https://cryptohayes.medium.com/patience-is-beautiful-9434fd04a9a2

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

The weekend before I travelled to Miami for this year’s edition of the annual celebration of our Lord Satoshi (aka the Bitcoin Conference), I hung out in Tokyo. Most of my time was spent ambling around the metropolis eating and drinking the sumptuous creations of a wide range of talented humans. In particular, I drink a lot of coffee — I am an unabashed coffee snob, and Tokyo produces superior cups of black gold.

One morning, I decided to venture to a previously unexplored neighbourhood in search of a celebrated coffee roaster I had heard about. I arrived at the venue 30 minutes after it opened, and all the seats inside were already filled with patrons and a queue had formed. By my (apparently naive) estimation, the line looked pretty short, so I decided to stick around. After about 15 minutes, no additional patrons had been served and the shop was half empty. I thought to myself, “hmm, that’s strange…why hasn’t anyone from the line been let into the shop to order?”

Out walked what I assumed to be the manager, and she was the embodiment of the quintessential Japanese hipster. Her outfit was on point, complete with a baggy top and pants (it’s all about the drape), an oversized tweed vest, and a faux beret. She walked to the middle of the line, and in a soft, respectful, but firm tone, said, “I just want to inform you that the wait will be about 45 minutes. We hand make each cup of coffee one by one because we are committed to creating beautiful coffee.” The subtext was, “we are not in any way sorry that you will be waiting a long time outside because our coffee is the shit, and if you don’t like it, you can fuck right off.”

That was my cue to exit stage left, because I had a lunch appointment for some bomb-ass teppanyaki and couldn’t wait all day outside for a cup of coffee (regardless of how delicious it might be). However, I knew I was coming back to try this coffee. My patience paid off, and two days later, I showed up before opening time at their other Tokyo location. To my surprise, the same woman emerged from the store, and remarked, “I remember you from the other day — sorry the wait was so long.” I smiled and expressed my excitement to finally sample their product.

The coffee was sublime. I drank a Panamanian geisha varietal. The brew and roast was excellent. The floral notes sung in the cup, and the anaerobic processing method allowed the flavours to punch hard. My patience paid off, and my taste buds thanked me.

Patience is also required in the financial markets. Since the onset of this year’s US banking crisis, I and others have been banging on our proverbial drums and shouting to all who will listen that when it comes down to it, the US and global fiat banking systems will be bailed out by a fresh round of central bank-driven money printing (which should in turn drive up the price of risk assets). However, after the initial spike in Bitcoin and gold, these hard monetary assets have given back some of their gains.

With respect to Bitcoin, volatility and trading volumes across spot and derivatives have sagged. Some have begun to wonder why, if we are truly in the midst of a banking crisis, Bitcoin hasn’t continued rising. And in a similar vein, why the US Federal Reserve hasn’t started cutting rates, and why yield curve control hasn’t started in America.

My answer to those sceptics? Patience. Nothing goes up or down in a straight line — we zig and we zag. Remember “Kaiseki:” the destination is known, but not the path.

Money printing, yield curve control, bank failures, etc. will all come to pass, starting in America and eventually spreading to all major fiat monetary systems. The goal of this essay is to explore why I believe the fireworks and the real Bitcoin bull market will begin in the late third and early fourth quarter of this year. Between now and then, chill the fuck out. Take a vacation, and enjoy nature and the company of your friends and family. Because come this fall, you better be strapped into your trading spaceship, ready for liftoff.

As I have said many times, the Bitcoin price is a function of fiat liquidity and technology. Most of my essays this year have focused on global macro events that influence the fiat liquidity side of the equation. I hope that during the lull of the northern hemispheric summer, I can transition to writing about exciting things happening on the technological front of Bitcoin and crypto more broadly.

The goal of this essay is for readers to come away with a solid road map of how the fiat liquidity situation will evolve in the coming months. Once we are comfortable with how USD and fiat liquidity will expand into year end, we can focus completely on what technological aspects of the certain coins are most exciting. When you combine “money printer go brrr” with truly innovative technology, your returns will vastly outstrip the cost of energy. That is ultimately our ever present goal.

The Premise

The bureaucrats in charge of central banks and global monetary policy believe they can rule a market of over 8 billion humans. Their hubris is ever present in the way they talk about certainties based on economic theories developed in academia over the past few hundred years. But however much they would like to believe they have, these men and women have not solved the monetary version of the Three Body Problem.

When the “debt to productive output” equation gets out of whack, economic “laws” break down. This is similar to how water changes state at what would appear to be random temperatures. We can only know the behaviour of water through ex-post observations and experiments, but not by theorising in an ivory tower. Our monetary masters refuse to actually use empirical data to inform how they should adjust their policies, instead insisting that the theories taught by their esteemed professors are correct regardless of the objective results.

Throughout this essay I will delve into why, contrary to common monetary theory, due current debt to productive output conditions raising interest rates will cause the quantity of money and inflation to rise, not fall. It sets up a situation wherein regardless of which path the Fed chooses, be it to hike or cut rates, they will accelerate inflation and catalyse a general rush for the exits from the parasitic fiat monetary financial system.

As true believers of Lord Satoshi, we want to time our trading around this mass exodus as carefully as we can. I want to hang out in fiat earning a phat yield for as long as I can until it becomes necessary to dump my dollars and go all in on Bitcoin. Of course, I’m engaging in my own form of hubris by believing I’ll be able to divine the most opportune time to jump off the burning ship without catching fire myself. But what can I say? At the end of the day, we are all fallible humans — but we have to at least try to understand what the future might look like.

With that out of the way, let’s move on to some statements of (debatable) fact.

• Every major fiat monetary regime has the same problems, regardless of where they sit on the capitalism to communism economic spectrum. That is, they all are highly indebted, have a declining working age population, and feature a banking system in which the assets of the banks are low-yielding government and corporate bonds/loans. A global rise in inflation renders the global fiat banking system functionally insolvent.
• Due to its role as the largest global economy and issuer of the reserve currency, the US is experiencing those issues more acutely than anyone else, and is in the most dire situation.
• Central banker groupthink is very real, because all senior officials and staffers of central banks studied at the same “elite” universities which teach versions of the same economic theories.
• Therefore, whatever the Fed does, all other central bankers will eventually follow.

Keeping that in mind, I want to focus on the situation in Pax Americana. Let’s quickly run through the players in this tragedy.

The Fed exerts influence using its ability to print money and warehouse assets on its balance sheet.

The US Treasury exerts influence using its ability to borrow money by issuing debt to fund the federal government.

The US Banking System exerts influence using its ability to gather deposits and lend them out to create credit and fund businesses and the government. The solvency of the banking system is ultimately propped up by the Fed and the US Treasury with printed or taxpayer money.

The US Federal Government exerts influence using its ability to tax and spend on various government programs.

Private businesses and individuals exert influence through their decisions on where and how to save their money, as well as through their decision to borrow (or not borrow) money from the banking system.

Foreigners, and specifically other nation states, exert influence through the decisions they make regarding whether to purchase, hold, or sell US Treasury bonds.

By the end of this essay, I hope to distil each of these constituents’ major decisions down into a framework that shows how we’ve reached a point that leaves each actor with very little room to manoeuvre. This lack of flexibility allows us to forecast with high confidence how they each will respond to the current monetary issues of Pax Americana. And finally, because financial crises are still very attuned to the cycle of agricultural harvests, we can be fairly certain the market will wake up and realise shit is fucked right on cue in September or October of this year.

The Harvest

Bear with me, as I have just a bit more setup before we jump into the details. I am going to lay out a few axioms that I believe will occur by or intensify into autumn.

Inflation will reach a local low this summer and re-accelerate into the end of the year.

I am talking specifically about US Consumer Price Inflation (CPI). Due to the statistical phenomenon known as the base effect, the high month-on-month (MoM) inflation readings of 2022 will drop out to be replaced with lower MoM inflation readings of summer 2023. If June 2022 CPI MoM inflation was 1% and it is replaced by June 2023 CPI MoM inflation of 0.4%, then YoY CPI declines.

As the chart above shows, some of the highest MoM CPI prints of last year (which are accounted for in the current YoY data) occurred in May and June. For 2023, MoM CPI has averaged 0.4%, which means if we just take the average and replace all readings from May to December 2022 with 0.4%, we get the following chart:

The Fed doesn’t care about real inflation — they care about this make-believe thing called ”core inflation,” which strips out all the stuff people actually care about (like food and energy). The below chart conducts the same analysis for core CPI:

The takeaway is that the Fed’s 2% core inflation target ain’t happening in 2023. Which means, if you believe Powell’s and other Fed governors’ rhetoric, the Fed will continue to hike. This is important because it means the rates paid to money parked in the Reverse Repo (RRP) and Interest on Reserve Balances (IORB) facilities will continue rising. It will also contribute to higher US Treasury bill (<1 year maturity) rates.

Don’t get bogged down trying to work out why these inflation measures don’t correspond to how prices actually change for you or your family. This is not an exercise in intellectual honesty — rather, we just want to understand the metrics that influence how the Fed adjusts its policy rates.

The US Federal Government cannot reduce its deficit due to entitlement spending.

The baby boomers are the richest and most powerful members of the US electorate, and they also are getting older and sicker. That makes it political suicide for a politician to campaign on a platform of reducing boomers’ promised social security and medicare benefits.

For a country that has been at war for almost every year of its existence, it is also political suicide for a politician to campaign on a reduction of the defense budget.

HHS + SSA = Old age and medical benefits

Treasury = Interest paid on outstanding debt

Defence = War

Entitlement plus defence spending will only increase into the future. That means the USG’s fiscal deficit will continue rising. It is estimated that deficits of $1 to $2 trillion per year will become the norm in the next decade, and unfortunately there is zero political will on either side of the aisle to alter this trajectory.

The end result is a consistent gargantuan flow of debt that the market must absorb.

Foreigners

As I have written about a few times this year, there are many reasons why foreigners have turned into net sellers of US Treasury debt (UST). Here are a few:

• Property rights are dependent on whether you are a friend or foe of the ruling politicians of Pax Americana. We have already seen the rule of law take a backseat to the rule of national interests, with the US freezing Russian state assets held in the Western financial system due to the Ukraine war. Therefore, as a foreign holder of USTs, you cannot be sure you will be allowed to access your wealth when you need it.
• More countries have China as their biggest trading partner than America. That means that, from a purely trade-driven perspective, it makes more sense to pay for goods in Chinese Yuan (CNY) rather than in USD. As such, more and more goods are being invoiced directly in CNY. That results in lower demand for dollars and USTs at the margin.

