BitMEX Co-Founder: What Trends Might the Cryptocurrency Market See in 2022 Amid Macro Economic Influences?

"In the past few weeks, I have reviewed my entire cryptocurrency asset portfolio. I have disposed of any shitcoins that I am unwilling to add to my position, leaving behind Bitcoin, Ethereum, and some other tokens in the metaverse and algorithmic stablecoins."

(This article is authorized to be reprinted from Block Beats, original article here)

Original title: "Maelstrom"
Original author: Arthur Hayes (Founder of BitMEX)
Original translation: Wu Zhuocheng, Wu Shuo Blockchain

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The most psychologically impactful measure of your portfolio's health is the annual return rate. As always, our goal is to maintain or increase the purchasing power of assets relative to the cost of energy. The essence of human civilization is the conversion of the potential energy of the sun and earth into kinetic energy that supports our physical functions and modern way of life.

Making money is not the goal, as money is just an abstract concept of energy. The correct way to measure your financial success is to determine how much energy (in this case, using oil as an example) your current lifestyle consumes and how much it will consume in the future (which is, of course, difficult to measure). Then, you must ensure that the growth rate of your financial savings exceeds your expected rate of energy consumption.

The market does not stop because of the clock striking 12:01 am on January 1, 2022; returns are inherently compound and path-dependent (translator's note: referring to the inertia of price trends). Unfortunately, only a few trading days are truly significant. A simple example can illustrate this point.

Let's go back to January 1, 2020, when the world was still simple, and the global madness of the coronavirus had not yet taken shape. At that time, the price of Bitcoin was $7,216. By the end of that wonderful year, Bitcoin's price was $28,996, with an annual average return rate of 302%. Who made more money, Bitcoin investors or Pfizer?

Although this is an impressive annual return rate, it masks the intense turmoil the market experienced in mid-March. Let's focus on March 2020.

On March 16, Bitcoin experienced a correlated moment as the global realization of the COVID-19 pandemic being real and highly destructive, causing Bitcoin and all other global risk assets to plummet together.

A correlated moment is when all risk assets fall simultaneously, and investors in margin trading are eager to sell all assets to increase the global reserve currency (currently the US dollar) to repay loans. No asset is spared. Only when the dust settles and fear dissipates will asset prices begin to move again in a more peculiar way.

From January 1 to March 16, Bitcoin's price plummeted by 38%. Many were stopped out, either psychologically or forcibly (psychological stop-loss is when the price of an asset reaches a certain internal pain point that forces you to press the "sell" button. Forced stop-loss is when your leverage provider closes your position to retain some collateral value).

The table above illustrates the results of path-dependent outcomes, both good and bad. The most important lesson is that the trading behavior on March 16 was the most crucial day of the year so far. Exceptionally skilled traders who were on the trading spaceship had the opportunity to significantly increase their portfolio return rate from the low point on the 16th to the end of the year by over 250 percentage points higher than those who started investing on January 1.

If you unfortunately exited on the 16th but have the energy and financial capability to re-enter the market, the date of regaining your position is crucial. It was not until April 21 that Bitcoin returned to the level of January 1. The longer you wait, the lower your compounded return rate for 2020.

Active traders must appear on days like March 16, sell positions and buy back shortly after to create a consistent compounded return rate.

For investors unwilling to watch Bitcoin all day, you must construct a portfolio that exhibits convexity on catastrophic days like March 16 (translator's note: a portfolio profit curve showing the right half of a smile curve, where profits from price increases are greater than losses from price declines, simply put, earning more and losing less).

The most important psychological barrier to overcome is abandoning the concept of annual arithmetic returns (translator's note: single compound returns calculated by arithmetic averages) and transitioning to compounded returns (translator's note: compound returns calculated by geometric averages). The example above illustrates the negative impact of compounding; if you do not protect your chips during downturns, you cannot participate in the rebounds.

To achieve the above, you must eliminate emotional factors when making investment decisions and use leverage wisely. The former requires more skill than the latter because completely changing your investment philosophy is very difficult (especially considering that most investment literature focuses on arithmetic returns). What's worse is that all fiduciaries (fund managers) are paid annually.

If your fund manager loses all your assets, the worst-case scenario for them is temporary unemployment, while if the market moves in their favor, you pay them a percentage of your earnings annually, which over time can ruin your compounded returns. I do not have a solution to the custody problem, but remember it exists and adjust your behavior accordingly.

The significance of this Bitcoin price history lesson is to discuss how I am positioning my investment portfolio this year before what I believe will be a series of catastrophic trading days like March 16, 2020. As usual, this is related to the Fed reducing the growth of its balance sheet to 0% and subsequently raising interest rates one to three times in 2022.

I will start the discussion from why interest rates are so important, then discuss how the aggressive short-term policy rates set by central banks will cause the most pain to global risk assets within three to six months. I believe the Fed and other central banks around the world will have no choice but to continue printing money.

