Chain Hill Capital: Deduction framework for black swan events in the encryption market

特邀专栏作者

2020-10-18 16:43 (UTC+8)

This article is about 13966 words, reading the full article takes about 20 minutes

The liquidity crisis in March may happen again, but it is less likely to happen, or even if it happens, the intensity will be much smaller than last time.

AI Summary

Expand

The liquidity crisis in March may happen again, but it is less likely to happen, or even if it happens, the intensity will be much smaller than last time.

Original Author: Carrie | Chain Hill Capital

This article was originally published by Chain Hill Capital Carrie, and it is strictly forbidden to reprint without authorization. For authorization, please contact the official account of Chain Hill Capital.

first level title

Part 1 Fragile US stock liquidity

Monetary easing policy and the current main market factors of US stocks have formed a market incentive cycle. When uncertain events occur, each link creates or intensifies the fragility of market liquidity. The Federal Reserve chose to intervene in the financial period in 2008, and directly intervened in the market through monetary policy to solve liquidity pressure, thus starting a "bull market" for more than ten years. Until the new crown epidemic interrupted this carnival, the once powerful power turned against each other and turned into a violent backlash, and the market collapsed instantly. This time, the Federal Reserve still chose to extend a "helping hand" to rescue the market, and a new cycle began...

From the flash crash in 2010 to the flash crash in February 2018, to the four circuit breakers in March 2020, the frequency of flash crashes in the US stock market seems to be increasing. However, these crises were accompanied by a decade-long melt-up in US stocks from 2010 to 2020.

Fed policy is clearly the dominant factor in this phenomenon. Since the beginning of the financial crisis in 2008, the Federal Reserve has continuously introduced quantitative easing policies, which has led to an increase in investors' risk appetite. When the market is stressed, investors generally seek to deleverage and reduce risk, resulting in a rapid drying up of liquidity.

In 2008, during the largest global credit crisis in modern history, the Federal Reserve and central banks around the world began an era of experimental monetary easing in an effort to stabilize markets and economies. These monetary policies had two major effects: (1) incentivized investors to take greater risk by lowering short-term interest rates; and (2) increased confidence in investment risk taking through market stabilization programs.

image description

Figure 1, data source: callan.com

Increased demand for riskier assets can in turn reduce risk premiums and raise asset prices. This can be seen from the valuation level of US stocks.

image description

Figure 2, data source: gurufocus.com as of September 25, 2020

image description

Figure 3, data source: fred.stlouisfed.org as of September 28, 2020

The S&P 500 Shiller PE indicator and Wilshire 5000/GDP show that stock market valuations are rising and are at historically high levels.

image description

Figure 5, data source: Zhongtai Securities Research Institute

image description

Figure 6, data source: Federal Reserve, JP Morgan

The Fed's policies could completely distort markets and introduce new risk factors. Specifically, investors' increased risk appetite may lead to non-linear responses related to market volatility that are generally procyclical under market stress, that is, as market volatility increases and liquidity decreases (2 The latter are essentially two sides of the same coin), as investors seek to reduce risk, putting further pressure on market prices and liquidity. This led to the flash crash of US stocks mentioned at the beginning of the article. The common feature is a rapid decrease in the depth of liquidity in a short period of time (the depth of the order book is greatly reduced, and the bid-ask spread is significantly expanded), that is, a liquidity crisis.

To use the current industry term on Wall Street"Risk on/risk off"It can be explained simply. When the market risk is on, investors generally have no fear of risks and pour into risk assets such as stocks, commodities, and financial derivatives; when the market risk is off, investors sell a large number of risk assets and buy US dollars in order to avoid risks and safe assets such as treasury bonds. exist"Risk on/risk off"The volatility of risky assets is highly correlated, and the market is full of uncertainties.

In addition to loose monetary policy, there are two other contributing factors to the phenomenon of increasingly frequent liquidity crises.

(1) The growth of passive investment and index investment has caused certain distortions to the market

The first effect is to create price momentum. First, active managers are increasingly using indices as performance benchmarks. This led investors to "divest money from underperforming fund managers, causing them to sell underperforming stocks". Instead, "outperforming managers receive funds and accumulate assets that perform well". Second, marginal buying and selling as investors switch from active to passive investing also contributes to price momentum. By observing the average holdings of value (Value), momentum (Momentum), size (size), and quality (quality) ETFs, it can be found that active funds basically reduce their holdings of the stocks with the largest market capitalization in the S&P 500 Index. Therefore, when the market shifts toward passive investing, there will be marginal selling pressure on smaller cap stocks and marginal buying pressure on large cap stocks. Sustained over time, this pressure can cause large-cap stocks to consistently outperform small-cap stocks. These two reasons create price momentum.

