As a result, ETH and Alts have started to outperform BTC. ETHBTC is higher by 7% this week. SOL is up about 40%. LUNA is up about 27%.

Luna Foundation Guard’s (LFG) BTC buying program, which was accelerated from the middle of March this year, has been pivotal in fomenting this recent bullish sentiment and has effectively placed a psychological floor in the crypto market.

Clearly, the buying itself has helped push prices higher. LFG have accumulated about 30,000 BTC with about half more to go to complete the planned $3bn purchase. And the longer term goal is to accumulate $10bn worth of BTC for the UST reserve.

We think that LFG’s BTC buying program has greater significance beyond the buying itself. The program is a formalised transmission mechanism for the billions raised in the crypto VC space to flow into BTC and other underlying crypto assets. It has set a precedent that will create a positive self-reinforcing cycle as other project treasuries are compelled to do the same.

This effect could be the reason that allows crypto to decouple from other macro assets. Crypto has so far been trading in lock-step with NASDAQ. And we have been concerned about downside in equities as the Fed continues to tighten aggressively and China experiences a hard landing. This inflow could keep crypto prices supported even if macro assets take a hit.

The option market is showing signs of this effect with significant demand for back-end (December-March) topside in BTC and ETH. Most desks (including our own) have been skewed to the topside for risk reversals (buy calls / sell puts). BTC December risk reversals made a sharp move higher from -4.5% to -2.7% (Chart 1).

Our conviction view now is to be short vol as macro factors place pressure on markets while the LFG effect supports the market. We think crypto prices will grind higher towards the second half of the year and any dip with be met with confident buying.

We’ve positioned ourselves short vega (longer-term options) and long rega (long calls / short puts). Also long gamma (short-term options) in ETH and Alts vs. flat in BTC.

— — — — — — — — — — — — — — — — —

Do look out for our quarterly research piece “Just Crypto” that will be posted in the next few days. This piece will dive deeper into the recent weaponization of Fiat and it’s significance for crypto.

Also, Darius will be Miami for Bitcoin 2022 next week and London the week after. Do feel free to reach out if you would like to meet up or get invites for our events in both Miami and London.

One notable buy flow this week was the 125 million USDT purchase of BTC by Luna Foundation Guard (LFG). This purchase is part of the plan to systematically accumulate a total 3 billion USD worth of BTC as a reserve for TerraUSD (UST).

This comes on the back of a broader rally in global asset prices. And the bullish momentum is likely to continue in the near-term.

A buy signal was triggered this week on Bank of America’s Bull & Bear Indicator (the last buy signal was in March 2020). This means that the rally has some legs as the market recovers from extremely oversold conditions. This signal has worked well in the past with equities rallying 8% on average in the 12 weeks following the signal. (Chart 1)

In vols, this bullish sentiment flip was most clearly seen in ETH front-end risk reversals (calls minus puts) which rallied a whopping 12% from -16% to -4%. This is somewhat expected as the narrative around the coming ETH merge has been building and the market continues to unwind FOMC-related downside protection.

Short vega (longer-term options) has been a real winner with the usual quarter-end vol compression. From last week BTC 1-month implieds have dropped 18% from 76% to 58% and ETH 1-month implieds down 22% from 90% to 68%.

We’ve started taking profit on our core short vega position and will continue to lighten up towards the US CPI print on 12 April.

We are now long gamma (short-term options) in both ETH and Alts and hoping for some explosive short-covering in the coming week. SRM calls have performed well for us this week as spot rallied almost 70% on positive developments around the DEX.

— — — — — — — — — — — —

As the Avalanche Summit comes to a close, we’d like to give a shoutout to the Avalanche team for a great conference at the most stunning venue we’ve ever seen. The QCP team will be heading back to Singapore for a few days before taking off for Bitcoin Miami.

No immediate surprises on Wednesday with the 25bp rate hike and no shocking statements from Powell. The market reacted positively as a result.

But make no mistake, the overall message was clearly hawkish. The most aggressive we’ve seen since before the 2008 Global Financial Crisis.

1. The Fed’s forecast for hikes has moved aggressively to match the market’s expectation of 7 hikes for 2022 and 3 hikes for 2023.

