WBD366 Audio Transcription
How Bitcoin Derivatives Work with Juthica Chou
Interview date: Wednesday 30th June
Note: the following is a transcription of my interview with Juthica Chou. I have reviewed the transcription but if you find any mistakes, please feel free to email me. You can listen to the original recording here.
In this interview, I talk to Juthica Chou, Head of OTC Options Trading at Kraken. We discuss how bitcoin derivatives work, the different types of contracts, and Microstrategy's leverage plays.
“You need to be able to withstand the fluctuations because one of the biggest dangers of leverage is you get closed out at precisely the wrong time...if you’re short and bitcoin rips up you get closed out.”
— Juthica Chou
Interview Transcription
Peter McCormack: Hi there, Juthica. How are you?
Juthica Chou: Hi. Good. How are you?
Peter McCormack: Not bad. It's been a while since we met in New York, it feels like two years maybe?
Juthica Chou: I want to say it was more than that, but time gets so messed up in this space so it could have been more than two years, yeah.
Peter McCormack: Yeah, it's like dog years; I feel like I've been doing this for two decades!
Juthica Chou: Oh, completely; January feels like three years ago!
Peter McCormack: Yeah, it's been just the wildest year. I can't even get my head around it. It's a bit overwhelming but, anyway, we are where we are. So, thanks for coming on. I've been doing these regular shows with Willy Woo, and a few people have been writing to me and saying, "Listen, I don't understand how derivatives work", or asking me questions about derivatives and I'm like, "I don't know! I don't know how they work, I don't use them. I'm just a spot buyer and transfer to cold storage".
So, I was speaking to my producer, he's like, "Why don't we reach out to Juthica again; why don't we get her on? She's the expert, she'll explain it all to us". So, are you ready for this?
Juthica Chou: I hope so!
Peter McCormack: Come on! Before we get into it though, the first thing I did want to get into with you, and I think you'll know a bit about it, is to do with MicroStrategy. I'm sure you track what they do; I'm sure you're quite aware of everything they're doing.
So, they've just done another $500 million bond sale and they're talking about launching it at-the-market securities offering for flexibility just up to another $1 billion of its asset class. What does this all mean? I've got no idea! What is a bond sale for a company; is it the same as a treasury bond; is it similar; how does it work?
Juthica Chou: Yeah, so, there are a couple of ways, or, as crypto has learned, there are a lot of different ways that you can raise capital whether you're a token or a company. So, the traditional way is that you issue shares which are securities, so people have a stake in your company; that would be like Coinbase going public in their initial offering.
Another way in the capital structure is that you can borrow money so you can issue debt, and that debt will have its own set of terms associated with it. There are some times when you would rather issue debt than equity. So, let's say you have a business that has good cash flows so that you can service your debt and may not be too expensive, and you'd rather do that rather than give up a stake in your company; that could be a reason to go after debt.
So, I think what MicroStrategy has done, and Saylor has shown, is that he clearly has good command of understanding his company's capital structure and when it makes sense to raise outside money, how to raise that money; even when they do these debt sales, they do them as convertible offerings. So, what that means is that, at a certain strike, the debt can convert into equity and so it combines those two pieces of the capital structure. That's near and dear to my heart because it has an embedded option in it.
Obviously, they're pretty sophisticated and I think he knows what he's doing in terms of how he set it up, but it's just such a cool way of bridging what are these traditional Wall Street desks that take down these large trades with the Bitcoin space.
Peter McCormack: Yeah, okay. So, you also tweeted about this because I was having a little bit of research. You said there are capital structure implications. What does that mean? Is there any risk with what they're doing here?
Juthica Chou: Well, I think as long as they can service the debt, so as long as they can pay whatever they would need to be able to pay so that they don't default on the debt, and I don't think that the market has concerns about that, at least based on what I've seen, I'm not super close to it; then it's not really an issue. Then they can basically sustain the price fluctuations of Bitcoin going up and down as long as they are fine on the debt side.
Where I think maybe retail investors might get into trouble is if you are collateralising that debt with Bitcoin and Bitcoin goes down. So, you just don't want to get into default on the debt, but I think they're fine. I think, on the capital structure side, I feel like there will be a case study on it, and I'm not predicting it's going to go one way or the other, but it's just a fascinating -- I don't think we've seen anything like this in terms of just the use of proceeds and how it's being used to invest so singularly in this commodity; I don't think we've seen anything of the sorts, and so I just think it's fascinating to watch from the outside.
Peter McCormack: Well, he's leveraging his business to speculatively attack the dollar with Bitcoin.
Juthica Chou: Yes, exactly. So, any time you take on debt, when you're borrowing money to invest in something like Bitcoin, you're leveraging up in some way. So, yeah, I think the amount of, and the nature of leverage that he's taking, it's very clear what he's trying to do and credit to him so far, it's been okay. Obviously, the market's constantly oversubscribing for these.
Peter McCormack: Well, it seems to me like his play is a decade-long play minimum in terms of the money he's raising to make these purchases, and one of the interesting things, I was talking to Lyn Alden earlier today; we make a monthly show, and one of the things we were talking about is that there have not been many other companies that have followed him, and those that have have made a certain amount of investment.
He's essentially turned his business into a Bitcoin business. Bitcoin has become the reserve currency for his business; it's almost become the unit of account in some ways for his business. We were talking about how nobody's done this, but I think he was in that advantageous position that he's first trade was, I think his average price was something like $11,666. So, he made such massive gains that he was in that position where he could consider making increased purchases; whereas now, you look at someone like Tesla, they're under water in their purchase, so I can imagine there's some pressure on Tesla around that decision.
