

This article discusses how well-known CEOs and investors like Tom Peterffy (Interactive Brokers) and Ray Dalio (Bridgewater) hold Bitcoin and other crypto assets to hedge against the decline of fiat currency.

While the wealthy running large TradFi companies can withstand severe price drops, their lemmings cannot. The asset management industry is very willing to invest in crypto assets as long as these overpaid imitation chefs do not lose their high-paying jobs when prices drop. They do not believe in or are loyal to Satoshi Nakamoto. Therefore, if external conditions prove the need to reduce their crypto asset allocation, they will not hesitate to liquidate their positions—regardless of how much they lose.

Institutional investors are constrained by the power of Eurodollars (dollars held outside the U.S. domestic banking system). Essentially, the whole world is shorting the dollar. When the dollar price falls, credit expands, and financial assets rejoice. When the dollar price rises, credit contracts, and financial assets become glum. Reading Alhambra Investments' blog can provide deeper insights into how this market operates.

The rate of change in the money supply, or its first derivative, is the most important factor determining whether institutional investors are accumulators or distributors.

The white line is the growth rate of U.S. M2, which gradually increased in 2019. In March 2020, the Federal Reserve used its magical printing press to nationalize the corporate bond market and rescue a group of over-leveraged macro hedge funds to save the U.S. Treasury market. This caused a leap in M2 growth. As the Federal Reserve's balance sheet grew, the larger M2 became, the slower its growth rate (law of large numbers), and the U.S. government did not implement enough fiscal spending to continue accelerating the printing of money.

Currently, the Federal Reserve predicts that the growth of its balance sheet will slow to zero. If they do not reinvest the maturing bonds in their portfolio, their balance sheet will actually shrink. The ugly white arrow in the above chart shows the potential impact this could have on the money supply.

The yellow line is the price of Bitcoin/USD. The loose monetary conditions in the U.S. certainly influenced the rapid rise in prices (although it was delayed by a few months). Since the stagnation of M2 growth, Bitcoin has been consolidating. If the M2 growth rate reaches 0% or even negative in the short term, the natural conclusion is that Bitcoin (without any incremental growth in user numbers or transactions processed through the network) may also be lower.

I could post more charts to depict the credit impulses of different countries, but they all paint the same picture. The villagers have awakened, as the prices of meat, vegetables, taxis, rent, and other necessities are rising faster than their wages. Now their number one enemy is inflation. If domestic politicians around the world want to continue to enjoy the spoils, they must pretend to do something. Therefore, it is time for central banks to stage some song and dance routines; at least for a short time, they will be willing to loosen their balance sheets and return to positive interest rates reflecting various domestic economic realities.

Benchmark Assets

Bitcoin is the crypto representation of currency/energy.

Ethereum is the decentralized computer of the internet.

In most cases, every other major crypto asset can be classified as follows.

1. Tokens bound to Layer 1 protocols are expected to become "the next Bitcoin or Ethereum." These networks have greater scalability, can process more transactions per second, or are anonymous. For example, Monero to Bitcoin, or Solana to Ethereum.

2. Another category uses existing Layer 1 protocols as tokens to fulfill certain expected functions, such as Axie Infinity, a token-based game that uses NFT assets residing on the Ethereum blockchain to generate income.

A token is either trying to be a better version of Bitcoin or Ethereum or is leveraging the functionalities of these two networks to create a new product or service.

Both Bitcoin and Ethereum have some quite obvious shortcomings, and if another crypto asset can replace either of them, its value will naturally explode. Anyone who discovers the above tokens early will become wealthy in crypto assets. Many Layer 1s have high and rising expectation premiums, but these protocols are traded based on expectations, as their fundamentals (such as the number of wallet addresses or the actual transaction fees paid in native tokens) are pale compared to Bitcoin or Ethereum.

This does not mean that a specific coin cannot become a winner over a long enough time. However, we are not concerned with the long term; we care about the next 3 to 6 months and protecting our portfolio's downside.

Regarding tokens that rely on the Bitcoin or Ethereum blockchain to function, the value of these tokens (theoretically) should not exceed the protocols they are built on. This is the distinction between investing in a general application of a technology and a specific application—general applications are more likely to provide iterative momentum for multiple successful specific applications, and thus should be valued higher.

