“It’s like I am inside this ethereal sphere wherein exists no logic, no reasoning, no typicality, no explanations, no realism, no comparisons, nothing ordinary, and no normalcy. And then if you are to understand me, you have to step into my realm and leave all of those things behind. I’m not typical. I’m not ordinary. And I’m not normal. And I never will be ‎. So I don’t see the point of waking up in the morning and wishing to be so.” ― C. JoyBell C.

Before I tell you a story about the 1987 stock market crash, let me preference this article by saying I am not a Bitcoin hater. If anything I am a fan, but not a speculator. I can see an enormous advantage of using the protocols to move money around the world bypassing Swift, thus taking advantage of mostly free domestic transfer rates. And I can even imagine paying with crypto for purchases bypassing credit cards and banks. But we are a long way off from those days. We will need a vastly more mature, regulated and secure market structure for that to happen. Today’s crypto world is but a foreshadow of its future. A blimp; what we see today will be nothing like what we see in 5 or 10 years. You see, for sure, the price of Bitcoin (or any crypto that is used) doesn’t matter to a customer in the case of money transfers involving fiat, since anyone who uses crypto to move fiat just cares about the input and output prices being as close to equal as possible (stable). So, if Bitcoin goes to $100, or Bitcoin Cash $1, I don’t care, except of course if there isn’t enough of it (i.e. liquidity at that price) to do effective transfers at any given time (in which case, I would use another coin!). It might surprise you to learn that it’s entirely possible for dollar volumes to significantly exceed dollar market capitalizations. But probably a stable coin or similar asset-backed coin designed for this purpose would be better anyway then Bitcoin or similar ilk. And, so, this brings me to my story.

In 1987, I was an institutional salesman sitting on a desk in front of the Deutsche Mark futures pit on the Chicago Mercantile Exchange. From that viewpoint, I could send an order (via hand signals) to all the major foreign exchange pits. But this story begins on Sunday, October 18th, 1987. I was a Vice President at Drexel Burnham Lambert in Chicago. The stock market took a beating on Friday, October 16th and I came into the office early Sunday night to watch Simex (Singapore futures exchange) trade. We knew it was going to be exciting, but we didn’t know how exciting. My boss was short two N225 contracts and when the market opened we were in shock. The initial quotes had Simex down 30%-50%. We all looked at each other; what? 50% open lower? It was a total anomaly, but such things can happen in cash-settled futures when liquidity dries up. I can’t remember the exact price, but Ricky, my boss, immediately covered those two shorts something like 30–40% below the previous days close. We all knew at that point, tomorrow, Monday, October 19th (Black Monday) was going to be a very busy day, but little did we know how bad.

Most people today have lived through 2008/2009 and they think they know what a stock market crash looks like, but 1987, was very different than 2008/2009. 1987 was a panic, and, that panic spread like wildfire to liquidations across the board. Everyone sold everything; there were mass liquidations not only in shares but in commodities too. For example, I remember NYMEX copper dropped from around $1 to $0.60 in a few hours after the opening. But the real problems were in the CBOE (S&P 100) cash and S&P 500 futures options. A few traders had sold out of the money puts that were suddenly in the money a few days before expiration. The losses were staggering. A company called First Options, which was a division of the Continental Bank of Illinois represented many of these floor trader members. The next morning, First Options had locked everyone out — door’s shut. But the Fed stepped in immediately, and in force. Greenspan deserves a lot of credit — he flooded the system with liquidity and that time it worked. First Options was recapitalized by Continental Bank (which got money from the Fed) and reopened its doors the next day. The CBOE and CME breathed a sigh of relief, averting a catastrophe. The way exchanges worked in those days, was similar to how Lloyd’s of London worked. All the members jointly guaranteed the capital of the entire exchange. The idea was the combined capital of all members ensured that the exchange would never need capital, even in a crisis. But it was clear to everyone, had the Fed not stepped in, the integrity of the entire exchange (perhaps the US financial system) was in peril. I should point out, however, that throughout Lloyd’s history, as an insurance market, there were many crises related to capital irrespective of this joint capital guarantee method which never worked. And Lloyds never had an implicit guarantee from the Bank of England like the US financial system has provided exchanges and other financial institutions.

After dissecting the 1987 crash in the S&P 500 futures, one of the common theories to blame was the use of portfolio insurance. The idea was that leveraged futures could be used to hedge cash equity positions and manage risk. Equity managers wanted to hoard shares (much like true believers want to hoard Bitcoin). The problem was that as futures prices fell, more selling was required. Futures were forced into backwardation (as speculators chased prices lower), causing sales of shares at the same time arbitrageurs were attempting to buy shares (matching their sales in futures). The cycle created a panic. Yes, computer trading existed then, but I’ll admit it wasn’t as efficient as today.

My lesson brings us to two issues, but it raises a third. The first is that the amount of capital available is critical to the integrity of an exchange (and there is never enough), the second is that when panics happen, you always need additional capital. The third is related to the last point, a well-regulated system will have a lender of last resort available to provide additional capital.