• Over the past two decades, USTs have lost purchasing power in terms of energy. Gold has maintained its purchasing power in terms of energy. Therefore, in a world where energy is in shorter supply, it is better to save in gold vs. USTs at the margin.

TLT ETF (20-year+ US Treasuries) Divided by WTI Oil Spot Price (white)
Gold Divided by WTI Oil Price (yellow)

The net result of this is that foreign ownership of USTs is falling. Governments outside the US are not buying new issues and are also selling their stock of existing USTs.

TL;DR: if there is a large amount of debt to be sold, foreigners cannot be counted on to purchase it.

US Domestic Private Business and Individuals — The Private Sector

What we are most concerned about with this cohort is what they will do with their savings. Remember that during COVID, the US government (USG) handed out stimmies to err’body. The US provided more stimulus than any other country in order to fight the disastrous economic effects of lockdowns.

This stimulus was deposited into the US banking system, and ever since, the private sector has been spending its free money on whatever it pleases.

The US private sector was happy to keep their money in the bank when yields on deposits, money market funds, and short-term US Treasury bills were all basically 0%. As a result, deposits in the banking system ballooned. But when the Fed decided to fight inflation by raising interest rates at the fastest clip in its history, the US private sector suddenly had a choice:

Keep earning essentially 0% at the bank.

Or

Pull out their mobile banking app and within minutes purchase a money market fund or US Treasury bill that yields up to 10x as much.

Given that it was so easy to move money out of low-to-no yielding bank accounts into higher yielding assets, hundreds of billions of dollars started fleeing the US banking system late last year?

The big question going forward is, will this exodus continue? Will businesses and individuals continue to move money from 0% yielding bank accounts into money market funds yielding 5% or 6%?

Logic tells us the answer is an obvious and resounding “absolutely.” Why would they not, if all it takes is a few minutes on their smartphones to 10x their interest income? The US private sector will continue to pull money from the US banking system until the banks offer competitive rates that match at least the Fed funds rate.

The next question is, if the US Treasury is selling debt, what type of debt would the public like to buy (if any)? That’s an easy question to answer as well.

Everyone is feeling the effects of inflation, and therefore has a very high liquidity preference. Everyone wants access to their money immediately because they don’t know the future path of inflation, and given that inflation is already high, they want to buy things now before they get more expensive in the future. If the US Treasury offered you a 1-year bill at a yield of 5% or a 30-year bond at a yield of 3% because the yield curve is inverted, what would you prefer?

Ding ding ding — you want the 1-year bill . Not only do you get a higher yield, you get your money repaid faster, and you have 1-year inflation risk vs. 30-year inflation risk. The US private sector prefers short-term USTs. They will express this preference by purchasing money market funds and exchange traded funds (ETF) that can only hold short-term debt.

Note: an inverted yield curve means long-term yields less than short-term debt. Naturally, you would expect to receive more income to lend money for a longer period of time. But inverted yield curves are not natural and point to severe dysfunction in the economy.

The US Federal Government

I touched on this above, but indulge me as I expand on the same theme in a more colourful and illustrative manner.

Imagine there are two politicians.

Oprah Winfrey wants everyone to be happy and live their best lives. She campaigns on a platform of ensuring that everyone has food on the table, a car in the garage with a full gas tank, and the best possible medical care, all the way up until they expire. She also says she won’t raise taxes to pay for this. How will she pay for all these goodies? She’ll borrow money from the rest of the world to do it, and she believes it can be done because the US is the global reserve currency issuer.

Scrooge McDuck is a miser and hates debt. He will give little to no government benefits because he doesn’t want to raise taxes and doesn’t want to borrow money to pay for things the government cannot afford. If you have a job that allows you to afford a full fridge, a pick-up truck, and top notch medical care, that’s your business. But if you can’t afford those things, that’s your business as well. He doesn’t believe it’s the government’s job to provide them for you. He wants to preserve the value of the dollar and make sure there is no reason for investors to hold anything else.

Imagine you are in the late stages of an empire where income inequality has skyrocketed. In a “one human, one vote” democratic republic, where mathematically, the majority of the population is always below average in terms of income, who wins? Oprah wins every single time. Free shit paid for by someone else via the use of a money printer always wins.

The number one job of a politician is to get re-elected. Therefore, regardless of which political party they belong to, they will always prioritise spending money they don’t have in order to garner the support of the majority of the population.

Absent a serious rebuke from the long-term debt markets or hyperinflation, there is no reason not to run on a “free shit” platform. Which means that, moving forward, I don’t expect to see any material change in the spending habits of the US Federal Government. As it pertains to this analysis, trillions of dollars will continue being borrowed every year to pay for goodies.

The US Banking System

Simply put, the US banking system — and all other major banking systems — are fucked. I will quickly recap why.

Due to the COVID stimulus provided by governments globally, assets in the banking system ballooned. Banks followed the rules and lent these deposits to governments and businesses at very low rates. That worked for a while because banks paid 0% on deposits but earned 2% to 3% lending to others on a longer-term basis. But then, inflation showed up and all major central banks — the Fed being the most aggressive — raised short-term policy rates well above what government bonds, mortgages, business loans, etc. yielded in 2020 and 2021. Depositors could now earn vastly higher amounts of money buying money market funds that invested in the Fed’s RRP or in short-term USTs. Therefore, depositors started pulling money out of the banks to earn a better yield. The banks could not compete with the government because it would destroy their profitability — imagine a bank with a loan book that yields 3% but pays 5% on deposits. At some point, that bank will go bust. Therefore, bank stockholders started dumping shares in banks because they realised those banks mathematically cannot earn a profit. This has led to a self-fulfilling prophecy in which a number of banks’ solvency has been called into question due to their rapidly falling stock prices.

In my recent interview at Bitcoin Miami with Zoltan Pozar, I asked him what he thought of the US banking system. He replied that the system was ultimately sound and it was just a few bad apples. This is the same message trumped by various Fed governors and US Treasury Secretary Janet Yellen. I vehemently disagree.

The banking system will ultimately always be bailed out by the government. However, if systemic problems facing the banks are not addressed, they will be unable to fulfil one of their most crucial functions: channelling the savings of the nation to long-term government bonds.

Banks now face two choices:

Option 1: Sell assets (USTs, mortgages, car loans, commercial real estate loans, etc.) at a massive loss and then raise deposit rates to attract customers back to the bank.

This option recognises the implicit loss on the balance sheet, but guarantees the bank cannot be profitable on an ongoing basis. The yield curve is inverted, which means the bank will pay a high short-term interest rate on deposits without being able to lend those deposits out longer term at a higher rate.

US Treasury 10-year Yield Minus 2-year Yield

The banks cannot purchase long-term government bonds because it will lock in a loss — VERY IMPORTANT!

The only thing banks can buy is short-term government bonds or park their money with the Fed (IORB) and earn slightly more than they pay out as deposits. The banks will be lucky to generate 0.5% of Net Interest Margin (NIM) following this strategy.

Option 2: Do nothing, and when depositors flee, swap your assets with the Fed for freshly printed dollars.

This is essentially what the Bank Term Funding Program (BTFP) is. I talked about this in great detail in my essay “Kaiseki”. Forget about whether what the bank holds on its balance sheet is eligible collateral for the BTFP — the real problem is that the bank cannot grow its deposit base and then take those deposits and buy long-term government bonds.

The US Treasury

I know the media and markets are focused on when the US debt ceiling will be hit and whether the two political parties will find a compromise to raise it. Ignore this circus — the debt ceiling will be raised (as it always is, given the much bleaker alternative). And when it is, sometime this summer, the US Treasury has some work to do.

The US Treasury must issue trillions of dollars worth of debt to fund the government. The important thing to focus on is what the maturity profile of the debt sold is. Obviously it would be great if the US Treasury could sell trillions of dollars worth of 30-year bonds, because those bonds yield almost 2% less than <1-year maturing bills. But can the market handle that? Nope nope nope!

Maturity Profile of US Treasury Debt

Between now and the end of 2024, ~$9.3 trillion of debt must be rolled over. As you can see, the US Treasury has been unwilling or unable to issue the lion’s share of debt at the long-end, and has instead been funding at the short-end. Rut-roh! This is bad news bears because rates at the short end are higher than rates at the long end, which increases the interest expense.

Here we go.

Here is a table of the major potential buyers of US Treasury bills, notes, and bonds:

None of the major buyers want to or are able to purchase long-term USTs. Therefore, if the US Treasury tried to stuff the market with trillions of dollars worth of long-term debt, the market would demand a vastly higher yield. Imagine if the 30-year yield doubled from 3.5% to 7% — it would crater bond prices and mark the end of many financial institutions. That is because those financial institutions were encouraged by regulators to load up on long-term debt using almost infinite amounts of leverage. Y’all crypto folks know what that means: REKT!

US Treasury Actives Yield Curve

Janet Yellen is no fool. She and her advisers know it is impossible to issue the debt they need at the long end of the yield curve. Therefore, they will issue debt to where the demand is off the charts: the short end of the yield curve. Everyone wants to earn high short-term rates, which will probably be going even higher as inflation kicks back into gear later this year.

As the US Treasury sells $1 to $2 trillion of debt, yields will rise at the short end. This will further exacerbate the bank system problems, because depositors get a better deal lending to the government than to the bank. This in turn guarantees the banks cannot be profitable with negative NIM on newly issued loans, and therefore cannot support the government by buying long-term bonds. The circle of death is fast approaching.

The Fed

And now for the finale. Sir Powell has quite a mess on his hands. Every constituent is pulling his central bank in a different direction.

Cut Rates

The Fed controls/manipulates short-term interest rates by setting the rate on the RRP and IORB. Money market funds can earn a yield in the RRP, and banks can earn a yield in the IORB. Without these two facilities, the Fed is powerless to paint the tape where it wants.

The Fed could cut the interest rates of both facilities aggressively, which would immediately steepen the yield curve. The benefits would be:

1. The banks become profitable again. They can compete with the rates offered by money market funds, rebuild their deposit base, and start lending long again to businesses and the government. The US banking crisis ends. The US economy goes gangbusters as err’body gets cheap credit again.
2. The US Treasury can issue more debt with longer maturities because the yield curve is positively sloped. Short-end rates would fall but long-end rates would remain unchanged. This is desirable because it means the interest expense on the long-term debt is unchanged, but the attractiveness of that debt as an investment increases.