So, some of this stuff, it's like people today panicking about the price of Bitcoin. For you and I, who've been in Bitcoin for a long time, our average buy should be considerably below what the price is now, but people coming in new are in that tricky position and you almost have to time the market right to be able to make these decisions.
Juthica Chou: Yeah, you definitely see that, whether it's individuals or companies, that the resources you have available to you change your risk reward calculus over time. I just look at a lot of the companies in the space and you definitely see this massive differentiation between companies that either put their treasury into Bitcoin, when I say "treasury" not like corporates but literally Bitcoin start-ups, or even start-ups that raised ICOs, take Block.One for example, holding 200,000 Bitcoin.
So, you have these companies that never really had to have a business model, never had a business that worked, never found product market fit, but they're still around because they just held their treasury in Bitcoin. It affords them now, at the height of the, well not anymore, not today at the height of the bull run, but it affords them a different set of utility and risk reward calculus because they are sitting on all these gains. So, yeah, I agree that, with MicroStrategy getting in at the level -- I want to say Square got in around that level too.
Peter McCormack: They did, yeah.
Juthica Chou: But they obviously took a more conservative path, I guess.
Peter McCormack: Well, I can't remember if they followed on, but they did a $50 million purchase which was quite a small amount for them compared to someone like MicroStrategy. One of things I always say to people, especially people are listening, because I get a lot of new listeners when you're in a bull market, is that one of the things you really need to do is survive four years. If you can survive four years in Bitcoin, the next four years become pretty easy.
We all took a massive haircut this last few weeks and whilst it's not great, it's quite easy to handle because I've done my four years; I've still got my initial investments, well some of them, and I was stacking through the bear market. I think if you came in in the last six months, this is quite a tricky thing to handle, so just hold tight, be patient.
Juthica Chou: Yeah, completely. I think, not to drill this and take it to derivatives, but that’s where they come into some degree too is because you can put on these trades that have this limited loss or very fixed risk reward calculus because I think, at the end of the day, a lot of it is just survival.
If you can just survive through, whether it's something like March of last year or May of this year or through 2015, 2016 when all people cared about was blockchain, but if you can survive through those periods then you don't have to anything crazy in the bull runs, you just have to be there and that's really about it. I think the people who run into problems, they just get too greedy or too fancy and get liquidated at the worst time, just when you don't want to be liquidated.
Peter McCormack: Yeah, that's right, and this is why I wanted to get you on to talk about these. I don't use leverage. The only time I've ever used leverage is when there was a market crash and I was all in Bitcoin and I took out a loan, as like doing a mini MicroStrategy thing, I took out a loan and bought Bitcoin at $17,500 and that's fine because my cash flow's great and I can service it. So, it's like a retail version of MicroStrategy at miniscule level, but it's absolutely fine. It's a really easy thing for me to do, and that Bitcoin's still nearly up over 100%.
I did have a little play with CFDs just to try and learn to time the market when there's a big dip, and I think, out of the eight strikes I tried, six profited and I sold out, because I was trying to learn about trading. I still don't know if I'll do it, but I am getting a lot of questions about derivatives. People want to understand how they work.
I see, on exchanges, the kind of leverage you can get is crazy. Doesn't one exchange have like 125X, which is obviously crazy? But all the expert traders I speak to, their leverage tends to be around 1.5%, 1.5X, maximum 3X. None of the expert successful traders seem to go above that, yet I worry about all these new traders who are getting absolutely rekt because they're trading with very high leverage.
So, you're obviously one of the biggest experts on this; you might be humble enough to say not, but you're my first choice. I want to teach people about this today, and you know what I do in my show, keep it absolute basics. When I ask you things, if I don't understand, I'm just going to say, "Please explain it again", etc. So, starting off, for people who don't know, just explain what derivatives are.
Juthica Chou: Yeah, so derivatives are contracts or assets that's value is derived from a particular underlying. So, in the case of Bitcoin, we had Bitcoin as an underlying asset, you could exchange it on the Bitcoin blockchain, you can trade Bitcoin for dollars, and then you can create a contract on top of that, whether it's an options contract or a futures contract, that's a tradable contract you can trade between two different parties, and its value derives in some way from the underlying Bitcoin, depending on the exact contours of that contract.
Peter McCormack: Okay. So, shall we start with futures?
Juthica Chou: Sure.
Peter McCormack: Okay. Explain what futures are, how they work. My first exposure to futures was in Trading Places. Do you remember that film?
Juthica Chou: I do remember the film, yes.
Peter McCormack: They were talking about orange juice.
Juthica Chou: It’s not that bad. Yeah.
Peter McCormack: So, explain what futures are, their history, where they come from and then how they're used in the Bitcoin.
Juthica Chou: Yeah. So, futures, I don't know how far back they go, but definitely back to the commodities markets, are a natural example of futures and one that I love because they actually make economic sense. So, futures are an agreement to buy or sell a particular commodity or asset at some date in the future.
So, a reason that you could, in the traditional commodities world, want to trade futures is if you are a wheat farmer. I don't know much about farming, but you have your wheat crop and you're trying to get it to grow and you expect it to --
Peter McCormack: It all comes down to the weather, right?
