Title: ETF Wif Hat

Author: Arthur Hayes

Compiled by: Joyce, BlockBeats

Editor's Note:

After the approval of the Bitcoin ETF, both the crypto community and traditional financial institutions are closely watching the impact this event will have on the global financial market.
In this article, Arthur Hayes analyzes the reasons behind the approval of the Bitcoin ETF—its anti-inflation characteristics make it an ideal asset in the current global inflationary environment, providing an opportunity for funds that want to avoid inflation impacts but cannot leave the realm of traditional government control. Then, Arthur Hayes delves into the potential market impacts of a Bitcoin spot ETF and explains in detail the creation and redemption process of ETFs, as well as the arbitrage opportunities that may exist during the operation of a Bitcoin ETF.

• (Any opinions expressed herein are solely those of the author and should not be construed as investment advice or recommendations for engaging in investment trading. Image source: X user @CryptoTubeYT) *

Why Now?

The last moments of life are the most expensive from a medical perspective. We are willing to spend unlimited funds on treatments that can delay inevitable death. Similarly, the elites responsible for maintaining the current world order, led by American hegemony and its vassal states, are willing to do whatever it takes to protect this order, as they benefit the most from it. However, since 2008, when improper mortgages extended to broke Americans triggered a global economic crisis comparable to the Great Depression of the 1930s, American hegemony has been lying on its deathbed. And what prescription are the medieval New Keynesian barbers, who blindly follow Ben Bernanke, writing? The same as those of a dying empire… "The printing press hums."

The United States, Europe, and some other vassal states, competitors, and allies have adopted the method of printing money to address different symptoms of the same problem: a severely imbalanced global economic and political system. The U.S., led by the Federal Reserve (Fed), prints money and buys U.S. government bonds and mortgages. Europe, led by the European Central Bank (ECB), prints money and buys government bonds of Eurozone member states to maintain the survival of a flawed monetary (but not fiscal) union. Japan, led by the Bank of Japan (BOJ), continues to print money in pursuit of the elusive inflation that disappeared after the real estate crash in 1989.

This reckless money printing has resulted in a rapid increase in the global debt-to-GDP ratio. Global interest rates have reached the lowest levels in 5,000 years. At its peak, nearly $20 trillion of corporate and government bonds had negative yields. Since interest is compensation for the time value of money, if interest is negative, are we implying that time is no longer valuable?

Thanks to Danielle DiMartino Booth of Quill Intelligence for this chart.

As you can see, in response to the 2008 global financial crisis (GFC), interest rates were pushed to the lowest levels in 5,000 years.

This is the Bloomberg index of the total amount of global negative-yielding debt. From nothing before the 2008 global financial crisis to a peak of $17.76 trillion in 2020. This is the result of global central banks lowering interest rates to 0% and below.

Most of the world's population does not own enough financial assets to benefit from this global fiat currency devaluation. Inflation of various commodities has emerged like mushrooms after rain. Do you remember the Arab Spring of 2011? Do you remember when an avocado toast cost less than $20 in every major global financial center? Do you remember when a median-income family could afford the median price of a house without needing to rely on "parental banks"?

The only somewhat viable escape route is to own some gold. However, holding gold is impractical. Gold is heavy and difficult to hide in large quantities, making it hard to evade greedy government oversight. Thus, ordinary people can only silently endure while the elites continue to revel in Davos as if time has stood still since 2007.

However, like a lotus blooming in a cesspool, Satoshi Nakamoto released the Bitcoin white paper in an empire that is morally, politically, and economically bankrupt. This white paper outlines a system where, for the first time in human history, people can separate money from the state in a globally scalable way through machines connected via the internet and cryptographic proof. I say "globally scalable" because Bitcoin is weightless. Whether you hold 1 satoshi or 1 million bitcoins, its weight is the same: 0. Moreover, you can protect your bitcoins with just your mind by remembering the mnemonic phrase to unlock your Bitcoin wallet. Bitcoin provides everyone with a complete financial system that is no longer subject to the old regime, requiring only a device connected to the internet.

People finally have a way to escape the global fiat currency devaluation frenzy. However, after the 2008 financial crisis, Bitcoin was not mature enough to provide a credible escape route for believers. Bitcoin, along with the entire crypto market, had to grow in user numbers and prove that it could withstand severe crises.

