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CBOE/CME futures and arbitrage

Someone asked me…

Do you know why the XBT futures price is always 1xxx higher than the spot XBT? Does it mean we can simply take arbitrage if we long spot and short the futures at CBOE?

The reason bitcoin futures are higher on CBOE than spot is that there are large numbers of people that want bitcoin exposure but can’t hold bitcoin directly.  This includes corporates and high net worth individuals who don’t have the expertise or interest to hold physical bitcoin.  Or people that want to for example have bitcoin exposure as part of a US retirement account.

And yes, shorting futures and holding spot is a viable strategy, but there are some dangers.

The big one is that if the price of bitcoin spikes upward, the futures price and spot price are likely to diverge as people want to pull into bitcoin.  The absolute worst situation is if you get margin called on your short position, and you can’t sell and move the bitcoin from your spot position fast enough, since you’d have to sell your bitcoin, move the cash and cover the margin.  You can run into a situation where everyone does this at the same time, the price spikes because of a short squeeze, and then after your margin position is closed, the price crashes.

(By the way, if it sounds like I’m talking about this because it happened to me before…. Well….  It turns out that when people hear that I trade bitcoin, they assume that I’m a lot richer than I am, because I’ve learned dozens if not hundreds of ways of losing money.)

There are also operational issues.  Getting hacked.  Exchanges goes under.  Exchanges getting hacked.


Space Aliens and Why Bitcoin is the currency of the future

I can explain why bitcoin is the currency of the future by pulling out my astrophysics hat and talking about space aliens, and they pulling out my investment banker hat and talking about making money trading with space aliens.

Suppose tomorrow flying saucers land and little green men come down to earth and announce that they’ve been watching us for a lot time.  This is all cool.

Now since I’m an investment banker, and I notice that they have all of this cool technology, I want to trade stuff with them.  It turns out that I want their hyperspace drive, and they want to buy fingernail clippings because it turns out that human fingernails happen to have a chemical which the space aliens find tasty, that’s all the rage among the young hatchlings on planet Kudzu.

So I want to do a deal, I want to buy their hyperspace drive.  They want human fingernail clippings.  What do we pay with?

It turns out that planet Kudzu doesn’t take US dollars.  However, I can explain to them the concept and mathematics of bitcoin.  Since it’s based on mathematics and not politics, it turns out that bitcoin is worth something on planet Kudzu.  Now it turns out that planet Kudzu has this similar thing called Kudzu coin, which uses a different algorithm, and then explain to me how Kudzu coin works, and we start trading.

The important thing is that we have a currency that is based on mathematics and not politics.

OK.  I don’t see flying saucers.  But…..

I do see Tanzanian farmers and Chinese factory workers.  It turns out that lots of people in China happen to want to buy this thing called “coffee” and lots of Tanzanian farmers want to buy Chinese manufactured goods.  The trouble is that the Tanzanian farmers need Tanzanian shillings and Chinese factory workers need Chinese Renminbi.  Trying to work through the politics of it all is a nightmare, so the easiest thing is to rely on mathematics.  Putting on my astrophysics hat, I realize that the problem that you have trying to buy and sell stuff between China and Tanzania are *exactly* the same as doing trade with space aliens.  And putting on my investment banking hat, I realize that there’s a ton of wealth you can generate if you can exchange fingernail clippings for hyperspace drives, or coffee for automated spice grinders.

ICO’s made easy – Come to Hong Kong

I’ve been trying to promote HK as an ICO hub, and one reason is that the securities laws here are not as insane as they are in the US.

If you try to do an ICO in the United States then you are looking for a hell of a time complying with SEC regulations.  The easy thing to do is to target non-US investors, at which point you are exempt from SEC regulations under Regulation S.  At that point your costs go way, way down.

There are Hong Kong regulations on securities, but securities that are subject to private placement are not subject to registration, and you can summarize everything by saying don’t actively market tokens to non-professional investors in Hong Kong.

Tokenizing hedge funds

I’ve been talking to a lot of people about tokenizing hedge funds, and let me explain where the problems are.

One thing that’s not a problem is regulation.  If the regulators come to you and say “what are you doing?”  You tell them, “we are running a hedge fund.”  At that point you don’t have any regulatory issues.