This price momentum could pose a risk to market stability. Market participants focusing on convergent (eg value or mean reversion) strategies have a stabilizing effect on prices as winners are sold and losers are bought. Strategies that focus on divergent (such as momentum or trend) can destabilize prices as winners are bought and losers are sold. Passive and indexed strategies (including so-called "smart beta" ETFs) are divergent strategies, as recent winners will be more heavily weighted and recent losers will be less heavily weighted. As a result, positions will become more crowded as funds move from convergent to divergent strategies (momentum or index strategies), destabilizing the pricing of individual stocks and cross-sector assets.

The second impact is the potential impact on the microstructure of the market. The job of active fund managers is to identify those stocks they believe are undervalued and buy them. Whereas with passive funds, the trade is not to discover the correct value of the stock, but to track the index while minimizing the impact of that trade on the market and executing the trade as efficiently as possible (keeping the ETF price pegged to its NAV). This could also have a destabilizing effect on the market. Because “market makers cannot distinguish price movements caused by factors related to the asset from other factors not related to the asset”, they cannot synchronize their prices in time, which may lead to further price distortions. In fact, stocks with a higher proportion of passive fund shareholders exhibit significantly higher volatility, higher transaction costs, higher "return synchronicity," and lower "future earnings returns" and lower analyst coverage , and there is even evidence that ETFs may even introduce a new source of noise to the market. In a healthy market environment, other players step in and reprice. However, in a troubled market environment, there may not be enough liquidity (or willingness) to step in and correct this behavior. The problem could be further exacerbated if the market is dominated by index traders who cannot distinguish between asset prices and their value.

(2) Leverage exacerbates the imbalance of liquidity structure

Driving characteristics of modern market structures include electronic liquidity providers and high-frequency traders. High frequency trading firms typically trade with high leverage. In the current increasingly complex market environment, fast trading may lead to the risk of a pro-cyclical spiral, especially as the market becomes more and more concentrated in a few large trading firms. Because high-frequency traders rely on leverage to provide liquidity, they often have to reduce capital investment due to risk budget constraints in volatile markets, resulting in a pro-cyclical decline in available margin.

In addition, the growth of complex derivatives markets and their associated leverage has led to an explosion in demand for liquidity in tail events, further exacerbating market pressures. Markets can also experience structural imbalances when there is systematic (often convex) hedging pressure in markets such as options markets, leveraged ETPs, and inverse ETPs. Because, hedging (especially with derivatives) is generally a convex function, and in many cases, its liquidity requirements increase as markets fall. Contrast this with the supply curve for liquidity, which is concave relative to market pressure. Thus, during periods of market stress, where liquidity scarcity meets high liquidity demand, a catastrophic mismatch can occur in the market, causing liquidity to dry up.

To sum up, the loose monetary policy, the rise of passive investment and the unbalanced liquidity structure exacerbated by leverage have a common potential risk factor: liquidity. When combined, they create a market incentive cycle: when there is disruption in the market, there is a chain reaction that leads to the collapse of the entire market structure.

first level title

Figure 7

secondary title

History of BTC Price Correlation

In the first few years of Bitcoin's birth, its audience was only a small part of the population, including cypherpunks, technology developers, illegal traders, and libertarians. These audiences are usually not those making money in traditional markets.

As the price continues to break through, Bitcoin has begun to attract the attention of some traditional investors. For example, California-based investment firm Social Capital invested in Bitcoin in 2013 and has held it ever since.

image description

Figure 8, data source: Grayscale Investments

Beginning in 2017, the isolation between traditional markets and Bitcoin has changed. The world's first regulated Bitcoin fund was officially launched, opening the door for institutional clients; the Winklevoss brothers tried to launch a Bitcoin ETF; As a legal investment asset, not just a dark thing confined to the fringes of society; CBOE and CME Bitcoin futures are online, institutional investors and traditional investors join the Bitcoin army...

image description

Figure 10, data source: pwc

image description

Figure 10, data source: Grayscale Investments

According to a survey released by Fidelity Investments in June 2020, 36% of large institutional investors own digital assets such as Bitcoin; looking forward to the next five years, 91% of respondents believe that at least 0.5% of investment exposure is allocated to digital assets.

As more and more high-net-worth individuals and institutional investors flock to Bitcoin to allocate exposure, the firewall between traditional markets and Bitcoin investors is broken. This means that many people who trade in the crypto asset market are also trading in other markets at the same time. Will this development lead to a stronger correlation between Bitcoin and other assets?