2. Every FOMC meeting going forward is live with the possibility of a 50bp hike.

3. The 2024 forecast of 2.75% is actually higher than the long-run equilibrium estimate of 2.375%.

4. Balance sheet runoffs (Quantitative Tightening) to start as early as May.

A strong hawkish mandate from the Fed with the primary goal of curtailing inflation. The Fed’s ‘short call’ is firmly in place. Meaning that asset prices will probably be capped at all-time highs in the medium-term given the Fed’s clear tightening bias.

But why did markets rally when the Fed was hawkish? We were not surprised at all by the positive reaction and we are also bullish in the near-term for the following reasons:

a. China and global tech equities were oversold and the relief rally will have some momentum.

b. De-escalation and possible ceasefire in the Russo-Ukrainian conflict.

c. Further unwinding of FOMC downside hedges.

With the Fed’s cap on the topside on one hand and bullish momentum supporting the downside on the other, the obvious trade is to sell vol! The market caught on quickly with the VIX dropping sharply during the FOMC window itself.

Crypto vols

It’s been a while since we’ve seen such interesting moves and opportunities in vols.

1. The market was clearly caught long gamma (short-term options). The desk saw a tremendous amount of vol selling post-FOMC. From the highs of nearly 100%, both BTC and ETH front-end vols have dropped to 60%. A truly massive move! (Chart 1)

This has caused the curve to steepen significantly as we expected from our previous update.

The overall vol collapse has been great for our core short vega (longer-term options) position. We are keeping short vega overall in anticipation of the usual quarter-end vol selling.

2. ETH front-end vols traded at a discount to BTC! (Chart 2) This rarely happens and must have been caused by larger unwinding of FOMC hedges in ETH versus BTC.

Not an opportunity we could ignore. We’ve gone long ETH gamma against short BTC gamma at a 3% discount. And short ETH vega against long BTC vega at a 12% premium.

We are now long gamma overall as these levels have to be oversold (or so we hope).

This will be the most interesting FOMC in recent memory as the Fed is walking on a tight rope. On one hand, crumbling global economic growth and on the other, relentless inflation.

Here’s what we think:

1. A 25 basis point hike and end of Quantitative Easing is pretty much a certainty. We don’t expect any surprises here.

2. To get a clue on the Fed’s stance, we will be paying very close attention to the GDP and inflation estimates, Fed Funds projections as well as Powell’s answers on stagflation, global risk contagion, energy prices, inter-meeting hikes, Quantitative Tightening, crypto and sanctions.

3. There is a chance that signs of dovishness will cause a short squeeze in asset prices (we already started seeing some signs of this in the crypto markets from Asia morning).

However, we think any upside in equities is going to hit significant resistance due to serious global stagflation risks. Particularly the overhang of war in Europe as well as the sell-off in China from ‘common prosperity’ policies and Covid lockdowns.

4. In this scenario, we are not sure if the FOMO-buying in crypto will be enough to break out of its correlation with equities. A convincing break to end the crypto downtrend would probably need to see BTC close above 46,000 and ETH above 3,400.

5. The Fed might sound dovish but to determine if the market is convinced, we will be looking out for a sell-off in USD as well as a recovery in Tech stocks and Chinese equities.

6. Wild price swings in price are likely today given the illiquidity in markets. We will refrain from reacting too quickly until key levels are breached.

In the vol markets:

a. Naturally, 18-March implieds have been trading exceptionally high (Chart 1) even with realized vols trending lower (Chart 2).

b. Massive buying of longer-tenor options (June-December) as BTC back-end vols rallied to 74% and ETH vols to 89%.

c. Relatively larger demand for ETH back-end vols (possibly because of the ETH 2.0 narrative picking up with the launch of the Kiln merge testnet). ETH-BTC 6-month vol spread has widened from 10 to 15% (Chart 3).

d. Huge demand for ETH puts. Over the last few days, a single US hedge fund bought over 40,000x ETH April puts. That probably contributed to the risk reversal (calls vs puts) moving down from -10% to -14%.

e. We expect the vol curve to steepen after FOMC as vol selling from the DOVs continue to press the front-end down while back-end vol demand persists amidst the geopolitical and macroeconomic uncertainties.

f. We have been trading a decent amount of ERKO options (European Reverse Knock-Out). This makes sense given the higher options prices. ERKOs allow the buyer to speculate on direction or hedge a position at a fraction of the cost of buying an outright vanilla option.

Positions:

Our short vega (longer-term options) position continues to disappoint. We have reduced but will continue to keep a core short position there.