Juthica Chou: Right! Then you have existential things like weather. So, let's say it takes three months for it to reach the point that you can actually have wheat that you can then sell to people. Well, in those three months, the price of wheat, a lot of things could happen. So, what you may want to say is, "Okay, I want to lock in the price of wheat and deliver it three months in the future when my crop has matured". So, it allows you to lock in a price today for a delivery on a particular date in the future.
Now, where this comes in with Bitcoin, or where I think it's interesting to people with Bitcoin, is not so much because it allows people to trade in the future; there are some advantages that you could in theory say, "Okay, well maybe I don't have to the custody the Bitcoin for three months and so I'd rather buy a future to save on the custody", but you can custody basically for free and there are so many custodians, so those are not really the reason that people are drawn to futures.
I think why they're drawn to futures is that, as compared to a spot trade, and spot is just when we trade wheat, I give you wheat, you give me dollars, or I give you Bitcoin, you give me dollars; as compared to that, a future is just a contract, so we don't actually have to exchange the full amount of the underlying.
So basically, futures lend themselves to margin much more easily, because trying to do a spot margin trade gets a little bit weird because, if you want the Bitcoin and you want to go do something with it, if I bought it on margin, then it's weird and it's hard to settle it cleanly. So, it's much easier to say, "Hey, let's just trade a futures contract", and then you can trade it and you don't have to have the full Bitcoin, you can have one-tenth of a Bitcoin and just post that as collateral against the futures contract.
Peter McCormack: Right, so give me an example of how you might buy a futures contract now or why you might buy it. Look, we're in June, the prices, we've just bounced up to around $32,000, give me an example of a futures trade that you might make and why; what would be an attractive one for you?
Juthica Chou: So, for one, on the margin side, let's say something like 50% margin, so let's say that in this current market, we just had a crash down to $30,000 and people want to conserve some of their dollars; they don't want to just allocate it all directly back in, but they want to get some upside exposure, particularly I think where margin and derivatives come in is for traders. I'm not saying that everybody should be a short-term trader, but it is for traders who are looking to capitalise on some of these short-term price movements and may not necessarily have the collateral and everything's moving around.
So, futures would provide an opportunity to say, "Okay, well, I have $10,000 that I'm willing to put at risk", and then you have to understand the risks that you're taking. With $10,000, I can get exposure to 1 Bitcoin, so $30,000 worth of Bitcoin. So now, if Bitcoin goes up, I have that exposure, I didn't have to put up the full $30,000.
Now, of course, there is the risk there, and the risk is that you're borrowing money and borrowing that $20,000, from an exchange usually, and so the exchange can then say, "Well, if Bitcoin goes down and you no longer have 30% of the trade and 40% or 50% locked up in equity, we're going to liquidate you which means we're going to sell that contract for you and we're just going to sell it at the market, and so what you get is what you get". But there could be reasons, particularly for traders. I think, for traders, there are more natural reasons to use margin and also to try to capture some of the price discrepancies that happen between futures and spot.
Peter McCormack: Is another one of the reasons that people might use this is that you tend to buy these futures contracts with Bitcoin, that tends to be the collateral that you use, whereas spot price, you tend to buying directly with the dollars? So, you have the ability to leverage your Bitcoin to essentially acquire more Bitcoin?
Juthica Chou: Yeah, absolutely. I think that's one of the arguments for even just like the BitMEX, the initial perps taking off and stuff is that you can -- so Bitcoin itself makes a good form of collateral but then, to your point, if you can trade instruments on top of it, turn your Bitcoin into more Bitcoin, it's more leverage, and not just leverage in dollars and cents but more leverage to Bitcoin. So, absolutely.
Peter McCormack: So, the risk really is, if you don't have a lot of collateral and you overexpose yourself, if you hold a lot of collateral but you don't want to sell for spot but you want exposure to more Bitcoin, and as long as you can cover the margin, then essentially, you're fine.
Juthica Chou: Yeah. So, if you can comfortably manage enough collateral that you can -- you need to be to withstand the fluctuations, because I think one of the biggest dangers of leverage is that you get closed out at precisely the wrong time.
Peter McCormack: Always.
Juthica Chou: You get closed out when something's going against you. So, let's assume there's some mean reversion, if you're short and Bitcoin rips up, you get closed out even if it's going to dip back down, and the other way too. But, if you have collateral to manage those positions, then you're at least buying yourself the safety that you can withstand those fluctuations and you can still close out of the position when Bitcoin goes up or down, but you do it on your terms and not the exchange's terms.
I think managing that is a lot of what professional traders do very well. I think actually, if you look at a lot of the professional trading shops and you talk to a lot of traders, they're very insightful about markets, they understand the signals; but they also really have a good handle on collateral management because, in the Bitcoin space or in the crypto space, it's real-time gross settled, so it's all prefunded.
So, you can have a margin call to liquidation be way too close together for you to even try to move on one or two confirms on chain, so it can be difficult to get that collateral where you need to. But if you have enough collateral, then, yeah, you can sustain those moves.
Peter McCormack: When might a retail user consider this, someone like myself? Imagine, I don't know, I know at the end of the year, I've got a pretty successful job, say I think I'm going to get a $100,000 bonus at the end of the year, but I want to buy Bitcoin now and I know that money's coming, I think Bitcoin's going to be significantly higher by the end of the year. Is that a time where I may consider a futures, knowing I've got that money coming in the future; is that a scenario you think people might use this?