Indeed, since 2019, we seem to have increasingly felt the correlation between Bitcoin and traditional assets.

image description

Figure 11, data source: Coin Metrics

image description

secondary title

The third part is the deduction framework of the black swan event in the encryption market and thinking about the future

In the previous two parts, this article discussed the macro and micro factors that caused the black swan of the encryption market in March this year. Summarized as follows:

Monetary easing policy and the current market structure of US stocks have formed a market incentive cycle around the epidemic, resulting in the vulnerability of US stock liquidity;
More and more traditional market investors are entering the encryption market, and the connection between the encryption market and the traditional market has become closer than ever before; when the uncertainty of the epidemic puts pressure on the market, investors sold a lot to avoid risks Risk assets, including hard assets represented by gold. Since the encryption market has fewer trading restrictions and is easier to liquidate than any traditional asset, the short-term selling pressure of encrypted assets is greater than other traditional assets; and this sell-off is mainly from short-term traders, who often hold for speculative purposes Cryptoassets, therefore, are more susceptible to market sentiment;
The market structure factors of encrypted assets themselves, including reverse contracts, technical limitations, and immature market infrastructure, further amplified the price decline.

The plunge in March has left many investors in the crypto market with lingering fears. Due to the recent increase in the correlation between crypto assets and U.S. stocks, the crypto market has paid more attention to U.S. stocks than ever before. Coupled with the many uncertainties in the current macro environment, including whether the epidemic will break out again, the U.S. presidential election, geopolitical Political crisis, etc., it seems that any disturbance in the external environment will cause market concerns about the reappearance of 312.

Indeed, multiple factors, including US stocks, led to the turmoil in the encryption market in March, but the exact same situation may not necessarily recur in the future. Because the interplay between macro and micro factors affecting the crypto market is complex and still evolving dynamically. However, it is meaningful to establish a thinking framework based on past experience, which helps us to recognize the current market environment and identify the possibility of black swan occurrence. Therefore, this article proposes a "encryption market black swan event deduction framework" (Figure 19) applicable to the current environment.

image description

Figure 19

In this deduction framework, different types of risk events, encrypted investor structures and encrypted asset narratives, and different possibilities of the three factors of encrypted market infrastructure have formed different permutations and combinations. When certain conditions are met, a certain A combination may lead to a black swan event in the encryption market.

If this framework is used in the deduction of the 312 incident, its path is in the sector of liquidity crisis: long-term loose monetary policy --> market risk on --> uncertain events (epidemic) --> market risk off (Short-term) --> Due to the liquidity crisis, risky assets, speculative products, and even hard assets such as gold will be sold, because encrypted assets are also sold, and the market plummets --> Problems with the structure and infrastructure of the encrypted market Further amplify the black swan effect.

It is important to note that in the case of a liquidity crisis, it is meaningless to consider the structure of crypto investors and the narrative of crypto assets, because at least so far, the safe-haven asset of the liquidity crisis is still the US dollar (JPY, CHF is OK, but not as effective as USD). This was evident in March, when other safe-haven assets such as gold and U.S. Treasuries sold off. Perhaps, under the continued loose monetary policy, the credit of the US dollar will one day go bankrupt, and at that time, this framework will be rewritten.

But at the current stage, the dollar's monetary policy is still the biggest risk variable in the black swan event caused by the liquidity crisis. The US dollar continues to maintain a loose policy, which is good for encrypted assets, because the attributes of high-growth technology stocks and digital gold are good tools to hedge against the depreciation of the US dollar; even for speculators, they also have good hype value. However, if the epidemic recurs or the Federal Reserve tightens monetary policy, causing a liquidity crisis to recur, market volatility similar to 312 will recur.

Whether other types of risk events will lead to black swan events in the crypto market depends on the structure of crypto investors and the narrative of crypto assets. Specifically, only when encryption is dominated by value investors and its safe-haven value is widely recognized, can it avoid shocks in risk events such as economic crises or geopolitical events.

secondary title

Will the Fed stop releasing water?

Now, the question we face is, when will the world be free from COVID-19? How will the global economy recover? Will there be prolonged disruptions to global supply chains? No one can answer these questions, but it is clear what the Fed will do.

Looking back at the last crisis, the Fed's playbook was simple:

The first stage: a crisis occurs, and a large amount of liquidity is quickly injected
The second stage: the initial large-scale release of water, and it stabilized after several months
Phase 3: A full 7-year systematic quantitative easing program

image description

Figure 20, data source: BOARD OF GOVERNORS of the FEDERAL RESERVE SYSTEM

image description

Figure 21, data source: BOARD OF GOVERNORS of the FEDERAL RESERVE SYSTEM

So far in this round of water release, the Fed's balance sheet has expanded by 67% (Figure 21), and in the same period after 2008, it has expanded by 150%. The total Fed balance sheet ended up growing by nearly 400% in the 7 years after 2008.