We have a small nett long gamma position (short-tenor options), very long in Alts against short in BTC and ETH.

We increased our long wing (far-strike options) positions especially in ETH. This means on a big spot move, we will turn increasingly long gamma very quickly.

==================================

Travel announcements:

Darius will be speaking at the AVAX conference in Barcelona next week! Please reach out if you would like to connect with the team.

Darius will also be speaking at Bitcoin Miami early April. The team will be headed to Manchester and London after. Finally, Darius will also be speaking at Crypto Bahamas towards the end of the month.

QCP will be throwing side events at the conferences starting in Barcelona next Thursday, 24 March with co-hosts DYDX! Do reach out for invites.

- US & EU regulators look to impose tighter regulations in response to crypto becoming increasingly identified as a means to bypass international sanctions.

- Further escalation of the Russo-Ukranian conflict saw crude oil prices spike close to 130 USD. Exacerbated inflation heightens the risk of recession combined with an even more hawkish Fed. Markets reacted badly with equities selling off hard and BTC fell back under the 40,000 level.

- Just earlier today, Putin banned the exports of products and raw materials until the end of the year. The risk of a protracted inflationary environment hangs over markets.

- Andre Cronje, a principal figure in the DeFi ecosystem, announced that he is stepping away from crypto. Alts took a beating as ETHBTC closes in on the 0.65 level.

One silver lining has been the increased activity in the crypto vol market. Naturally, there has been overwhleming demand for front-end vols, especially 18 March expiries which cover US CPI and the ECB conference tomorrow as well as the FOMC rate decision next Wednesday, 16 March.

In particular, we’ve seen demand for:

1. ETH 18 March 2,200 puts. Over 30,000x contracts traded earlier today in Asia morning alone! (Chart 1)

2. ETH end-March 3,000 calls. 20,000x contracts traded earlier in Asia evening.

3. BTC 18 March 34,000/40,000 strangle. At least 1,000x traded by a Chinese trading desk earlier in Asia afternoon.

4. ETH December vols as well. Implieds have rallied close to 85% from 77% last week. (Chart 2)

We’ve managed to take some profit nicely on our 18 March long vol position but the elevated vols have not been pleasant for our overall short vega (longer-term options) position.

We plan to keep fairly nimble amidst the geopolitical uncertainty and significant risk events in the next two weeks. We remain nett short vega. Long gamma (short-term options) in the Alts and long on the wings (far-strike options).

Our longer-term bullish conviction in crypto (especially DeFi) continues to get stronger. We reckon any Russian or resident of fringe, non-NATO countries would be seriously thinking about moving assets out of the traditional finance system and into crypto or DeFi.

The fact that crypto has become something of a ‘safe haven’ for this segment of assets should give everyone some food for thought.

So where do we go from here?

We are moderately bullish in the short-term. From the historical post-invasion analogs in modern wars that we highlighted in our February month-end report (https://docsend.com/view/d63s5rynein2r25v), we expect the market to remain supported in the next 3–6 months or so.

In the next few weeks, we expect volatility from significant macro events. US CPI on 10 March and the FOMC rate decision on 16 March will shift the market’s focus back on the Fed.

The market is keen to see how the Fed responds to war and the severe inflationary impact that has followed. Already Powell’s testimony earlier today in the House was noticeably more dovish and the probability of a 50 bps hike in March has been priced down.

We maintain the view that there will still be some downside risk as we head into the 2nd half of the year as macro markets deleverage on the back of Fed tightening and balance sheet reduction.

However, this coming dip could be the best opportunity to build up a structural long position in crypto. The war has instigated a tectonic shift that we think will form the foundations of a multi-decade crypto bull run in time to come.

In response to the Russian invasion, the West has launched the largest and most coordinated campaign of economic warfare in history. This includes widespread sanctions (even from historically neutral countries like Singapore and Switzerland) and the effective weaponization of the SWIFT system.

This might not seem like a big deal on the surface but it really is. If the global fiat system becomes a geopolitical tool that can be used to alienate a superpower, then alternatives to fiat become critically significant.

Crypto becomes an important method for transactions and a vital avenue for the large storage and preservation of wealth. We think that this war has fundamentally shaken the credibility of the fiat financial system. On the other hand, it has subtly but definitively established crypto as a necessary alternative.