Let me tell you what the real problem is.  Someone invests USD 10 million buying tokens for your hedge fund.  They lose their cell phone.  Have no idea what the keys are.  What happens?  “You’ve just lost USD 10 million dollars” is a wrong answer.  Or the hedge fund manager is vacationing in South Elbonia.  They get kidnapped, and the hedge fund manager gets a gun to his head saying “give us those USD 10 million dollars” or we shoot you.

This is not going to work, so you need some mechanism by which you can register the ownership of the tokens.  So if you have someone kidnap you, you give them the tokens, which turn out to be worthless after they release you.  You might want stock certificates, you might want casino chips.  You don’t want gold coins.

And so someone has to do the work to come up with the distributed apps and legal documentation that creates stock certificates and casino chips.  And trying to figure out how that works is going to be tricky.

The problem is that you then run into the problem of cost recovery.  You come up with the system to create stock certificates and casino chips.  The way that law firms normally do this is that they create the legal structures, and then they go to a copy machine and the use the same structure for each ICO.  That’s not going to work.  Once someone figures out the mechanism then the legal agreements and source code are pretty quickly going to go on the internet.

But then you run into the problem of who is going to do it.  One reason I’m not spending much time on this is that someone will do it, so someone else can do it.  The thing is that there is enough money flowing around so someone will end up doing this sort of thing.  We just have to wait a few months.

But here is what I hope will happen.  Right now it costs about USD 100,000 to set up a hedge fund.  The technology will be able to reduce the cost of setting one up to USD 1k.  At that point *everyone* can start of own a hedge fund.  There are a ton of structures and systems that are now only available to the wealthy, but if you push the cost of administration down, it will be like a Model T.  Everyone will have a hedge fund.  Everyone will have a family office.  Everyone will have a private banker.  If you want to set up an ICO, you go into an office and they’ll have all of the documents ready within 24 hours.


Sometimes I get a little depressed thinking about this.  You have this grand vision of the future, but you have to deal with the annoyance of living in the present.  This isn’t a new idea.  I’ve had it for about a decade.  But I’m seeing that the time has finally arrived.  All of the pieces are there.  Just need to dig the ditches.


Regulation doesn’t matter and if it does it shouldn’t

Let me start with a quote from Bertrand Russell talking about China in the 1920’s.

The corruption and anarchy in Chinese politics do much less harm than one would be inclined to expect. But for the predatory desires of the Great Powers —especially Japan—the harm would be much less than is done by our own “efficient” Governments.  Nine-tenths of the activities of a modern Government are harmful; therefore the worse they are performed, the better. In China, where the Government is lazy, corrupt, and stupid, there is a degree of individual liberty which has been wholly lost in the rest of the world. – Bertrand Russell – The Problem of China

One reason I have an extremely negative view of regulation is that I’m in the coffee business and I’m seeing how regulation is just destroying the farmers in Africa.

It turns out that in order to export coffee from Tanzania, you have to follow the following set of laws,_2003_sw.pdf

Which I find amusing and sad because in Hong Kong, I don’t have to do anything special to buy and sell coffee.  If I open a restaurant, there are some health and safety stuff, but those are pretty easy to follow.   Also you can show how this is killing innovation.  For example, it turns out that the coffee husk can be exported and sold for tea.  I was wondering why farmers didn’t do that, and the answer is simply that there’s no form to do that.  There’s no forms.  There’s no regulation.  It can’t be done.

And Tanzania is one of the better places.  In Kenya, the situation is 100x worse.

So I’m getting annoyed that people are trying to follow the same approach with ICO regulation.  I was at a panel, where someone mentioned that they had hired four law firms and they were paying them a total of more than USD 1 miilion for an ICO, and I was truly shocked.

The thing that annoys me is that pretty much every ICO has exactly the same sets of issues, and you could create a set of standard forms and disclaimers that every ICO that isn’t doing anything new and original can sign.  You’d need a lawyer to sign off on this, but it would cost USD 5000 and not USD 1 million.

