Tuesday, November 21, 2023

Desperately Seeking Retail

The SEC has a long history of refusing to approve spot Bitcoin ETFs, on the reasonable basis that the Bitcoin market was heavily manipulated. Crypto-skeptics like Bitfinex'ed and Davd Gerard have been pointing out obvious instances of manipulation for many years, and there is a considerable academic literature demonstrating manipulation, such as Crypto Wash Trading by Lin William Cong et al, which demonstrates:
abnormal first-significant-digit distributions, size rounding, and transaction tail distributions on unregulated exchanges reveal rampant manipulations unlikely driven by strategy or exchange heterogeneity. We quantify the wash trading on each unregulated exchange, which averaged over 70% of the reported volume.
Unfortunately, despite knowing about the manipulation, the CFTC approved Bitcoin futures ETFs. Among the requests that the SEC refused was one from Grayscale Bitcoin Trust. Grayscale sued the SEC and, back in August, the panel of judges ruled in their favor:
The court's panel of judges said Grayscale showed that its proposed bitcoin ETF is "materially similar" to the approved bitcoin futures ETFs. That's because the underlying assets— bitcoin and bitcoin futures - are "closely correlated," and because the surveillance sharing agreements with the CME are "identical and should have the same likelihood of detecting fraudulent or manipulative conduct in the market for bitcoin."

With that in mind, the court ruled that the SEC was "arbitrary and capricious" to reject the filing because it "never explained why Grayscale owning bitcoins rather than bitcoin futures affects the CME’s ability to detect fraud."
The prospect of the SEC approving this ETF and others from, for example, BlackRock and Fidelity led to something of a buying frenzy in Bitcoin as shown in the "price" chart, and in headlines such as Bitcoin ETF Exuberance Drives Four-Week ‘Nothing for Sale’ Rally:
Bitcoin is climbing for a fourth consecutive week, with the digital token’s price lingering just below an 18-month high of $38,000, as more investors bet that US exchange-traded funds that hold the largest cryptocurrency are on the verge of winning regulatory approval.
Below the fold I look into where this euphoria came from, and why it might be misplaced

There already are spot Bitcoin ETFs, just not in the USA. I believe the first launched in:
February 2021, when the Purpose bitcoin ETF launched in Canada. Unlike GBTC, which trades over-the-counter, Purpose trades on the Toronto Stock Exchange, close to NAV. At 1%, its management fees are half that of GBTC. Within a month of trading, Purpose quickly absorbed more than $1 billion worth of assets.
So why would a US-based Bitcoin ETF be a big deal? The thesis is that by making it easier for US investorsgamblers to put money into BTC it would increase demand and thus the price. This anticipated flood of retail money would solve the long-standing problem for cryptocurrency exchanges and whales, the Greater Fool Supply-Chain Crisis. There is a shortage of suckers:
The number of over-the-counter desks has declined, with mainly the more conservative ones remaining, according to Tegan Kline, co-founder of Edge & Node, which developed a crypto project called The Graph. That, combined with the erosion of leverage, has sapped liquidity.

“Leverage is gone,” Kline said. “A lot of people have pulled money out of the system or they have money stuck at FTX.”
The "price" has been soaring, even though the anticipated flood of retail dollars hasn't yet, and may never, show up. That is the real problem, as shown in the graph of Coinbase's trading volume. Volume, and thus liquidity, has collapsed since the heady days of 2021. In Coinbase Q3 earnings: Regulatory clarity is all we need. And a miracle or two, Amy Castor and David Gerard lay out the recent history of Coinbase's income from trading fees, which I have re-formatted into a table.