Now here is an additional fun fact:

For America’s first 70 years, private entities, and not the federal government, issued paper money. Notes printed by state-chartered banks, which could be exchanged for gold and silver, were the most common form of paper currency in circulation. From the founding of the United States to the passage of the National Banking Act, some 8,000 different entities issued currency…

Now I will bet it won't surprise you that there was a lot of counterfeiting, fraud and banking crises associated with that system; that brought regulation to the system:

“The National Banking Act eliminated the overwhelming variety of paper money circulating throughout the country and created a system of banks chartered by the federal government rather than by the states.”

Of course, banks who printed money in those days often did so fractionally as they needed to make loans. So, when panics happened, there were banking runs on the gold and silver that these banks couldn’t honor. As a result, there were large banking failures in 1819, 1847 and 1857 — with no lender of last resort, paper holders lost money. It’s also worth noting that long periods of time happened before the trust was lost and regained in these bank-issued notes. Well, think about it, doesn’t a bank-issued note sound a lot like a cyrpto currency, sans the implicit backing of gold and silver (which in many cases turned out to be a mirage since banks operated on a fractional reserve basis). It sure does sound a lot like the miracle system that is bitcoin and its brethren to me. Especially the wild west self-regulation and opaque financial reporting. Perhaps it just took 200 years (1819 to 2019) for us to forget such systems don’t work.

Here are some hard realities from history for the exchanges: when panics happen, a) even exchanges with multiple members are not enough to ensure capital adequacy, b) exchanges that offer leveraged products need a lot of capital, and, c) good regulation combined with a lender of last resort reduces (but does not eliminate) the risks that the exchange might fail. If there is no buyer or lender of last resort history tells us the system will eventually collapse, especially if any leverage is involved. I wonder who is the buyer of last resort in the cryptocurrency sphere? Who will bail out these unregulated opaque casinos that are disguised as financial exchanges? For the record, I’m not picking on any single exchange, I am merely pointing out that the entire market structure is vulnerable by design.

As for money, banks in the past have issued gold/silver backed certificates on a fractional basis. That system has failed over and over again. Money without some sort of backing isn’t “money” worth much. And trust without some verification is useless; Satoshi Nakamoto understood that which makes it interesting how a cult ‘group think’ has re-spun the narrative to allow centralized opaque exchanges to control and trade the vast majority of decentralized transparent crypto. We can debate gold’ and silver’s values, but both have legitimate uses outside their monetary values that create demand for the commodity. So, unfortunately, the better analogue to Bitcoin are those wild west bank notes that ended up such a bitter disappointment. It’s especially true given a financial system that corrupts the intended structural design.

All of this brings us back to the quote with which I started this article. The owners of Bitcoin are living in a fog. Bitcoin is not money, it “might” be a commodity, but it has no use other than being a protocol for moving value; but since it’s open-source, dated technology, and easily replicated, one needs to question that thesis carefully. In fact, it’s been replicated over 2000 times so far! And the copying continues; there are even different versions of Bitcoin that have improved the protocol significantly (lowered transaction costs and increased confirmation times). Add this to a financial structure that has clandestinely retooled the ecosystem and it spells serious trouble. The only reason for any current cryptocurrency to go higher and higher is speculation. Demand for Bitcoin is entirely based on the greater fool theory. Its supply is irrelevant (Bitcoin halving is therefore meaningless) unless there is continuous demand and hoarding of supply. While there is some hoarding of Bitcoin, there is definitely not continuous demand.

Now a lot of people point to increased transactions on exchanges in 2019 as proof demand for Bitcoin is growing.

Something happened in 2019, but it wasn’t increased demand for physical Bitcoin. What happened was that exchanges were seeing a fall-off in cash turnover, so they decided to add new products. One such product was leveraged futures on crypto. What a wonderful product. A total bastardization of Satoshi Nakamoto’s dream. Now you could buy Bitcoin without ever owning much of it because now exchanges would extend you credit to speculate on its price movements up to 100x. But this is not Bitcoin. In fact, these contracts are all cash-settled, you just need a little collateral (in BTC) to leverage a lot of BTC. Volumes as a percentage of total market capitalization went from around 8% in 2017 to 25% in 2019 even as market capitalizations fell. And just like the Simex on that fateful Sunday evening prices can get very distorted over short periods of time (even with the interconnected 24/7 Bitcoin exchanges all using APIs for high-frequency trading and arbitrage).

The futures contracts have indeed increased volumes, but they have brought tremendous risk to the already shoddy, opaque, unregulated and now undercapitalized capital structure of crypto. Very few exchanges offer any real capital guarantees (Coinbase being an exception, but it doesn’t offer futures). Very few, if any, report their actual financial condition, provide audits or issue any sort of information on their legal structure, and all are running centralized systems, that don’t provide any information on the amounts of crypto they hold on behalf of customers. What regulatory reporting exists (and some does now exist) is so limited in scope (mostly KYC/AML) that it lacks any real value.