However, at some point, domestic politics in many countries may require tightening the money supply to quell civilian dissent as their food, housing, and transportation costs rise significantly.

Listen Up

When it comes to central banks, transparency in future actions is considered fashionable. However, despite the obvious data, top officials refuse to acknowledge that printing money is the cause of social tearing currency inflation. Since the Great Recession of 2008, those in power have accumulated a vast amount of fiat currency. Those who care about fundamentals and similar nonsense are underperforming. Don't be silly, hurry up and buy this damned market.

Although policies often change, the Fed is very clear about what they intend to do. The "temporary" currency inflation has now been put on hold, and the Fed has hinted that it is time to curb food, energy, and transportation inflation at the expense of financial asset prices. To achieve this, they have decided to stop buying bonds by March this year, and if their "dot plot" holds, the first rate hike will occur between March and June.

Most market participants believe that the Democrats will instruct the Fed to raise rates, and the Fed will comply. Democrats must prove their tough stance on inflation to avoid being completely defeated in the November congressional elections. However, there is no consensus on how short-term rate hikes will affect financial assets - whether they will withstand the storm or succumb to pressure.

Let's forget about the views of non-crypto asset investors. My interpretation of the sentiment of crypto asset investors is that they naively believe that the growth of the entire network and user base will continue to drive the rise of crypto assets without decline.

In my view, this foreshadows a serious collapse, as the harmful impact of rising interest rates on future cash flows may prompt speculators and margin investors to sell off or significantly reduce their crypto assets. I do not deny that faithful hodlers continue to accumulate after price crashes, but in the short term, these "diamond hands" cannot prevent catastrophic price drops. Remember, as long as the trading price of one Bitcoin is $20,000, the eventual price will be $20,000, even if there are still 19 million Bitcoins not being traded in the market. The final trading price is determined by the marginal sellers giving up, even if the trading volume is small.

The most destructive impact of the final trading price is the psychological impact on weak traders, which will affect the liquidation of underwater positions on leverage trading platforms. So, don't tell me that all the OGs in the crypto market are busy buying the dip; when fund managers ruin your position, none of this matters anymore.

For over a decade, crypto asset investors have been coveting the entry of "institutional" investors into the field. Now, they have finally arrived, as indicated by the headline from Bloomberg below. Although the allocation of assets is small, there are enough believers from the TradFi world to make a difference.

"Billionaires Are Embracing Crypto in Case Money 'Goes to Hell'"

This article discusses how prominent CEOs and investors like Tom Peterffy of InteractiveBrokers and Ray Dalio of Bridgewater hold Bitcoin and other crypto assets as a hedge against fiat decline.

While wealthy individuals operating large TradFi firms can withstand significant price drops, their followers may not. The asset management industry is eager to invest in crypto assets, as these overpaid mimic chefs won't lose their high-paying jobs when prices drop.

They neither believe nor are loyal to Satoshi Nakamoto. Therefore, if external conditions prove the need to reduce their allocation of crypto assets, they will not hesitate to liquidate their positions - no matter the losses.

Institutional investors are constrained by the power of Eurodollars (holding dollars outside the U.S. domestic banking system). Essentially, the world is shorting the US dollar. When the dollar price falls, credit expands, and financial assets rejoice. When the dollar price rises, credit contracts, and financial assets frown. Reading Alhambra Investments' blog can provide a deeper discussion on how this market operates.

The rate of change in the money supply, i.e., its first derivative, is the most crucial factor determining whether institutional investors are bullish or bearish.

The white line represents the U.S. M2 growth rate, which steadily increased in 2019. In March 2020, the Fed nationalized the corporate bond market using its magical money printer and rescued the U.S. bond market by bailing out a group of macro hedge funds that were over-leveraged.

This led to a jump in the M2 growth rate. As the Fed's balance sheet expands, the rate of M2 growth slows down (by the law of large numbers), and the U.S. government has not allocated enough fiscal spending to continue accelerating money printing.

Currently, the Fed predicts a slowdown in the growth of its balance sheet to zero. If they do not reinvest maturing bonds in their portfolio, their balance sheet will effectively shrink. The ugly white arrows in the chart above indicate the impact this could have on the money supply.

The yellow line represents the Bitcoin/USD price. The loose monetary conditions in the U.S. certainly affected the rapid rise in prices (though delayed by a few months). Since the M2 growth stagnated, Bitcoin has been consolidating. If the M2 growth rate reaches 0% or even negative in the short term, the natural conclusion is that Bitcoin (without gradual growth in user count or transactions processed through the network) may also decline.

I could paste more charts depicting the credit impulses of different countries, but they all paint the same picture. Villagers have awakened because the prices of meat, vegetables, taxis, rent, and other essentials are rising faster than their wages. Inflation has become their number one enemy.