Juthica Chou: It could. So, it depends at that point on how the cash flows work, and that's really specific to every exchange in terms of how do they margin it; what do they require you to post today versus at some point in the future? But I think actually, for a case like that, that's where something like an option becomes really interesting because an option, you're paying a smaller amount upfront today for the right to buy it at a certain price on a date in the future.
So, that's a great way to get, again, a little bit of natural leverage, because you don't have to lay out the full $30,000 for a Bitcoin; you can pay $1,000, $2,000 for an option and you know you have this limited downside that is, again, smaller than if you were to buy a Bitcoin; it's $1,000, $2,000.
So, you can measure your risk reward, get yourself that exposure, not miss out if there's another big run, and then, on that date in the future, let's say the option was struck at $30,000 and let's say at the end of the year, Bitcoin's $50,000 and you get your $100,000 bonus, well then you can just pay the $30,000 to exercise and get that $20,000 upside. So, I think, in those kinds of cases, options make a lot of sense.
Peter McCormack: So, if that does hit, I'm essentially getting Bitcoin at a fairly cheap price if the price has gone up. Who's on the losing side because there's somebody therefore selling it at a price lower than it's worth?
Juthica Chou: Yeah, so it's a good point, or a good question. So yes, in derivatives, in the scope, I think zero sum is really all a matter of scope, but it is correct in that for every buyer of a contract there's a seller of a contract. Now, the seller might lose on the trade itself, but not necessarily if you consider what the seller's doing and why and what the world looks like to them outside of that particular trade.
So, a great example of a seller would be let's say somebody who's a long holder, holds a whole bunch of Bitcoin, and they want a little bit of liquidity, maybe it's just to pay their rent; maybe it's just to make a purchase; maybe they're a miner, they need dollars; a company needs to meet payroll, things like that. So, one thing they could do is they could just sell some Bitcoin in the open market, so maybe they sell it at $30,000. But another thing they can do is they can sell that option.
So, the advantage of selling the option is they could sell maybe a higher strike option, maybe they sell a $40,000 strike option. So, they say, "Look, I would have to sell Bitcoin at $30,000 anyway, I can sell this $40,000 strike option, collect dollars today, so collect a few thousand dollars today that I can use today, and at the end of the year, if Bitcoin is above $40,000 and I have to sell it, well, I was going to sell it at $30,000 anyway so I'm okay selling it at $40,000". They had that price target in their minds. If Bitcoin's below it, then they just keep the value that they collected from the option.
So, to them, even though if Bitcoin's at $50,000, it looks like, yes, they're the loser on the trade because in that scope they were, outside of that, it actually makes sense compared to what their opportunity cost was or what other things that they were considering.
Peter McCormack: So, are the exchanges themselves really a marketplace for these contracts rather than the exchanges taking on the risk themselves of pricing the market?
Juthica Chou: Yeah, that's correct. So, the exchanges serve as marketplaces. I think where exchanges do take on risk is that there are exchanges that offer margin trading for options and so, to some degree, then the exchange starts taking on risk where, if you trade on margin and then they have to liquidate you, how do they handle that? But, for the most part, they serve as just the marketplace.
Peter McCormack: Okay. So, help me understand another thing then. Sometimes when the market drops, like we have a level today where we've been hovering around $30,000 to $32,000, we suddenly wick down to $28,000 and it feels to me like that's a psychological stop level. It's like, "Oh, I'm not going to set it at $30,000 because I think it will just get under, so I'll set it for $28,000". We always seem to dip below and we see these cascades and these positions being wiped out. Somebody told me this is whales going stop hunting; what does that actually mean? When they going stop hunting, what are they actually doing? Who are these people? Is this real; is this a myth?
Juthica Chou: Well, I can't really comment. I don't know if it's real or not, but I think that, in general, a lot of these activities overlap a lot with what professional traders are in the business of doing, which is they're in the business of understanding market microstructure, so understanding what does the order book look like here; what does it look like if you start to get some liquidations? Do we expect that that's going to cascade? How do exchanges liquidate people; do they just submit limit orders; do they send market orders, understanding those dynamics so that they can be well-positioned to understand like, "Hey, is this move just a liquidity-driven move that we think would revert, or is it a real supply demand shift?" Those all filter into their view of the order book and of what kind of strategies they want to run, and it's a normal way that professional traders look to understand the order book.
Peter McCormack: So, why is Bitcoin so wild then? You might tell me, "Look, there are other markets that are wild like this". My only trading history is I've traded a few amounts of equities here or there and that's about it over my lifetime, and nothing has ever been as wild as Bitcoin. The only thing that actually was quite wild is I was trading Tesla back in 2014 I think when it was going wild, but outside of that, everything else seems to be fairly tame towards Bitcoin. Why is Bitcoin so wild?
Juthica Chou: Yeah. So, I think Bitcoin is the most wild, even compared to any equity, and I think the reason, the think that distinguishes it in why I would say it's more wild than any equity is because, I would have to say just off the top of my head, it has to be the most volatile highest market cap asset that exists.
A lot of other equities that move a lot, so you mentioned Tesla in 2014, there are biotech companies that have an FDA approval coming out and those will be very high volatility, but those are very small market cap. There are a few billion, $10 billion, even maybe $50 billion in market cap, fine, but Bitcoin it was a $1 trillion market cap and still 100 vol, and I don't think we've seen that with anything else.
It's quite remarkable, but I think that it speaks to just how early it is overall. It still moves almost like a start-up would. I think of Bitcoin as a start-up sometimes; you're buying Bitcoin, you're making an equity-like investment or you're investing in the equity and people are going to help make that equity do well and have equity-like returns. So, it's almost like a really, really big start-up. So, even though the market cap has grown, I think it's just still that early.
