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Why Is The Bitcoin Curve So Steep… And Could A Bitcoin ETF Be The Worst Possible Thing For Crypto

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Having repeatedly tried (and failed) to “bash” bitcoin in what we said was a glaring attempt to force clients to offload exposure to JPM’s own prop traders, one which almost worked judging by bitcoin’s all time high price today (or else, is a testament to how terrible JPM’s research desk is)…

JPMorgan’s daily bitcoin hitpiece is out. Just how bad does JPM prop want to be long this?

— zerohedge (@zerohedge) January 25, 2021

… JPMorgan’s analysts are pivoting away from making blanket (and consistently wrong) value determinations especially and hilariously when it comes to defining bitcoin’s “intrinsic value” like when in its initiating coverage report from Feb 2014, the bank said that “bitcoin looks like an innovation worth limiting exposure to”, and anyone who listened has lost out on the single best investment opportunity of the millennium…

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… starting to analyze bitcoin as an established asset class – one interest in derivatives and other sources of leverage is exploding – and finding that not only is Wall Street ignoring all of JPM’s periodic hit pieces on bitcoin, but just can’t get enough of the cryptocurrency to the point that the futures curve has gotten extremely steep as an indication of mounting institutional demand.

The good news is that in finally shifting away from nearly a decade of attempting to convince clients not to invest in bitcoin, JPM is actually starting to provide some value, like for example a report published by JPM’s rates strategist Joshua Younger, who traditionally focuses on such arcane topics as repo market plumbing and negative overnight rates, and who overnight published an article asking a critical question with profound consequences, namely “why is the bitcoin futures curve so steep?

Younger notes that as has been the case in the past, the growth and maturation of cryptocurrency markets has generated interest in derivatives and other sources of leverage and though futures trade against a range of pairs, “Bitcoin unsurprisingly dominates this nascent marketplace.” Similarly to the spot market, Younger notes that these products trade within a highly fragmented ecosystem, with nearly 30 active venues. The vast majority is traded offshore as well, with less than 15% of the total open interest listed on major, regulated domestic venues like the CME (Exhibit 1 below), with JPM noting that normalized depth in futures has also kept pace with the deepening of the cash market, suggesting it too is benefiting from institutional inflows and improved liquidity provision in spot (Exhibit 2).

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In total, futures represent a rather modest and consistent 2-3% of Bitcoin’s total capitalization. While this may not seem like a large fraction, there is reason to believe that price discovery in Bitcoin – where a handful of whales own the bulk of the float and rarely if ever make any market moves – is driven by high turnover in a relatively small fraction of the total stock. For example, recent analysis of the public blockchain suggests that less than 10% of tokens qualify as highly liquid while roughly half have not changed hands in more than a year.

Further, turnover in derivatives is often higher than the spot market, particularly in the offshore exchanges that dominate activity, which suggests they are overrepresented in price discovery and risk transfer. That makes a clear sense of what positioning and pricing in derivatives is telling us about the underlying balance of flows key to understanding the market as a whole, and also suggests that derivatives have far more signal to institutional participation than the Grayscale bitcoin Trust which many, inexplicably, continue to believe best represents institutional flows.

Still, as Younger notes, even a cursory look at positioning raises a puzzle, however. Though not the largest venue by any measure, Bitcoin futures listed at the CME have the benefit of public disclosure in the CFTC Commitment of Traders Report. Those data suggest that leveraged funds have increased their net short exposure to BTC futures over the past few months, with longs from smaller funds and retail investors who do not meet the reporting threshold and, more recently, institutional investors who do not fit neatly into the other major categories taking the other side.

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Similar to the Gamestop squeeze, this brings up a pertinent question: how could investors who are presumably very sensitive to short-term P/L fluctuations not just maintain but grow wrong-way exposure in the face of an explosive rally in spot prices?

Here, Younger makes a critical point which many superficial analysts often ignore: as with many asset classes, the downside to these data are they only show one leg of the trade (the futures) and do not account for potential offsetting exposures in cash. Basis positions, which seek to earn carry by shorting the contract against longs in spot or equivalents (e.g., closed-end funds or ETFs) are not reflected. As the JPM strategist note, these trades are functionally offering leverage to the market by lending out cash holdings via derivatives, in most cases hoping to monetize the richness of futures which implies high funding costs.

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Such basis trades are particularly attractive in the cryptocurrency market: consider that as of this moment, the June CME Bitcoin contract offers ~25% annualized slide relative to spot! The richness of futures is even more acute if we broaden our view to include unrelated exchanges, where carry can be as high as 40+% (see chart above). To put this in context, very few fiat currencies, including both developed and emerging markets, offer easily monetizeable local yields (e.g., from FX swaps) in excess of 5%.

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There is of course the special case of TRY, but as JPM admits “with local consumer price inflation around 10% or higher, as compared to the explicitly deflationary monetary policy and cross-border transferability of Bitcoin, this hardly seems a plausible substitute.” Yes, to JPM bitcoin is now a more viable currency than the Turkish Lira. But we digress…

The above brings up another key topic: how and why has such attractive pricing not simply been arbitraged away?

As JPM suggests, one could perhaps blame counterparty and repatriation risk in unrelated offshore markets, but certainly not the CME. As the bank further points out, “in a market with rampant bullish sentiment and heavy retail involvement it is tempting to simply blame demand for leverage” (demand which would not have been there had the broader investing public listened to JPM in recent months when the bank unleashed one hit piece after another seeking to slam the cryptocurrency) And that is certainly true to some extent. However, as Younger points out, there are also some more idiosyncratic but equally important aspects of how these contracts are designed in the context of market segmentation that are specific to Bitcoin and likely explain a substantial fraction of this richness.