If politicians around the world want to continue reaping the benefits, they must pretend to do something. Therefore, it's time for central banks to put on some song and dance, at least temporarily, and they will be willing to relax their balance sheets, returning to positive rates that reflect various domestic economic realities.

Baseline Assets

Bitcoin represents the currency/energy of the encrypted world.

Ethereum is the decentralized computer of the internet.

In most cases, every other major crypto asset can be classified as follows.

1. Tokens tied to Layer 1 protocols have the potential to become the "next Bitcoin or Ethereum." These networks have greater scalability, can process more transactions per second, or are anonymous. For example, Monero to Bitcoin, or Solana to Ethereum.

2. Another type is tokens that use existing Layer 1 protocols to perform certain expected functions, such as Axie Infinity, which is a token-based game that uses NFT assets residing on the Ethereum blockchain to make money.

A token either tries to be a better version of Bitcoin or Ethereum, or it uses the functionalities of these two networks to create a new product or service.

Both Bitcoin and Ethereum have some fairly obvious drawbacks, and if another crypto asset can replace either one, their value will naturally explode. Anyone who discovers the above token early will become rich in crypto assets.

Many Layer 1s have high and rising expectations premiums, but these protocols are traded on expectations because their fundamentals (such as the number of wallet addresses or the amount of actual transaction fees paid in native tokens) are pale compared to Bitcoin or Ethereum.

This does not mean that a particular coin cannot become a winner over a long enough period. However, we are not concerned about the long term; we are concerned about the next 3 to 6 months and protecting the downside space of our investment portfolio.

Regarding tokens that rely on the Bitcoin or Ethereum blockchains to fulfill their functions, the value of these tokens (in theory) should not exceed the protocols they are built upon. This is the difference between the general application of investing in a technology and a specific application - a general application is more likely to provide iterative impetus for multiple successful specific applications, hence a general application should be valued higher.

While there is a significant gap between the market values of Ethereum and ERC-20 dApps, in a specific timeframe, the price of dApps will rise faster than Ethereum. Of course, during a decline, these dApps will lose value faster than Ethereum.

This is how I view the world. Therefore, I benchmark all returns in my crypto asset portfolio against Bitcoin or Ethereum. I enter this crypto world by exchanging fiat for Bitcoin and Ethereum, as these tokens always lead some rebound, followed by the time to buy low and sell high shitcoins. In this process, my holdings in Bitcoin and Ethereum may increase.

If I believe that in 3 to 6 months, the trading prices of Bitcoin and Ethereum will be below $30,000 and $2,000, I will sell all my shitcoins. This is because Bitcoin and Ethereum are the highest-quality tokens, and their decline is less than all unconfirmed competitors. Any specific application using Bitcoin or Ethereum will also experience a free fall greater than 9.8m/s in a real crypto asset hedging environment, and these shitcoins may fall 75% to 90%.

The trend of the TradFi system primarily depends on the fluctuation in the cost of Eurodollars, while the crypto market may be pegged to Bitcoin and Ethereum. I do not have concrete data on this, but my intuition tells me that there are currently billions of dollars worth of Bitcoin and Ethereum used as collateral, with holders depositing Bitcoin/Ethereum and receiving dollars as returns.

These dollars are used to purchase assets such as cars or houses, as well as to mine shitcoins. If you think we are in a bull market and you already have a benchmark, it makes sense as a trader to leverage up and buy a shitcoin, as a 10% rise in Bitcoin can yield a 10x return.

Whether you purchase a shitcoin or more SHIB, if Bitcoin or Ethereum drops by 20% to 30%, you will be forced to sell assets and raise Bitcoin or Ethereum to avoid liquidation. The contraction of the benchmark asset's fiat price will lead some margin traders to sell their shitcoin positions regardless of profitability. This is the reason for the final price being influenced by marginal weak sellers.

It doesn't take much margin selling pressure to burst this bubble. Those CTMD thieves with high Farming APYs will exit to profit once shitcoins start to tank. Even if only a small percentage of traders acquire a significant amount of shitcoins with leverage, due to the illiquidity of these coins, it will be challenging to find large buying orders during a downturn. Remember, easy in, easy out.

Timeline

What if I'm wrong? What harm will my investment portfolio suffer if the crypto market continues its bull run without major declines?

1. March to June

During this period, the Fed will either raise rates or not. The market expects the Fed to raise rates, and they will be disappointed if one of three things happens.

1. The Consumer Price Index (CPI) growth rate falls below 2%. Given that this index is "managed" by government statisticians, this is almost impossible to happen. But if the CPI trend significantly declines, political pressure from voters dissipates, and the Fed might be able to publicly reverse the trend.

