Market-Making and Phantom Liquidity in the Bitcoin Market

Transcript

all right let's get this afternoon going thank you for coming in after the lunch break it's always like hurting cats I know you all want to Network and and talk to each other but we have a very special and very very impressive person on the stage next uh deela Hayes she is the head of research at coin Telegraph um among many of the other titles that she holds she's the co-chair of our investor working group at CVA and uh she's also a brainiac at zelner en Co I actually don't know your official title there but I'm sure you will mention it um I will give the floor to demelza thank you so much for and let's give her a big round of

applause uh thank you Nikki for the warm introduction so as Nikki mentioned my name is uh deela Hayes and I'm no longer the the head of research at coin Telegraph but he is around here somewhere uh no no problem I I'm the chief Economist at coin Tegra gra and I'm also a portfolio manager at zelner inco and that's a finma licensed asset manager in Zur so um today uh we're going to be discussing Market making for Bitcoin and the problem of phantom liquidity so during this presentation uh I'm going to start out with talking about global adoption of Bitcoin and some of the obstacles that are standing

in the way of Bitcoin coin being used as a medium of exchange unit of account and eventually as money and then I'm going to discuss um how flash crashes happen what we've seen from the cryptocurrency market and I'm going to uh discuss the unique solution that zelner andco has designed so that we can provide real liquidity to the Bitcoin market so if we talk about uh trading volume what we see currently for Bitcoin on on spot markets is that we're looking about 10 billion to 20 billion per day um in spot trading volume now this isn't

the whole picture of course because we've got a lot going on with OTC desks and we don't know exactly how much is happening with the OTC desks but what we can see is that we're not quite as uh as we don't have as high of a trading volume as we did back in the last uh peak of the market in 2021 but one aspect of uh bitcoin's adoption is having a stable purchasing power so for example if you have uh let's just imagine we have a standard that's based on gold and everything at the grocery store is priced in Gold so if you go and you try to buy a gallon of milk and today it's one gram of gold just as an example and tomorrow it's

1.05 gram of gold the producer of the milk doesn't know if the demand for milk went up or the demand for gold went up right so if the producer of the milk thinks okay the prices are up I should produce more he then goes and buys More Cows hires labor and and gets more land produces more milk then at the end of the year maybe he realizes that actually the price of milk only went up because the demand for gold went up and then there's a misallocation of capital so one of the key things that we need from our money is actually to be like a a non-noisy surrogate of information to entrepreneurs that are deciding how to

allocate Capital so this is going to give information from demand from consumers to entrepreneurs that are providing goods and services to the economy and if we have noisy signals which is what we have right now right we have Fiat currencies that very noisy signal of what the real demand is behind because we don't know what what is caused by inflation versus what's really caused by change in demand and this is where the misallocation of capital happens so one thing that's stopping Bitcoin from being globally adopted as a medium of exchange is this volatility right so if we really want to come in and change that volatility we have to look at the liquidity now in terms of uh volatility

we have been coming down so even though our spot Market volume has not been increasing our volatility has been decreasing which is putting us in the right direction that we want to go if we're going to see Bitcoin as a global uh standard and and Reserve asset so we used to be around 100% uh annualized volatility now we're down around 50% so maybe one would think okay there's sufficient liquidity if we look at the spreads uh for Bitcoin in the US dollar spot Market they're as low as 0.001 so we can all pack our bags and go home because it's the problem's been solved right there's no more volatility

the spreads are tight but that's not the whole story that's only if you want to sell one Bitcoin if you want to sell more than that you're going to find out that the spreads are a lot larger than what they are at the top of the order book okay so for example um if you look at the Euro US dollar market you can move about $100 million um instantly with within about 0.02 to 0.03% of the market okay now who thinks you can move a $100 million worth of bitcoin right

now without moving the price anyone from hidden Road here no no that it's impossible it's impossible right now if you try to move $100 million in Bitcoin you're definitely going to impact the price so what we see with Bitcoin if you look at cracken for example if you look at binance in the top row right now minus 2% is around $16 million so if you put in $16 Million worth of trades on binance for USD Bitcoin spot you're dropping the price by 2% so in terms of liquidity the euro dollar market is

about 40 times as liquid as the Bitcoin US dollar market right now so we have a long way to go in terms of actually having real liquidity that's there in case people do want to sell if you were to put this in comparison to to the euro dollar market you would have to move about2 billion do to have the same effect as moving 50 million in the Bitcoin market right now so another issue with the liquidity in the Bitcoin Market is that we don't know how much of it is real liquidity right for example Forbes did a study last year and they said that about

