Research

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Fasanara  Digital

December Commentary

  

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Figure 1: Spark Airdrop Liquidity Squeeze on XRP Derivative Contracts. Represented in the picture the price of Ripple’s token XRP (dark area chart) with superimposition of the premium/discount on the most traded XRP derivatives (Perpetuals and Dec/Mar Future maturities). During the hours before the wallet snapshot at midnight, the buyers of derivative contracts disappeared, pushing the cost of hedging the spot holdings to a nominal 3-5%. At midnight, in few seconds, all spreads converged. During the following 12 hours the spot price dropped more than 15%. Source: TradingView

Commentary

With a performance North of 30%, Bitcoin has signed another record month to conclude a record year that saw a trough to peak appreciation of more than 600%. All the while, Bitcoin ripped through the 2017 all-time high of $20,000 to proceed undisturbed to $28,000 and reaching a total market cap in excess of $0.5T. We show in Figure 2 the daily performance of Bitcoin since mid-2016 using a logarithmic scale, and the trend cannot be mistaken. The strong exponential appreciation has been interrupted by considerable drawdowns in the past, but the current move does not appear to be overextended when compared to the longer-term cycle.

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Figure 2: Multi-year daily time series for Bitcoin price in logarithmic scale in orange, superimposed the 90days MA in red. It should be noted that the trend appears to be linear in this scale, highlighting the long-term exponential growth. Historical TWAP starting at different dates are represented as shaded black lines. Source: TradingView

Despite Bitcoin’s incredible price action, Ripple has managed to capture the market practitioner’s attention in expectation of the Spark token airdrop on December 12th. Flare Network, a decentralised protocol built on top of Ripple blockchain, announced it will kickstart its distribution via an airdrop to all the XRP token holders (initially set at 2 Sparks for each XRP token).

An airdrop, similarly to a fork or a listing, is a special situation where it is known that a certain value transfer event will take place at a given time in the future. In the case of the airdrop, in particular, token holders are entitled to a “dividend” of unknown market value (the token is not yet traded as it is not circulating). In an efficient market, it is expected for the asset (XRP) to immediately rise in price to match the market expectation of the airdrop. At the same time, hedging the drop in price expected after the distribution of the Spark token, should cost as much as the value of the airdrop itself.

During the days leading to the airdrop, market participants started to buy up XRP spot and hedge the position through derivatives and margin accounts. The growing imbalance in demand for spot compared to derivatives started to bid-up the borrowing rates and deepening the discounts on derivative contracts, leading more traders to take notice, and thereby increasing the demand for hedged positions (either to bet on the convergence of the spreads or to hold the spot). The perverse incentive to dump the XRP token right after the airdrop distorted the market dynamics, driving discounts on perpetual contracts at the same levels as the futures, as both instruments served the same hedging purpose. In Figure 1, it can be observed how both Futures (dotted lines) and Perpetuals (solid lines) reached heavy discounts just before the airdrop. It should be further noted that the Perpetual contracts also incur funding payments to compensate for the deviation from the spot index price, and both hedging strategies (Futures and Perpetuals) incurred similar costs during the last couple of days leading to the airdrop. In comparison, the overnight funding costs charged OTC on the 12th was approximately 500% APR, or approximately 1.3% of the notional. The unexpected surprise, for those, like the author, sceptical of the recent appreciation, was the SEC charging Ripple and two executives with conducting $1.3B unregistered securities offering, causing the price of XRP to tumble more than 50% shortly after the announcement on December 22nd.

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Figure 3: Annualised Future Basis for March maturity on FTX, Binance and BitMex. The latter still shows a noticeable discount (regulatory risk) compared to the other two exchanges. Rates have remained high throughout the month. Source: TradingView

Throughout the month, yields on other major cryptocurrencies have also not failed to amuse, with the demand for leveraged long spiking multiple times during the month as spot prices moved higher and higher. We show in Figure 3 the Basis on the March Future on three major derivative exchanges. Current annualised returns above 25% signal that market participants are willing to borrow at usury rates, in order to get leveraged exposure to the asset class. Historically such rates have not been sustained for long, due to their Ponzi-like dependence on price appreciation to remain well above the opportunity cost of providing leveraged-long exposure rather than taking it. By the time this balance breaks (or the market realises it is broken) spot demand may be long gone to allow an orderly deleveraging, therefore causing the underlying price to crash.

December, despite the positive price performance, has seen a strong increase in implied volatility (ceteris paribus options are more expensive), with an uptick in short term Put-Call skew (Jan 1st maturity in particular) signalling that investors are seeking protection (perhaps in order to delay the sale of the assets for tax deferral purposes).

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Figure 5: YTD holding behaviour of small (>10BTC), medium (>100BTC) and large (>1000BTC) institutional and speculator wallets. It can be observed how over the last two months all categories (medium first, then small and more recently large) have reduced their holdings in anticipation of a potential price correction. Source: glassnode

On chain metrics provide additional signs that many investors might have already started decreasing their exposure to Bitcoin. In Figure 5 we show the YTD holdings of small, medium, and large institutional investors and speculators wallets (>10 BTC at least). It can be observed that all three categories have started reducing their holdings during the rally and are now on a decreasing trajectory.

Despite the warning signals that we read on the market, and as discussed in our 2020 yearly review, long term demand for Bitcoin and Crypto assets more broadly is poised to increase during 2021 and the years to come with new players entering the space and, in the process, growing the size of the market manyfold. Both positive and negative volatility should in fact be expected, more so as Bitcoin becomes part of the tradable universe for long-short funds, and many other investors whose majority of portfolio is deployed in equities and traditional asset classes, tying its dynamics with the wider market movements.