While there is a significant gap between the market capitalization of Ethereum and that of ERC-20 dApps, within a specific timeframe, the price of dApps will rise faster than Ethereum. Of course, during a downturn, the aforementioned dApps will lose value faster than Ethereum.

This is how I view the world. Therefore, I benchmark all returns in my crypto asset portfolio against Bitcoin or Ethereum. I enter this crypto world by converting fiat currency into Bitcoin and Ethereum, as these tokens always lead a rebound, after which it’s time to buy low and sell high on altcoins. In the process, the Bitcoin and Ethereum I hold may increase.

If I believe that in the next three to six months, the trading prices of Bitcoin and Ethereum will be below $30,000 and $2,000, respectively, I will sell all my altcoins. This is because Bitcoin and Ethereum are the highest quality tokens, and their declines will be less than all unproven competitors. Any specific application using Bitcoin or Ethereum will also experience free fall greater than 9.8m/s; in a true crypto asset risk-off environment, these altcoins could drop 75% to 90%.

The trends in the TradFi system mainly look at the fluctuations in Eurodollar costs, while the crypto market may benchmark against Bitcoin and Ethereum. I do not have conclusive data on this, but my intuition is that currently, billions of dollars worth of Bitcoin and Ethereum are being used as collateral, with holders depositing Bitcoin/Ethereum and receiving dollars in return. These dollars are used to purchase assets such as cars or houses, as well as to speculate on altcoins. If you believe we are in a bull market and you already have the benchmark, as a trader, it makes sense to leverage and buy an altcoin, as a 10% rise in Bitcoin could yield a 10x gain.

Whether you buy junk coins or more SHIB, if Bitcoin or Ethereum drops 20% to 30%, you will be forced to sell assets and raise Bitcoin or Ethereum to avoid liquidation. The contraction of the benchmark asset's fiat price will lead some margin traders to sell their altcoin positions at all costs, regardless of whether they are making a profit. This is why the final price is influenced by marginal weak sellers.

It does not take much marginal selling pressure to burst this bubble. The ridiculously high Farming APY of CTMD will cause everyone to exit to take profits once the shitcoin starts to tank. Even if only a small portion of traders leverage large amounts of altcoins, due to the illiquidity of these coins, it will also be difficult to find larger buyers during the downturn. Remember, big entrance, small exit.

Timeline

What if I am wrong? What harm will my portfolio suffer if the crypto market bull run continues without significant declines?

1. March to June

During this period, the Federal Reserve will either raise interest rates or not. The market expects the Federal Reserve to raise rates, and they will only feel disappointed if any of the following three things happen.

1. The Consumer Price Index (CPI) growth rate falls below 2%. Given that this index is "managed" by government statisticians, this is nearly impossible. However, if the CPI trend drops significantly, the political pressure from voters will dissipate, and the Federal Reserve may publicly reverse the trend.
2. Certain parts of the extremely complex and opaque money market and U.S. Treasury market will collapse. When you see it, you will know—this is the one thing the Federal Reserve fears most. Given that all assets in TradFi are valued based on U.S. money market prices, the Federal Reserve must ensure this market operates smoothly at all costs. Typically, restoring order requires a lot of printed money.
3. Inflation is no longer the number one concern for American voters before the November elections.

Among these three scenarios, I believe the second is the most likely to occur. No one can predict what will happen to the money/Treasury market when the Federal Reserve stops providing funds. There is so much leverage embedded in this system that we cannot know whether methadone will kill the addict.

Given the law of large numbers, simply restoring previous asset purchase trends will not lead to a sudden sharp acceleration in money supply growth. Therefore, while risk assets will rejoice, including crypto assets, the best-case scenario is that asset purchases slowly climb back to previous historical highs. Even if this happens, the only way for the crypto market to rise is if the Federal Reserve publicly opens the taps, allowing fiat to flow into cryptocurrencies.

If this begins to happen, there will be enough time to sell fiat, increase your total holdings in crypto assets, or move along the risk curve of crypto assets by increasing your altcoin holdings. You always go up the stairs and come down in the elevator.