In fact, the mass outflow of assets from Russia might explain the material crypto inflow (especially into BTC) in the last few days. This makes sense given BTC’s place within crypto as a ‘safe haven’ coin. We’ve been seeing significant buying in BTC spot and BTC calls this week (1,500x BTC MAR 45k C on Monday alone!)

The focus on BTC was reflected even in the vol markets with 10d realized volatility 4% higher for BTC than ETH (99% vs 94.5%). Anecdotally, there has also been much more topside interest in BTC compared to ETH. This has caused the implied vol spread between BTC and ETH to drop back to lows of around 7% (Chart 1).

With the recovery bounce in spot, implied vols have been trading softer as well. BTC 1-month implieds have fallen back to 65% from 80% highs. ETH 1-month has fallen to 75% from 93% highs (Chart 2).

We added to our short vega (longer-term options) position, selling the vol spike post-invasion. We are nett neutral gamma (short-term options) and continue to be long on the wings (far-strike options). We have been tactically accumulating long vol position in the 18 March bucket as we expect outsized volatility going into the FOMC rate decision on 16 March.

However, selling pressure quickly resumed, on the back of increasing Fed hawkishness and negative headlines out of Ukraine. BTC has since traded to 37,215 lows today and ETH to 2,575 yesterday. A large weekly range.

Vols have naturally inched higher over the week given the sharp dip in spot. BTC 1-month implieds from 57% to 65% and ETH from 69% to 79%. (Chart 1)

In spite of this, we’ve been seeing aggressive vol selling with every spike. Our sense is that selling vega (longer-term options) at these levels is the right trade.

While spot swings in the short-term from Russia-Ukraine or Fed headlines are to be expected, we don’t think that spot prices will crack just yet. Two reasons:

1. A good portion of the leveraged longs have been taken out with funding rates relatively flat.

2. An aggressive Fed hiking schedule has been priced in by the market.

We think it will be more of a grind lower with the possibility of short-squeezes on positive headlines. These spikes in spot price would probably be met with aggressive spot selling, capping the topside.

We have turned nett short vega on this vol rally while keeping neutral gamma (short-term options) and long on the wings (far strike options) for protection.

— — — — — — — — — -

Part of our short vega conviction was formed by some interesting findings from our Quant team.

The data shows that short vega in BTC and ETH has been the winning strategy of the last 6 months.

The GIFs below (Chart 2 & 3) play out the changes in the implied and realised vol curves over the last 6 months. In that time, implieds have traded at a material premium over realised vol, across all tenors with very few exceptions.

*Research footnote:

We made some modifications to the typical implied and realised vol data for this piece of analysis.

Typical implied vol is forward looking while realised vol is historical and backward looking. This means that comparing the two does not accurately indicate if the strategy is actually profitable due to the time period mismatch.

Instead we used lagged variance swap price (“Sqrt implied variance”-black) versus the forward vol (“Clairvoyant future realised vol”-blue) for a better comparison.

The stunningly high inflation print followed by the call for an extraordinary Fed meeting today (Monday) has led to talk about a possible inter-meeting hike by the Fed.

Naturally, asset prices have come under pressure. BTC traded below 42,000 and ETH below 2,850 after trading at highs for the week of 45,855 and 3,285 respectively.

While the market has been fixated on rate hikes, our primary concern has actually been Quantitative Tightening (QT), which is the shrinking of the Fed balance sheet. More specifically, we want to know how QT will be carried out.

The addendum note of the January Fed meeting “called for primarily reducing the bond portfolio passively by allowing securities to mature without replacing them”.

We think this suggested passive reduction (i.e. allowing assets to expire instead of selling) will be bullish for the market.

However, an active reduction (ie selling down the portfolio) would pose the real downside risk. And this is what we will be looking out for in this week’s FOMC minutes (17 February).

Equity vols have started to reflect this tail risk, with the VIX index rallying a massive 10 points, from 20 to 30 since the CPI print (Chart 1).

In stark contrast, crypto vols have hardly moved. BTC implieds remain stuck in the low 60s (Chart 2), in line with realised vol levels.

Which vol market is reflecting the risk accurately?

Our approach to this uncertainty is to remain long on the wings (far strike options) across the board while the rest of the book remains relatively neutral:

- Long ETH and Altcoin gamma (short-tenor options) against short BTC gamma.
- Long Altcoin vega (longer-tenor options) against short BTC and ETH vega.