Now, the market has grown larger and achieving the same goal requires an injection of more liquidity. Therefore, it seems more meaningful to focus on the growth rate of the balance sheet than on the net worth. If the Fed continues with the same policies, the total balance sheet could grow to $15 trillion over the next decade.

image description

Figure 22, data source: fred.stlouisfed.org

The housing sector experienced a similar V-shaped rebound as record low mortgage rates and pent-up demand boosted property sales, with total U.S. real estate market capitalization increasing by about $458 billion quarter-on-quarter in the second quarter.

image description

Figure 23, data source: CNBC

There are two possibilities for the future.

The first possibility is that the dollar liquidity crisis breaks out again. Although the unprecedented monetary easing policy has rapidly stabilized the market, it is also continuously strengthening the market incentive cycle, making liquidity more and more fragile. Once there is a new stimulus, such as the resurgence of the winter epidemic, or changes in monetary and fiscal policies brought about by the general election, the dollar liquidity crisis may break out again. However, this article believes that the market shock brought about by the recurrence of the epidemic is indeed likely to cause a liquidity crisis, but this time the intensity will be much smaller than last time, because, first, the US dollar has expanded by 67% since March; The main theme of the signal is "Under the current situation, the budget deficit should not be a priority, and the risk of overdoing the proactive fiscal and monetary support policies is relatively small." The worries about future liquidity will not be as serious as in March. Considering liquidity factors alone, the market risk off sentiment will not occur on a large scale. In addition, these signals from the Federal Reserve have also reduced the impact of the US presidential election on monetary and fiscal policies. Therefore, considering the above factors comprehensively, the liquidity crisis in March may happen again, but the possibility of happening is small, or even if it happens, the intensity will be much smaller than last time.

secondary title

The Narrative of Bitcoin's Future

digital gold

Essentially, Bitcoin is an alternative currency system that provides currency independence, which makes Bitcoin a hedging asset. Moreover, this is the only monetary system that has implemented a deflationary policy so far, so it has better inflation hedging properties than gold. Bitcoin is "digital gold" and has always been the most respected narrative in the encryption market. Many people believe that Bitcoin was built to withstand the turmoil of the global economic crisis.

Indeed, Bitcoin has been a relatively independent and uncorrelated asset in its past history. However, the plunge in March and the level of correlation between Bitcoin and U.S. stocks have made many people question Bitcoin's safe-haven asset attributes. Because, if Bitcoin is going to be a true safe-haven asset, it must be resilient against volatility in other financial markets, especially in times of turmoil like this.

This view is not entirely accurate, because in the previous two parts, we have discussed that this market crisis is a US dollar liquidity crisis, and even gold has been affected in this case. It is necessary to distinguish different hedging logics corresponding to different types of risk events. As a monetary system not controlled by any sovereign state, Bitcoin is an insurance against the collapse of the financial system, economy and political system. This should not be denied because of its performance in this liquidity crisis. And as analyzed earlier, the market structure and infrastructure at that time also had an unshirkable responsibility for the collapse of the encryption market.

Of course, it is undeniable that compared with gold, the public's awareness and acceptance of Bitcoin as a safe-haven asset still has a long, long way to go. Thankfully, we've seen some encouraging changes. After experiencing the plunge in March, more mainstream institutions and groups saw the safe-haven value of Bitcoin.

Legendary Wall Street hedge fund manager Paul Tudor Jones announced in May that he would hold Bitcoin as a macro hedge. Paul was not particularly keen on Bitcoin in the past, but after witnessing the Fed's flooding, Paul said that "Bitcoin reminds me of gold when I first entered this industry in 1976."". In a letter to investors, Paul offered:"We are witnessing enormous monetary inflation—an unprecedented inflation of all forms of money, unprecedented in the developed world. The best profit maximizing strategy is to bet on the fastest horse, and if I had to make a prediction, it would be Bitcoin."

As manager of a nearly $40 billion hedge fund and legendary trader, Paul's opinion carries more weight than anyone else's. I believe that other hedge fund managers will also have to pay attention to the emerging thing of Bitcoin and encrypted assets.

