“Keep me posted when anything material pops up,” I told our team, scanning Twitter feeds for developments in the unfolding FTX drama, everything moving fast. “This is unlike anything I’ve seen in my 33yrs of doing this,” I said. “It has hints of many crises - Lehman, Enron, Madoff, MF Global - but moving at light speed with no lender of last resort. It’s like banking in the late-1800s.” We had no exposure to FTX or its token FTT, avoiding each for different reasons, intuitive/qualitative/quantitative risk management at work. “This smells like the kind of thing that happens toward the bottom. Near the end. This is the kind of catalyst that ushers in the capitulation, the flush, that then leads to the next stage we’ve been building for: the first regulated market cycle in digital assets.”
Overall: “There was no way US policymakers were going to relax regulation to accommodate new technology,” said The Chairman, repeating advice he’s shared for a couple years, helping guide me through the innovation maze. “If you want to introduce new technology into financial markets, you need to start with the premise that it performs the regulatory functions at least as well as the current technology,” he continued. FTX was imploding in the Bahamas, the crypto market’s third largest exchange collapsing in on itself, crypto markets in free fall. “And only with that condition satisfied will you be able to capture the efficiencies these new technologies represent.” Creative destruction sounds great in a sentence, though less so when you live it, and this makes navigating change so interesting, worthy, profitable. “With the FTX crisis following the Three Arrows collapse, Celsius, Luna and the others, this perspective will become a regulatory reality,” said The Chairman. “And the question for the industry and the regulators today is how do we transition from where we now are to a place where tokenization is consistent with the fundamental principles of sound financial regulation,” he said. “Those principles are (1) liquidity transformation needs prudential regulation, (2) customer assets need to be segregated and accessible, and (3) leverage of all forms needs to be limited and commensurate with liquidity in times of stress,” said The Chairman. “And it is fundamental that you can’t sell financial products to retail customers on a caveat emptor basis; transparency and a level informational playing field are necessary,” he added. “The US has a choice now, and there is only one to make. Regulators must incrementally accommodate crypto products, making way for the products, actors, and services that comply with these fundamental principles while keeping out the others. Identifying what is in and what is out has been bogged down in semantics and in the search for regulatory gaps,” he said. “The key financial regulators should collectively move forward with the identification of compliant and non-compliant products as well as paths to compliance for those that can get there. And wherever the US draws the line, people will be disappointed. That’s okay. That’s part of bringing discipline to activities that are out of step. What’s not okay is to do nothing and cede many of the opportunities that crypto represents to our competitors and adversaries, while subjecting our retail investors to the risk.”
Marcel Kasumovich, One River Digital’s Deputy CIO, published an excellent piece on leverage in digital asset markets and the acceleration toward greater regulatory clarity for these technologies. To read it [click here].
Week-in-Review (expressed in YoY terms): Mon: Chinese health officials vowed to unswervingly stick to their Zero Covid policy after last week’s rumors of imminent shift, FTX under pressure after Binance said to be selling FTT token, UK Chancellor Hunt set to outline £60b in tax increases / spending cuts, reports of behind the scene negotiations between Russia / US to not escalate the war further and US urging Ukraine to talk to Russia, PBoC deputy governor Fan being investigated for graft, Fed’s Collins says a downshift will come but 75bp still possible for Dec, ECB’s Guindos says govt support should be temporary & targeted, ECB’s Villeroy says inflation may not have peaked and ECB should not stop hiking rates, Netanyahu returns as PM in Israel after last week’s elections, Meirelles not a candidate for fin min in Brazil, Apple said to make 3m fewer iPhone 14s due to softer Chinese demands, China expts -0.3% (4.5%e) / impts -0.7% (0%e) / trd bal $85.15b ($95.97b exp), EU investor conf -30.9 (-35e), US cons credit 24.976b (30b exp), S&P +1.0%; Tue: Binance to acquire FTX pending dd in fire sale, BoE’s Pill