The downside is that inflation would accelerate. The price of money would fall, and the things the electorate cares about — like food and fuel — would continue rising in price faster than wages.

Raise Rates

If Powell wants to keep fighting inflation, he must continue to hike rates. For you economic wonks, using the Taylor rule, the US rates are still deeply negative.

Here are the negative consequences of continuing of raise rates:

1. The private sector continues to prefer lending to the Fed via money market funds and the RPP vs. depositing money at the bank. US banks continue going bankrupt and getting bailed out due to a falling deposit base. The Fed’s balance sheet might not be warehousing the mess, but the Federal Deposit and Insurance Corporation (FDIC) is now chock-full of dogshit loans. Ultimately, this is still inflationary, as depositors get paid back in full with printed money, and they get to earn more and more interest income lending to the government rather than to the bank.
2. The yield curve inversion continues, which removes the ability for the US Treasury to issue long-term debt in the size it needs.

I want to expand a bit more on the notion that raising rates is also inflationary. I subscribe to the point of view that the quantity of money is more important than the price of money. I am focused here on the quantity of USD injected into the global markets.

As rates go higher, there are three buckets in which global investors are receiving income in the form of printed USDs. The printed money comes either from the Fed or the US Treasury. The Fed prints money and hands it out as interest to those invested in the Reverse Repo facility or to banks who hold reserves with the Fed. Remember — if the Fed wishes to continue manipulating short-term rates, it must have these facilities.

The US Treasury pays out interest to debt holders in greater sums if it issues more debt and/or if interest rates on newly issued debt rises. Both of these things are happening.

Combined, the interest paid out by the Fed via the RRP and IORB and the interest paid on US Treasury debt is stimulative. But isn’t the Fed supposed to be reducing the quantity of money and credit via its quantitative tightening (QT) program? Yes, that’s correct — but now, let’s analyse what the net effect is and how it will evolve in the future.

As we can see, the effect of QT has been completely nullified by interest paid out via other means. The quantity of money is expanding even as the Fed shrinks its balance sheet and raises rates. But will this continue in the future, and if so, in what magnitude? Here’s my thinking:

1. The private sector and US banks prefer parking money at the Fed, and therefore RRP and IORB balances will grow.
2. If the Fed wants to raise rates, it must raise the rate it pays on money parked in the RRP and IORB.
3. The US Treasury will soon need to finance $1 to $2 trillion deficits into the foreseeable future, and it must do so at higher and rising short-term rates. Given the maturity profile of the total US debt stock, we know that actual money interest expense can only mathematically rise.

Taking those three things together, we know that the net effect of US monetary policy is currently stimulative and the money printer is churning out more and more fiat toilet paper. And remember, this happens because the Fed is raising rates to fight inflation. But if raising interest rates is actually increasing the money supply, then it follows that raising interest rates actually increases inflation. MIND FUCKING BLOWN!

Of course, the Fed could increase the pace of QT to offset these effects, but that would require the Fed to at some point become an outright seller of USTs and MBS, on top of foreigners and the banking system. If the largest holder of debt is also selling (the Fed), UST market dysfunction will rise. This would spook investors and long-end yields would spike as everyone rushes to sell what they can before the Fed does the same. And then the jig is up, and we see what the emperor is workin’ wit. And we know it’s a teenie weenie.

Let’s Trade This

To read my thoughts on how I will be trading this, please visit my Substack. There is no cost to becoming a subscriber.

Link to Cryptohayes Substack

https://cryptohayes.medium.com/the-denominator-68c3ad8f4ae4

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

The economics of nightclubs and national banking systems have a lot in common.

Patronising a nightclub is a lot of fun. You get to listen to good music, hang out with your friends, and for some, find a mate. However, after all the fun is had, there is always a bill to pay — and sometimes it can be quite substantial. Absent an agreed upon set of rules on how the cost should be allocated, the conversation as to who pays and how much can get quite heated.

“I was only there for a little bit.”

“I only had one drink.”

“I didn’t bring any girls to the table.”

Your scrub friend (you know the one) will always use excuses to avoid being part of the denominator of people who must split the bill. Early on in my banking career, my tight group of friends (we call ourselves the Fam) had a chat one day at work to codify the “bottle rules.”

The bottle rules determined whether or not a member of the crew was a part of the denominator and thus had to pay an equal share of that night’s bill.

The rules were simple:

1. Girls don’t pay.
2. If you have one drink, you are in for the whole bottle.
3. If you bring one girl to the table and she drinks, you are in for the whole bottle.
4. If you bring a friend who is male, and he has one drink, he is in for the whole bottle and you pay his share.
5. If you order champagne, you pay for that entirely by yourself. This rule is crucial. There is one member of the Fam whose ego always gets ahead of his willingness to pay on various occasions. One time a few years ago at 1 Oak in Tokyo, he got the maths wrong and thought a train of 6 bottles of Dom P could be had for the price of one. He ordered the train, felt like a baller, and then — after realising his maths error when presented with the bill — tried to charge the entire group for his folly. He got a stern rebuke from another friend and paid for it entirely on his own in the end.
6. If you order a bottle at the end of the night right before the club closes, you pay for that entirely on your own. (The same champagne friend is frequently guilty of this infraction, too.)

And now to the more pressing issue of how banking systems allocate inevitable losses.

Nations love robust banking systems. A good banking system allows the savings of the citizens to be aggregated and lent out to the government and productive companies. In an ideal world, this lending creates economic growth.

However, banking systems get into trouble quite often because they are fractionally reserved — i.e., they lend out more than they have on deposit. Their willingness to lend out money they don’t have frequently lands them in situations where they are unable to fulfil all of their depositors’ withdrawal requests, particularly during times of stress. These situations usually arise after some combination of political pressure, profit motives, and/ or poor risk management cause the banks to suffer massive losses, typically stemming from poorly underwritten loans or loan losses driven by rising interest rates. A bank run ensues, and then the government has to decide who is responsible for paying the bill to drag its glorious banking system back into solvency.

Should some combination of depositors, shareholders, or bondholders bear the cost of bailing out the bank? Or, should the government print money to “save” the defunct bank and pass on the cost to the entire citizenry in the form of inflation?

The most well-run banking systems establish an agreed upon set of rules governing these types of situations before any crisis occurs, ensuring that everyone knows how a failed bank will be dealt with, eliminating any surprises. Because banking systems are believed by the financial and political elite to be so integral to a well-functioning nation state, it’s safe to assume that in almost every country, banks will always be bailed out. The real question becomes, which schmucks get included in the denominator responsible for paying to recapitalise the bank? Regardless of what division of costs has been agreed to prior to any bank failure, once a bank actually collapses, every stakeholder involved will always lobby the government to avoid being part of the denominator.

Bianco Research published a truly epic chart pack clearly illustrating the current and future disaster that is the US banking system. A few of their charts will be presented in this essay.

United States of America or United States of China

The US government is at a crossroads and has so far been indecisive about the kind of banking system it wants for Pax Americana. Does it want a decentralised system of small- to medium-sized banks who lend locally (i.e., the US banking system pre-2008)? Or does it want a centralised system of a few mega banks who primarily lend to the national champions, super-duper rich people, and Jeffrey Epstein (i.e., the Chinese banking system)?

Post the 2008 Global Financial Crisis, the pencil pushers in charge of banking regulations decided that they would create a two-tiered system. Eight banks were determined to be Too Big to Fail (TBTF) and given an unlimited government guarantee on their deposits.JP Morgan leads the pack, holding 16% of all US deposits. There is no risk in depositing to these mega banks. If a TBTF bank fucks up, the USG will print the money needed to make sure all depositors get their money back. Essentially, these 8 banks are state-owned enterprises for which the profits are privatised to shareholders, but the losses are socialised to the citizens. In return for this sweetheart deal, these eight banks were given a fuck-ton of new rules to follow. These mega banks then spent hundreds of millions of dollars on political campaign donations to help tweak those rules and achieve the most favourable set of restrictions possible.

Every other bank must weather the rough-and-tumble free market all on their own. All deposits are not guaranteed — and because of the risks involved, you would think that depositors should be clearly informed of exactly how these banks are lending out their money. Instead, depositors are left to decipher the banks’ purposely obtuse and misleading financial statements and arrive at their own conclusion regarding whether a given bank is well run.

All banks cater to different types of customers. The TBTF banks are geared towards servicing large corporations and super-rich individuals, and they are pros at securities lending and trading. TBTF banks are also conduits of the Federal Reserve (Fed) and US Treasury’s monetary policy, and they support the USG by buying lots of the country’s debt.

The non-TBTF banks, on the other hand, power the real engine of the US economy — that is, by providing loans to the small- to medium-sized businesses and loans to individuals of more modest means. They take the scraps the TBTF banks discard from the proverbial table, filling their loan books with commercial real estate, residential mortgages, car loans, and personal loans (just for example). Take a look at the next two charts that depict how integral a robust network of smaller non-TBTF banks are to the US economy.

While both cohorts of the US banking system are exposed to different types of credit risks via their respective loan books, they share the same interest rate risk. The interest rate risk is that if inflation rises and the Fed raises short term rates to fight it, the loans they underwrote at lower rates are worth less. That is just bond maths. (I discussed this phenomenon at length in my essay “Kaiseki”.)

When 3 banks failed within one week this March, the Fed and US Treasury hastily concocted a bailout scheme called The Bank Term Funding Program (BTFP). Under this plan, any bank that held US Treasury bonds (UST) or US Mortgage-Backed Securities (MBS) could give them to the Fed and receive 100% of their face value in newly printed USDs.

Given that the fiat-based fractional reserve banking system and the financial system of Pax Americana in general is a confidence game, the powers that be do not react kindly when the market calls bullshit on their antics. The financial markets rightly saw through the BTFP and recognised it as a thinly disguised way to print $4.4 trillion to “save” one portion of the US banking system. The market expressed its displeasure with this inflationary move by ramping the price of gold and Bitcoin. On the political front, various US elected officials did their best acting and cried foul at these banking bailouts. Con artists never like being called out, and the Fed & US Treasury realised that next time a bank(s) needed to get bailed out, it couldn’t be so obvious about what they were up to. That meant any tweaks made to the BTFP would need to be implemented surreptitiously. The tweak we are most interested in is related to the type of collateral that is eligible for the BTFP program.

From 11 March 2023 when the BTFP was announced, gold is up 5% (white) and Bitcoin is up 40% (yellow).