Q4 20212,185.890.84.2
Q1 2022965.847.24.9
Q2 2022616.239.06.3
Q3 2022346.119.85.7
Q4 2022308.813.44.3
Q1 2023352.422.36.3
Q2 2023310.017.15.5
Q3 2023274.514.15.1
The numbers show three things clearly:
  • Retail trading fee income has collapsed, down 87% from its peak.
  • Institutional trading fee income has collapsed 84% from its peak.
  • Coinbase is wholly dependent upon retail traders, who account for around 95% of its fee income.
Castor and Gerard write:
Trading volume is the lifeblood of a crypto exchange — and Coinbase’s is through the floor. The exchange saw $76 billion in total trading volume in Q3, down from $92 billion in Q2. (They did $547 billion in trading volume in Q4 2021, their last profitable quarter.)
So volume is down 84% from its peak. No wonder Coinbase laid off staff in June 2022 and January 2023. And why Blockchain.com just raised money at less than half its valuation in 2022.

The problems are exacerbated by the fact that last June the SEC sued Coinbase for:
selling unregistered securities and running an exchange, a broker-dealer, and a clearinghouse as part of the same operation — and without registering any of these.
Castor and Gerard point out that:
If the SEC wins, Coinbase may have to stop trading in any cryptos other than CFTC-regulated commodity coins such as bitcoin. There isn’t enough volume in those for Coinbase to live on.

This is why Coinbase is so insistent on trading blatant unregistered securities — it’s all they have left for a business model.
Lynn Parramore transcribes an interview with Jim Chanos in Jim Chanos: “The Crypto Ecosystem Is Well-Suited for the Dark Side of Finance.” that expresses the famed short-seller's skepticism:
JC: ... The last iteration that you just touched upon is the hope by aspects of Wall Street that crypto gets institutionalized because the one thing that Bitcoin really has — and we’ve pointed this out to our clients — is ridiculous levels of transaction fees associated with it. So Coinbase, for example, which is one of our shorts, charges customers over 4% per round trip trade to transact in a so-called currency.

LP: Why would people be willing to pay that?

JC: Well, exactly. They think the asset price is going to go up. It’s like a Nasdaq stock, not a currency. So they’ll pay, and Wall Street wants the fees. The cost structure in crypto is quite high and so the fees are really high. You need retail investors because institutions aren’t going to be paying 4% per round trip to buy and sell Bitcoin. Mom and Pop are, so Wall Street needs to keep the public interested in the crypto space. The paradox, of course, is that if BlackRock and Vanguard and whoever do get ETFs, it’s actually going to force fees down, not up, because ETF fees will be a fraction of the cost of what Coinbase or Binance charge. It’s like mutual fund fees and stock trading fees: they’ve all converged to zero.
So, even if there is a flood of retail money into Bitcoin ETFs, the exchanges' fee income isn't going to recover. Chanos' students share his skepticism about the industry:
LP: Are your Wisconsin students still excited about crypto?

JC: They were much more enthusiastic in 2021, 2020, 2019. There’s a lot less enthusiasm now in terms of students going to work for a crypto startup or whatever. I had a number of them in 2020 and 2021 who said they were going to work in the digital currency or blockchain space. I don’t hear that as much anymore.

LP: How about your Yale students?

JC: The last two springs, they’ve been skeptical. During the spring semester of 2022, Bankman-Fried’s now-infamous interview with Bloomberg dropped about an hour before my class started. I ran to the audiovisual department to see if I could get the interview up on our screen because to me it was such a bombshell. This was where Bankman-Fried basically called the crypto ecosystem a giant Ponzi scheme. I told the class it was very rare to get an industry leader telling you that his industry is a Ponzi scheme. That was seven months before the collapse.
Will the flood happen? Teresa Xie's Former Crypto Day Traders Say No Thanks Even as Bitcoin Roars Back presents some negative evidence:
Craig Murray, who estimates he made almost $200,000 in the market, says he escaped losing everything to FTX by a hair after friends in the industry heard whispers about its imminent collapse. By that point, the 23-year-old — who lives in New York and recently dropped out of Vanderbilt University — had made up his mind.

“That kind of put me over the edge,” Murray said. “I just decided it wasn’t worth it. Why would I have my money in this space when there’s a chance that one day it could just all go away?”

Another sign that retail investing in crypto isn’t returning to previous levels can be seen in weekday versus weekend volumes, with the presumption that the typical person trading on a weekend is a day trader.

