The Bitcoin Liquidity Shortage and the Time Value of Bitcoin.

Disclaimer: This is not financial advice and does not constitute a solicitation to buy or sell any financial instrument and/or virtual currency such as Bitcoin. You should always do your own research and consult a professional financial advisor before investing. The views herein represent the private views of the author only and not necessarily of his employer.

The Debate

One of the major topics among Bitcoiners is the current debate about a potential ‘liquidity crisis’. In fact, the biggest Bitcoin exchanges have seen their BTC reserves decline at a pace not seen before in the history of the virtual currency. From the peak of on-exchange balances on the 13/03/2020 until today (10/04/2021), there was an aggregated net outflow of -707655 BTC off exchanges.

On-exchange BTC balances usually represent the majority of liquid Bitcoin supply which only makes up around 12.6% of total circulating supply as long-term private and instititional investors usually hold their balances off-exchange in cold storage for security reasons. At the time of writing, on-exchange Bitcoin balances stand at 2.348 mn BTC based on calculations by Glassnode. So price discovery on exchanges mainly happens on the back of a relatively small amount of the total amount of Bitcoins in circulation.

As a scarce asset, Bitcoin’s supply is usually at the heart of discussions about the potential for price appreciations, especially after halvenings that obviously create an intensifying supply shortage of Bitcoins over time. One of the best representations of these mechanics has been provided by Croesus (@Croesus_BTC):

While halvenings are probably one of the major mechanisms that drive Bitcoin price appreciation via supply shocks in the long-term, this article rather focuses on exchange liquidity and the implications for Bitcoin price appreciations.

The Herd is Here

The latest entry of institutional investors into Bitcoin has most-likely exacerbated the scarcity of Bitcoin and has led to the onset of the liquidity issue. According to calculations by GeertJanCap (GeertJanCap), based on data provided by https://bitcointreasuries.org/, institutional investors currently buy Bitcoin to the tune of approximately 1.5 mn BTC per annum which is ~4.6 times the amount of current annual Bitcoin production.[1] It is quite likely that this pace of Bitcoin adoption by institutional investors will intensify liquidity strains on exchanges as large institutional investors usually buy Bitcoin OTC (“Over-the-Counter”) and put these Bitcoins off exchanges into cold storage.

For instance, the Grayscale Bitcoin Trust uses Genesis Trading for buying Bitcoin and Genesis Trading uses the Coinbase OTC desk for executing their trades. Other large institutional Bitcoin investors such as Ruffer Investment Management have also used Coinbase for their BTC purchases. As the biggest Bitcoin exchange, Coinbase has become the major trading venue for institutional investors. Whenever there is an OTC purchase of Bitcoins via Coinbase, the BTC purchased are put into cold storage off exchange. Therefore, Coinbase outflows can be regarded as a proxy for instituional investor demand which again reduce on-exchange liquidity.

The ‘Time Value of Bitcoin’

But how to assess the liquidity shortage in real-time? Besides the fact that falling on-exchange balances have been inversely correlated to the BTC/USD exchange rate since the beginning of 2020, the liquidity issues are evident in other market prices as well.

In traditional money markets, the interest rate itself provides a good real-time indicator of liquidity conditions. If liquidity is ample, interest rates are usually low and if liquidity tightens, interest rates tend to increase as well. Interest rates are often referred to as the “time value of money” or simply the “price of money”.

How can we observe the Bitcoin interest rate in real-time?

There is been a recent increase in Bitcoin borrowing and lending plattforms such as BlockFi or Celsius Network. Although these companies do publish their annualised interest rates, they do not change on a daily basis and are not considered to be an accurate representation of liquidity conditions in the Bitcoin market. A more accuarate and timely representation of current liquidity conditions can be observed via the so-called Futures Basis and the derived Bitcoin interest rate. According to the so-called “Covered Interest Parity”, the Futures Premium or Discount of a given exchange rate for a given maturity has to be equal to the difference in the respective interest rates in order to satisfy the so-called “no arbitrage condition”.

If for instance the futures premium was lower than the respective difference in interest rates, a trader could borrow the lower-yielding currency, invest into the higher-yielding currency and hedge via futures by exchanging the funding currency at a future date for a fixed price, pocketing the difference as risk-free profit (i.e. “arbitrage”). So much for the theory.