We loyal believers faced a severe test in 2022. The Federal Reserve, followed by most central banks globally, began tightening financial conditions at the fastest pace since the 1980s. The banking system and bond market of American hegemony could not withstand the Fed's onslaught. In March 2023, three American banks (Silvergate, Silicon Valley Bank, and Signature Bank) collapsed in just two weeks. If calculated by market value, the American banking system is bankrupt, and this situation persists, especially considering the U.S. Treasury and mortgage-backed securities they hold. Therefore, U.S. Treasury Secretary "bad girl" Yellen created the Bank Term Funding Program (BTFP) as a secret way to save the entire American banking system.

Cryptocurrency was not spared from the disruptions caused by high interest rates. Centralized lending platforms like BlockFi, Celsius, and Genesis went bankrupt due to loans extended to over-leveraged trading firms like Three Arrows Capital. Terra Luna, a stablecoin pegged to the U.S. dollar, also went bankrupt due to the drop in the price of its governance token Luna, which supported the issuance of the UST stablecoin. This event wiped out over $40 billion in illusory value within two days. Then, centralized exchanges began to go bankrupt, with FTX being the largest. FTX, operated by the "right" type of American hegemonic white man Sam Bankman-Fried, stole over $10 billion of customer funds, and his scam was exposed as cryptocurrency prices plummeted.

What happened to Bitcoin, Ethereum, and DeFi projects like Uniswap, Compound, Aave, GMX, and dYdX? Did they fail? Did they call the central crypto banks for help? Absolutely not. Over-leveraged positions were liquidated, prices fell, people lost vast amounts of money, centralized companies disappeared, but Bitcoin blocks continued to be produced on average every 10 minutes. DeFi platforms did not go bankrupt on their own. In short, there was no bailout because crypto cannot be bailed out. We suffered, but we persevered.

In the ashes of 2023, it became clear that American hegemony and its vassal states could not continue to implement tight monetary policies. Doing so would lead to the bankruptcy of the entire system, as leverage and debt had piled up too high. An intriguing thing happened: as U.S. long-term Treasury yields began to rise gradually, Bitcoin and cryptocurrencies rebounded, while bond prices fell.

Bitcoin (white) vs. U.S. 10-Year Treasury Yield (yellow)

As you can see in the chart above, when interest rates rise, Bitcoin, like all other long-term assets, shows a decline.

After the Bank Term Funding Program (BTFP), this relationship reversed. Bitcoin rose in sync with yields. Especially in the context of a steepening bear market, the rising yields indicate that investors lack confidence in the "system." In response, they began to sell the safest government bonds of the American empire, namely U.S. Treasuries. This portion of capital primarily flowed into the "magnificent seven" AI tech stocks (Apple, Alphabet, Microsoft, Amazon, Meta, Tesla, Nvidia), and to some extent, into cryptocurrencies. After nearly 15 years, Bitcoin finally showcased its true nature, becoming "the people's currency" rather than merely a derivative of imperial risk assets. This presents a very tricky problem for traditional finance.

Capital must remain within the system to eliminate a large amount of non-productive debt through inflation. Bitcoin exists outside the system and now shows a zero to slightly negative correlation with bonds (remember, when yields rise, bond prices fall). If the guardians of bond security express their dissatisfaction with government bonds by selling them and buying Bitcoin and other cryptocurrencies, the global financial system will collapse. Its collapse will occur because the inherent losses caused within the system will eventually be recognized, and large financial firms and governments will have to significantly downsize. Bitcoin exists outside the system and now shows a zero to slightly negative correlation with bonds (remember, when yields rise, bond prices fall).

To avoid this liquidation, the elite must financialize Bitcoin by creating a highly liquid exchange-traded fund (ETF). This is similar to the tricks they played in the gold market when the U.S. Securities and Exchange Commission (SEC) approved ETFs like SPDR GLD in 2004, which supposedly held gold bars in global vaults. If all the capital wanting to escape the collapse of the global government bond market buys a Bitcoin ETF managed by large traditional financial firms (like BlackRock), then the capital remains safely within the system.

It is evident that to protect the global bond market, the Fed and all other major central banks must once again turn to money printing, and BlackRock officially applied for a Bitcoin ETF in June 2023. A spot Bitcoin ETF has been approved in the U.S. However, by 2023, the U.S. SEC seems to have finally accepted such applications. I present the following to emphasize the strangeness of the current events surrounding the ETF approval process. The Winklevoss twins applied for a spot Bitcoin ETF in 2013, but the SEC rejected their application for over a decade. BlackRock applied and received approval within six months. One can't help but exclaim, "Hmm…"

As I wrote in my previous article, Expression, a spot Bitcoin ETF is a trading product. You buy it with fiat currency to earn more fiat currency. It is not Bitcoin. It is not a path to financial freedom. It does not detach from the traditional financial system. If you want to escape, you must buy Bitcoin, withdraw it from the exchange, and store it yourself.