“It’s not unusual nowadays to see weekday trading volume average 50% higher values than weekend trading volume, whereas in the past this ratio was almost 1:1,” said Fredrick Collins, chief executive and founder of crypto data platform Velo Data.
So it seems unlikely that there will be a huge flood of retail dollars into the market. Even if there were, they would go into Bitcoin ETFs, which would present the exchanges with two big problems:
  • much less retail trading, because it would migrate to ETFs for low fees and the security of dealing with institutions like BlackRock,
  • and a much higher proportion of very low fee institutional trading.
It seems likely that even if the cryptosphere's hopes for ETFs materialize the exchanges will end up in an even worse position than they now are.


David. said...

My take on the Binance settlement, which at $4.3B sounds large but in context is just the cost-of-doing-business, is that DoJ didn't want to and didn't need to take the heat for shutting Binance down.

I agree with David Gerard and Amy Castor when they argue that compliance will severely hamper the future Binance, both because it will shed the most profitable customers who are "here for the crime", and because of the large extra costs of compliance. But I also think that DoJ figured out that, as this post argues, the future for regulated exchanges is grim. The DoJ knows the SEC is going to let BlackRock and Fidelity stomp all over Binance's fee income, and that of the other regulated exchanges. So there was no reason to draw flak by explicitly shutting Binance down; compliance and ETFs will do the trick for them without leaving DoJ's fingerprints on the corpse.

David. said...

Patrick McKenzie's take on Binance in The Bond villain compliance strategy is well worth reading:

"Binance will suffer a wave of tag-along enforcement actions, in the U.S. and globally. Partly this will be for face saving; global peers of the U.S., which Binance has transacted billions of dollars in, will largely not want to signal “Oh we’re totes OK with money laundering for terrorists and child pornographers”, and so they’re going to essentially copy/paste the U.S. enforcement actions. They will then play pick-a-number with Binance’s new management team, who will immediately cave.
Many crypto advocates believe the U.S. institutionally wants to see Binance reform into a compliant financial institution. They are delusional. The U.S. is already practicing their lines for the next press conference. This course of action allows them to deflate Binance gradually while minimizing collateral damage, which responsible regulators and law enforcement officials actually do care quite a bit about."

David. said...

David Pan reports that there are some places the hype may be working in Bitcoin ETF Optimism Spurs Largest Asset Inflows Since Late 2021:

"Anticipation of an eventual US spot Bitcoin exchange-traded fund has helped to spur inflows into digital-asset investment products for a ninth consecutive week, the largest run since the crypto bull market in late 2021.

Those products, such as trusts and exchange-traded products, saw inflows of $346 million last week, with Canada and Germany contributing to 87% of the total, according to CoinShares. Only $30 million came from the US, a sign of continued low participation from the country, the asset-management firm said in a report on Monday.
Bitcoin products raked in $312 million last week, pushing inflows to over $1.5 billion since the start of the year. Ether products saw $34 million in inflows last week, almost negating outflows all of 2023."

$1.5B is 9% of daily BTC volume, or 0.2% of "market cap", so don't get carried away.

David. said...

Henry Farrell's How the Feds bounced Binance is well worth reading. Farrell focuses on how cryptocurrencies' use of "incentive compatibility" is fine in theory but not in practice:

"It is how the Binance outcome - or something like it - was plausibly written into the contradictions of the cryptocurrency economy from the beginning; in particular, the contradictions between the theoretical mechanisms that it relies on, and the practical ways in which the economy operates.

To expand that out a bit: the key theoretical grounding of crypto can be found in applied economic theory - specifically, the kinds of ideas about ‘incentive compatible mechanisms’ that were super popular among micro-economists in the 1980s. But a lot of the practice of crypto is anything but incentive compatible. If you, as a crypto entrepreneur, want to maximize profits, you’re going to behave in ways that make the incentives break down."

This is a re-casting of the problem I wrote about in Economies Of Scale In Peer-to-Peer Systems. I first wrote about incentive compatibility in this context in 2013's The Bitcoin vulnerability.

In the decade since I haven't seen anyone propose a viable technology that would push back against these economic forces, and we keep seeing their effects in practice.