notes de-anchoring of infl exp but skeptical about front loading hikes, BoJ report shows some concern abt side effects of easing, MOF report shows October intervention at $42b as exp / shows some evidence that US treasuries were sold to fund intervention, Sweden shelves planned tax cuts to help with infl, UK/EU close to deal on N. Ireland trade, Australia cons conf 78 (83.7b), Japan leading index 97.4 (97.8e), US NFIB 91.3 (91.4e), S&P +0.6%; Wed: US midterm elections: Democrats perform better than expected but still likely to lose control of House / Senate still a toss-up / Trump backed candidates disappoint / DeSantis does exceptional in Florida, Fed’s Williams says long run infl exp remain stable but uncertainty has increased, Meta to cut 11k jobs, RBA’s Bullock inflation likely near peak, Binance to walk away from FTX deal, Russian troops ordered to pull back from Kherson / Putin not to attend G20, China CPI 2.1% (2.4%e) / PPI -1.3% (-1.5%e), Mexico CPI 8.41% (8.45%e) / Core CPI 8.42% (8.44%e), Russia CPI 12.63% (12.8%e), S&P -2.1%; Thur: US CPI 7.7% (7.9%e) / Core CPI 6.3% (6.5%e), China increased covid restrictions in some of the biggest cities (incl Beijing) as cases hit highest levels since April, FTX’s SBF says needs cash injection to fill $8b hole, Fed’s Logan says CPI ‘welcome relief’, Fed’s Daly sees a slowdown in hikes but pause isn’t an option, Fed’s Mester sees restrictive policy persisting for a while, Biden/Xi meeting set for G20, ECB’s Schnabel says no time for a pause, BOJ’s Kuroda says more monetary easing to come / MOF intervention has been appropriate, US general Milley says more than 100k Russian troops killed so far (similar to Ukraine), fears over large fiscal waiver in Brazil weighs on Brazilian assets, Mexico CB hikes 75bp as exp, China new loans 615.2b CNY (800b exp) / M2 11.8% (12%e), Brazil IPCA infl 6.47% (6.36%e), US init claims 225k (220k exp), S&P +5.5%; Fri: China announces new 20 measures to revamp covid policy / cuts quarantine time for inbound travelers and close contacts, SBF steps down as FTX CEO / FTX to start bankruptcy proceedings, Musk warns TWTR staff that bankruptcy looms if cash burn lingers, ECB’s Holzmann said politicians undermining infl fight by overspending, SNB’s Jordan says can use the currency to fight infl, Japan PPI 9.1% (8.8%e), Turkey IP 0.4% (3.3%e), UK 3Q GDP 2.4% (2.1%e), Germany CPI 11.6% as exp, UK IP -3.1% (-4.4%e) / mfg prod -5.8% (-6.6%e), Mexico IP 3.9% (4.5%e), India IP 3.1% (2%e), US UofM 54.7 (59.5e) / 1y infl exp 5.1% as exp / 5-10y infl exp 3% (2.9%e), S&P +0.9%; Sat: Democrats hold the Senate.
Weekly Close: S&P 500 +5.9% and VIX -2.03 at +22.52. Nikkei +3.9%, Shanghai +0.5%, Euro Stoxx +3.7%, Bovespa -5.0%, MSCI World +5.2%, and MSCI Emerging +0.5%. USD rose +30.7% vs Ethereum, +25.2% vs Bitcoin, +5.3% vs Brazil, and +0.1% vs Turkey. USD fell -5.3% vs Yen, -4.8% vs Sweden, -3.8% vs Sterling, -3.8% vs Euro, -3.8% vs Chile, -3.7% vs South Africa, -3.5% vs Australia, -2.0% vs India, -1.6% vs Indonesia, -1.5% vs Canada, -1.5% vs Russia, -1.2% vs China, and -0.1% vs Mexico. Gold +5.5%, Silver +4.2%, Oil -3.9%, Copper +6.2%, Iron Ore +0.0%, Corn -3.5%. 5y5y inflation swaps (EU +1bp at 2.38%, US +1bp at 2.61%, JP flat at 0.90%, and UK +2bps at 3.65%). 2yr Notes -33bps at 4.33% and 10yr Notes -35bps at 3.81%.
YTD Equity Indexes (high-to-low): Turkey +71.1% priced in US dollars (+139.8% priced in lira), UAE +25.2% priced in US dollars (+25.2% priced in dirham), Chile +18.9% priced in dollars (+24.2% in pesos), Argentina +15.1% (+80.1%), Brazil +11% (+7.1%), Mexico +2.2% (-2.5%), Singapore +1.4% (+3.4%), Indonesia -0.7% (+7.7%), Saudi Arabia -0.7% (-0.6%), India -2.2% (+5.7%), Portugal -4.7% (+5%), Venezuela -5.1% (+71.9%), Thailand -8.4% (-1.2%), South Africa -8.5% (-0.9%), Norway -8.6% (+2.9%), Greece -8.7% (+0.5%), Canada -9.6% (-5.2%), Australia -11.5% (-3.9%), Israel -13.6% (-3.2%), UK -13.6% (-0.9%), Spain -15.1% (-7.1%), Malaysia -15.8% (-6.3%), Switzerland -16.1% (-13.6%), Russell -16.1%, Denmark -16.2% (-8.3%), S&P 500 -16.2%, France -16.3% (-7.8%), Czech Republic -17.4% (-11.7%), Germany -18.2% (-10.5%), Euro Stoxx 50 -18.3% (-10%), Italy -18.3% (-10.6%), MSCI World -18.4% priced in US dollars, Japan -18.5% (-1.8%), Netherlands -20% (-11.9%), Ireland -21.2% (-13.2%), Philippines -21.2% (-11.7%), Finland -22.1% (-14.8%), New Zealand -22.6% (-13.2%), Belgium -22.8% (-15%), Sweden -23.8% (-12.9%), China -24% (-15.2%), Colombia -24.1% (-10.2%), Austria -24.2% (-17%), Korea -24.7% (-16.6%), HK -26.3% (-26%), NASDAQ -27.6%, Russia -27.9% (-41.5%), Hungary -28.3% (-13.8%), Poland -31.2% (-21.5%), Taiwan -31.8% (-23.1%).