But first, it’s important that we understand what precipitated this tweak. The TBTF banks — as well as any bank that held a large percentage of its assets in UST or MBS securities — benefited from just the announcement of the BTFP. The market knew if and when these banks suffered deposit outflows, they could easily meet their cash needs by giving the eligible bonds to the Fed and getting back dollars. But the non-TBTF banks were not so lucky, because a large percentage of their assets were ineligible for BTFP funding.

In less than one financial quarter, the market saw through the BTFP and put stress on the non-TBTF banks. The market wondered, “who is going to pay the bill for the interest rate losses on their loan books if they can’t access the BTFP?” And that led them to ask themselves, “why would I own equity in a bank that can’t receive implicit or explicit support from the government?” That question is especially important as the recent First Republic bailout demonstrated that he “price” for the FDIC arranging a shotgun marriage between a failing non-TBTF bank and healthy TBTF bank is a complete wipeout of equity and bondholders. As a result, equity owners started dumping their stakes in the regional banks … a 99% loss is better than a 100% loss. Whoever sells first, sells best.

First Republic was the first post-BTFP casualty, and the way in which it was wound up gives us more clues as to who is in and who is out of favour with the USG. The politics of bank bailouts is toxic. Many plebes are pissed off that they lost their house, car, and/or small business in 2008, while the large banks got hundreds of billions of dollars-worth of support from the government and paid record bonuses. Therefore, politicians are loath to support optically obvious banking bailouts, especially since America is (in theory) a capitalist society where allowing companies to fail is supposed to be part of the system.

I’m sure US Treasury Secretary Janet Yellen got reamed out for the BTFP and was told that under no circumstances could the USG be seen bailing out additional failed banks. I imagine she was told the private market must find a solution for managing a non-TBTF bank failure — meaning that a tweak to the BTFP that would make any and all banking assets eligible for funding was off the table. A while back, US President Joe Biden told Jerome Powell — the Chairman of the Fed — that stopping inflation is his number one priority. Not wanting to go against the President’s wishes, the Fed could not lower interest rates enough to help stem the deposit outflow from these shaky banks while inflation was still at 5% (I will expand on this later in this essay). The two major financial arms of the government (Fed & US Treasury) could not alter their policies to effectively deal with this banking crisis for political reasons.

“I ran for president because I was tired of the so-called trickle-down economy. We now have a chance to build on a historic recovery with an economy that works for working families. The most important thing we can do now to transition from rapid recovery to stable, steady growth is to bring inflation down. That is why I have made tackling inflation my top economic priority.”

US President Joe Biden in a WSJ op-ed from May 2022

The Federal Deposit Insurance Corporation (FDIC), the US government body in charge of winding up failed banks, tried its best to bring together the TBTF banks to do their “duty” and purchase the loser banks. Unsurprisingly, these profit-motivated, government-backed enterprises wanted nothing to do with bailing out First Republic unless the government was willing to chip in even more. That is why, after many days and a stock price drop of 99%, the FDIC seized First Republic in order to sell its assets to meet depositor liabilities.

Note: A bank’s stock price is important for two reasons. First, a bank must have a minimum amount of equity capital to back its liabilities, aka skin in the game. If the stock price falls too far, then it will be in breach of these regulatory requirements. Second, a bank’s falling stock price prompts depositors to flee the bank for fear that where there’s smoke there’s fire.

In the 11th hour, just before markets opened on Monday 1 May 2023, the FDIC offered JPM, the largest TBTF bank, a sweetheart deal, and it agreed to purchase First Republic. The deal was so good that JPM CEO Jamie Dimon cooed on a shareholder call that the bank would recognise an immediate $2 billion profit. JPM, a bank with a government guarantee, refuses to buy a failed bank until the government gives it a deal so favourable that it makes $2 billion instantly. Where is Jamie’s patriotism?

Don’t let the numbers distract you from the important lesson of this bailout. The First Republic transaction illustrates the pre-conditions for getting nationalised via a purchase by a TBTF bank. Let’s walk through them.

Condition:

Equity holders and bond holders get wiped out. A donut … A bagel … A goose egg. Capeesh?

Response:

If your bank has interest losses on its loan portfolio (which every single bank has), and these loans are ineligible for the BTFP, you must sell that stock IMMEDIATELY! You don’t want to get deaded by the FDIC. Short sellers are not responsible for the collapse in these dogshit bank stocks. It is long holders selling for fear of a 100% loss of capital if and when the FDIC steps in.

Condition:

A TBTF bank with a government guarantee must purchase the failed bank by assuming its assets. The TBTF bank will only do this with additional government assistance provided by the FDIC.

Response:

In the First Republic situation, JPM got cheap loans from the FDIC, and the same agency bore 80% of any losses on the loan book. Essentially, it appears the government will only expand BTFP-eligible collateral if a TBTF bank buys a bankrupt bank first. This is clever, and most politicians and their constituents won’t realise that the USG expanded their support of the banking system without formally declaring it. Now the FDIC’s balance sheet will be bloated with potential losses from failed bank loan books and low interest loans to TBTF banks. Therefore, Powell, Yellen, and the Biden administration cannot be easily accused of printing money to bail out a bank.

The Critical Assumption

If you believe that, when push comes to shove, US policy makers will always do what it takes to save the banking system, then you must agree that all deposits in federally chartered banks will eventually be guaranteed. If you don’t agree, then you must believe that some bank depositors will suffer losses.

To assess which side is more likely to be true, look no further than the banks that have failed so far in 2023 and how they have been dealt with.

Note: Technically Silvergate was not seized by the FDIC as it declared bankruptcy before failing completely.

In all circumstances where the FDIC seized the bank, depositors were made whole. Thankfully Silvergate, even though it declared bankruptcy, was still able to make depositors whole as well. Therefore, even if you are in a non-TBTF bank your money is most likely safe. However, there is no guarantee that if the FDIC seizes the bank a TBTF bank will swoop in and make depositors whole; there is also no guarantee that if a bank declares bankruptcy it will have enough assets to fully cover all deposits. Therefore, it is in your best interest to move all your funds over the insured $250,000 limit to a TBTF bank who has a complete government deposit guarantee. This will inevitably drive large deposits from non-TBTF to TBTF banks and further exacerbate the issue of deposit flight.

The reason US Treasury Secretary Yellen cannot offer a blanket deposit guarantee to all banks is that it requires an act of the US Congress. And as I argued above, there is no appetite for more perceived banking bailouts by politicians.

Deposit Outflows

Non-TBTF banks will continue to lose deposits at an accelerating rate.

First, as I argued above, in order to be 100% sure your deposit is safe, you must move your money from a non-TBTF bank into a TBTF bank.

Second, all banks will lose deposits to money market funds, which deposit money with the Fed and/or invest in short-term US Treasury bills. Think about it — you can earn almost 5% in a money market fund, or 0.50% as a bank depositor (see the above chart). If you could move your money and almost 10x your interest income using your mobile phone within the time it takes to consume a few TikTok videos, why would you leave your money on deposit at a bank?

Even if you can’t be arsed to figure out what a money market fund is and want to just leave your money in the bank, there’s no reason to do it at a non-TBTF at this point. The TBTF banks can lose deposits and you don’t have to care, because at the end of the day, the USG explicitly guarantees you will always get your money back. Non-TBTF banks are just plain fucked, and deposit outflows will continue to drive failures.

If inflation, interest rates, and banking regulations remain as they are right now, there is no scenario where every single non-TBTF bank does not fail. There will be a 100% failure rate. Guaranteed!

Ok … maybe that’s a bit aggressive. The only banks that would survive are those that operate in a fully reserved model. That means they accept deposits, and immediately deposit those funds with the Fed on an overnight basis. This is a super safe way to do banking, but unfortunately the Fed no likey this type of banking. They have denied applications for banks wishing to employ this business model for unknown reasons.

The Denominator

If my prediction about the ultimate fate of all non-TBTF banks is correct, then how much larger can the US money supply get? That is the real question. With the BTFP, we know that the potential expansion is at least $4.4 trillion (i.e., the amount of UST and MBS on US banks’ balance sheets which can be exchanged for cash at any point).

We also now know that the preferred sleight of hand of the Fed, US Treasury, and banking regulators is to heavily insist that a TBTF bank assume the liabilities of a failed non-TBTF bank. The TBTF banks undertake this public service by receiving cheap capital and loss absorption paid for with government-printed and American taxpayer money. Therefore, the money supply will in essence be expanded by the total amount of loans of non-TBTF banks, which is $7.75 trillion.

Note for Ned Davis Research subscribers: I encourage you to look at the report ECON_51 to verify my $7.75 trillion number.

As a reminder, the reason why these loans must be backstopped is because deposits fled. As deposits flee, the bank must sell loans for much less than face value and realise a loss. The realisation of the loss means they fall below regulatory capital limits and, in the worst case, do not have enough cash left over to pay out depositors in full.

The only way all non-TBTF banks don’t go bankrupt is if one of the following things happens:

1. The Fed cuts rates such that the yield of the reverse repo facility or three-month T-bills drops below the 2% to 3% range. The 2% to 3% range is an estimation of the blended yield of the banks’ loan portfolio. The Fed might cut rates either because inflation is falling, or they want to prevent further stress on the US banking system. Banks can then raise deposit rates to match or slightly exceed what money market funds can offer, and bank deposits will grow again.
2. The BTFP eligible collateral is expanded to any loan on a US bank’s balance sheet.

Option 1 loosens financial conditions and risk assets like Bitcoin, gold, stocks, real estate, etc., all pump.

This is a decline in the price of money.

Option 2 enlarges the amount of money that will eventually be printed. And again, this is only supportive of risk assets that are outside of the banking system. That means that gold and Bitcoin pump, and stocks and property dump. Stocks drop because bank credit disappears and companies are unable to finance their operations. Property is outside of the financial system, but it is so expensive in nominal dollar terms that most buyers must finance purchases. If mortgage rates remain high, no one can afford the monthly payments, and prices fall.

This is an increase in the supply of money.

Either way, gold and Bitcoin are going up because either the supply of money increases, or the price of money decreases.

But what if the price of money continues to increase because inflation refuses to slacken and the Fed continues raising rates? Just last week, Sir Powell continued stressing that the Fed’s goal is to slay the inflationary beast, and he followed it up by raising rates by 0.25% in the midst of a banking crisis. In this case, non-TBTF banks will continue going bankrupt as the spread between money market funds and deposit rates grows which causes depositors to flee, and that results in bankruptcy eventually leading to their loans being backstopped by the government anyway. And as we know, the more loans the government guarantees, the more money must eventually be printed to cover losses.