50% of all orders in the Bitcoin spot Market were fake okay so they when they call by fake they mean done by other market makers and not done by retail investors that are looking for economic activity so in history what we saw on the stock market is that when market makers were pushed out we would have flash crashes okay so for example there was a 2010 crash is quite famous my doctoral Supervisor was the chief Economist at the Commodities Futures Trading commission when this flash crash happened and subsequently in 2015 when another flash crash happened and the Dow Jones indust Industrial lost about 9% in 3 minutes and when they went and did an

analysis of what caused this they found that there was a gentleman who had created a whole wall of basically spoofing orders that he had planned to cancel with about 19,000 trades and the goal of it was to manipulate the price um in the direction that he wanted it to go so that he could profit and I think he made about $40 million off of that trade but this was a trillion dollar loss for the market so what we really need with Bitcoin is market makers that are there to stay that they're not leaving when there's real volatility okay so for example like the March 12th 2020 crash in Bitcoin when we lost double digits within hours a lot of market makers left the market right and that's why at

zelner and Co we've created a strategy where we are always in the market so just to talk a little bit about our strategy and how it works um it's a very simple approach so we have 70% allocation to bitcoin 30% allocation to US Dollars uh which are stored in treasuries we have um a risk adjusted exposure which I'll explain shortly but basically that's because we're not fully invested um in Bitcoin and we collect a volatility premium because we're doing about 800 trades per day where we're constantly rebalancing and doing um a couple million per day on Kraken in volume we have low costs so we are priced like an ETF so we actually priced

less than the valkyrie ETF already and we have no performance fee and we're priced this way because we want to attract liquidity because we cannot actually smooth the vol volatility in the Bitcoin spot Market unless we have sufficient assets under management we also have a very affordable custody fees so we're at 20 basis points per year at Amina um and that's due to our volume which uh at this time we're managing over 50 million in this fund sorry in this certificate so that's why we were able to negotiate fees that are much lower than if anyone just walked into Amina and asked for a custody account finally we're also audited um and as I mentioned uh zelner and Co is uh regulated by FMA and and and they're

based in Zurich we have reduced counterparty risks and uh the product is bankable so it's it can be you can invest in it with Bitcoin you don't have to go into Fiat first or you know you can invest in kind so just to explain how this strategy Works um this is a very simplified example but we start out with 70% allocation and if the price of Bitcoin starts to fall we rebalance and buy High Bitcoin so that we're always back at that 70% allocation in this example it shows us getting down to 50/50 but we never get close to that we rebalance the second week get down to 69.9% for example and this is how our algorithm

works so on the horizontal axis we have different time periods so this could be minute one minute 2 minute 3 minute 4 minute five and on the left hand side axis we have the price so for example if we started a a price of um $10 per Bitcoin as the price of Bitcoin goes down we trigger one of our orders that are sitting in the order book waiting to get executed waiting to get filled and then on the upside as Bitcoin starts to go up in price we sell we sell into that pressure and over time this allows us to collect a a volatility premium because we're always buying low and selling High which I'd be happy to discuss uh more if anyone has questions but this is basically how the systematic approach

Works to providing liquidity and the result is that our distribution our return distribution is slightly narrowed compared to just a direct investment in Bitcoin because as I mentioned we're only 70% exposed plus we have the 30% allocation to cash which is um earning five 5% right now because it's invested in treasuries then we have the volatility premium now you can do something like this on Kraken and on uh binance they'll they'll take your funds and they'll lend them out to people shorters people uh doing the Perpetual Futures and they'll pay you 10 basis points to 30 basis points per year but you're buying a

whole another risk when you uh lend them your coins in this in these earn programs as as we've seen so if you read the terms uh and conditions it's no longer your asset so if you if if they go under or anything like that they don't have to uh give you back your funds so it's a totally different risk versus the return that you're getting now in addition to our strategy making the distribution narrower we're also shifting it slightly to the right because we have the volatility premium now just to kind of give an example of what this would look like in the long run this is how we came up with our Benchmark so for example if you look at

uh the left hand side this is the spot of Bitcoin sorry the price of Bitcoin and this gray line is basically your return from investing in Bitcoin so if you look at the black line for example if Bitcoin drops in price you would get the black line return and we would ours is the uh green line so we would have basically uh sorry ours is the the two pink pink lines so you would have less of a maximum draw down with our strategy on the uph hand side if Bitcoin goes straight up we won't outperform Bitcoin because we're only 70% exposed but now if you imagine that Bitcoin has an s-curve of adoption eventually our strategy will

catch up right because over time as Bitcoin starts to Plateau our strategy will still earn the market making premium so for example in the last two months we were able to outperform bitcoin and generate volatility premium which will help us catch up when Bitcoin has a large move upwards so the main idea of this product is to really be a buyer of Last Resort for Bitcoin to always be in the market and to actually smooth the volatility of Bitcoin and if we can really achieve that then that will unlock one of the obstacles that's stopping Bitcoin

from being uh used as a medium of exchange and and unit of account and eventually a money so if anyone uh would like to join us in that Journey I'd love to uh speak with you afterwards and if anyone has any questions I'm also uh happy to have your feedback so thank you very much for your attention anybody would ask yes well that's a great question so if

you um were to copy paste our algorithm across the whole order book and you wanted to smooth the whole order book we would need about $8 billion in today's current prices now of course as the price of Bitcoin goes up will'll need proportionately more but right now at current prices we need $8 billion to to smooth Bitcoin across the major regulated exchanges and trading pairs yeah but thank you for the question thank you so much appreciate sharing all this knowledge thank you