The funny disclaimers don’t bother me.  What bothers me is that I haven’t seen an single ICO in which the founders have decided to go 100% transparent and make public all of their legal documentation.  The reason for this is that law firms do not want people to make legal documentation public because one thing that will become very obvious is that 99% of the legal documentation is exactly the same.  The problem with keeping all of this private is that the energy goes into filling out forms rather than addressing some of the fundamental legal issues.

What annoys me more is that people aren’t working on the fundamental legal issues of ICO’s.  Regulation is pretty easy.  In the end, you fill out the right forms.  We can argue over how many forms you fill out, but it’s just filling out forms and including stupid disclaimers.

No one is looking at the fundamental legal issues.  For example, some time in 2018 some person that put USD 10 million into an ICO will lose his phone.  Or they will get hit by a bus or have a divorce.  No one that I know of is looking into the legal ramifications of what happens in that situation.  So I predict that there will be some conference room in which people are yelling at each other, followed by some court room where an annoyed judge is trying to unscramble the egg.

Now you can have it either way.  You can have “you lose the coins, tough luck” or you can have “you lose the coins, here is a method of recovering the coins.”  It turns out that it is very, very hard under an English based system to disclaim all liability.  It’s easier to do it under Swiss law which is why a lot of ICO’s are set up as Swiss foundations, but if you have any assets in an place with English based law, you are setting up a legal fight.

It also turns out that most people probably *don’t* want a “you lose your coins, tough luck” model, and so people will have to come up with work arounds for that.

Silly ICO disclaimers and why they exist

One thing that you are starting to find in ICO’s are silly disclaimers who everyone ignores, like “this ICO is not available to purchase by US residents” but when you actually purchase it as a US resident, nothing happens.

Let me explain the legal situation.

You’d think that securities law would make selling illegal securities, illegal, but it doesn’t for an important legal reason.

In countries with legal systems based on English law.  There’s a reason for this.  Suppose you buy cocaine.  It turns out that you get scammed, and the person takes your money and doesn’t give you your cocaine.   Well, you aren’t going to be able to sue them to get your money back.  Also suppose you get your cocaine, you aren’t going to be able to keep it.

I should point out that this is only for places based on English law like the US, Canada, UK, Hong Kong, Singapore.  This isn’t the situation with places based on German or French law, where an invalid contract requires that everyone move everything back to before the contract is signed.  The reason for this has to do with different notions of contract.  In English law, you can contract for anything in any way, and if the contract is invalid, it’s usually for some “bad” thing like you are trying to sell cocaine.  In German or French law, a contract has to follow a specific form in the civil code, and so there is a decent chance that a contract will be invalid without anyone being “bad”.

So the people that wrote the law *didn’t* want to make selling the securities illegal, because it’s not cocaine.  You want to be able to sue the people to get your money back, and if they’ve already sold you bad securities, you still want to keep them.

So what they did was to make marketing and offering securities without permission illegal as well as putting in a registration requirement that you will be committing an illegal act by non-registration.

But then you hit reality…..

The trouble with making marketing in country X illegal, is that you can put a website now outside of country X, and unless you want to filter out the internet at the border, this becomes impractical.  The trouble is that if you try to police the internet for this sort of stuff, then you run into free speech issues.  China might be able to censor offers of securities from outside of China, but the US and UK can’t.  So in order to compromise with reality, they’ve interpreted the law to say that the restrictions on marketing only apply if you are *actively targeting* people in country X.  So if you have a webpage that says you aren’t targeting X, you aren’t targeting X.

What about offering securities.  Well the issue here is that “offer” has a specific legal terms.  If I send you a contract saying “if you sign this paper, then we have a contract” then that’s an offer.  If you just put an sign saying “I have securities for sale, come and talk to me” that’s not an offer.  It’s legally an invitation to treat.  If you see a sign saying “I have securities for sale” and you come to me and say “hey, I saw your sign, I’d like to buy some securities” *you* are the one making the offer.

OK, that leaves registration.  If you try to sell unregistered securities, then you have a problem with the SEC.  The trouble is that if you apply that rule strictly, you end up with crazy situations.  If I sell a French security to someone in France, then technically speaking I have to register that security with the US, which is just crazy.  Now if someone in the US just happens to buy a French security, then at that point it would be crazy to just send people to jail.  Remember that we aren’t selling cocaine here.