I wrote this lengthy preface to explain "Why Now?" Why, at this critical moment for the empire and its financial system, has the spot Bitcoin ETF finally been approved? I hope you can appreciate the significance of this development. The global bond market is estimated to be worth $133 trillion; imagine if bond prices continue to fall, even if the Fed might start cutting rates in March, capital will flood into Bitcoin ETFs. If inflation bottoms out and begins to rise again, bond prices may continue to fall. Remember, wars lead to inflation, and wars are certainly occurring in the empire's periphery.

Market Impact of the Spot Bitcoin ETF

The remainder of this article will discuss the market impact of the spot Bitcoin ETF. I will focus solely on BlackRock's ETF, as BlackRock is the largest asset management company in the world. They have the best ETF distribution platform globally. They can sell products to family offices, retail financial advisory firms, retirement and pension plans, sovereign wealth funds, and even central banks. All other companies will also try their best, but in terms of asset management, BlackRock ETFs will undoubtedly emerge as the winners. Regardless of whether this prediction is correct, the following strategies will work for any issuer with high ETF trading volume.

This article will discuss the following topics and how the internal workings of the ETF will create surprising trading opportunities for those able to trade in both traditional finance and crypto markets: the creation and redemption process of ETFs, spot trading arbitrage and time series analysis of trades, and ETF derivatives such as listed options and the impact of ETF financing trades.

Putting all that aside, let's make some money!

Cash Rules Everything Around Me

The problem is solved. The injection (creation) and withdrawal (redemption) of funds can only be done in cash. The most concerning aspect of this ETF is that it allows ordinary people to purchase the ETF with fiat currency and choose to redeem the ETF in Bitcoin. The purpose of this product is to store fiat currency, not to provide an easy way to buy Bitcoin with retirement accounts.

Creation

To create ETF shares, authorized participants (APs) must send the dollar value of the creation basket (i.e., a certain number of ETF shares) to the fund before a specific time each day.

APs are large traditional financial trading firms. Some significant institutions in traditional finance have registered as APs for different ETFs. Some companies that once called for the government to ban cryptocurrencies, like JP Morgan's CEO Jamie Dimon's firm, will also participate. This surprises me; )

Example:

The value of each ETF share is 0.001 BTC. The creation basket contains 10,000 shares, and at 4 PM EST, the value of these bitcoins is $1,000,000. The authorized participant (AP) must wire this amount to the fund. Then, the fund will instruct its counterparties to purchase 10 bitcoins. Once the bitcoins are purchased, the fund will credit the ETF shares to the AP.

1 basket = 0.001 BTC * 10,000 shares = 10 BTC

10 BTC * 100,000 BTC/USD = $1,000,000

Redemption

To redeem ETF shares, the authorized participant (AP) must send the ETF shares to the fund before 4 PM EST. Then, the fund will instruct its counterparties to sell 10 bitcoins. Once the bitcoins are sold, the fund will pay the AP $1,000,000.

1 basket = 0.001 BTC * 10,000 shares = 10 BTC

10 BTC * 100,000 BTC/USD = $1,000,000

For us traders, we want to know where Bitcoin must be traded. Of course, the counterparties helping the fund buy and sell Bitcoin can trade on any exchange they prefer, but to minimize slippage, they must match the fund's net asset value (NAV).

The fund's NAV is based on the BTC/USD price from CF Benchmark at 4 PM EST. CF Benchmark obtains prices from Bitstamp, Coinbase, itBit, Kraken, Gemini, and LMAX between 3-4 PM EST. Any trader wishing to perfectly match the NAV and reduce execution risk by trading directly on all these exchanges can do so.

The Bitcoin market is global, and price discovery primarily occurs on Binance (I guess based in Abu Dhabi). CF Benchmark excludes another large Asian exchange, OKX. This will be the first time in a long while that predictable and lasting arbitrage opportunities will appear in the Bitcoin market. I hope billions of dollars in trading flow will converge on those exchanges with lower liquidity, which tend to follow the prices of their larger Asian competitors. I expect there will be some attractive spot arbitrage opportunities to exploit.

Clearly, if the ETF achieves great success, price discovery may shift from the East to the West. But don't forget about Hong Kong and its mimicking ETF products. Hong Kong only allows its listed ETFs to trade on regulated exchanges in Hong Kong. Binance and OKX may service this market, but new exchanges will also emerge.