Peter McCormack: Yeah, I also wonder if there are just still some big players who are able to push the price around a bit too much. If we had a more even distribution of the coins, a more even distribution of the asset, then maybe that wouldn't happen so much.
Juthica Chou: I think it still happens to a degree but I guess, if I compare it to back five, six, seven years ago, that dynamic has definitely -- the market's been able to absorb more and more; I think, over time, that'll just be a natural evolution as it gets larger and more stable. You look at even what some of these corporate treasuries are buying and stuff, or what some of the macro guys are putting on, and they've been able to do it; granted they're trying to do it with little impact which is a different MO, but they've been able to do it with fairly little impact. Even if things dry up in some of these market moves, there's some base level of liquidity that will stick with us.
Peter McCormack: I think I was reading about MicroStrategy or Tesla, maybe it was Tesla's buy, and I was speaking to another person who activates trades like this, and they're saying one of their important things is you don't signal to the market there's a big buy; you need to just incrementally buy small amounts and be careful about which wallets you're sending these to, etc, because these are seen as indication and that might push the price around.
Juthica Chou: Yeah, and the thing is I think, even if you try to execute strategies like volume-weighted average or time-weighted average price in the market, people are looking out for that stuff, and so they can pick up on it as well. But, yeah, there are a lot of times -- macro guys will probably be great at this, there's an order of operations, and so the order of operations is you quietly work into something and then you get very not quiet about it, but you don't want to mess up that order of operations.
Peter McCormack: No. Well, you want to be not quiet about it to push up the price, but then again, even with that, sometimes I've seen somebody announce something and the price quickly shoots up and then it goes back to the level it was previously, so I don't know. Sometimes it feels like the market does find its natural price.
So, you mentioned calls; I'm going add in there, there's puts. So, puts are essentially the opposite of a call; you believe the market's going to drop. Now, one of my very early lessons in trading and why I don't trade anymore is that there's one significant difference between going long and going short with leverage in that, when you go short with leverage, the essential downside to you if the price goes up is infinite, whereas the price can only go down to zero, and we know Bitcoin's not going to go to zero; it probably won't even reach $20k.
So, you know the bounds that you're in right now is probably between $30k and $20k, maybe even $30k and $25k, whereas if you're going short, we know the price could to $100k, $200k, and that presents a different kind of risk.
Juthica Chou: Right. Yeah, absolutely. So, on the upside, that unlimited upside versus the limited downside presents different risk, different types of risk reward, and I think that's what makes selling a call option if you don't have Bitcoin, I don't think we see anyone who even wants to do that from a risk point of view, let alone an exchange or somebody who would actually finance that trade, but it's exactly that reason.
On the put side, so you have this limited downside, so the natural reason for buying a put is protection to the downside. So, in a traditional market, if people want to buy, like S&P 500 puts or on a specific stock, you'll buy a lower strike and what that lets you do is sell your stock or sell the index at that lower strike to the person who sold the put. So, let's say, for Bitcoin, if you buy a $25,000 strike put and Bitcoin goes to $20,000, then now you can sell your Bitcoin for $25,000 instead of $20,000.
So, in traditional markets, people typically use this for protecting against crashes and prices going down. I think they're less used in Bitcoin because, at least from what I see from my vantage point, is that people who want to hedge would rather sell a call option because Bitcoin is so volatile that options get very expensive. So, paying for a put option, paying for that insurance month after month can get expensive, whereas selling a call option hedges you a little bit as well, but it's a different cash flow that's a little bit more palatable.
But on the other side, what's interesting is in traditional markets, there are not a lot of people who want to sell puts because it's selling this crash risk which seems like a prudent thing not to sell. I think, in Bitcoin, if you start thinking about price targets in your head, people are always talking about buying the dip, things like that; so if you start thinking, "Okay, if Bitcoin went to $25,000, I would be willing to accumulate a little bit", then what people will do sometimes is sell the $25,000 strike put.
So, what that lets them do is collect the dollars today, monetise some of that volatility, and then, if Bitcoin goes to $20,000, they get the Bitcoin put to them, so they end up buying Bitcoin at $20,000.
Peter McCormack: Interesting.
Juthica Chou: I think that's part of the way that people think about it. Now, I should note that the other side of that, or the clear argument against that is, well if Bitcoin gets to $20,000, who knows what the world looks like, and maybe when you're $30,000 you think $20,000 looks good, but you get to $20,000 and you're like, "Oh man, $20,000 does not look good", so there's that side of it too.
Peter McCormack: All right. Tell me about, is it perpetual swaps; are they called perpetual swaps? Like I say, I've not really looked at this because I avoided trading. Having trading in 2017, did really well, thought I was a genius and then completely crashed in 2018 and realised I was moron, I tried to look at trading. I was like, "Do you know what, it's just not for me. I can't spend all the time looking at a screen, plus the 24/7/365 thing means you need protections in for when you're asleep".
I made the decision; my strategy is to buy and stack sats. Each month I want to have more sats than the previous month, and that worked for me. Still, when I started looking into this, somebody said, "Oh, I don't like call options; I like perpetual swaps", and I was like, "Oh God, what are these?! Another thing to learn about!" Tell me about perpetual swaps.
