In a week in which we are yet again reminded how sharply sentiment can shift in crypto asset markets, it’s appropriate to look at the role volatility plays in our narratives, our portfolios and our psyches.
I also want to examine what volatility is not, as its specter takes on a disproportionate influence in times of turmoil.
This confusion is not unique to crypto markets – volatility is misunderstood across all asset groups. As with virtually all market metrics, however, it has particular nuances when applied to our industry.
Setting the table
First, let’s review what we mean by volatility. Technically, it is the degree to which an asset price can swing in either direction. Generally, by “volatility” we mean realized volatility, which is derived from historical prices. This can be measured in several ways – at CoinDesk we take the annualized rolling 30-day standard deviation of daily natural log returns.
Implied volatility represents market expectations of future volatility, as inferred from options prices. More on this later.
The volatility of an asset is an important part of its narrative, especially in crypto markets, which are associated with volatility in the minds of many investors. A survey of institutional investors, carried out earlier this year by Fidelity Digital Assets, singled out volatility as one of the main barriers to investment.
This is because many investors conflate volatility with risk. This is a fundamental investment error that says more about our psychological makeup than it does about our portfolio management insight.
We are, as a species, risk-averse, and have needed to be for survival. This extends to our vocabulary – higher risk also means the possibility of higher rewards, but you don’t hear anyone claim to be reward-averse. “Risk” will forever be associated with something bad, especially when it comes to investments. Investment advisors don’t warn about “upside risk.”
Our aversion to risk when it comes to finance is understandable. Risk implies irredeemable loss, which can mean total ruin for some. Yet the degree of our aversion is generally not compensated by the actual possible loss, especially in mature markets where downside can be managed. In other words, our fear of risk may be prudent but it is usually not rational.
Conflating volatility with risk makes the former also something to be avoided, in the minds of most investors. Yet volatility is not the same as risk. Volatility is a metric, a number, a measurement. Risk is an ambiguous concept.
A high volatility implies that the price can experience a handsome rise. It also means that it can come down sharply, and that possibility of doing us harm is what leads us to conflate it with risk and instinctively avoid it.
The fact that the CBOE Volatility Index (VIX), which measures the S&P 500 implied volatility, is also known as the “Fear Index” gives an idea of what a bad rap volatility has.
Conflating the two concepts leads us to another potentially dangerous disconnect: If we equate volatility with risk, then we are implying that we can measure risk. We can’t. Risk is based on the unknown. Bad things can happen from any direction, at any time, at any speed, in an infinite array of forms and configurations.
Volatility, on the other hand, is knowable. Implying that risk is knowable could lead us to underappreciate the potential damage.
Telling a story
Not only is volatility knowable; it can also tell us much about any given asset. Generally, the higher the volatility, the higher the return – but not always. When constructing a portfolio, the relative volatilities should be compared to the relative historical returns to evaluate whether the additional “risk” is worth it.
For instance, the 30-day volatilities of ether (ETH) and Litecoin (LTC) have been similar, while the returns over the same period have been notably different. (Note that historical performance does not guarantee future performance, and none of this is investment advice.)
Not only can we glean stories from recent (“realized”) volatility, we can also calculate investors’ expectations of volatility looking forward, through options prices. If this “implied” volatility is higher than realized volatility, that tells us that investors expect volatility to increase. The implied-realized differential has been positive in the past, but earlier this week it reached its widest point in over a year. That’s the market saying “buckle up.”
Crypto is different
Bitcoin (BTC) is the benchmark crypto asset, the oldest and the most liquid, and easily the one with the most developed derivatives market. Traditionally, the introduction of derivatives mitigates an asset’s volatility, as it adds liquidity and hedging opportunities. Not surprisingly, for this reason bitcoin’s volatility is among the lowest of the crypto assets.
What is surprising is that bitcoin’s volatility often moves in the same direction as the price. That is, when the price comes down, so usually does the volatility.
The VIX, on the other hand, tends to move inversely to the S&P 500. The average 60-day correlation between the two for the month of August was -0.84, an almost perfect negative association. Using bitcoin’s 30-day realized volatility as a proxy for a bitcoin VIX, we get an average 60-day correlation for August of 0.45. A very different scenario.
