— This article is excerpted from the FTX November Report, written by Matt Kaye.

*Matt Kaye is the managing partner of Blockhead Capital, a long-short cryptocurrency hedge fund founded in 2017.

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existFTX Monthly Report for OctoberMiddle, Z @SplitCapitalmakes a convincing case for why coin-margined derivatives (which drove bitcoin’s price surge) in 2017 are no longer the main driving force behind its price discovery (see the full article atThe end of Bitcoin's magic? Traditional financial institutions step into the cryptocurrency space!"). In his article, Z reviews the rise and fall of BitMEX, and further emphasizes that decentralized finance is taking market share from centralized institutions and companies.

I intend to build on the foundation laid by Z to build a case for how the market structure of Bitcoin is changing, and how it may change in the future, given the trends shown by today's capital flows.

2. Marginal spot seller? Marginal spot buyer? Derivatives Dominate Price Discovery?

As an asset manager, I ask myself three simple questions every day and night:

• Who are the marginal spot sellers?

• Who is the marginal spot buyer?

• Will Derivatives Dominate Price Discovery?

When answering these questions, I will try to build a convincing case for the question that I think can be answered best, so that I can better make (or not make) directional judgments. Readers who have read the section written by Z in FTX’s October monthly report should immediately understand one of the conclusions he raised, and I agree with that conclusion, that derivatives do not currently dominate cryptocurrency price discovery. With this conclusion, I will focus more on answering the remaining two questions.

Allow me to take a moment to cover some basic terms. If you have no problem understanding some of the concepts mentioned above, you can skip the following paragraph:

Since prices are determined by supply and demand, we try to answer the question: at a given time/price level, is there an oversupply or a short supply? Knowing this answer, we will know whether the price will rise or fall. When supply exceeds demand, there are marginal sellers, and when supply exceeds demand, there are marginal buyers. If we conclude that derivatives can control price discovery, then we are exploring an entirely different set of questions, which we will not discuss in this article.

3. Identify marginal sellers

In a bull market, the relationship between the price of a cryptocurrency and sellers is such that as the price rises, so does the selling. However, this relationship is not destined to lead to lower prices, and prices can continue to trend upwards while selling volume increases. It is not until the number of sellers exceeds the number of buyers that the price starts to trend down. In the image below, you can clearly see the tendency of Bitcoin holders to increase their positions (buy) when the price is low and reduce their position (sell) when the price rises to a high.

Certain bitcoin stakeholders are asked to sell bitcoin on a regular basis with little regard to price, as second-order factors drive their selling decisions. The best example of this is miners, the primary natural sellers of Bitcoin. Miners must sell bitcoins to fund their mining operations with fiat currency. Of course, there are other natural sellers of Bitcoin, but they don’t always have to be sellers and can easily become natural buyers. Market makers fall into this category as they employ numerous strategies to profit in the form of spreads and/or premiums. In detail, a market maker with full control over volatility may need to buy and sell spot bitcoin to hedge the delta exposure of its books, while an arbitrage-focused strategy may prefer to buy futures and sell spot from inefficiency profit in the market. Determining a market maker's position is no easy task, but if you can gather the necessary information, you'll find yourself significantly better at understanding the near-term directional movement of an asset.

Another point is that as the profitable holders/traders get more and more profits, they will become natural sellers (generally considered to be safe, not many people can hold the huge profits that have not yet been pocketed ). Hopefully by this point, when sellers (miners, market makers, and holders/traders) combined outnumber buyers, it will be apparent that the price will drop, and we will then be able to characterize the market as a marginal sellers market. Therefore, if marginal sellers can be identified, it may help to monetize them.

4. Identify marginal buyers

If you wanted something in this article, I really hope it came from this subsection. Contrary to the rules governing the relationship between price and sellers, the relationship between price and buyers is such that when prices rise, buyers become more emboldened and confident, and thus buy more. For the sake of argument, we can consider the number of bitcoin sellers to be limited to the number of people currently holding bitcoins, however, the number of bitcoin buyers is almost the total number of qualified buyers who can buy digital currencies in the world (and this A total number is far from reaching saturation). This is very important, as it is the driving force behind Bitcoin's rising price even as selling volume has been increasing. So, who are these marginal buyers who are pushing the price of Bitcoin higher? The answer is institutional buyers in the spot market, and I think this trend is just getting started.

Institutional buyers differ from crypto-born foundations in that they must adhere to stricter regulations and systems. As a result, their options in this area are rather limited. They are currently involved in institutions such as LMAX and CME that focus on providing services to institutional clients and accept supervision.

Greater institutional buying pressure has come from Grayscale's Bitcoin Trust (GBTC), which provides exposure to Bitcoin to traditional institutions and investors who are unable or unwilling to buy and hold Bitcoin directly. The nature of GBTC is that when demand for the product increases, the premium on the value of its share over NAV increases. This results in market makers and cryptocurrency principals arbitrage premiums by buying spot bitcoin and contributing it to the trust. After the lock-up period, if there is still a premium, spot suppliers can cash in these premiums relative to net asset value. As GBTC’s premium to NAV increases, so does the demand for spot Bitcoin to buy from those looking to capture the spread. Currently, Grayscale’s Litecoin product is an extreme example of this phenomenon.

Apparently, the demand for GBTC has also increased bitcoin spot buying. However, it is worth noting that arbitrage of GBTC's premium may lead to increased selling of Bitcoin spot later, because as the transaction ends and the premium is in hand, arbitrageurs may sell Bitcoin (whether they will actually sell depends on the transaction base currency required by investors and willingness to take directional risk).

Derivatives

Woo Woo (@woonomic) recently posted an opinion that, in my opinion, captures the cyclical timing of the market well:

“The reaccumulation phase of this bull market coincides with the longest and deepest depletion of BTC inventory on spot exchanges in Bitcoin’s 12-year history.

The bout of exhaustion has lasted 10 months so far, double the five-month span of the previous cycle. Likewise, the amount of Bitcoin withdrawn from exchanges and deposited into cold wallets accounted for 19% of the inventory, compared to 11% in the previous cycle. With this in mind, the market is expected to be very bullish in 2021. "

While not the most appropriate metric, the number of active entities transacting on the Bitcoin blockchain also points to significant institutional buying. The number of new entities has grown steadily in 2020, but the indicator of total active entities remains below the all-time high reached in 2017. The divergence between the price and the number of active entities suggests that larger institutional players are driving the market, as opposed to the large number of small retail traders that dominated the market previously.

5. Influence of institutional buyers on market structure

The market turn is actually very simple. As long as there are marginal spot buyers, the price of Bitcoin will rise, and the role of derivatives and technical analysis will continue to weaken. Successful players adapt themselves, learn how to follow the flow of the market, and in the process learn to identify marginal buyers and marginal sellers.

Institutional buyers, who are more concerned with the long-term prospects of the asset, are relatively less price-sensitive, and they compete with each other for a piece of Bitcoin's existing supply in the hope that Bitcoin will outperform gold. After this round of vertical accumulation led by institutions, Bitcoin, a penniless reverse asset in the past, is entering a stage of trend. When we shift our perspective to understand what macro factors are attracting traditional wealth distributors (financial institutions) into the Bitcoin space, we can draw a reasonable conclusion that unless there is a major impact on the current global monetary and fiscal policies Otherwise, institutional buyers will step up their purchases of Bitcoin for at least the next six months. Players who do not adapt to the new market structure of Bitcoin will most likely fall behind. Either adapt to the market, or wait to be eliminated.

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