Gamemaker Watch: Why Bitcoin Crashed and The Franc Spiked

[The following post is by Scott Freeman]

Two events from the past week stand out as particularly memorable. One may or may not be remembered a year from now, depending on how things unfold going forward. The other – the Swiss franc revaluation – definitely will be.

The possibly memorable event I am referring to was the spike down in the bitcoin price to $160 / 900 RMB. If we consider the shake-out scenario discussed last week, we did indeed reach the $160 target price level, but the price did not remain under $180 for long. Those who bought at $160 did well, since the rebound went as high as $233.

If the goal behind recent price action is to scare speculators into selling, several weeks of sideward movement at today’s relatively low levels could be an effective psychological tool to accomplish that.

Time will tell, however, so it’s simply too early to judge if current price levels will do the trick, or if prices still need to go a bit lower, or if a completely different scenario unfolds. All we can say with any confidence is (a) that this is one plausible scenario, and (b) that a bottoming out of the bitcoin price in the near future would potentially fit in with a broad-based reversal in the fortunes of the US dollar. More on that later.

With regard to potential bitcoin price action over the next several months, one development worth mentioning is the tightening of Chinese margin requirements for stock trading. This week the minimum deposit was raised from 300000 to 500000 RMB (approx. US$80000), thus squeezing out some of the gambling public. As a result, the Shanghai stock market promptly fell by 260 points (7.7%).

Both of these developments can be seen as potentially positive for the bitcoin market. Why? For one thing, the Chinese stock market looks ripe for a continued correction to the downside, while the opposite is true of the bitcoin market. Secondly, there are no comparable restrictions applicable to bitcoin exchanges. On the contrary, several offer up to 20:1 leverage to all comers. While these factors alone are unlikely to be sufficient to drive a sustained rebound in price, they certainly supply an ideal context for such a scenario.

UNEXPECTED REVALUATION?

Without a doubt one event will not be forgotten, and that was the revaluation of the Swiss franc by approximately 20% early on January 15th. The Swiss National Bank finally threw in the towel and conceded to reality, dropping its “exchange rate floor” of 1.20 Swiss francs (CHF) per euro, and allowing the Swiss franc to return to its pre-peg rate of 1:1 to the euro.

Apparently the bank’s management decided that the equivalent of 495 billion Swiss francs in rapidly devaluing “reserves” was enough. It was a big day on the financial markets, with both gold and oil jumping on the news.

Media coverage almost universally asserted that the move was “unexpected” and shocked the financial world.” (As always, thanks to Mr. Krugman for that cutting-edge analysis.) Shock or not, for multiple reasons, it was certainly a momentous event.

Before we consider how and why this was such a big deal, let’s consider briefly whether the revaluation was actually as unexpected as Mr. Krugman claims.

As a result of the various bailouts of southern European EU members during 2010 and 2011, during the same period the European Central Bank effectively printed up lots of new euros. All other things being equal, this implied that a 2012 euro would likely be worth less than a 2009 euro.

Since the Swiss National Bank was not participating in this printing orgy, some major players on the financial markets decided that it might be a smart idea to sell euros and buy Swiss francs. Clearly they were on to something, because by August 10th 2011, i.e. in little over 19 months, the Swiss franc had risen from 1.48 francs/euro at the beginning of 2010 to par.

At that point the #1 gamemaker for the Swiss franc, the Swiss National Bank, apparently decided that enough was enough. The bank issued several statements to the effect that things had gone too far and that any additional rise would not be tolerated. About a month thereafter a “temporary” exchange rate floor of 1.20 francs per euro was declared. Take a note of that word.

In the following three years, the Swiss National Bank repeatedly intoned its continued support for the exchange rate floor, right up until early January 2015. Though they have been widely criticized for this, could they realistically have done otherwise while maintaining the floor? Obviously not. And did any of those statements negate their earlier declaration that the floor was temporary? Nope.

Just as was the case with the Russian ruble devaluation several weeks earlier, speculators who simply read carefully and placed their long-term bets accordingly did well.

PLAYING WITH FIRE

There are several reasons why the Swiss franc revaluation was such a big deal.

For starters, it was very profitable for some, at least in theory. Profits on options amounted to 4,000% or more, with an option purchased for US$425 returning US$15700 24 hours later. Speculators holding Swiss francs purchased on margin also reaped exponential returns.