Juthica Chou: Yeah, so perpetual swaps, they are, like the name says, they are perpetual, so there's no expiration date. So, we've started off by talking about futures, which expire on a particular date; perpetuals don't expire. So, especially in Bitcoin, that provides some advantages to folks, because when futures expire, you have to worry about what they're going to settle to, what the risk looks like and more than that, everybody has to want to be trading the same expiration date in order for it to be liquid. But with perpetuals, because there's no expiration date, everybody trades the same perpetual swap and so they just have become incredibly liquid in the source of price discovery.
They're basically a way to get exposure to the underlying, usually with margin, so you get this exposure by having a reference price and then there's a price that the perpetual trades at; and the difference is just a difference that's paid between me and you on a continual basis. So, if I long the perpetual and the funding rate is higher than what the current index is, then I'm paying you to be long that.
So, it's not something that's unique to crypto; traditional markets have them, like total return swaps, I think. They exist in different forms and different ways, but I think what's made them really big in crypto is that they provide another form of leveraged exposure that's easier than trying to trade leveraged spot directly, because a spot needs to settle instantly. So, in this case, we can just have this ongoing contract with cash flows that are exchanged between the long and short holders every eight hours, and I can maintain that constant exposure and the other side gets compensated for it in the funding that I'm paying for it.
Peter McCormack: Right, okay. Let me try and understand this. So, say I take out a contract, am I taking it out for just a specific price?
Juthica Chou: Yes.
Peter McCormack: Yeah. So essentially, if I think the price of Bitcoin might hit $100,000 by October and I get a specific price, and that's going to essentially be priced in that that person doesn't think it will hit by October, but even if it does --
Juthica Chou: Oh, so there's not a strike price, you're just trading it --
Peter McCormack: There's not a strike?
Juthica Chou: No, you're just trading it at a price relative to what the current spot price is, and it's similar in a future in that regard that there's no strike price, you're just buying at what the current price is and you're just settling it almost continuously, almost daily. But, if you think it's going to $100,000, maybe the index is $30,000, maybe the perpetual is $30,500, you can just buy it at $30,500 and basically get leveraged margin exposure to Bitcoin. So, in some ways, it would be similar to trading leveraged spot except that you can't really trade leveraged spots super easily.
Peter McCormack: Right, I definitely have no idea what you're talking about. I think we need to break this one down. Literally talk me through the trade. I'm buying from you; what exactly am I doing here because I don't understand this? Say the price is $30,000 today, I can buy that on spot, I transfer my $30,000 to the exchange, just forget fees for the moment, I get my Bitcoin back, I own it and I'm done. If I'm buying a perpetual swap from you, what am I exactly buying; what am I transferring; what's it costing me?
Juthica Chou: So, you can transfer Bitcoin again and you can pay some spread, typically above spot, in order to own this swap. So, you're not buying Bitcoin, you're just owning a contract, and that contract is a perpetual swap and, if there's a lot of buying demand, the seller will demand some of -- the market will price at some ongoing rate that you're going to pay to be long that swap.
So, you might pay, let's say, $30 every 8 hours or something, and that's what you pay to be long that swap, to get that Bitcoin exposure. So, it's exposure that you get to Bitcoin, but you can get it for less because you can trade it on margin more easily than spot where you have to transfer 30,000. Here, you might be able to transfer $10,000.
Peter McCormack: So, if the price suddenly shoots up to 100,000, I still get it at that price, the original price?
Juthica Chou: Yeah, exactly.
Peter McCormack: Right, okay. So, I understand that. One of the things is, the only trade I've ever done once, I once did a call option and then the option closed at the end of the month and I was like, "Aargh!" and the price didn't hit and I essentially lost my funding, whereas I could have, with the perpetual swap, said, "Look, I'm happy to keep playing this funding rate because I believe that price is going to hit".
Juthica Chou: Yeah, exactly, and that is the issue with options, is that there is that time dimension, and that's what makes the options so valuable or so interesting maybe in a lot of ways, is that it introduces this component of time. But, like you said, the right trade at the wrong time in options is the wrong trade.
Peter McCormack: So, this swap contract, I can close out at any point that I want?
Juthica Chou: Yeah.
Peter McCormack: And I pay the price that we originally agreed on the contract?
Juthica Chou: No, you'll pay the market price to close out on it. So, mechanically, it's almost like entering into a future, well maybe not a future because it expires, but a spot in terms of there is a market price that you will pay to buy and sell it; it's just the difference between the index price and the market price that is the financing cost that you're paying to be long that exposure, and that's driven by supply and demand.
Peter McCormack: Fine. I still don't know how it works! I think that's one of the ones I'm going to have to actually go and create one and see what it is so I fully understand it. I'd probably never do it anyway. I still say to most people, "Don't do this". Okay.
Juthica Chou: You and me both, yeah.
Peter McCormack: Right, shorting, so I understand shorting; I was trying to explain this to somebody when I was away on my travels and I was trying to explain to them you're borrowing an asset from somebody at a price to short it and then you're paying back later. Do you want to explain this fully to people so they understand how shorting works?
Juthica Chou: Yeah. So, it's like you described, so you're selling an asset that you don't own and so you borrow it from somebody for purposes of selling it, and then you sell it, and then you still owe that asset back to that person at some point. Now, ideally what happens is, so you borrow this asset that you don't own, you sell it at $30,000 let's say, Bitcoin goes to $20,000, you buy it back and then you deliver it back to whomever you borrowed it from, whether that was from the exchange or from a lender or something like that. So that's how it works in an ideal world, but you're selling an asset that you don't own.