Another peculiarity of crypto volatility is that crypto markets trade 24/7. Traditional markets don’t. So, measures of traditional asset volatilities are working off fewer data points than crypto assets. Theoretically, were stocks to trade on Saturdays and Sundays, we could have a wild swing up on one day followed by a wild swing down on the other, with the Friday-Monday measurement showing no volatility at all. These movements are captured in crypto asset volatility calculations.
In reality, this doesn’t seem to matter too much for the bitcoin narrative – the 30-day average volatility for BTC when you take weekend trading out of the equation is not that different from the full data set result. For August, for instance, the monthly average using daily standard deviations was 51.2%, while the monthly average using only S&P 500 trading days was 51.6%.
So, volatility is higher in the crypto asset markets. It is also more measurable, in that there are a greater number of data points from which to glean information.
And finally, the relatively high volatility of crypto markets is a barrier for some but a magnet for others. Many professional traders have entered the crypto market because of the volatility. They bring with them liquidity which reduces spreads and further pushes market maturation forward. And as one asset’s volatility starts to settle down, another younger, more restive asset is but a couple of clicks away.
Volatility may not be for everyone, but it should be respected and harnessed, not avoided. Bitcoin has a lively derivatives market to help manage that volatility, and that of ether (the second largest cryptocurrency by market cap) is rapidly growing.
All portfolios aim to have a mix of volatilities, with the relative weightings determined by individual investor profiles and preferences. The high volatility of bitcoin should not be a reason to stay away. Just the opposite – it gives the asset group an even more compelling role in asset diversification. As investors of all types get more comfortable with the main fundamentals supporting the value case for bitcoin and other crypto assets, and as the volatilities become more manageable, we are likely to see this particular characteristic become less of a barrier and more as a quality to be embraced.
Anyone know what’s going on yet?
Just when there seems to be glimmers of vaccine-related hope, markets around the world lose their enthusiasm and head down. At time of writing on Friday afternoon, the board is a sea of red, with the Nasdaq leading the dip.
So far the moves are barely a blip on the charts, but the mood seems to have shifted. To highlight the shaky ground on which the tech stocks’ recent gains stand, the Cboe Nasdaq 100 Volatility index (VXN) reached its highest differential with the S&P 500’s VIX equivalent since 2004.
This correction could be temporary, but it feels like election fear is muscling its way to the front of the queue of big-things-to-worry-about, understandable given the escalating mutterings about the possibility of no conclusive result. I imagine that if there’s one thing markets don’t like, it’s not knowing who the leader of the Free World is going to be.
Bitcoin, as usual, showed investors that it wins at volatility, with weekly losses several times greater than the main stock market indices. While analysts scramble to make sense of the move, bitcoin yet again has thrown its narrative up in the air – not quite a safe haven, not quite a correlated asset – and who knows where it will land.
Tyler and Cameron Winklevoss, founders of crypto exchange Gemini and investment firm Gemini Capital, have laid out their macroeconomic thesis on bitcoin and why they believe it could go to $500,000 (spoiler, it’s to do with the value of gold). TAKEAWAY: One criticism often labelled at tech people touting a new form of finance is that they are trying to fix a problem they don’t understand. That doesn’t mean we shouldn’t check out the potential solutions, though, as long as we are aware that every solution does bring with it new problems. And sometimes a view from outside an industry can highlight big-picture issues that are hard to see from within. The whirlwind of ideas is the key to understanding both the problems and the potential, so, whether you or agree or disagree, essays like this are worth a read.
Ark Invest has produced, in collaboration with Coin Metrics, an excellent treatise on the role of Bitcoin as an economic institution. It points out why the current financial system falls short of basic economic assurances, how Bitcoin can satisfy them, and some excellent charts that make it easy to understand some of Bitcoin’s thornier issues such as governance.