The first is that CME futures are cash settled to their Bitcoin Reference Rate (BRR) Index. This is not a single observation of spot trading levels, but rather a 1-hour VWAP across a range of major exchanges as of 4pm LST. That may seem trivial, but the extreme volatility of Bitcoin relative to more traditional assets is worth bearing in mind here. Over the past month, for example, 60-minute volatility has not just been high (~0.6% based on volume-weighted prices) but also varied considerably over the course of the trading day (a high of ~0.9% around New York morning versus a low of ~0.3% during the Asian afternoon). Over a longer horizon, using just Coinbase prices, the monthly tracking error of BRR versus 4pm LST mids has at times been 2% or higher over the past year. Backtesting the performance of basis trades against spot levels as of the same time results in an annualized tracking error of more than 10% over the past year

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This raises a potentially more important issue presented by market segmentation. As JPMorgan confirms what we said three months ago, “not only is it rather difficult to replicate the settlement index in spot markets, but many institutional investors do not have access to Bitcoin , owing to concerns around custody, ambiguities around taxation and accounting, reputational risk and the origin of some tokens, and other potential issues.” This is hilarious because  back in December, when looking at the most recent Fund Manager survey, we said that Wall Street professionals were convinced that Bitcoin is becoming the most crowded trade on Wall Street, which as we said was impossible for the simple reason that most of these same “professionals” were not even involved in bitcoin. And now JPMorgan admits as much.

Wall Street professionals, most of whom can’t trade bitcoin in their work accounts, are convinced that “long bitcoin” is the third most crowded trade. Shows just how meaningless these surveys are pic.twitter.com/4dPk3y1iUn

— zerohedge (@zerohedge) December 15, 2020

Rather, according to the JPM strategist, a significant fraction of inflows to the space have been channeled through closed-end funds like GBTC. A number of factors have led to significant volatility in the price of these shares relative to NAV, introduce a new and often more important source of hedge inefficiency relative to final settlement prices to the futures contract. The problem has been particularly acute this year—were one to have been long GBTC versus the front Bitcoin contract over the past year, the annualized tracking error relative to ex-ante slide was more than 50%  Under those circumstances, one should expect significant risk premium priced into the futures.

This raises what JPM correctly notes is an important question: what could drive a curve normalization?

One likely critical catalyst would be the listing of a Bitcoin ETF tracking spot exchange rates in the U.S. or other major jurisdiction: not only would create/redeem for physical features result in much lower tracking error than closed-end funds, but it would also presumably be easier for prime brokers to take those securities as collateral. Access to leverage on the cash side will be key. At the moment listed basis trades require ~40% initial margin against the futures position in addition to ongoing variation margin and fully funding the opposing long GBTC positions, making return on cash noticeably less attractive than headline slide. One could of course turn to one of the increasing number of crypto-native lenders, but that likely represents an even higher hurdle than accessing the spot Bitcoin market directly.

This – to JPMorgan  – makes launching a Bitcoin ETF in the US key to normalizing the pricing of Bitcoin futures. Such a move could reduce many barriers to entry, bringing much more new potential demand into the asset class. and pushing the price of cryptos even higher. That said, a risk factor worth considering, however, is that it would also make basis trading much more efficient and attractive at current pricing, particularly if those ETFs can be purchased on margin.

Such a development would bring more basis demand into futures markets, especially the CME but also potentially other onshore exchanges, according to JPM. To the extent that contango normalizes for those contracts, we would expect some pass-through to  pricing on unrelated exchanges as well, since presumably there is some arbitrage activity between the two. Normalizing these implied funding spreads with more two-way flow is a prerequisite for broadening the base of participants in Bitcoin derivatives more generally, since it takes quite a bullish outlook to be willing to pay 30-40% annually to source levered long exposure.

Another critical question is how closely tied these basis trades are to the nascent DeFi industry, particularly cryptolending. The value of tokens locked in these platforms has exploded along with other aspects of the market, increasing from less than $1bn only a year ago to more than $25bn as of this writing, which coincides with comparable growth in the futures market.

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Many of these products offer double-digit returns to borrow Bitcoin—expensive liabilities which must be offset by even higher-yielding assets. Though details are naturally hard to come by, because they are crypto-native, these platforms are ideally situated to onward lend those tokens via the unregulated derivatives market, making a healthy spread in the process. To the extent this is the case, if a listed ETF in the U.S. leads to compression in the CME-listed Bitcoin cash/futures basis which ultimately spreads offshore, they would naturally lower their own offering rates. JPM makes another good point that under these circumstances, it is unclear how the nascent DeFi industry would react to the resulting decline in crypto-based yields. Though far from a perfect analogy,  the Chinese experience in alternative payments suggests that the economics of participation tend to be a more reliable driver of inflows than network externalities or other more intangible considerations.

The conclusion, ironically, is that the crypto industry and its de-fi spinoff space, appears to have now found a perfect niche for itself one where it is flourishing precisely because of the SEC’s refusal to greenlight a bitcoin ETF. If JPM is right, should the SEC reverse itself and allow one or more bitcoin ETFs, while the immediate outcome would be far greater demand, the consequences on the crypto market where curve and yield normalization would promptly follow, could be – paradoxically – quite devastating especially for the DeFi space which has seen exponential growth in the past year.

While the Securities and Exchange Commission has thrown out all applications for Bitcoin ETFs in the US (unlike Canada where three local bitcoin ETFs have been approved), citing a manipulable market, a new administration, SEC chair and renewed institutional interest, means ETF applications are on the rise and the SEC is taking another look at them. Ironically, would an ETF approval be the worst thing possible for bitcoin?