The only way the money printer doesn’t go brrr is if the USG decides it will let the banking system actually fail — but I have full confidence that the US political elite would rather print money than right size the banking system.

Many readers might think to themselves that this banking issue is purely an American thing. And given that most readers are not citizens of Pax Americana, you may think this does not affect you. Wrong! Due to the USD’s reserve currency status, most nations import American monetary policy. More importantly, many non-US institutions such as sovereign wealth funds, central banks, and insurance companies own USD-denominated assets. Like it or not, the USD will continue to depreciate against hard assets like gold and Bitcoin, as well as useful commodities like oil and copper. You are in the denominator too, just like a red-blooded Jane Doe American schmuck.

Boom Boom Boom

If inflation stays high and the Fed continues raising rates — or even just keeps them where they are today — then more banks will fail, we’ll see more TBTF bailouts, and the government will continue to support the creation of larger and larger TBTF banks. This would expand the supply of money and gold, and Bitcoin would rally.

If inflation falls and the Fed cuts rates quickly, eventually, banks would stop failing. But, this would reduce the price of money, and gold and Bitcoin would rally.

Some may ask why I didn’t consider the outcome where the banks survive long enough for their low interest rate loans to mature, and be replaced by loans underwritten at a much higher yield. Depositors are not going to wait 12 to 24 months earning basically 0% at the bank vs. 5% in a money market fund. Tap tap, slide slide, and in less than 5 minutes your deposit base is gonzo, courtesy of your slick mobile banking app. There is just not enough time!

You just can’t lose owning gold and Bitcoin, unless you believe the political elite is willing to stomach a complete failure of the banking system. A true failure would mean that a large swath of chartered banks fold. This would stop any and all bank lending to businesses. Many businesses would fail, as they would be unable to finance their operations. New business creation would also decline in the absence of bank credit. House prices would plummet as mortgage rates spike. Stock prices would dump because many companies gorged on low-interest debt in 2020 and 2021, and when there is no longer affordable credit available to roll over their debt they would go bankrupt. Long-dated US Treasury bond yields would surge without the support of the commercial banking system buying bonds. If a politician reigned during a period in which these things happened, do you think they would get re-elected? No fucking chance! And therefore, while the various monetary authorities and banking regulators may talk a big game about no more bank bailouts, when the shit really hits the fan, they will dutifully press dat brrrr button.

Therefore, it’s Up Only! Just make sure you are not the last sucker in the Western financial system when the bill comes. Get your Bitcoin, and get out!

https://cryptohayes.medium.com/exit-liquidity-3052309e6bfa

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

Repeat after me …

“I Will not be exit liquidity!”

Being someone’s exit liquidity means you’re one of those schmucks who is buying or holding when the smart or connected folks are selling. In the context of this essay, exit liquidity refers to the unfortunate plebes who have been — and continue to be — on the losing side of the economic arrangement that is the US dollar’s reserve currency status.

The debate over whether the USD can be replaced as the global reserve currency is a heated one. On the one hand, some vocal elites of Pax Americana are incredulous that any country could step up to the plate and hold the world economy on its shoulders (America, Fuck Yeah!). On the other hand, there are increasing signs that certain corridors of trade are de-dollarising, and actually have been for some time.

1. LNG deals between France and China invoiced in CNY
2. Brazil and China to trade with each other using no dollars
3. BRICS explores creating new currency

Even the mighty French are tired of being America’s towel garçons and mademoiselles. French President Macron recently said that he believes his nation needs to reduce the “extraterritoriality of the US dollar.”

Reserve currency status comes with benefits, but it also foists certain costs upon the host nation. The primary benefit is clear — the host nation gets to print currency at will to pay for real goods. But that benefit is not distributed equally amongst the citizens of the empire. Though it has maintained its status as the wealthiest nation in the world, America’s levels of wealth inequality are currently among the worst in the developed world — and the situation continues to get worse and worse. The costs of being the reserve currency are felt acutely by the vast majority of the population that owns little to no financial assets. Below are a few distressing charts from Pew Research.

While even some former vampire squids are starting to acknowledge that the country’s role as the issuer of the global reserve currency is weakening the country overall, the most common retort to their concerns is, “well, who or what could possibly replace the dollar?” Many might erroneously suggest that China is itching to promote the CNY / Yuan / Renminbi as the dollar’s replacement, given that it’s the second largest economy globally. But, those who are sceptical that anyone besides the US can handle the gig will respond by trotting out some hard truths about the Chinese economy, including the fact that the country’s capital account is closed, and that the vast majority of trade is still priced in dollars — with no signs of slowing. “What can you buy with the Yuan?” those sceptics will ask.

This debate raises a few highly pertinent questions that deserve further exploration, including:

• Is de-dollarisation actually underway, and to what extent?
• Is the dollar’s role as the global reserve currency good for the majority of Americans at this particular time in history?
• Does China actually want to be the issuer of the global reserve currency?
• What currency or currencies will eventually replace the dollar, given that history has taught us that all empires come to an end eventually?

These questions are critical to predicting how financial policy around the globe might develop as the influence of Pax Americana continues its natural decline. You’ll be shocked to hear that I think crypto is a key part of the conversation, too — but more on that in a bit.

Forming a view on whether de-dollarisation is a thang is extremely important, as it should drive how you save your wealth. This is especially important if you are a citizen of the West. Even if your country issues its own form of fiat toilet paper, you are still an American vassal, courtesy of your flag’s military and economic alliances. Your capital is at risk of being expropriated as the American financial elites struggle to stay in power while their empire crumbles beneath them. Do you really want to fuck around and find out what a rabid dog will do when cornered? Are you going to let yourself become exit liquidity?

Maybe after reading this, you’ll think to yourself, “well, I’m actually a card-carrying member of the financial elite, so this doesn’t really apply to me. In fact, this arrangement will probably benefit me!” That might be the case in the short-term, but ask yourself this … would you want to be a noble in King Louis XVI’s court on the eve of the French Revolution? Does the political situation between the polarities of political power in America point to cohesion, or is there seething rage lurking just beneath the surface, ready to explode when handed the right match? Your meticulously coiffed head is probably feeling mighty heavy on those shoulders of yours, but don’t fret — I’m sure some righteous woke or proud boy warrior would happily remove it for you.

Before I get to the end game, though, it behoves us to understand the simple economics that underpin the ongoing discussions around de-dollarisation. Many people do not understand how the flows of capital and trade work, and thus are driven to the wrong conclusions. So bear with me, as I’m going to start by going deep on the fundamental economics that support my assertions. And if your TikTok-addled brain can’t focus for 30 minutes, I suggest you save yourself the trouble and just open up a new tab, Google “ChatGPT-4,” and ask our future AI overlords for a summary of this essay.

Mirror, Mirror on The Wall

A currency is said to be the global reserve currency when the majority of international trade is priced in said currency. To help us better understand the economic impacts of a global reserve currency, I am going to present a simplified global economy of two actors: the US (global reserve currency issuer and consumer of goods) and Asia (which is composed of China and Japan, who produce goods).

Europe, and specifically the UK, isn’t a part of the conversation because it destroyed itself over the course of two world wars (from 1914 to 1945). America picked up the pieces and quickly became the richest nation globally. It opened its markets and allowed countries outside of the Soviet Union’s sphere of influence to sell it stuff.

China and Japan (aka Asia) are lumped together because they both pursued the same mercantilist economic policies to achieve growth. Asia financially repressed savers so that heavy industry could get cheap capital to build manufacturing capabilities. Asia then undervalued its currencies vs. the USD and suppressed workers’ wages so that goods would be extremely cheap for Americans purchasing them with dollars. This strategy was easy for Asia to implement because, well — let’s just say that if you’re thinking about trying to start a workers’ union in China or Japan, I wouldn’t recommend the “fuck around and find out” approach. Following WW2, these policies made Asia so rich that it became the largest economy globally.

In this simple model, the US buys stuff from Asia in dollars. Asia uses those dollars to buy energy and raw materials from the rest of the world, so it can produce more stuff for the US. Asia now has a lot of excess dollars that it earned from selling stuff, and it can do two things with those dollars:

• Option 1: Buy dollar-denominated assets.
• Option 2: Sell dollars in exchange for local currencies and give some of the earnings back to workers in the form of higher wages.

Option 1 keeps Asia’s currencies undervalued from a purchasing power perspective and allows Asia to keep on making and selling cheap stuff. Option 2 is desirable for the workers in Asia, who would be able to consume more because they would have higher wages and/or could buy imported goods cheaper. But, Option 2 does not favour Asia’s large corporate industrialists, because if the prices of their goods approached American price levels — driven by increased labour costs and an appreciating exchange rate — then they would sell fewer goods.

The post-WW2 global economy would not be in its current shape (that is, with America running a trade and capital deficit vs. Asia) without the following being true:

1. America has an open capital account. That means anyone with dollars can buy assets inside America in any size they like. A foreigner can buy US-listed stocks, US-incorporated companies, US real estate, and US government debt. If this weren’t the case, Asia would have nowhere liquid enough to invest its large amount of dollar income. If Asia wasn’t allowed to invest its dollar income in the US, then Asia’s currencies would appreciate and wages would increase. That is just maths.

2. America has little to no tariffs on imported goods. No country practises truly free trade, but America has always made it a priority to offer as close to free trade as possible. Without little to no tariffs on Asian stuff, Asia would not have been able to sell things to Americans for cheaper than American companies could produce domestically.

As trade rose after WW2, Asia needed an increasing amount of dollars, irrespective of whether the domestic American economy required a larger money supply. The more stuff Asia sells, the more commodities it must buy (in USD). If America is unwilling to provide more dollars to the world through its banking system (e.g., via loans from its private sector banks), then the dollar skyrockets in value vs. all other currencies because there are not enough dollars around to facilitate the increased level of global trade. For those who are perennially short in dollars due to their USD borrowings, a supercharged dollar is the kiss of death.

This presents a very big recurring problem in American politics. Having the global reserve currency means that the Federal Reserve (Fed) and Treasury must print or provide dollars by whatever means necessary whenever the global economy demands them. However, increasing the amount of dollars globally can stoke the fires of inflation, which hurt voters domestically.