In practice, there are usually “violations” of the no-arbitrage condition even in highly-liquid FX markets like the EUR/USD on account of regulatory reasons, counterparty risks or other factors.

Nonetheless, we can use the Futures Basis (difference between BTC/USD Futures and BTC/USD Spot) in order to derive the Bitcoin interest rate in real-time based on this simple formula:

Where F/S represents the ratio of Futures to Spot BTC/USD exchange rate (i.e. Futures Basis), rBTC the derived Bitcoin interest rate and rUSD the current USD interest rate, in our case the LIBOR USD money market rate.

First, I have used historical data provided by Bitmex in order to calculate the rolling 3-month BTC/USD Futures Basis on a daily basis. Bitmex has been one of the first major Bitcoin futures exchanges where the first futures contracts started trading in late 2014. I have used the first and second nearby contracts in order to linearly interpolate the rolling 3-month Futures Basis. Where there was only one traded contract available, I have only used this futures contract and annualised the respective basis. I have used the last traded price on a given day which usually trades around 12 pm UTC in order to calculate the Futures Basis.

Second, I have used data on the 3-month LIBOR USD interest rate provided by the St Louis Fed (FRED) in order to derive the 3-month Bitcoin interest rate according to the abovementioned Covered Interest Parity formula. This is what the derived 3-month Bitcoin interest rate looks like based on these calculations:

As you can see, the derived 3-month Bitcoin interest rate has increased lately to ~18.2% p.a. (08/04/2021) which is the highest reading since January 2018. So liquidity conditions are probably as tight as they used to be at the end of the last bull market. Nonetheless, before 2018, there were instances when the derived Bitcoin interest rate was even higher than 100% p.a. (September 2016) and even in 2017 during the last bull market there were two instances when the derived Bitcoin interest rate was higher than 50% p.a. (June 2017 & December 2017). Thus, the current level is still relatively small compared to these instances.

But what is more striking is that this derived Bitcoin interest rate shows an inverse relationship with net exchange flows as well.

In other words, an increase in on-exchange BTC balances is associated with a decline in the derived Bitcoin interest rate and a decrease in on-exchange BTC balances is associated with an increase in the derived Bitcoin interest rate.

However, this hasn’t always been the case. As far as our dataset is concerned, the inverse relationship between changes in on-exchange balances (i.e. cumulative net exchange flows) and the change in the derived 3-month Bitcoin interest rate is only evident from 2018 onwards. Before 2018, there is no significant relationship between changes in on-exchange balances and the change in the derived Bitcoin interest rate.

Nonetheless, since 2018 a net exchange outflow of -1000 BTC over 30 days was on average associated with a +2.3 percentage points increase in the derived 3-month Bitcoin interest rate over 30 days.

Bottom Line

We can derive a hypothetical Bitcoin interest rate via the Covered Interest Parity condition which represents the “time value of Bitcoin” and can serve as a real-time indicator for on-exchange liquidity conditions.

Since 2018, an increase in on-exchange BTC balances has been associated with a decline in the derived Bitcoin interest rate and a decrease in on-exchange BTC balances has been associated with an increase in the derived Bitcoin interest rate.

The derived Bitcoin interest rate has increased lately to levels comparable to the end of the last bull market, providing evidence that the liquidity shortage has indeed intensified. However, it hasn’t reached the extreme levels observed in 2016 or 2017.

Thanks for reading!

References

[1] GeertJanCap on Twitter: https://twitter.com/Geertjancap/status/1376776615154249728/photo/1

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About the author of Avantgarde Digital Research Blog:

André Dragosch has been working for almost 10 years in the German financial industry, mostly in Portfoliomanagement and Investment Research. He is currently working as a cross asset analyst and investment strategist at one of the largest German asset managers in Frankfurt where he is also responsible for digital asset research and in particular Bitcoin. He is currently doing a PhD as well in financial history at the University of Southampton, UK, where amongst others Prof. Richard Werner has supervised his work. He is been a private crypto investor since 2014. He is a married father who loves playing drums, running and travelling.

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Avantgarde Digital Research Blog

Avantgarde Digital Research Blog

Leading research on macro themes that move Bitcoin.