Filtering: There are nearly twenty-two thousand digital tokens. They are experiments. Most will fail and become worthless, which is natural in periods of great innovation. Some projects will succeed and become extremely valuable. Our preferred way to gain exposure to the beta of this advance is through investing in dynamic indexes. Marcel Kasumovich and his team built our institutional indexes to filter out tokens that fail to meet sensible fundamental and regulatory thresholds. Such filters are serving us well, having eliminated Terra’s token Luna and FTX’s token FTT from our indexes.
Trending: Investors flocked to digital asset arbitrage trades. Such things last for short periods. Trend strategies stood the test of time, as have strategies that trade patterns between fundamentals and prices. We have managed such strategies for a decade. We brought Sarah Schroeder and Paul Ebner onto the digital team; they spent their careers building these strategies for leading firms in traditional finance. Digital trend strategies can profit in up and down markets. And building a deep library of quantitative relationships between fundamentals and price movements will power our digital strategies in the years to come.
Lending: Traders raced into digital asset borrowing/lending strategies that offered absurdly high rates of return. It made little sense unless you accounted for the obscure risks which in time manifested fantastically. It was not that the blockchain technology went wrong (Defi performed well), it was the behavior and business models built around it that led to huge losses. Marcel and team chose a conservative fiduciary path when lending money. We engaged in boring tri-party repo agreements, loans were 150-200% overcollateralized using bitcoin. When markets crashed, we re-margined the loans in real-time, earned interest and retrieved 100% of our capital.
Oil & Gas: The bitcoin network allows users to exchange value directly, without a trusted intermediary. It is an entirely novel system and is fully decentralized, operating independently from the incumbent financial and political systems which govern nearly all modern economic activity. It is the most secure network in human history. The security is derived by the industrial activity of miners, who utilize computer hardware, software, hosting facilities and electricity to produce a commodity: bitcoin.
Oil & Gas II: When we chose to explore opportunities in bitcoin mining, we hired Doug Wilson, a trusted friend who spent 20+ years trading/investing/analyzing the oil & gas sector. He quickly recognized the impending bust in bitcoin mining. The 2020-21 investment boom in mining computing equipment resembled classic oil & gas cycles. Doug built a team to map the mining industry, meet/research all the players, and position our firm for a historic opportunity in the deeply distressed credit of miners. That collapse is unfolding. The opportunity is here.
Anecdote: By November 2020, it had become evident that government had adopted policies to accelerate the inflating away of its extraordinary debt and entitlement obligations. We figured the process would take ten years or more. Digital assets represented an unorthodox and highly convex way to play this investment theme. We executed the largest institutional purchase of these assets, inspired and funded by one of our truly iconoclastic clients. When the investment was publicly disclosed in December 2020, digital asset prices surged to new all-time highs and raced away. The subsequent gains were extraordinary, and we crystallized them into that euphoria. We also glimpsed the technological promise these protocols represented. We saw a future in which all assets are tokenized, fractionalized, traded, and settled on blockchain rails. The process would dramatically increase transaction speeds, lower settlement times, improve transparency, security, and reduce fees. These functional enhancements would eventually reduce systemic risk and would thus be supported by prudential regulators. They would also allow for low-cost customization of asset management products, which would level the playing field for smaller investors, inviting greater financial inclusion as well as investor protection. We built an esteemed Academic and Regulatory Advisory Council to help think through how to take a leading role in the realization of this future, brought some of the greatest financial firms on board as equity partners, and quietly raced ahead toward the intersection of crypto rails and traditional finance. We built a suite of conservatively designed asset management products for institutions, delivered using resilient, well-regulated counterparties. We embarked on two blockchain infrastructure development projects which will bridge the vast advantages of blockchain technology to traditional financial markets. And we engaged with government to advocate for the adoption of rigorous and sensibly regulated private sector stablecoin, which we believe is in the US national interest and will extend dollar reserve currency dominance well into the future. Through it all, we have assumed that second movers in this nascent field will have a distinct advantage, and that most early players with little experience in both traditional finance and in the reasons for regulation, will disappear. That process accelerated this week with FTX. It will continue and, unfortunately, will be painful, sloppy. Such is the nature of creative destruction. Innovation.
Good luck out there,
Chief Investment Officer
One River Asset Management
Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, converse with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.