In whose interests do the domestically elected politicians typically act? The foreigners who need cheap and plentiful dollars, or the Joe-six packs who want a stronger dollar to repel the terrible effects of inflation? As much as the politicians want to help the average American, the health of the entire world’s economy — along with America’s desire to remain the global reserve currency issuer — typically take precedence. So, when asked, the dollars are almost always provided. And if not, a global financial crisis ensues.

To give two recent examples, consider the Mexican Peso Crisis of 1994 and the Asian Financial Crisis of 1998. In both circumstances, US banks that were flush with deposits — many of which were from foreigners with lots of dollar earnings — lent to foreign countries in order to earn more yield and fully deploy the insane amount of capital they had on deposit. The sheer volume of dollars that needed to find a home caused malinvestment abroad. But the music was playing, so err’body had to get up and two-step.

In both instances, the Fed started raising short-term rates because the US economy needed tighter monetary conditions domestically. The rise in rates caused the banks to slow down lending abroad. Many of these loans were of dubious quality, and without a continuous flow of cheap dollars from banks, the foreign borrowers became unable to service their debts. Trade faltered as companies who depended on this dollar funding started going bankrupt in Mexico and Asia, respectively. The banks had to recognise their bad loans, which put their solvency at risk.

The Fed and Treasury are now facing a hard decision. The domestic economy needed tighter money, but putting the American people first would also put US banks in harm’s way due to their international loan portfolios. Y’all already know what happens when financial policymakers face a choice between supporting the people or the banks, so you can guess the rest — the Fed and the Treasury eventually caved and lowered rates to bail out the US banking sector. Of course, there were some elected officials that hooted and hollered about how unfair it was to their constituents to bail out banks that gave bad loans to foreigners, but the American economic model necessitated this policy response.

American banks will always have a deposit base larger than the domestic lending opportunities because foreigners flood the banks with cash earned by selling stuff in dollars. Banks will always lend too aggressively and sacrifice tomorrow to boost earnings today. The Fed and Treasury will always bail out the banks because they must in order to prevent a financial crisis that makes the dollar more expensive and lowers its supply globally. When banks contract dollar lending en masse to repair their balance sheets, it removes dollar credit globally, which in turn pushes up the price of dollars and lowers their supply.

So, we just walked through the impact that the dollar’s role as the global reserve currency has on the American banking system. But what about American financial assets?

Asia doesn’t just deposit dollars with US banks. They also buy stocks, bonds, and property.

The wealthiest 10% of Americans own 90% of all stocks. The global reserve currency arrangement benefits them significantly. The Fed will never let the banking system go bust, which means it will always print money to fill holes bigger than Sam Bankman-Fried’s legal bills. This printed money causes financial asset prices to increase. The wealthy also benefit because foreigners provide constant buying pressure in the stock, bond, and property markets.

If the 10% benefits, what about the other 90% of Americans?

For-profit American companies must do everything they can to maximise revenue and minimise costs. For companies that make real stuff (as opposed to software), labour is one of their biggest costs. Sir Elon recently binned 75% of Twitter’s work force and the company’s software continued working. Imagine if General Motors fired a similar percentage of its staff. How many cars would make it off the factory floor?

But remember, this is America — so manufacturers have to find some way to keep juicing those margins. Wouldn’t it be great if American companies could relocate their factories outside of America to capitalise on cheap labour in Asia, which intentionally undervalues its currencies and suppresses the wages and negotiating power of its labour? And wouldn’t it be great if those companies could then produce all their products cheaper abroad, and then sell them back in America at a cheaper price with no import tariffs? Surprise, surprise — that’s exactly what happened. Corporate profit margins went up, and union membership declined in tandem with the decimation of the American manufacturing base.

Chart on the Effects of Globalisation

Global Trade and Services Volume (white)

S&P 500 Index (yellow)

Case Shiller US National Home Price Index (green)

Manufacturing Value Added as a % of US GDP (magenta)

As you can see from this chart, financial assets like stocks and property received a significant boost from globalisation. The more the world trades, the more dollars need to be recycled into the US. US labour did not receive the same benefits, though, as evidenced by the lone falling purple line, which represents the share of manufacturing value added as a % of US GDP. Basically, if you’re an American, you’re much better off learning financial engineering than how to engineer the actual making of goods.

This historical chart from NDR clearly shows that US corporate profit margins are at the highest they have been since the 1950’s. However, in the 1950’s, the US was the world’s workshop (since everyone else was destitute after the ravages of WW2). In 2023, China occupies that role — and yet US companies are still enjoying profit margins that are similar to those experienced during the height of the US’ manufacturing prowess.

Corporate executives are rewarding themselves with generous stock options packages. These chieftains are also rewarding shareholders (which includes themselves) with stock buybacks and dividends, all the while decreasing CAPEX. This has resulted in CEOs making 670x more than the average worker, on average. Take a gander at the below charts for a fuller understanding of the pay distortion of American firms.

The good manufacturing jobs vanished, but hey — now you can drive an Uber, so no harm, no foul, right?! I’m being a bit flippant, but you get the point.

This outcome is guaranteed to continue — and likely worsen — so long as America continues to covet its role as the issuer of the global reserve currency. In order to maintain its seat on the currency throne, America must always treat capital better than labour. It must allow Asia to invest its dollars in financial assets. Capital invested in the stock market demands a return. And capital will demand that executives continue to raise profit margins by reducing costs. Reducing costs necessitates replacing expensive domestic labour with cheap foreign labour. If America does not treat capital this way, then there is no incentive for Asia to sell goods in dollars (since it wouldn’t be able to buy or invest in anything with those dollars).

If America resorted to pro-manufacturing mercantilist policies, then America / Asia trade would need to be conducted in a neutral reserve currency. And by neutral, I mean a currency that isn’t issued solely by one country. Gold is an example of a neutral reserve currency.

The current trade arrangement has benefited the financial elite who run America, but it has also been a boon to the general populations of Asia, who have been rebuilding their countries after a devastating global conflict. Which brings us to the next important question — is there any reason Asia would want to change this relationship?

Asia

In some respects, China and Japan have very similar cultures and economies. They are collectivist — i.e., the wellbeing of the community is considered more important than the individual’s. The stated goal of both Chairman Mao and the post-WW2 Liberal Democratic Party (LDP) that ran Japan was to rebuild their respective countries. The message to the plebes of both nations was essentially, “bust your ass, and we can get wealthy together as a country.” That is a gross oversimplification, but the end result was that these two countries became the 2nd and 3rd largest global economies in under a century.

These countries got rich, and the average Zhou / Watanabe enjoyed a much better standard of living than pre-WW2. Of course, labour in general did not receive the full benefit of the countries’ rising overall productivity, but again, the goal was never for the individual to flourish at the expense of the group.

So, as Asia looks at how far its current economic arrangement has gotten them, and then looks at the US’s precarious current position, they have to be asking themselves, “is being the reserve currency issuer even something we should be striving for?”

Does Asia want to have free trade?

No. Asia wants to raise the standard of living of its locals by selling stuff to rich Americans. It doesn’t want money flowing out of the region to purchase imports. The whole reason Asia got rich is that it restricted foreigners from selling things at an attractive price to locals. On paper, Asia is a member of the World Trade Organisation and is committed to free trade. In practice, there are a variety of ways in which Asia constrains the ability for foreign products to compete domestically on an equal playing field. America is perfectly happy to turn a blind eye to this, because the financial elites that control the country are the same cohort that own the companies that benefit from cheap goods and labour from abroad.

Is Asia for sale?

China’s capital account is closed. Foreigners are allowed to invest in a very limited subset of Chinese assets. There are specific quotas for the level of foreign ownership in the stock and bond market. Majority foreign ownership of most companies is not allowed. Even if you had a bunch of CNH (offshore Yuan or CNY), you couldn’t buy anything with it in size like you can in America.

Japan’s capital account is open — or at least, that’s what they claim. Japan has very polite ways of discouraging foreign ownership. Companies place a bigger emphasis on social stability — i.e., providing jobs for more people than they need — over turning a profit. There is also a high degree of cross-company ownership, which restricts the ability of minority investors to influence corporate direction. As a result, returns on Japanese equities are much lower than in the US.

As readers know, I love skiing in Japan. A foreign property owner there told me that during COVID, while the foreigners were away due to travel restrictions to enter Japan, one town passed a policy lowering the building density allowed on undeveloped land. This lower density regulation makes it practically impossible to build a hotel or large apartment block. This primarily impacts foreigners, who bought land in hopes of developing hotels and selling high-end condos. The locals will be perfectly happy if no additional visitors come and ruin their bucolic ski fields. There are more than enough hotel beds for the domestic Japanese visitor. Capital wants in, but society says no.

Bubble Gum

The US, China, and Japan are all grossly indebted. If you count the present value of future mandatory entitlements (US Social Security and Medicare), all three nations sport debt-to-GDP ratios of over 200%. The difference between the US and Asia is that a large part of US debt is owned by foreigners, whereas Asia is largely indebted to itself. This does not alter the likelihood that the debt will be repaid, but it does influence the speed at which the reckoning occurs.

When debt must be repaid quickly, a financial crisis ensues. If the debt is primarily concentrated at the sovereign level, this accelerated repayment of debt leads to outright default and regime change. You can look at the history of Argentina to better understand how this tends to play out politically.

China and Japan know they are overleveraged. However, because capital cannot come and go freely, the authorities have a lot of latitude in determining who bears the losses and how quickly those losses are realised. Japan experienced the severe bursting of a property and stock market bubble in 1989. The policy response was to financially repress savers using quantitative easing and yield curve control, and that remains Japan’s policy to this day. Its banking system and corporate sector has deleveraged over the past 30 years. There has been little to no growth over that time period, but there has been no social upheaval, either, because the costs of the bailout are being amortised over a longer period of time.

China’s property bubble has kind of burst. Real Chinese growth is likely between 0% to 2%, not the advertised 6% to 8%. The communist party is now undergoing the painful political process of assigning who bears the losses for a gargantuan amount of malinvestment and its associated debt. But, China is not going to have a financial crisis so severe that it shakes the people’s faith in the party and causes them to seek the overthrow of Xi Jinping. That’s because China will do the same as Japan and subject the population to decades of little to no growth and financial repression. They can do this because there is low foreign ownership of their debt, and capital cannot come and go freely from China.