2. Certain parts of the extremely complex and opaque currency and U.S. bond markets collapse. When you see it, you'll know - this is the Fed's worst nightmare. Since all assets in TradFi are valued based on U.S. currency market prices, the Fed must ensure that this market operates orderly at all costs. Typically, restoring order requires a significant amount of money printing.

3. Inflation is no longer the number one concern for U.S. voters before the November 2022 elections.

Among these three scenarios, I believe the second is the most likely to occur. No one can predict what will happen when the Fed stops providing funds and the currency/U.S. bond markets collapse. There is so much leverage embedded in this system that we cannot know if the methadone will kill the junkies.

By the law of large numbers, simply restoring the previous trend of asset purchases will not lead to a sudden acceleration in the money supply. Therefore, while risk assets will be excited, including crypto assets, the best-case scenario is that asset purchases slowly climb back to previous historical highs. Even if this happens, the only way for the crypto market to rise is for the Fed to openly turn on the faucet and have fiat flow into crypto assets.

If this scenario begins to unfold, there will be enough time to sell fiat, increase your total holdings of crypto assets, or move along the crypto asset risk curve by increasing your holdings of shitcoins. You are always going up the stairs and then down the elevator.

If I am wrong and the crypto market continues to rise, I will not suffer significant losses from stepping on air. Being patient will not cost me much.

2. From June Onward

Assuming I am correct, and the Fed will raise rates at least once before the June meeting, if any of the following scenarios occur, the Fed will suddenly cut rates to zero and start the money printer faster than Usain Bolt.

1. The S&P 500 index drops 20% to 30% from its historical high (reached in the first half of 2022). Whether you are an Asian or European net exporter, or a wealthy American, you likely have massive U.S. equities. The U.S. stock market is the best-performing stock market among developed countries, it is also the largest and most liquid. Too many wealthy people are taxed and spend recklessly, and if the stock market experiences severe turmoil, the Fed will not disappoint them.

Another interesting reflexive fact is that maintaining a 60/40 stock-bond portfolio traditionally means that if 60% of stocks fall, fund managers with trillions of dollars must sell bonds to maintain this ratio, it's written in the playbook.

Therefore, if the Fed allows stock prices to fall, it will increase the borrowing costs for the federal government - as bond prices fall, yields rise - and the government is facing record deficits at this time.

2. Certain parts of the extremely complex and opaque currency and U.S. bond markets will collapse.

3. The November 2022 elections have concluded.

The worst-case scenario is that after November, the parties start acting again. In reality, neither of the two U.S. parties wants to stop the rise in asset prices. Both parties prove their worth by shouting to the world: "I'm in power, and the S&P 500 index is rising!" This makes everyone wealthy and keeps your wealthy donors happy.

After the common people have gone through the dramatic process of voting and expressing their dissatisfaction with the skyrocketing cost of living, they can be forgotten until the next election. The government will continue to raise asset prices through money printing. This is America's business model, and due to the structure of the global economy, this model must be maintained.

Chaos

I am not actively trading around my positions. My goal is to build an investment portfolio that I believe can participate in the uptrend while limiting losses during downturns. As I mentioned earlier, if the return curve of my portfolio is convex, then I am doing well.

While I have mostly talked about the crypto assets in my investment portfolio in this article, I expect my long-term interest rate and forex options portfolio - through my investment in volatility hedge funds - to compensate for any losses in crypto assets.

However, if I am honest with myself, I may need to increase more so that I have enough Vega (translator's note: sensitivity to changes in volatility) to act in a downturn.

I don't want to sit in front of the screen for hours on end, day after day, staring at my Bitcoin. I don't like that.

Some traders do this and are successful short-term traders, but these traders must be very focused. If you cannot or do not want to be on call 24/7, watching over your crypto asset portfolio, don't attempt short-term trading.

Over the past few weeks, as these thoughts brewed in my mind, I made a decision to take action. I reviewed my entire crypto asset portfolio. Any shitcoin I wouldn't be willing to increase my position in, after dropping 75% from current levels, I cut loose.

This left me with Bitcoin, Ethereum, and some other assets in the Metaverse and algorithmic stablecoins. The size of holdings does not depend on the nominal amount you hold, but the percentage they make up of your total assets. A 100 BTC position can be significant for some and too small for others. Everything is relative.

Now, I am waiting. I am still fully invested in my benchmark crypto assets. Your benchmark may be similar or different from mine. I've given you my reasons, and you should think about why you believe your benchmark is effective in your energy-targeted background.

If the price of Bitcoin reaches $20,000 or Ethereum reaches $1,400, I will start to doubt the energy value of these crypto assets. These two prices were historical highs during the 2017 bull market, but that was in fiat prices. If oil goes negative again, who will care if the fiat price of benchmark crypto assets decreases.

I hold fiat, ready for vertical candles. I've been trading in this market for a long time, enough to detect the final blow that breaks the speculative