However, it does not appear that very many retail speculators were amongst the winners. If we look at the retail markets where published data is available, only approximately 7% of the open positions in the EUR/CHF market and 38% of the open positions in the USD/CHF were long Swiss francs. Moreover, of the 93% who were long euros in the EUR/CHF market, approximately 83.7% were either force-liquidated or stopped out.

In any case, regardless of who the winners and losers are, the problem is that this is a zero sum game. Where there are big winners, there are also big losers. And when losses are exceptionally large, sometimes the losers will be unable to actually pay the winners.

For a number of these losers the revaluation was spectacularly unprofitable. In fact, it was so unprofitable that it apparently left a number of businesses behind in the dust. Just to cite a few: FXCM, one of the world’s largest forex trading platforms, admitted to sustaining a loss of US$225m. FXCM was only able to stay afloat thanks to last minute financing of US$300m from Leucadia. Forex brokers Alpari and Excel filed for bankruptcy. The US$830 million Everest Capital Global Fund announced that it had been wiped out and would close down. Deutsche Bank, Barclay’s and Citigroup are rumored to have lost approximately US$400m. All in all, fairly substantial – and those are only the initial announcements.

You might wonder, how could so many inside players fail to protect themselves against such risks? Also, how is it possible that a premium of only $425 could justify accepting the risk of a $15700 payout? The answer to the first question is actually not very complicated: if a platform permits its users to purchase an asset on margin, then it is dependent on a functioning stop-loss system to protect itself against loss.

In other words, if Acme Forex Trading only requires you to put up 5% margin to finance a purchase (20:1 margin), and the value of that purchase starts to fall, then it must force-liquidate your purchase before that purchase falls by more than 5% in value.

Ordinarily this is no problem. Markets for currencies and major stocks are typically extremely liquid. However, “normal” does not equate with “always”, and this fundamental error can clearly be fatal. Moreover, we do not live in ordinary times.

The answer to the second question is a bit more complicated, but it boils down to this: as Michael Lewis pointed out in Liar’s Poker, the volatility-dependent pricing model in use for most derivatives is based on a normal distribution of outcomes, a scenario which even in “normal times” does not correspond to reality, much less in today’s highly distorted reality. (We’ll talk more about that in a moment.)

The reality is that the likelihood of sudden drastic change – what is sometimes referred to as punctuated equilibrium in evolutionary terms – is far higher than the 100:1 or 1000:1 probabilities which these models produce. Think about it: prior to the pegging 3 1/2 years ago, the Swiss franc rose almost to parity with the euro.

At the time, the 1.2 CHF/EUR floor was announced as a “temporary measure”. In other words, a return to the pre-peg exchange rate was always within the realm of possibility. And yet, the option pricing implied that the probability of such a return was considered to be less than 3%. Realistic? Not at all.

LOOK MOM, NO HANDS!

This sort of systematic miscalculation is of course a loophole in the system, potentially offering exponential returns to those able to take advantage of it. At the same time, even if we guess right and bet accordingly, getting paid requires picking a counterparty which has deep enough pockets to pay for its foolishness. All of the above should serve to remind us of the precarious base on which the current financial system rests.

Central banks around the world have been printing the equivalent of trillions of new dollars every year for the past 6 years. And yet, in dollar terms the prices for most asset classes have fallen, in many cases drastically. Is this some kind of magic? How can this be? The answer is that it isn’t and it can’t, at least not for very long. Yes, the gamemakers are very clever. They can and do pull many a rabbit out of their bags. But at the end of the day, though their tricks are many and resources enormous, they are not unlimited. In fact, the primary tool in their box of tricks is not money, but rather psychology.

As long as they can maintain “bearish sentiment” in the market for asset X, the speculating public may be willing to suspend belief and refrain from buying it. For obvious reasons this cannot however be maintained indefinitely. The Swiss franc revaluation is the first major break in the mirage of dollar supremacy, but it unlikely to be the last. The reality is that all these paper assets floating around are worth a LOT less than current asset prices would have us believe. The dollar pump show has now been stretched out for 3 1/2 years. It may soon be time to call it a night and go back to the real world.

Questions or comments? Join us at the TDV Blog.

Scott Freeman is the CEO of the IT Group, which is a Shanghai-based group of companies focusing on information technology and financial services. He’s always on the lookout for self-starters who bring along creativity, enthusiasm and know-how. He can be contacted at [email protected].

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