Even after 30 years, Japan is still mired in debt. China tried to tame its property market, but the financial stress brought on by that policy proved too great to bear, forcing them to revert to their original plan of “extend and pretend.” Given the current state of both countries, Asia will not open its capital accounts and allow foreign hot money to come and go, since it would only serve to further destabilise China and Japan’s financial systems. Take note — trapped Asian capital is the exit liquidity that pays the price for over indebtedness (since it experiences financial repression and little to no growth).

A note about financial repression: I define financial repression as the inability to earn a rate on savings via government bonds that meets or exceeds the rate of nominal GDP growth. For example, if government bonds yield 3% but the economy is growing at 5% then savers are financially repressed to the tune of 2%. The citizens lose income that the government gains. And these gains are used to inflate away government debt.

Checklist

I confidently assert that Asia does not want to be the issuer of the global reserve currency. Asia is unwilling to accept the necessary pillars of a global reserve currency:

1. Asia does not want to allow foreigners to own any assets they wish in any size they like.

2. Asia does not want to disenfranchise labour to a significant extent vs. capital.

3. Asia wants to deleverage on their own time scale, which means foreigners cannot be allowed to own a large amount of government debt or other financial assets like in the US, nor will foreign capital be allowed to come and go as quickly as it pleases.

But just because Asia is unwilling to enact the policies needed for it to become the issuer of the global reserve currency, doesn’t necessarily mean that Asia wants to keep accumulating and trading dollars.

Regime Change

De-dollarisation is getting a lot of reps in the current conversation around the future of the global economic arrangement. However, the concept of de-dollarisation is not some new phenomenon. I have a couple of charts from Joe Kalish, the chief global macro strategist for Ned Davis Research, to illustrate my point.

Remember my simple global economic model: Asia earns dollars by selling stuff to America. Those dollars must be reinvested in a dollar-valued asset. US Treasuries are the largest and most liquid asset that Asia can invest in.

2008 was the apex of dollar hegemony. Right on schedule, the American banking sector spawned yet another global financial crisis. The response, as always, was for the Fed to print money to save the US dollar banking system. Holders of US Treasuries don’t like being shat on repeatedly. The amount of money printed in the ensuing decade was so egregious that holders of Treasury bonds started dumping en masse.

What did the producer countries start buying instead? Gold. This is an extremely important concept to understand, as it gives us a big clue as to what asset is most likely to dethrone the dollar as the future currency for settling trade and investment flows between countries.

Gold as a percentage of emerging market (EM) central bank holdings bottomed in 2008 — i.e., at the same time the dollar was at its mightiest. Following the financial crisis, the global South decided it had had enough of being exit liquidity for Pax Americana and started saving in gold rather than treasuries.

Together, these two charts clearly suggest that de-dollarisation began in 2008, not in 2023. Huh — now that I think about it, Lord Satoshi also published the Bitcoin whitepaper in 2008… what a coinkydink.

Understanding the top-level economic movements of the last 15 years allows us to understand why and how China and Japan changed their behaviour. When your entire economic model is predicated on selling stuff to — and investing the proceeds in — America, you lose financial independence. Like it or not, the People’s Bank of China (PBOC) and Bank of Japan (BOJ) import the monetary policy of the Fed. That may seem bad enough on its own, but trillions of dollars of Asia’s wealth also depend on the good graces of American politicians. As Russia recently found out, rule of law and property rights are not ironclad.

I will focus this next part of my analysis on China, because Japan is a dutiful ally of the US. Just as one example, the US recently told Japan to increase their defence spending, and they obliged. Japan also hosts a large US military presence (even if the general population wishes the American GI’s would get the fuck out). As a result of this alliance, the BOJ and Ministry of Finance typically do what they are told when the Fed and/or US Treasury make strong suggestions about Japan’s monetary policy.

China, on the other hand, is in a bind. China still earns hundreds of billions of dollars per year exporting stuff to the US (and the world in general). China also holds trillions of dollars’ worth of US Treasuries and other dollar-denominated financial assets. Even though China owns a significant chunk of America, she is still listed as a strategic competitor of Pax Americana. But, China can’t just ditch the dollar, because China doesn’t want a bunch of foreigners flush with CNY to destabilise its financial system. Nor can it just market sell its treasuries, as it would get a terrible price for them.

As a result, China must work through a multi-step process to safely de-dollarise — not to replace the USD with the CNY as the global currency, but to simply lower its economic reliance on the US. The process goes something like this…

The first step is for China to start paying its major trading partners in CNY. As Saudi Arabia’s largest customer of oil, it makes sense for China to pay in CNY — and the same is true for all of its purchases from large energy exporters. If the energy input to the Chinese economy is priced in CNY, it requires China to “save” fewer dollars, which it previously used to buy energy. China has already begun to implement this step.

From there, the energy exporters can spend their CNY on Chinese manufactured goods. After almost 50 years of modernisation, China is the workshop of the world, and it produces just about everything a country might need.

If there is a large enough imbalance in trade between China and its trading partners, the difference can be settled in gold. China has a very liquid physical gold/CNY market located in Shanghai. If you don’t want to hold CNY, you can purchase gold futures contracts for physical delivery. This is super important because China allows the gold market to soak up any trade imbalances. If this gold link were absent, China would have to permit greater ownership of CNY denominated stocks and bonds. I explained earlier why China does not want to allow foreigners to own Chinese financial assets in size.

To further incentivise its largest trade partners to invoice in CNY when trading with China or Chinese companies, the PBOC will begin to aggressively roll out the e-RMB, a central bank digital currency (CDBC) that it has been testing since 2020. The e-RMB will allow instant, free, and zero-risk payments across the global South, which will replace the USD as the “hard” currency in places like Africa. Why fuck around with the intrusive banking system of your former colonial oppressors and slavers, when you can use a currency sponsored by a nation that just wants to trade and not get involved in your politics?

The goal of the e-RMB is to replace the USD in trade with China’s largest non-aligned trading partners. China doesn’t need or want to convince staunch US allies to drop their use of the dollar. China will still trade in dollars, but the size of China’s dollar earnings abroad will fall dramatically. With fewer dollars to invest, China can reduce the need to engage with the Western financial system. As China’s treasury holdings mature over time, China can sell these dollars and acquire gold. A recent disclosure points to an already steady rise in the official gold holdings of China.

Political Risk

One of the reasons investors previously favoured “developed markets” — and especially the US — was the absence of political risk. Political risk is the risk that when power shifts from one ruling party to another, the incoming party jails the opposition, and/or changes rules and regulations enacted by the previous regime just because they are of a different party. As an investor in countries with volatile politics, you can’t focus on the merits of one asset vs. another when your attention is fully centred on political power dynamics. Rather than engage in this risky exercise, investors instead chose to place their capital in an environment with a stable political arrangement. Previously, that was the US.

Power has seamlessly transferred between Democrats and Republicans since the end of the American Civil War in 1865. American presidents are no less crooked than any other heads of state — but for the sake of the system, the elites have managed to pass the baton between themselves without much in the way of sour grapes. Former President Richard Nixon was impeached for breaking laws while in office, and his replacement President Gerald Ford pardoned him.

For many years, capital has had nothing to worry about with regards to American politics. That has changed. Former President Trump was indicted by a court in New York City for a variety of alleged crimes. Trump might be a born-and-bred New Yorker, but the city has no love for him. Whether or not there is merit to his charges isn’t important. What’s important is that half the country voted for him, and the other half did not. A political flashpoint has been created that will be extremely divisive. Regardless of whether Trump wins or loses, half the country will be upset and believe the system is corrupt to its core.

2024 is an election year, and as you know, the number one job of any politician is to get re-elected. If you thought Trump owned the media airwaves before, then this public trial is only going to cement him further as a permanent fixture in the 24-hour news cycle for $free.99. News about this trial is everywhere. It doesn’t matter where you are in the world — the mass market news media are talking about this story. Politics is always about name recognition, so if Trump decides to run for president, it’s nearly a guarantee he will be the Republican party nominee.

President Biden’s house is made of glass as well. Allegations about shady dealings of his spawn Hunter Biden might lead one of Trump’s acolytes to indict Hunter for something. It doesn’t really matter for what — the narrative is that Hunter is crooked and his daddy is protecting him. Following such a move, each side would have the other’s king in check.

Again, the question (at least for those looking to trade on the future of American politics) isn’t whether Trump or Hunter is guilty or innocent. The question is, will the American public sit idly by and watch their hero be impaled by their political enemy? Will the 90% of America that has watched their good jobs go to Asia and their cost of living skyrocket be docile in the face of yet another affront? Or could this political instability be the match that ignites them to start asking the hard questions about why the wealth of Pax Americana hasn’t flowed to their household? Keep in mind that this is a relative discussion. It is not about whether Americans are richer on average than a family in Sub-Saharan Africa. It is a question about how a family in Flint, Michigan bathing in toxic water feels vs. a family in Manhattan that shops at Whole Foods.

Are the leaders of the Democratic and Republican parties concentrating on protecting their respective Lords, or investors’ capital?

As a steward of your capital, you must ask yourself — “do I want to continue to hold assets in a regime with these political and financial issues? Or would I rather ride it out in the (relative) safety of gold and or crypto?”

The Financial Balkans

The future will feature various currency blocs, but no global reserve currency hegemon. Trade with the West will continue in dollars, trade with the rest will be in CNY, gold, rupees, etc. When the blocs have imbalances between them, they will settle in a neutral reserve currency. Historically, that has been gold, and I don’t believe that will change. Gold is a great global trading currency if you can transport bulky, heavy items. Governments are good at these kinds of logistics — it’s a bit more difficult for the average person to lug their gold savings around.

As the global financial system balkanises, there will be less demand for US financial assets. Mohamed ain’t buyin’ no 57th street penthouse in NYC when he just saw how Yevgeny got his assets stolen for sporting the same passport as Putin, the “devil’ incarnate. The global South, which used to produce stuff to sell to the world in exchange for fiat toilet paper dollars, will begin accepting other currencies instead. Without the foreign demand for stocks and bonds at the margin, prices will fall. The biggest impact will be that, without a new bout of money printing, US bond yields will need to rise (remember: as bond prices fall, yields rise).

The West cannot allow general capital flight from its markets to places like crypto or foreign stock and bond markets. They need you, the reader, as exit liquidity. The colossal debts accumulated since WW2 must be paid, and it’s time for your capital to be eviscerated by inflation. A capital flight would also definitely spell the end for the USD’s role as the global reserve currency.