The open interest in options on ether (ETH), the native token for the Ethereum blockchain and the second-largest crypto asset in terms of market cap, has reached a record high on leading crypto options exchange Deribit. TAKEAWAY: This signals a growing maturity in the ether derivatives space which in turn should support greater trader interest in both the derivatives and the underlying asset. ETH is generally more volatile than bitcoin (BTC) – a more robust derivatives market might tame some of that volatility, which would also make it more attractive to longer-term investors.
Crypto lending firm BlockFi now offers yield on PAX Gold (PAXG, a gold-backed token issued by Paxos) and stablecoin tether (for non-U.S. accounts). TAKEAWAY: According to the company, the initial APY on PAXG will be 4%. This is interesting because yield on gold has been an elusive concept for centuries. There are traditional platforms that offer interest on gold deposits, but the custody angle is cumbersome. Here, BlockFi is offering yield not on gold itself but on a token issued by Paxos, backed by physical bullion. This sounds more liquid and more flexible. It also allows clients to use PAXG as collateral for loans. PAXG volume has shot up over the past couple of months after a slow start, so it will be worth keeping an eye on whether this propels it even further.
And speaking of tether (USDT), derivatives exchange Opium has introduced credit default swaps for the world’s largest stablecoin and the fifth largest cryptocurrency overall. TAKEAWAY: This pays out in the event of default by Tether, the issuer of USDT. The token has become the de facto base currency for most crypto trades, and the very idea of it breaking would send tremors through the market. Last year there was turmoil when Tether was having banking issues and it turned out that not all of the issued tokens were 1:1 backed with U.S. dollars. Since then, the market has settled into a new kind of trust, and for many, the idea of Tether folding is laughable. For others, it’s terrifying.
Huobi Futures, the crypto derivatives unit of Huobi Group, now offers trading in weekly, bi-weekly and quarterly bitcoin options. TAKEAWAY: Deribit is such a giant in the crypto options market that challenging it will be tough, but greater diversity and liquidity in options will be good for the market as a whole. A lively options market not only supports hedging strategies, it also encourages new investment by mitigating volatility, and it gives rise to new revenue opportunities for options writers.
Zero Hash, the crypto asset clearing organization spun out from former crypto exchange Seed CX, has closed a $4.75 million funding round led by tastyworks, the owner of the app-based brokerage tasytrade, with other participants including app-based broker-dealer Dough, retail-focused futures market Small Exchange, Bain Capital, TradeStation and others. TAKEAWAY: It’s not a large raise, but it is indicative of the growing interest in crypto market infrastructure. The settlement layer is arguably one of the most immature for now, and its development will be key for more mainstream platforms to enter the industry.
Podcast episodes worth listening to:
Craig Wright Sues Bitcoin Developers Over Stolen BTC Worth $5 Billion
The self-proclaimed Satoshi Nakamoto, Craig Wright, has filed yet another lawsuit within the cryptocurrency industry. This time, he has targeted the developers of BTC, BCH, BSV, and BCH ABC requesting that they retrieve access to BTC stolen from his personal computer worth about $5 billion.
CSW Sues BTC Developers Because he was Hacked
Wright has publicly claimed that he is the person behind the Bitcoin network for years – Satoshi Nakamoto. This narrative, which lacks any conclusive evidence, has been highlighted once more by the latest law firm that will represent him in his most recent lawsuit against representatives of the cryptocurrency space.
Ontier, a UK-based litigation law firm, has published a press release asserting that it has informed the developers of Bitcoin (BTC), Bitcoin Cash (BCH), Bitcoin SV (BSV), and Bitcoin Cash ABC (BCH ABC) of the lawsuit.
With these “ground-breaking legal proceedings,” the firm acts on behalf of Tulip Trading Limited (TTL) – a Seychelles-based company with a primary beneficial owner – Craig Wright. The nature of the lawsuit is somewhat controversial, to say the least.
“In February 2020, Dr. Wright’s personal computer was hacked by persons unknown and encrypted private keys to two addresses, which hold substantial quantities of Bitcoin belonging to TTL, were stolen. These assets were, and continue to be, owned by TTL. The theft is the subject of an ongoing investigation by the Cyber Crime division of the South East England Regional Organized Crime Unit.”