If I am wrong, I will not suffer significant opportunity loss as the crypto market recovers. Staying patient will not cost too much.

2. From June onward

Assuming I am correct and the Federal Reserve raises rates at least once before the June meeting, if any of the following occurs, the Federal Reserve will suddenly drop rates to zero and start the printing press faster than Usain Bolt.

1. The S&P 500 drops 20% to 30% from its historical highs (reached in the first half of 2022). Whether you are a net exporter in Asia or Europe or a wealthy American, you may own a significant amount of U.S. stocks. The U.S. stock market is the best-performing stock market among developed countries, and it is also the largest and most liquid. There are too many wealthy individuals who are consuming and spending recklessly; if the stock market experiences severe turmoil, the Federal Reserve will not let them down.

Another interesting reflexive fact is that the traditional wisdom of maintaining a 60/40 stock-bond portfolio means that if 60% of stocks drop, fund managers with trillions of dollars must sell bonds to maintain this ratio, which is entirely written in the directives. Therefore, if the Federal Reserve allows stock prices to fall, it will increase the federal government's borrowing costs—because as bond prices fall, yields rise—while the government is facing record deficits.

2. Certain parts of the extremely complex and opaque money market and U.S. Treasury market will collapse.

3. The November 2022 elections have concluded.

The worst-case scenario is that after November, the parties start acting again. Neither of the two parties in the U.S. actually wants to stop asset prices from rising. Both parties prove their worth by shouting to the world, "I am in power, and the S&P 500 is rising!" This makes everyone wealthy and pleases your wealthy donors. After the public has gone through the dramatic process of voting and expressing their dissatisfaction with the soaring cost of living, they can be forgotten until the next election. The government will continue to print money to inflate financial asset prices. This is America's business model, and due to the structure of the global economy, this model must be maintained.

Chaos

I do not actively trade around my positions. My goal is to build a portfolio that I believe can participate in the upside while limiting losses during downturns. As I mentioned earlier, if the return curve of my portfolio is convex, I am doing well. While I have spent most of this article discussing the crypto assets in my portfolio, I expect my long-term interest rate and forex options portfolio—through my investment in volatility hedge funds—to compensate for any losses in crypto assets. However, if I am honest with myself, I may need to increase more so that I have enough Vega to make a difference during downturns.

I do not want to sit in front of the screen for hours on end, day after day, staring at my Bitcoin; I do not enjoy it. Some traders do this and are successful short-term traders, but these traders must be very focused. If you cannot or do not want to be on standby 24/7 to watch your crypto asset portfolio, do not attempt to day trade.

In the past few weeks, as these thoughts have been brewing in my mind, I was determined to take action. I reviewed my entire crypto asset portfolio. After dropping 75% from current levels, I sold any altcoins I was unwilling to increase my position in. This left me with Bitcoin, Ethereum, and a few others in the metaverse and algorithmic stablecoins. The size of the position does not depend on the nominal amount you hold but rather on the percentage they represent of your total assets. A position of 100 Bitcoins is large for some and too small for others. Everything is relative.

Now, I am waiting. I remain fully invested in my benchmark crypto assets. Your crypto benchmark may be similar to mine or not. I have given you my reasons, and you should think carefully about why you believe your benchmark is valid in the context of your energy goals.

If the price of Bitcoin reaches $20,000 or Ethereum reaches $1,400, I will begin to question whether these crypto assets have energy value. These two prices were historical highs during the previous bull market in 2017, but that was in fiat prices; if oil goes negative again, who will care if the fiat price of benchmark crypto assets decreases?

I hold fiat, ready for vertical candles. I have traded in this market long enough to recognize the final blow that breaks the spirit of speculative bull markets. While I am confident in my ability to find the bottom, I have also learned not to try to catch a falling knife. So what if you miss the bottom? Let the market heal, and then buy at higher prices, as the marginal trades of sellers have ended.

Those who sell first, sell best. It is time to assess whether positive interest rates will severely damage your portfolio's ability to purchase more energy. No matter how hard governments try to suppress the universe's volatility, the normal state is chaos. We are entropy!