As I mentioned in Kaiseki, the West cannot easily enact draconian capital controls because an open capital account is a prerequisite for the type of capitalism it practises. Even so, if the West starts to sense that a mass exodus of capital is on the horizon, it will almost certainly make it more annoying and difficult to pull money out of the system. If you believe my thesis, then you should start to see many of the world powers’ recent financial policy changes in a different light.

The West is making it harder to buy crypto and store it in a private wallet. You can read about Operation Choke Point 2.0 and the Wall Street Journal to get a better understanding of this dynamic. President Biden’s administration keeps hinting that they may try to block US investors from investing in various sectors of China. Expect other such restrictions on investing abroad so that capital can stay at home and get disembowelled by persistently high inflation created by aggressive money printing.

Since 1971, investing in dollar assets has become such a no-brainer trade that many investors have forgotten how to actually do financial analysis. Moving forward, gold and crypto will be in focus. They are not tied to a particular country. They cannot be debased at will by a central bank desperate to prop up their financial system with printed fiat money. And finally, as countries start looking out for their own best interests rather than serving as slaves to the Western financial system, central banks of the global South will diversify how they save their international trade income. The first choice will be to increase gold allocations, which is already underway. And as Bitcoin continues to prove it is the hardest money ever created, I expect that more and more countries will at least start to consider whether it is a suitable savings vehicle alongside gold.

Do not let the financial media present this as an either/or decision between the dollar and the yuan. Do not let the lap dogs of the empire convince you that due to certain “deficiencies” in the Chinese economy, there is no currency ready to dethrone the mighty dollar. They are playing at misdirection — in the coming years, the world will conduct trade in a multitude of currencies, and then save when needed in gold, and maybe sometime in the near future, Bitcoin.

https://cryptohayes.medium.com/shapellas-show-e63d52378f7

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

As y’all know, I don’t fuck for free. While I love disseminating knowledge about macro and crypto for free on this blog, I gotta eat too. Bubbly water in the clerb ain’t cheap. In December of last year, I launched my crypto family office, Maelstrom. I hired BitMEX’s former head of corporate development, Akshat Vaidya, to run around the world looking for worthy crypto projects to invest in. Our goal is to invest in early stage projects that will deliver excess returns over just holding Bitcoin and Ether.

Moving forward, every once in a while, Akshat will grace readers with a thinkpiece on a crypto vertical that he is very excited about. Obviously, we are shilling our bags, but we’re also trying to educate the market on why the problems these projects are trying to solve are important to the goal of furthering decentralisation. Ultimately, we want to help power the teams that will completely destroy — *ahem* I mean, offer an alternative — to the parasitic, rancid TradFi financial system.

The below think piece speaks about the overall movement to decentralise validators of the Ethereum network. This space is super exciting, and I expressed a bullish view on the Ethereum Merge via increasing the percentage of Ether in my portfolio and purchasing LIDO (the governance token of Lido Finance). In the back of my mind, though, I always worried that Lido was not sufficiently decentralised, and that once the market started caring about this, the coin would tank. After Akshat invested in Obol and ether.fi and explained his rationale for doing so, I knew it was time to dump my Lido position, which I did recently. Read on to understand our thought process in more detail.

Shapella’s Show: ETH Staking’s Coming Shake-Up

By: Akshat Vaidya, Head of Investments @ Maelstorm

“Not your keys, not your crypto” has been the industry’s motto for as long as I’ve been in this space. But time and time again, traders, customers, and even founders and name-brand fund managers continue to fuck this up. Far too many keep repeating the same mistake again and again, cycle after cycle, of giving up control of their private keys — resulting in billions of dollars’ worth of lost or stolen funds (from Mt. Gox to FTX, and everything in between).

Prior to DeFi Summer (circa 2020), clients typically lost funds on poorly managed or outright fraudulent CeFi exchanges. But in 2021–2022, this issue reared its head in a new way — with a number of so-called “decentralized” (but still ultimately custodial) cross-chain bridges compromised, to the tune of $2.5B (e.g., the $586MM BNB Bridge exploit). Once again, individuals that voluntarily gave third-parties access to their private keys got rekt, and were reminded once more that “code is law.”

Giving up access to our private keys — to either centralized or “decentralized” entities — is not a compromise any of us should have to make, given infrastructure capabilities inherent to blockchains. Yet here we are in 2023, playing with fire all over again in our collective thirst for easy ETH staking rewards.

Post-DeFi Summer, we have come to expect yield on our crypto — particularly on our ETH, and even more so now given recent Fed rate hikes. However, since setting up a validator is still hard [if you’re working on elegant solutions to help bring down technical barriers to solo-staking, ping me], customers have found themselves forced to make a false choice between using staking services that are dangerously custodial in nature, and simply letting their ETH sit idle. Worryingly, too many have chosen the former, entrusting their private keys to the likes of 1) fully centralized services like Coinbase, Kraken and Binance; and 2) proto-decentralized ETH liquid staking derivative (“LSD”) protocols like Lido Finance. To be fair, these custodial projects have served as important steppingstones towards the trustless, decentralized future of ETH staking. However, they also prioritized speed-to-market at the expense of exposing stakers to potentially substantial operator, regulatory and security counterparty risks.

Fortunately, that false choice ends starting now. The Shanghai-Cappella (“Shapella”) upgrade, set to take hold in the next 24 hours, will allow stakers to withdraw staked ETH for the first time (at a rate of 0.4% of total staked ETH per day). 18 million+ ETH (~15% of all ETH in circulation, worth tens of billions of dollars) is about to be unshackled from the previously mentioned risk-prone, custodial staking business models of the past. These incumbents have the most to lose in terms of their existing market share of staked ETH, and possibly the least to gain from the tens of millions of forthcoming ETH about to be staked over the coming years. And of these incumbents, Lido — the largest and first proto-decentralized LSD protocol — might be the biggest (slowly) ticking time bomb of them all.

Let’s unpack how Shapella might pave the pathway for Lido’s ETH staking dominance to crack.

Lido, which accounts for ~75% of all ETH locked in LSD protocols, and ~30% of staked ETH overall, is essentially built upon stakers’ faith in the trustworthiness of node operators:

• Stakers deposit ETH with no contribution from node operators (unlike Rocketpool’s model, where node operators contribute 16 of the 32 ETH for each validator);
• Node operators, not stakers, generate keys (including both BLS private keys, as well as validator keys), and execute the staked ETH:ETH redemption process on a voluntary basis;
• The implication being, that stakers do not hold a direct claim on either their ETH or staking rewards, but only over a pool of hypothetical assets generated by the protocol itself (analogous to the business model of cross-chain bridge Wormhole, hacked last year for ~$321MM of its own similarly hypothetical ETH-derived asset).

To be clear — Lido works because node operators choose to play ball. Period.

If node operators, for whatever reason, are unwilling or unable to exit their validators in order to give you “your” ETH or “your” staking rewards, you’ve got a problem. Of course, there are meaningful steps Lido has taken to mitigate the risk that a major event — such as a hack compromising validator keys, or regulatory/legal action preventing node operators from releasing ETH — spirals out into a market panic. […At least by design. Lido’s entire redemption process will only be tested live, at scale, for the first time starting April 12th after Shapella, since it’s thus far been a one-way street]. But regardless, ultimately node operators can simply refuse to exit, effectively rendering “your” staked ETH illiquid and inaccessible for a period of time, with limited downside risks borne by node operators.

TL;DR: Lido’s revenue model (and that of its node operators) depends on you not only giving up your private keys, but also bearing the majority of the risk. All for just…4–6% yield on your precious asset. Sound familiar?

Fortunately, this is a risk none of us need to take anymore.

Lido was architected well before we knew what we do now — i.e., that withdrawal credentials sitting on the execution layer is not enough to make an LSD protocol non-custodial. We now know that it is not possible to simply create a smart contract-controlled redemption mechanism as a workaround. So, what if we could do it all over again post-Shapella? Knowing what we know now, how would we design Ethereum staking services that are both non-custodial and still scalable?

We launched Maelstrom, the family office of BitMEX co-founder Arthur Hayes, in December 2022, amidst the wreckage of numerous collapsed custodial business models, to invest in projects fixing what went wrong. We are backing teams committed to delivering on the full potential of blockchain — a scalable, privacy-enhancing, decentralized, non-custodial and interoperable stack of infrastructure capable of unleashing new trillion-dollar markets across various use cases.

To that end, we are starting with primitives, and investing in ETH staking infrastructure projects that 1) compete directly with the two risk-prone custodial business models described above (both fully centralized and proto-decentralized); and 2) those that are complementary with these same legacy incumbents to help them (as well as new entrants) further decentralize.

• Maelstrom’s debut investment was in an early mover in that second category, a project that isn’t competing with either the Lidos or the Coinbases of the world, but rather tooling them to eliminate single points of failure. Obol Labs, an investment we closed in January this year, is helping solo-stakers as well as fully centralized, proto-decentralized and genuinely non-custodial [see next bullet] services alike further decentralize. Obol’s distributed validator technology (“DVT”) middleware allows validator keys to be “split” among multiple node operators, effectively creating a “multi-sig” validator that can be run simultaneously across a collection of machines. These multi-validators still “speak” as one to the Beacon chain, avoiding penalties or slashing, while improving redundancy, security, and decentralization across the ETH staking space. More here.
• ether.fi, on the other hand, is our first investment in a project aiming to bring about a stepwise evolution from the legacy custodial models of both Lido and Coinbase. ether.fi is building one of the first genuinely non-custodial, delegated staking services for Ethereum (and other PoS networks in the future). In a post-Shapella world, where stakers are able to freely bounce from staking service to staking service to chase the highest yield, ether.fi circumvents the impending race to the bottom by competing on something other than just APY. With ether.fi, stakers generate and control their own keys throughout the staking process from creation to redemption, and can exit validators to claim their ETH back at any time, preventing node operator malfeasance. I.e., “your keys, your crypto.” ether.fi’s non-custodial model reduces risks for all parties, including node operators who will no longer be required to keep wallets connected or rely on a trusted middle party for coordination. More on the mechanics here.

Maelstrom is building a long-term investment portfolio of infrastructure companies that will serve as the foundation of our trustless, decentralized future. Giving up your private keys is not a compromise you need to make in order to participate in any decentralized ecosystem. The existing, legacy players in ETH staking — be they centralized or proto-decentralized — had prioritized speed-to-market during this past crypto Summer. But storm clouds are swirling over these incumbents, as new projects offering trustless, truly non-custodial ETH staking solutions are being built and scaled this Winter. And with today’s Shappela upgrade, the shackles are finally coming off.