In addition to investment institutions, companies with foresight have also taken an important step. In August of this year, MicroStrategy, a traditional industry giant, announced that it will adopt a new fiscal reserve policy and will continue to use Bitcoin as the main fiscal reserve asset. In the following month, MicroStrategy spent nearly $400 million to purchase approximately 38,250 bitcoins. This is the first listed company in the world to publicly announce that it will use Bitcoin as an asset allocation. The reason why MicroStrategy invested in Bitcoin is also very simple. They are worried about the macro economy and believe that Bitcoin is a reliable store of value better than cash. The reason to buy bitcoin instead of gold is that bitcoin is "harder" than gold.

Perhaps, more and more companies will join the ranks of Bitcoin allocation in the future. On October 8, square, the payments company founded by Twitter CEO Jack Dorsey, announced that it had purchased $50 million in bitcoin. "We think bitcoin has the potential to become a more common currency in the future," said the company's chief financial officer.

From the code in the hands of geeks, to the hedging assets in the eyes of top investment institutions, to the asset reserves on the financial statements of mainstream companies, perhaps, Bitcoin has gone from 0 to 1 on the road to becoming "digital gold".

Tech stocks and risk assets

Looking at Bitcoin's price history alone, the growth phase of Bitcoin's price action is like that of a tech stock -- both are driven by growth in the network (number of users, number of nodes, transaction volume). Furthermore, as a revolutionary technology, Bitcoin’s risk profile is very similar to that of tech stocks: if Bitcoin reaches its potential, its value could be enormous, but at the same time, it can fail completely and be worthless .

This perception makes sense, given the fact that Bitcoin is both a cryptocurrency and a technology. The underlying technology of Bitcoin is as new as the Internet. It may become a new global payment method that is popularized, it may also become a value storage tool that replaces gold, and it may become a next-generation financial system. Thus, cryptoassets such as Bitcoin may be experiencing the Dotcom stock market phase of the 90s that the Internet experienced, where Internet technology exhibited a very volatile asset class, which also included various speculative stocks.

Like any other technology that changes the world, early-stage bitcoin and crypto assets remain a high-growth, high-risk asset. This is why the price of Bitcoin has so far been characterized by such high volatility and high returns. Research by Chainalysis shows that Wall Street institutional investors are increasingly entering the Bitcoin and crypto markets. Some well-known stock market day traders have also taken an interest in Bitcoin - and they are scouting for exciting alternatives to stocks. When investors and traders view Bitcoin as a technology stock, they will adopt stock market thinking to react to the crypto market, and their actions will also be reflected in the price of Bitcoin.

So, what exactly is Bitcoin? For a single participant, it is one or more of payment methods, safe-haven assets, technology stocks, alternative investments, and the next-generation financial system; for the entire market, Bitcoin is all of the above. Of course, at some stage, one or more narratives are bound to dominate the market. This/these dominant narratives guide investor behavior, which in turn determines how the market reacts to the outside world.

Tech stocks and digital gold are the two narratives currently dominating the bitcoin and crypto markets. From the perspective of development stage, at this stage, Bitcoin may be 2/3 technology stocks (including speculative attributes), and 1/3 digital gold. These two specific ratios are just very subjective feelings. As more and more mainstream investment institutions, companies, and individuals use Bitcoin as a hedge against fiat currency depreciation and economic and political systemic risks, its narrative focus will increasingly be biased towards digital gold. But there is still a way to go "from 1 to 100".

Of course, the narrative and cognition about Bitcoin is constantly evolving, and there are more possibilities for it in the future.

image description

Summarize

Based on the research on the external and internal reasons of the recent black swan in the encryption market, this paper proposes a "black swan event deduction framework in the encryption market" suitable for the current environment, which is used to help investors identify the risks and black swans facing the current encryption market. Likelihood of swans happening. Finally, the article discusses two major influencing factors in the deduction framework, including the future direction of the Fed's policy and the development of Bitcoin narrative.

As for the possibility of a similar black swan event happening again in the near future, this article’s opinion is that the liquidity crisis in March may happen again, but the possibility of it happening is small, or even if it happens, its intensity will be much smaller than last time . However, the current dominant narrative of encrypted assets may still be high-growth and high-risk assets, which means that risky investment and speculation are dominating market pricing. In addition, the market structure or infrastructure problems exposed in the 312 incident will take longer to improve. Therefore, if there is another US dollar liquidity crisis, the crypto market is likely to be affected again.

But we need to think more about the possibility of crises other than liquidity, and the future development direction of the Bitcoin narrative. Fortunately, we have seen the shift in perception and actions of the mainstream crowd towards Bitcoin from cases such as Paul Tudor Jones, MicroStrategy, and square, and we believe that as the consensus on Bitcoin as a safe-haven asset continues to grow, it can Respond to and benefit from more types of external risks.

BTC

金融

Welcome to Join Odaily Official Community