Regardless of what happens in New York or Hong Kong, neither city will allow fund managers to trade Bitcoin at the best prices; they may only trade on "selected" exchanges. This unnatural state of competition will only lead to greater market inefficiency, from which we, as arbitrageurs, can profit.

Here's a simple arbitrage example:

Average Daily Trading Volume Days (ADV) = (Exchange CF Benchmark Weight * Daily Closing Market Price (MOC) Nominal Value in USD) / CF Benchmark Exchange USD ADV

Choose the least liquid exchange in the CF Benchmark, i.e., the one with the highest ADV days. If buying pressure increases, the Bitcoin price on the CF Benchmark exchange will be higher than on Binance. If selling pressure increases, the Bitcoin price on the CF Benchmark exchange will be lower than on Binance. Then, sell Bitcoin on the expensive exchange and buy Bitcoin on the cheap exchange. You can estimate the direction of creation/redemption flow by looking at the premium or discount to its intraday net asset value (INAV) when trading the ETF. If the ETF is at a premium, there will be a creation flow. The authorized participant (AP) shorts the expensive ETF and then creates at the cheaper NAV. If the ETF is at a discount, there will be a redemption flow. The AP buys the ETF at a low price on the secondary market and redeems it at a higher NAV.

To conduct this trade in a price-neutral manner, you need to place dollars and Bitcoin on both the CF Benchmark exchange and Binance. However, as a risk-neutral arbitrage trader, your Bitcoin needs to be hedged. To do this, you can buy Bitcoin with available dollars and short the Bitcoin/USD perpetual swap contract on BitMEX. Place some Bitcoin as margin on BitMEX, while the rest of the Bitcoin can be spread across the relevant exchanges.

ETF Options

To truly get the ETF casino running, we need leveraged derivatives. In the U.S., the zero-day options (0DTE) market has exploded. One-day-to-expiration options are akin to lottery tickets, especially when you buy them at out-of-the-money (OTM) prices. Now, 0DTE options have become the most traded options instrument in the U.S. Of course, people love to gamble.

After the ETF is listed for a while, options will start appearing on U.S. exchanges. Now, the real fun begins.

In TradFi, it's hard to get 100x leverage. They don't have places like BitMEX that can solve the problem. But the premiums on shorter-dated OTM options are very low, which creates high leverage or gearing. To understand why, brush up on your theoretical options pricing knowledge by studying the Black-Scholes theory.

Degen traders with brokerage accounts that can trade options on U.S. exchanges will now be able to make high-leverage bets on Bitcoin prices in a liquid manner. The underlying asset for these options will be the ETF.

Here's a simple example:

ETF = 0.001 BTC per share

BTC/USD = $100,000 ETF share price = $100

You think Bitcoin's price will rise 25% by this weekend, so you buy a call option with a strike price of $125. This option is an out-of-the-money option because the current ETF price is 25% lower than the current strike price. The volatility is high but not extreme, so the premium is relatively low at $1. You could lose a maximum of $1, and if the option quickly goes in-the-money (above $125), you can earn more profit from the change in the option premium, or if you just bought the option, you could earn 25% profit by selling the ETF shares yourself. This is a very rough explanation of leverage.

In the U.S. capital markets, these enthusiastic traders are a serious bunch. With these new high-leverage ETF options products, they will create some chaos in the implied volatility and forward structure of Bitcoin.

Forward Arbitrage

Call option price - Put option price = Long forward contract

As traders buying lottery tickets push up the prices of ETF options, the prices of out-of-the-money options will rise. This opportunity can be realized through arbitrage between the BTC/USD perpetual contracts (like those on BitMEX) and the ATM forward contracts derived from ETF option prices.

Futures basis = Futures price - Spot price

I expect the trading price of the ETF ATM forward basis to be higher than the BitMEX futures basis. Here’s how to trade it.

Short the ETF ATM forward by selling ATM call options and buying ATM put options.

At the same time, buy BitMEX Bitcoin/USD fixed expiration futures contracts with expiration dates similar to the ETF options.

Wait for prices to converge as expiration approaches. This will not be a perfect arbitrage because BitMEX and the ETF use different trading prices to construct the Bitcoin spot index price.

Volatility Arbitrage

To a large extent, when you trade options, you are trading volatility. Traders trading Bitcoin options on crypto-native non-U.S. exchanges have different preferences in terms of expiration and strike prices compared to traders trading ETF options. I predict that the trading volume of ETF options will dominate the global Bitcoin options liquidity. Because these two groups of traders, the dollar-based U.S. traders and the non-dollar trading traders, cannot interact on the same exchanges, arbitrage opportunities will arise.