So if the VIX is right and we do see some extreme spot moves, the book would have some protection from the long wings. Otherwise, we are keeping overall positions nimble and tactical until we form a stronger view.

To re-iterate, we formed a bullish view February for two keys reasons:
1. Moderation of market expectations for Fed hikes
2. Positive seasonality in February

Our bullishness been strengthened in the past week by some additional factors:

1. Real buying
Prices gapped higher literally seconds after the 8am UST option expiry on Friday. The buying pressure continued thereafter, indicating the move was not a one-off expiry-related flow but actual sizable demand in the market.

2. Crypto prices rallied even though NASDAQ traded lower towards the end of last week. We don’t think this means that crypto has necessarily decoupled from NASDAQ but this tells us there is tangible and targeted crypto demand right now.

3. Negative perp funding on many of the large derivatives exchanges (Chart 1) means that leveraged shorts are likely to get liquidated if prices continue to rally, adding more fuel to this short squeeze.

Given the absence of any significant macro events before the 17 February FOMC Minutes, we expect this upward momentum to continue.

Vols remain under tremendous pressure in spite of the fast rally in spot. BTC 1-week implieds traded close to the lows of 50% over the weekend! Levels have come up slightly now as spot breaks higher but remain in the low 60% handle across the curve. (Chart 2)

Position-wise, we took profit on our short skew (long puts vs. short calls) and flipped to a long skew position. This has probably been our best trade in the last two weeks with BTC 1-month skew rallying from -12% up to -2% and ETH 1-month skew from -16% to -7% (Chart 3).

The market is still very long gamma (short-tenor options) from the DOV strikes (BTC: 41,000–43000, ETH: 3,200). This would naturally cause some resistance up to around 45,000 in BTC and 3,400 in ETH (because market makers would be selling spot against the calls).

However, above those levels we suspect the market might start scrambling to cover shorts not just in spot but also in vols.

“We reckon actual “extreme fear” will kick in below 40,000 in BTC or below 3,000 in ETH. We intend to keep deltas (spot position) very short if these pivot levels break.” — 9 January Market Update

Friday, 21 January, saw the full break of 40,000 in BTC and 3,000 in ETH as equities tumbled hard as well.

As expected, the desk saw tangible fear kick in:
1. Heavy stop-less selling in spot
2. Aggressive buying of gamma (short-term options) particularly from large option desks who were covering short gamma (around 3000x of BTC notional of strangles)
3. 2000x BTC of February 25,000 puts on Bit.com (an unusual size for the exchange which leads us to suspect it might be miner hedging)

Price weakness carried into the weekend and accelerated on Monday with BTC trading to 32,933 and ETH trading to 2,159. “Extreme fear” kicked in with BTC risk reversals trading below -30% (puts more expensive than calls — Chart 1).

However, later in US hours, we saw a strong bounce off the lows. BTC ended the day positive and BTC risk reversals went back above -10% (Chart 1) as downside fear turned into fear of missing the bounce. Front-end vols sold off hard as well as confidence rushed back into the markets.

The question is whether we’ve already seen the lows and it’s going to be up only from here?

We are not sure.

While front-end vols spiked hard with BTC 1-week from 70% to 100% and ETH 1-week from 85% to over 120% (Chart 2 & 3), the longer end of the vol curve remained relatively tame. The curve from March onward moved higher by only 5–6% to a very modest 75% level.

This is distinctly different from the vol reaction in May last year which saw the whole curve elevated and ETH vols trade up to 250%! Does this mean that the market has yet to reach it’s true point of pain? Below 30,000 level in BTC perhaps?

A lot of the short-term price action is going to depend on the Fed statement later today (3am SGT). Given the bloodshed in equities, chances are we that we’ll get a fairly neutral statement and market will take that as an excuse to rally. A short squeeze across the board is likely.

Positions wise, we flipped short delta on the break of the pivot levels as planned. Thankfully, we were also extremely long gamma from winning most of the DOV flows on Friday evening.

The long wings (far strike options) position that we’ve been adding to (see 20 January update) also paid off nicely as the BTC butterflies (far strike vs at-the-money options) doubled on the sharp move lower.

We’ve taken profit on a lot of our long gamma but remain quite long still into the Fed meeting. We are slightly nett long vega (longer-term options) as well now, short BTC vega against long vega in ETH and the Alts.

We are keeping our deltas (nett spot exposure) only slightly long as we do not have any longer term directional conviction at this point.