This is a contributing article from Leslie Lamb, head of Institutional Sales at Amber Group.
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Written as of March 20, 2020
“Fragility is the quality of things that are vulnerable to volatility” – Nassim Nicholas Taleb
The view is never pretty on the front lines of a volatile economy. There is a lifecycle to all capital markets – what goes up must come down. This time is no exception. Coming out of the longest bull market in history, we now find ourselves in a fragile global economy staring mercilessly at a swinging wrecking ball. The swinging has just begun.
Newton’s First Law of Motion, otherwise known as the Law of Inertia, states that an object will remain at rest or in uniform motion unless acted upon by an external force. While this analogy may not perfectly map onto the capital markets (as markets are always in motion and moving in different directions), the point remains that market cycles are driven from peak to trough by the economic machine. Every once in a while, the clockwork symphony stops. And when it does, breakdowns in the market structure eventually cascade into a deafening silence. But not until an external force throttles the system are such underlying structural weaknesses fully realized. This time around, global economies are being put on edge, forced to grapple with the sudden wake of a worldwide health pandemic and the resulting supply and demand-side shocks. Some are already at a standstill. Perhaps, ironically, inertia can exist amidst market volatility.
As we bear witness to an unfolding global economy, we remain laser-focused on two parallel macro narratives:
We see a stronger dollar driven by three subtexts:
Flight to safety: Despite the Fed’s rate cuts and monetary stimulus measures, the markets are seeing increasing demand for cash, pushing up the value of the Dollar Index to record 18-year highs.
Dollar funding issues: Cross-currency basis swaps are a measure of investor preference to hold Greenbacks versus the Euro or Yen. On March 17, the premium on EUR/USD cross-currency basis swap widened from -60 bps to -120 bps, the highest since 2011. At the time of writing, the EUR/USD basis has snapped back to roughly -27bps, while the USD/JPY basis swap widened to -70bps. A negative basis indicates more significant dollar funding stress, meaning that hedging costs are higher for European and Japanese investors. The reality is that US banks, the main dollar funding source, are stockpiling cash reserves instead of actively lending short-term dollars to foreign banks. In light of near term balance sheet stress, more domestic companies are drawing down on their credit lines for cash. Additionally, Many foreign banks that lack direct access to U.S. dollar markets rely on central banks swap lines for funding.
This week, the Fed opened up new swap lines with several other central banks, providing between $30-$60bn each in dollar liquidity, hoping to ease the dollar funding stress.
Central banks in emerging markets are taking emergency measures and cutting benchmark interest rates: Fear of destabilizing domestic currencies is driving investors in the emerging markets to pile into the dollar. As reported by Bloomberg, all major emerging-market currencies have weakened against the dollar since January 20, the supposed onset of CoVid-19 in Asia.
Liquidity crunch in treasuries
Uncharacteristic credit market: In an otherwise ordinary market, volatility would prompt investors to rotate from risk-on assets (e.g. equities) into risk-off assets (e.g. bonds). While this was true at the start of the CoVid-19 panic, investors are now so desperate for liquidity (specifically, cash) that there have been massive sell-offs in bond markets globally, driving down prices and propping up yields.
Repo markets: The Fed’s “come and partake” directive is not working out as planned. In the past week, the Fed has implemented three repo or “liquidity” operations, hoping to ease the Treasury financing markets and lighten up primary dealers’ inventories. Demand, however, remains light.
Let’s now pull the macroeconomic thread through the cryptocurrency markets. Although not necessarily correlated, we find the two intimately tied.
It’s essential to frame price action within the context of volatility. The CBOE VIX Index, a 30-day forward-looking measure of the expected volatility of the S&P 500 Index, spiked up to levels not seen since the last global financial crisis. In tandem, we also saw Bitcoin’s (BTC) daily implied volatility on three-month options run up to 6.8% (130% annualized) and ending the week around 5.9% (113% annualized). As a result of BTC dropping 40% and Ether (ETH) 50% on March 12, now known as ‘Black Thursday,’ several leveraged positions went through forced liquidations. Bitmex alone reportedly triggered $700 million in liquidations of both long and short positions across trading pairs. Meanwhile, ETH’s sell-off wiped 40% from the DeFi ecosystem. Lending platforms such as Compound, dYdX, and MakerDAO saw a total of $10 million in collateral liquidations. But not all assets are behaving similarly in this volatile market.
While BTC looked correlated with equities during the initial stock market rout, coming off 60% its mid-February highs, it has since rallied back about 50% from the March 12 lows. In the past few sessions, we have seen heavy rotations from altcoins into BTC. As of March 20, depending on the venue, the futures curve is either in slight contango (futures contracts at a premium to spot price) or backwardation (spot price at a premium to futures contracts). Interestingly, futures on BitMEX continue to trade at a discount to other major futures exchanges. This phenomenon comes after a week of futures going into backwardation across all venues normalizing the effective funding rates. During this time, borrowing demand for Bitcoin significantly increased. For comparison, when the market was trading in contango prior to March 12, there was almost no borrowing demand for BTC. Now, we are seeing the going rates for BTC increase from ~3-5%p.a to 8%p.a and ETH from 2-4%p.a to 6%p.a across various platforms.
Amidst the wholesale crypto market sell-off, which shaved $45 billion from the entire crypto market cap (as of February 14), Tether’s (USDT) market cap jumped to nearly $5bn. USDT has emerged from the volatility as a safe-haven asset. We continue to see large buying flows in USDT, primarily driven by payment providers and arbitrageurs. USDT prices in China and Korea have been as wide as +7% over FX-implied prices this week. Meanwhile, we also saw USDC’s market cap climb to an all-time high of $630 million. BUSD is punching through the $150 million range, likely driven by the stablecoin’s increased utility within Binance’s ecosystem for lending and margin trading.
Amber’s near term outlook
We are keeping a close eye on the evolving macro narrative involving coordinated monetary and fiscal policy efforts from governments the world over. While we cannot foresee the market moving in a particular direction, we remain positive that crypto as an asset class will stand resilient. In short, our observations:
● Due to the recent market sell-off, open interest (OI) has shrunk by a significant amount, making overall market positioning cleaner.
● As liquidity providers have withdrawn from the market, this has increased the opportunity-set available for nimble and active market participants to take advantage of dislocations. In particular, derivatives (futures and perpetual swaps) continue to trade at a steep discount to spot markets, which has pushed up the interest rates for BTC.
● Shorting spot against a derivatives hedge allows you to earn a carry – a reversal of the market regime we saw throughout last year (with derivatives trading at a premium to spot).
● We also foresee continued growth in the volatility (options) markets, where activity has grown rapidly over the past six months.
● We are currently seeing better buying in both BTC and USDT on our OTC desk ( http://www.amberotc.com ) from hedge funds, arbitrage traders, and crypto corporates.
Volatility is part of the ride, and, through it all, we stay committed to servicing our clients and partners. The economic machine will start up again, but it may take a while. In the meantime, let’s push onwards together.