So what people have ended up with is something called Regulation S.  Regulation S is this big long and complicated rule, because if you make it simple, people will find loopholes.  But basically what the rule says is that if you are a foreign issuer and you are not targeting US residents, and a few US residents happen to buy your securities, that’s fine.  So you have all of these signs saying “US residents go away!!!!”  As long as you put up those signs and a small number of US residents sign up, then you are fine.

But wait, you might be wondering why they will let you buy the ICO even after they’ve done AML/KYC proving that you are a US resident…..

Well.  It turns out that the AML/KYC people and the securities regulation people are different bureaucracies that literally don’t talk with each other.  It also turns out that Rule 902 of Regulation S will let you sell securities to a person you reasonably believe not to be a US resident *at the time the purchase was made*.  If you believe someone was not a US resident *at the time you sell them your ICO* but later find out that they are in fact a US resident, you do not have to cancel the transaction.

So why do people do this….

Well in turns out that with ICO’s, you could theoretically police people and require that people supply proof that they are not US residents before you sell the shares.  The reason the SEC doesn’t require this is that for traditional securities, this is flat out impossible.  Imagine selling shares.  It goes through a dozen brokers, and the person on the trading floor has no idea who is actually selling the shares.  If the SEC required that people supply proof of identity before the transaction happened, everything would break down, especially since these shares are being bought and sold on markets that have no reason to listen to the SEC.

And that assumes that you are dealing in securities anyway…..

At that point you get into what I call layering…..  You say “I’m good because of arguments 1, 2, and 3”.  This is not a security, and even if it was, then you’d couldn’t get me anyway.

One final thing and that involves looking at the law.  I’ve gotten into some intense arguments with people that instead on doing everything “by the book”.  What invariably happens is that those people spend tons of money on lawyers and get in trouble anyway.  The idea that people have about the law is that it’s this sleek, efficient machine, that you just following the rules exactly and everything works.  You’ll find in practice that the law doesn’t work this way.  It’s a Rube Goldberg-sque mass of rules that doesn’t make sense.

But that gets at the *real* reason for putting up silly disclaimers.  It’s the same reason that judges in Hong Kong wear wigs and judges all over the place wear funny clothes.  The real reason for doing this is “symbolic”.  It’s like saying “please and thank you”.  If I put up a legal disclaimer, it’s to say “yes I think the rules are stupid, but I’m trying to comply with them, so at least give me credit for that.”  I’m bowing before the Queen, and ignoring the fact that the Queen has no real power.

The good news is that all of the silly disclaimers can be put into one small “howto” book.  Do this, do that, do the other thing, and everything will be fine.

ICO’s and legal marketing

Lawyers are funny people.

But they are people so that they have to make a living, and part of making a living is to convince you that they should give them your money.  There’s nothing wrong with that.  Lawyers have to advertise just like restaurants.  It so happens that in most places, lawyers can’t explicitly advertise, so what ends up happening is that they give talks and seminars and end up on panels.

Nothing wrong with any of this, but it does lead to some tricky situations.

The way that a lawyer convinces you to give them your money is *FEAR*.  If you listen to a lot of lawyers talk about ICO’s, then the message is that *if you don’t give me a ton of money, then you might end up in jail*.  They’ll tell you that *all the rules are really, really complicated, and if you don’t pay me money, you’ll mess up and get arrested and tossed in jail*.

The thing about this sort of marketing is that it is based on truth.  The rules are in fact quite complicated, and if you mess up, then you can end up in serious trouble.

But then you have a problem.  You want to scare people into them giving you their money, but you don’t want to scare them too much.  If they make you think that doing an ICO is too difficult or too complicated or too dangerous, then you aren’t going to do it at all, and they don’t get any money.

Now it turns out that my background isn’t law but international banking.  So I start from human emotion.  I look at a situation from basic human emotion.  Fear, greed, angry, guilt.  So I don’t mind lawyers marketing their stuff, because I’m doing the same thing.  Rather than starting from the fear side of the equation, I’m starting from the greed side of the equation.  You want to make money, and there is a ton of money to be made.  So I’m trying to explain what is going on so that you can channel your greed.  Also, I want you to make tons of money, because once you make tons of money, you can throw a few bread crumbs my way.

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