Peter McCormack: Okay. So, what I want to get into now is I want to understand the implications of derivative, because we've seen some pretty big collapses in the price this last year, it feels like the market really unwinding, these cascading drops in price; you go onto Twitter and you hear there was X billion in capitulation and then people saying, "Well, there's too much leverage in the system". Is that a fair point; can there be too much leverage in the system? Is this a systemic risk to Bitcoin having too much leverage in the system? Are we stopping proper price discovery or is the argument the opposite; do derivatives give better price discovery?
Juthica Chou: Yeah, so I think it is a spectrum, so introducing leverage definitely accelerates the price movements. So, if you were to suck the leverage out of the system, one could argue that you would still get maybe a steady climb from October of last year through March of this year, but it would be slower and not as accelerated.
I think in the crypto space in general, there are definitely retail pockets of leverage, but I don't think overall it's actually that enormously leveraged, particularly if you look on the notional side, a lot of the big shops that are holding water, the exposure, they're not holding it on definitely not on 10X leverage, not even 5X leverage; with crypto, I really don't see it as systemic risk. I think what's interesting about crypto is, because you have this dynamic where the exchanges are settling everything and when you trade on leverage, they basically take over the liquidations and stuff, honestly, the exchanges have built some pretty robust and resilient models and ways to liquidate folks.
If you look at the traditional world, you don't have anything of that scale because, in the traditional world, you have very, very few defaults; it's designed around avoiding default, avoiding liquidations. It's the last thing they want, so you have very, very few. But then, you get a 2008 and you get a Lehman that blows up and you get these massive liquidations. In crypto, you have them much more frequently and so, in a way, the exchanges, they're cutting off the risk early; they're not letting it grow to anything too big, they're getting a lot of data, refining their models. So, I actually think, from a systemic risk, it's actually not that bad and it's fairly contained.
I think the cascading piece is just more effective. There's just so much momentum and groupthink in the space. People get behind the same -- everyone's bullish together, everyone's bearish together, everyone's looking at the same technical; and so I think that just drives a lot of everyone putting the same trade on. But, overall, it seems pretty measured actually at a broad scale.
Peter McCormack: What about individual risk? You're an expert in this area, you must have friends that come to you and ask you questions; do you give advice? I know we're not meant to give financial advice, but I am at the bottom end of the spectrum, I say to everyone, "Don't trade, just buy spot, just stack your sats, ignore it", and then it's like, "Oh no, no". Some of my friends are like, "I really have to trade". I'm like, "Well, definitely don't trade shitcoins, because they're super risky and super volatile".
But, if they're going to trade, I say, "Okay, if you're going to trade, please be careful. Only use a specific amount of your stack. Please, please, please avoid leverage and, if you do use leverage, test very small amounts, etc". I'm ultra-conservative because I know I'm crap and whilst other people have criticised, they said, "Well, you don't know how to trade", I still know most people lose money trading. So, do you have advice on this area; what do you think people should do?
Juthica Chou: Yeah, so I stopped giving advice too, and I'll tell you when I stopped; I remember, it was December 2017 when I kept people not to buy XRP and then XRP kept going up and then everyone was getting so mad. They were like, "You told me not to buy XRP!" and I was like "You know what, I'm just going to stop telling --"
Peter McCormack: Thanks, Juthica!
Juthica Chou: I know, right! Then I realised what everyone else probably realised a lot earlier which is, it's not a good trade to give people advice; the risk reward is just not in your favour. So, yeah, I try to encourage prudence; I know some people will listen, some won't. I'll try to point to things like volatility and say, "Look, at 100 vol asset, that means it can easily move 30% in a month. So just make sure that you're comfortable with some of these deviations". But, yeah, outside of just stacking Bitcoin dollar cost averaging in, I try to stay away from too specific trading advice.
I definitely do not push people towards derivatives, because I think that whether it's options or futures or perps, just it's even more complicated than the traditional world, because you have to understand how they settle and how they get liquidated and all of that. So, I try to keep it simple.
Peter McCormack: But that's still advice, prudence is advice, and I think that is great advice. I always think people, especially if you're new coming in, you just need to take a bit of time. It's a bit like when you go to Vegas, you can easily go up the roulette table and strike lucky and suddenly make a load of money, but you could very easily then lose all your money.
You always seem to get that lucky streak when you do any new gambling and then you get a bit wild, and I think that's what can happen with his stuff. You might get a bit lucky; you're hearing about Bitcoin in the news, it's a start of a bull market, you get lucky, it flies up and then you can end up losing everything. I'm sure some people have got really, really hit quite hard in this last month, but I think prudence, I think that's advice; it's good advice.
Juthica Chou: All right, fair enough.
Peter McCormack: Yeah, okay. You covered my next point because I had one of your quotes. You called Bitcoin a 100 volatility asset, but you've already covered that. Last couple of things, I mentioned this, the reason I don't trade is because it's 24/7/365, but how does that actually change things for Bitcoin, because I don't believe there are many other assets that allow this? Outside of crypto, are there any other assets that do 24/7/365?
Juthica Chou: I don't think so. You get closish with the S&P 500 futures, but they're not 24/7/365.
Peter McCormack: I guess the biggest implication is that you can trade traditional markets around your job.
Juthica Chou: Yeah. I think, initially, there was definitely this glamorous idea because there was no asset that enabled it, though I think if you look in the traditional world, there's probably more legacy reasons why they don't have it. But I do think it's better from a risk management point of view. A lot of other assets, if you look at equities and stuff, they'll gap up, they'll gap down, they'll be much harder to hedge more continuously, whereas Bitcoin provides continuous hedging.