When options with the same expiration and strike price trade at different prices, there will be direct arbitrage opportunities. Additionally, there will be more general volatility arbitrage opportunities, where certain parts of the ETF options volatility surface exhibit significant differences from the Bitcoin volatility surface. Discovering and exploiting these opportunities requires more trading experience, but I know there will be many French speculators arbitraging in these markets.

MOC (Market on Close) Liquidity

As the ETF will lead to a surge in trading volume of ETF derivatives listed in the U.S., the CF Benchmark index's closing price at 4 PM will become very important. The value of derivatives comes from their underlying assets. With billions of dollars in nominal amounts of options and futures expiring daily, matching the ETF's closing trade price is crucial for aligning the net asset value (NAV).

This will generate statistically significant trading behavior around 4 PM EST and during trading hours on other days. Those adept at handling datasets and possessing excellent trading bots will earn substantial profits by arbitraging these market inefficiencies.

ETF Financing (Creation Loans)

Centralized lending platforms like BlockFi, Celsius, and Genesis have been very popular among Bitcoin holders wanting to borrow fiat currency using their Bitcoin as collateral. However, the dream of an end-to-end Bitcoin economy has not yet been realized. Loyal Bitcoin supporters still need fiat currency to pay for necessities, using that not-so-clean fiat currency.

All the centralized lending platforms I just mentioned have collapsed, and many others have as well. Borrowing fiat currency using Bitcoin as collateral has become more difficult and expensive. Traditional finance is very accustomed to lending against liquid ETFs as collateral. As long as you pledge Bitcoin ETF shares, it will now be possible to obtain large fiat currency loans at competitive prices. For those who believe in financial freedom, the challenge is to maintain control over Bitcoin while leveraging this cheaper capital.

The solution to this problem is to exchange Bitcoin for ETFs. Here’s how it works.

APs that can borrow in the interbank market will create ETF shares and hedge the Bitcoin/USD price risk. This is the creation of a lending business. In Delta-One terms, it is the repurchase value of ETF shares.

Here’s the process:

Borrow dollars in the interbank market and create ETF shares in cash.

Sell ATM call options on the ETF and buy ATM put options on the ETF to create a synthetic short forward contract.

The act of creating ETF units will generate a positive spread, i.e., forward basis > interbank dollar interest rates.

Lend out ETF shares in exchange for Bitcoin collateral.

Let’s bring Chad in to discuss how he needs to handle his Bitcoin:

Chad is a holder with 10 bitcoins who needs to pay his AMEX bill in dollars; those champagnes at the bar are expensive. Chad contacts his friend Jerome, a crafty Frenchman working at SocGen, who was once an alternative in major financial back offices and went to jail for aggressive futures trading but got his job back (in France, you can't fire anyone) and is now responsible for running the crypto trading desk. Chad asks Jerome for an exchange of Bitcoin for ETFs for 30 days. Jerome quotes -0.1%. This means Chad will exchange 10 bitcoins for 10,000 ETF shares, assuming each share is worth 0.001 Bitcoin, and after 30 days, Chad will get back 9.99 bitcoins.

During the 30 days that Chad holds 10,000 ETF shares instead of 10 bitcoins, he will pledge the ETF shares to his traditional financial brokerage for a very cheap dollar loan.

Everyone is happy. Chad can continue to show off at the club without having to sell his bitcoins. And Jerome earns the financing spread.

The ETF financing business will gradually become very important and will influence Bitcoin interest rates. As this market develops, I will focus on attractive ETFs, physical Bitcoin, and Bitcoin derivatives financing trades.

Your Size is My Size

To allow these trading opportunities to last a long time and enable arbitrageurs to execute them at sufficient scale, the complex structure of the Bitcoin spot ETF must trade billions of dollars in shares daily. On Friday, January 12, the total daily trading volume reached $3.1 billion. This is very encouraging, and as various fund managers begin to launch their massive global distribution networks, trading volume will only increase. There is a way to trade the financial version of Bitcoin within the traditional financial system, allowing fund managers to escape the predicament of poor returns currently offered in this global inflation environment.

We are in the early stages of this transition to a sustained period of global inflation. There is a lot of noise, but over time, those running stock-bond correlations will realize that things have changed. Below the zero interest rate boundary, especially in a sustained inflation environment, bonds cease to function in portfolios. The market will slowly recognize this, and the sell-off from the over $100 trillion bond market will destroy nations. Then, these managers will have to look for another asset class that has no substantial correlation with stocks or any traditional financial asset class. Bitcoin fulfills this task.