None of the exchanges promises to guarantee losses for another and no one has ever attempted to create any serious sort of self-regulatory body to protect users holding deposits on exchanges. Even Arthur Hayes, the CEO of Bitmex has been quoted as saying, “don’t keep your crypto on exchanges” at an event in Taipei in 2019. These exchanges are all run by young programmers or junior ex-bankers who have little knowledge or extended experience in financial markets. I reasonably question if they understand the risks. And, clearly, they understandably see little value in regulation or grasp why it even developed in the first place.

I always find it utterly laughable that in a decentralized system like Bitcoin it is so widely held and traded on centralized platforms with no transparency! It is totally against the idea of Bitcoin itself. Not only that, but Bitcoin was never intended to be fractionalized as a debt instrument — which is exactly what futures do — they create leverage on the price movements. That leverage is what is allowing increased trading volumes, but it’s also one of the many factors adding risk to the system.

We wrote a previous article here outlining these risks. But let’s revisit the Bitmex example, one of the more transparent (in a world of opacity) operators. Bitmex claims to offer an insurance fund which currently consists of 33,227 BTC. Bitmex does not publish information on its total deposits (including customer deposits) in crypto, so we don’t know how leveraged the exchange is as a whole. But let’s look at current leverage outside of customer deposits. Because we can assume that deposits are a fraction of open interest. Open interest in the XBT (another way of describing BTC) is currently 666,299,152 contracts priced at $1 each (or $666,299,152 worth of Bitcoin). But that insurance also covers ETH, and that has an open interest of 65,159,502 contacts priced at $1 each (or $65,159,502). The 33,227 BTC is currently worth ($7148 X 33, 227 or $238M USD) to cover open shorts worth $721M or a leverage ratio of 3 X 1 (excluding customer deposits). But here is the other problem, there is a collateral mismatch between the contract value (USD) and the collateral (BTC); one is priced in USD (the open interest) and the other in Bitcoin. As prices fall, leverage increases dramatically. The is probably the best case situation in the industry. The other exchanges offer insurance funds but don’t provide such transparency.

It’s important to note, that we don’t know the real leverage since we don’t have the customer deposit data, but the collateral mismatch is the bigger issue. We know nothing about the exchanges risk controls or internal control procedures. And we also don’t know if the insurance fund is audited or even if it will ever be used in a crisis. What we can guess, not only from historical examples but from data we get from Bitmex is just that the system is obviously vastly undercapitalized.

This market structure is a recipe for disaster: opacity, capital mismatches, no third-party oversight, no accountability, interconnected high-frequency trading via API, and centralized accounting with no audits. It's not a question of if a crisis will happen, it’s only a question of when. Crises usually are normally born of losses of confidence. And, the market is fickle, it is always up for a test — we just often just don't know when.

One such test is could just be a normal market sell-off, similar to what we had in 2018. But this time we have a lot more leverage in the system, so a sell-off could trigger a crisis. Future contracts represent the biggest risks. Currently, they trade in party with spot but users are charged a funding rate against their margin, so they actually trade contango, which to us doesn't make much sense since it’s hard to justify storage or other costs. Nevertheless, if they do go to backwardation, which they will if there is enough selling, watch out below.

I was once a true believer, just like you. But I woke up after a reality check and realized that BTC isn’t going to $100K, not even $20K. The “halving” means nothing. It’s time for everyone to wake up from the dream and walk back into reality and remember the real history of money, financial crisis and the madness of crowds.

Right now there are just too many exchanges, too much fake turnover, and too many high-frequency traders pushing the market around. Trading groups are using API access to attempt to game and arbitrage the markets. The underlying algorithms are just as opaque as everything else. True high-frequency trading requires real retail or institutional demand to feed on or it's a zero-sum game. Underlying cash Bitcoin demand just is not there to support what is happening. You need to login to several exchanges at the same time and look closely at market depth to see people are cross trading the markets. But it’s a safe bet these systems are doing some speculation and that is another concern; computers trading, plus speculation plus futures, plus a shabby financial structure and controls will lead to a crisis. There is simply no reason that Bitcoin can’t go to $1 despite all the hype. As for money transfers Bitcoin is already a poor choice, there are a plethora of blockchain currencies (forget ETH tokens) available to replace Bitcoin— many with much better protocols for this purpose.

It is an illusion and you are living in a fog if you believe that Bitcoin or any blockchain token (except a handful of stable coins) are stores of value.

There is a silver lining. The cryptocurrency industry will continue — there will just be new coins and new innovations. I would bet on privacy and stable coins. But the world we see now is going to change dramatically soon — several exchanges will disappear and new coins will emerge to replace the once almighty Bitcoin. Who can predict when and how it will end. But it will end, just like the unregulated banknotes issued by American banks failed in the 19th century. The phenomenal cryptocurrency bubble that is headed by ‘Bitcoin’ and its derivatives brethren will go down as one of the greatest financial mass hysterias in history; one that consumed some normally intelligent people who briefly dreamed that you can create ‘money’ out of thin air.