“Using volatility as a measure of risk is nuts. Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.” – Charlie Munger
The chart above is commonly misunderstood. You see, the VIX is often referred to as the “fear gauge”, the indicator that reflects perceived market volatility. With the VIX at record lows, many market pundits are pounding the table that volatility will wreak havoc on the markets in 2018 and the VIX will spike.
This may very well prove true, but I will explain how regardless of this index and general market volatility, the crypto market stands to benefit as institutional money enters the space.
For the sake of understanding, it is also worth explaining what the VIX index really is. Many believe the VIX accurately reflects the market’s perception of volatility. However, what the index is really is a compilation of pricing on near-dated options; 30 days to be exact. It is an index of volatility on 1 month until expiration at the money puts and calls on stocks in the major indices.
So, rather than considering all of the complexities in the market that may lead to volatility (i.e. geopolitical, social, macroeconomic, natural disaster, etc.) all VIX takes into account is what the pricing looks like for near-dated options in the public equity market.
Not such a reliable indicator then, is it? Like any other indicator it is useful when combined with a more holistic view, but on its own it’s practically worthless.
Let’s now dive into how VIX and, more importantly, volatility (or lack thereof) plays directly into a bullish scenario for the crypto markets.
While the stock prices for US Banks like Goldman Sachs, JP Morgan, and Citigroup have all been rising this past year their trading desks have all been posting double digit declines.
Why is this? Because volatility is at such a low extreme in the equity and bond markets so there is little room to navigate as a trader. There is little room to manipulate the markets and let momentum and public narrative work its wonders, in other words.
Traders love volatility because it allows market conditions to over-swing one way, oversold, and then soon thereafter revert the other direction towards overbought. Traders live and breathe these markets and understand better than anyone else when these conditions exist, and they profit from them at the expense of the people who are easily shaken from positions and buy at tops.
The fact that the best traders in the world are posting double digit losses tells me one thing: these trading desks are starving for volatility. They need volatility to stack the cards in their favor, to gain an advantage over us retail investors.
Crypto markets offer volatility more so than any other asset class out there. I expect banks to immediately setup trading desks dedicated entirely to crypto markets and begin operating in the space by buying weakness and selling strength, on repeat. Of course, they will be colluding with mainstream media to make sure they swindle the maximum profits out of the current structure as they do in any other market.
As more of these trading desks come into the space, they will be competing with one another, and this will have the effect of leveling off volatility. Goldman Sachs has already announced the initiation of a crypto dedicated trading desk, and it’s safe to assume the other banks are not too far behind.
Another very important piece of the banker trading desk puzzle to consider is regulation on trading desks since 2008. Following the financial crisis, regulators made it so banks must keep a higher ratio of capital on hand to cover operations in their trading desks. In other words, they put trading desks on tighter leashes by limiting leverage, and banks are obsessed with leverage. Leverage allows them to make more money on fees from the same amount of capital on hand.
Enter crypto at a time when yield starved trading desks are looking for volatility, the opportunity to create leverage, and a market that is easy to manipulate. Voila!
Okay, so what? Trading desks do not control the fate of trillions of dollars, merely billions. *hint of sarcasm here, but nonetheless, a fair observation...
Now let me explain why the real money will also come pouring into crypto markets, and by real, I mean the funds with trillions in assets. In short, it is also because short volatility is an overcrowded trade and nobody has any sense of what the broad market will do once this crowded trade breaks up.
Wall Street understands that volatility will not remain where it is for much longer. Naturally, they are looking to hedge their short volatility positions, and they will be looking for vehicles to synthetically go long volatility. Since long VIX is extremely overpriced, what better way to go long VIX than to go long the most volatile asset class possible, crypto?
Yet, this asset class can not only be volatile, it must also be proven to be uncorrelated to other asset classes in case of a broader market decline.
When a source as credible as the World Academy of Science, Engineering and Technology comes out and states that adding Bitcoin to a portfolio offers better risk-adjusted returns you know that Wall St is going to pay a lot of attention to it, and they are going to use it in their marketing campaigns to bolster their assets under management.
Never forget that Wall St makes its money based on assets under management (AUM), so it is in their best interest to increase this number relentlessly. They will develop narratives and peddle them to potential customers in hopes of luring their assets in under their management in an effort to maximize their profits from fees.
Not only does crypto offer banksters the advantage of owning a highly asymmetrical asset, but it also fits into their quest for low-beta (smart beta, as they call it), diversified portfolios. This is why the money managers with the serious money will begin allocating smaller portions (say 5%) of their funds to crypto in pursuit of an uncorrelated asset and one with high upside.
Conclusion:
Banks and institutions are coming to the crypto space. In fact, some have already done so. But equilibrium has not been reached yet and the line waiting to get in is pretty long.
Trading desks are fretting over their dismal performance in 2017, and they will be looking at the volatility offered in crypto as an opportunity to scalp profits in an immature, unsophisticated marketplace that is easily manipulated. They are likely frothing over this setup, it is almost too easy.
More importantly, the funds controlling trillions of dollars in savings are beginning to accept the narrative that Bitcoin and crypto offer value to a diversified investment fund. Namely, it is uncorrelated to the broad market and offers huge upside in an environment where yields are at historic lows. At least, this will be the narrative they push unto the general public in hopes of garnering more assets under management.
Stay informed my friends, and grab your popcorn! We will experience many things in 2018, but boredom will not be one of them.
DISCLAIMER : This content is for informational, educational and research purposes only. This post is not to be taken as personalized investment advice.