In the equities markets, it's one of those things that, any time you're trading options, all the models, all the actuals and models that people use, they have these assumptions around continuous hedging which everybody knows doesn't apply in equities. But now, in Bitcoin, you actually have something close to it.
So, I think it's good from a risk management point of view. I think it's terrible for the professional traders and I feel really sorry for them because, and you look at this most recent bull run, it was just non-stop and I think they all have to have all these alerts going off in the middle of the night and stuff. So, probably not good for their lifestyle but, yeah, it's probably better for just continuity of markets and it's just natural for it to be a true global phenomenon. I can't imagine if it wasn't the case, how it would actually be a global currency.
Peter McCormack: Lastly, what about regulations? We've had derivatives here, and I'm not sure if it's all derivatives, but I'm pretty such most derivatives have been banned with regard to Bitcoin. It's funny, I actually wrote to my local MP about the treatment of bitcoiners with regard to the government here. He wrote back and it was very much a reply that said, "I want to protect the holders of Bitcoin in their wallets from volatility", and I was thinking, "Well, I don't want protection from you; I'm an adult!" I'm like, "I have two children, and I really don't need protection from you for my own financial decisions!"
But, it feels like some governments feel like that they have to protect consumers from their own decisions. Look, I understand it; I don't agree with it. What is your view; do you think these markets should have any regulation or they should be treated like the Wild West and let anything happen?
Juthica Chou: Yeah, I see both sides of it, to be honest. I think in an ideal world, it's not ideal, but in an ideal world, if the market could prove that it could self-regulate itself and not have so many scams and rugs and stuff then that would be great, but it's not like that. I also think there's a side of it that, with decentralisation, a lot of that is about personal responsibility and not having somebody for better or worse who's going to try to take care of you and coddle you and stuff. You have to own it at the end of the day.
So, I think where I come out on it is, there's some stuff that's not ideal, but it's difficult, and I think some of it's out of the realm of regulators to try too hard to stop every little thing. At the end of the day, Mark Cuban's going to play DeFi games, he has to pay DeFi penalties, and there's part of me that thinks that that's just how it is and that's how it will have to be.
Regulation overall, whether it's derivatives or raw, I think it's going to be, and is becoming a little bit of a bifurcation, you're definitely seeing that. Whether it's companies or participants that operate in areas that are not regulated, they're able to move a lot faster, they're able to be a lot more nimble, they're able to participate in a lot more trading products. Someone in New York, in the US, is very limited in terms of what they can do, and so I think it's bifurcating in that way.
You're going to see probably more innovation come out of the unregulated space; I think more than that, you'll see companies that are designed from the ground up to not be regulated. People have got to the point where they understand regulations enough that they're designing companies so that they never fall into the purview of regulation.
Peter McCormack: Amazing. If not, they'll just move to El Salvador, which is a regulatory and friendly environment for Bitcoin companies.
Juthica Chou: Exactly.
Peter McCormack: I do wonder if some Bitcoin companies will think of a headquarter in there. There are so many incentives right now. Capital gains tax, corporation tax, personal tax, lifestyle, you get to live in the sunshine and you've got a regulatory-friendly environment; there's a massive incentive for companies to headquarter there now.
Juthica Chou: Totally, and I think once you get a critical mass, then you get a lot of the talent down there too, so then it becomes easier for recruiting and stuff like that. It's like a Puerto Rico v2.
Peter McCormack: Yeah, definitely. All right, well look, this is amazing. It's going to be very helpful for everyone, I'm sure they're going to love it. Is there anything I should have asked you that I haven't? Is there anything we've missed out?
Juthica Chou: No, I think we covered it.
Peter McCormack: Nailed it. Well, you have to thank my producer, Ben, because he did most of the research on this one.
Juthica Chou: For sure.
Peter McCormack: Okay. Well, listen, this is part of the show where I usually say, "Tell people how to get in touch", but you've got a bit news, right?
Juthica Chou: Well, yes. So, people can find me on Twitter, and then I do have a bit of news; I am, as of recently, running Kraken's OTC options trading.
Peter McCormack: Nice.
Juthica Chou: So, Kraken has an awesome OTC desk; they've built it, skilled it, institutionalised it over the years.
Peter McCormack: With Nelson?
Juthica Chou: With Nelson, yeah.
Peter McCormack: I love Nelson.
Juthica Chou: Yeah, he's awesome. Awesome guy, awesome group, and options is the one piece we've just been seeing so much client demand, and so we're ticking off some OTC options trading and building that business.
Peter McCormack: Awesome. Well, listen, Kraken seems to be getting everyone at the moment; there's a crack team of people over there. I love Jesse, love the company and I need to see Nelson again; I think perhaps when I'm in New York, I'll hit him up. Thank you for doing this. Thank you for explaining it. I think I got everything, just the perpetual swaps; I need to go and do a bit more homework on those, but I appreciate you coming on and dealing with my simple questions.
Juthica Chou: No, for sure. It was a lot of fun. Thanks for having me.
Peter McCormack: Well, listen, are you bullish?
Juthica Chou: Well, always long-term bullish.
Peter McCormack: Yeah, always long-term bullish; that's the perfect answer. You could have been a politician! Juthica, listen, thank you, take care and I'll see you soon.
Juthica Chou: Thanks.