Consequently, the lawsuit has requested that the developers “enable TTL to regain access to and control of its Bitcoin on the grounds that they owe Bitcoin owners both tortious and fiduciary duties under English law as a result of the high level of power and control they hold over their respective blockchains.”
Per their estimation, the sizeable amount has a value of over £3.5 billion or about $5 billion.
More to Follow?
Paul Ferguson, a Partner at Ontier, commented that Wright, the supposed creator of BTC, has “always intended Bitcoin to operate within existing laws.” Moreover, he believes that the Bitcoin developers have the power and obligation to deploy code to “enable the rightful owner to regain control” of his assets.
Should Wright’s lawsuit succeed, others in a similar position could follow suit, added Ferguson.
Craig Wright is no stranger to initiating lawsuits against crypto industry representatives. In his previous one, his lawyers requested two Bitcoin-related websites to remove the BTC whitepaper, which received quite adverse reactions from the community.
Featured Image Courtesy of TheConversation
All of the Federal Reserve’s wire and ACH systems are down
All of the services available through the Federal Reserve’s online portal have been down for more than an hour.
According to the Federal Reserve Bank Services’ website, the bank is experiencing a disruption in its account services, central bank, Check 21, check adjustments, FedACH, FedCash, FedLine Advantage, FedLine Command, FedLine Direct, FedLine Web, Fedwire Funds, Fedwire Securities, and National Settlement — all services typically available — which started at 6:18 PM UTC today. In addition, all the access solutions that the Fed offers, with the exception of FedMail, are also offline.
Washington Post reporter Rachel Leah Siegel reportedly received an alert from the Fed saying its staff were “currently investigating a disruption to multiple services” and would “continue to provide updates as soon as they are available.”
“A Federal Reserve operational error resulted in disruption of service in several business lines,” said Jim Strader from the Federal Reserve Bank of Richmond. “We are restoring services and are communicating with all Federal Reserve Financial Services customers about the status of operations.”
This story is developing and will be updated.
Why it’s critical to monitor Bitcoin miners’ position over the next 2 weeks
The narrative of a bear-led correction is always around, even during the headiest of bull runs. A similar situation is unraveling at the moment, with many still expecting Bitcoin’s performance to take a more calamitous turn.
At press time, while Bitcoin had recovered to climb north of $50,000, some key on-chain metrics seemed to suggest that selling pressure might not be done yet, especially on the miners’ side.
Bitcoin Miners’ Outflow Multiple, Volumes on the rise
According to Glassnode data, Bitcoin Miner Outflow Multiple climbed to touch a monthly high after BTC’s decline on the charts. The aforementioned metric relates to the period of time when the amount of Bitcoin flowing out of miners’ addresses is higher than the historical average.
Alongside the same, Outflow volumes of Bitcoin miners also climbed to a 1-month high with over $4.5 million on a 7-day average.
Now, while at first glance that may sound concerning over the short-term, the fact of the matter is that the long-term perspective is still in the green.
The Miners’ Position Index is a good example. When the market was correcting back in mid-January, the MPI had surged to a high of 12.65, underlining extremely high selling pressure from miners (An Index reading of over 2 suggests that a majority of miners are selling). On the contrary, the latest drop in Bitcoin’s price pushed the MPI only up to 3.50, with the same down to 2.56, at press time.
Further, additional data seemed to suggest that small miner outflows may have contributed to high outflow volumes since these entities need to balance out their cash reserves on a consistent basis.
Bitcoin hashrate and difficulty is still relatively high
The relative hashrate for Bitcoin has dropped over the course of February, but it is important to note that over the past 3 days, the relative change is very negligible. In fact, the current hashrate is still well above 2020’s highest rate, a finding that means that miners are still active and possibly profitable, despite corrections being the norm for most of the past 24-36 hours.
On the question of mining difficulty, the attached chart seemed to suggest that the difficulty was at an all-time high on 23 February with a hashrate of 21.724t. With a difficulty adjustment imminent on the charts, a minor correction would mean that bear-led corrections would not be dragged forward due to miners’ activity.
That being said, it remains critical to monitor miners’ position over the next couple of weeks.
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