Desk Commentary: Extr(m)emes

Disappointingly, at least for those hoping for some crypto market chaos, there’s been effectively little in the way of digital asset fanfare or fireworks from the pre-FOMC trading session to Chairman Powell’s presser and straight through to Thursday’s ECB decision. Vol markets for crypto majors have donned something akin to a habit of desperate apathy, as low volumes and listless price action prevail. IVs were apathetic going into the event risk, with two day Friday expiries barely registering a 60 handle before a hard fade immediately after 2pm on Wednesday.

And that’s not a shocker. Even with 10 day realized volatility in bitcoin that has nearly doubled from ~25% as of the 30th April close to 47+%, ether historical vols have shown few signs of life, as rolling 30 day realized stays pinned to 40%. That inactivity may be related to unabated overwriting pressure, pushing BTC and ETH IVs toward 50% in the September expiry, which has shaved associated volatility risk premium down to single digits.

Although this week’s latest banking woes and fresh outbreak of traditional financial sector instability have garnered a bit of enthusiasm for the prospects of a renewed run toward cycle highs for bitcoin, as of Thursday, that notion has not seen much of a sustained bounce in spot. That said, last weekend’s session spike, which saw yet another temperamental test of 30k, could be seen to justify the stickiness of longer dated risk reversals that remain firm to the call, in marked contrast to ETH’s negative skew across the entire term structure (puts over).

These details exemplify the extent to which idiosyncratic actions (such as size selling of ETH calls in concentrated strikes and tenors and a relative lack of the same in BTC) have dominated pricing realities. Consider that the clip size of the typical ETH call overwrite by an infamous if anonymous ‘whale’ tends to range from 25,000 to 50,000 units of ETH, while it may only be 300 to 500 BTC at most for a similar bitcoin program. In that vein, following hard on the heels of April’s lackadaisical tape, Genesis’ trading desk observed a hamfisted execution of large ETH December near-ATM call sale orders over the weekend. This initially pushed IVs in the Dec tenor to all-time lows as the ether options market continues to choke down a steady diet of buy-write vega.

The consequence of that regime has been a relentless convergence between BTC and ETH IVs, which briefly traded under bitcoin across the entire curve to start the first week of May. Repeated attempts by directional, relative value, and volatility-oriented players to long ETH vol and short BTC vol have found no joy in the face of the aforementioned supply. This demonstrates the extent to which large takers can dwarf the collective balance sheets of even the most well-capitalized buyside shops and market makers.

Fortunately, there was life in the crypto sphere beyond BTC and ETH this week, which witnessed an exponential surge in the value of meme-coins PEPE and WSB, hearkening back to the glory days of DOGE, SHIB and even PEOPLE. The reprisal of meme coins amid a growing banking crisis has left pundits gawking and detractors reeling. Still, it may be canonically conformant in many ways, according to some of the best quantitative research and based on well-trod trading rhythms.

In its seminal 2021 paper, “Risk Analysis of Crypto Assets,” Two Sigma made one of the first intellectually honest attempts to decompose financial risk vectors and explain the distribution of crypto returns. In addition to a traditional factor-based approach, they undertook a rigorous principal components analysis (“PCA”).

The PCA yielded an unexpected result, which is as follows: after a “beta” affiliated component, which explains 47% of crypto price variance, the second most powerful data-driven component of crypto price variance is, in fact, a “meme” proxy, which explains 22% of price variance!

It’s a slight oversimplification to trivialize the significance of this result as “Dogecoin dominance” or “all alpha is meme”, but the truth may not be so far off. Heuristically, it’s instructive to consider that over their respective lifetimes, bitcoin and dogecoin total returns are of a similar order of magnitude, but of course, the timing and nature of those returns was distributed entirely differently, with Doge awakening from its slumber in Q1 2021 in an explosive rally.

Alongside these quantitative considerations, though, the behavioral psychology of the current zeitgeist provides similar conclusions: as banking systems falter, humans contemplate the “meme” -ness of their very own bank deposits, in an existential almost ontological fashion. They may ask questions such as, “what is money? What is a paper bank note? Is there any intrinsic value to the supposed bedrock of the financial system and the default savings instrument?” If bank deposits can theoretically evaporate overnight, then there may exist a marginal propensity to allocate capital to a token with no other obvious use-case than a tautological self-deprecatory rallying cry.

Moreover, the rise of PEPE and WSB is not necessarily just a story of punting on “money I might have lost anyway,” i.e., a corollary to the YOLO impulse. It’s also an instance of the kind of risk recycling that’s been seen after pronounced market rallies, such as those which catalyzed the abovementioned moves in DOGE and SHIB.

In our 2022 piece “Darwin’s Game,” by Ainsley To, Genesis examined both the kurtotic nature of cryptocurrency returns and the concentrations of gains / losses amongst subsets of winners and losers, bucketed by absolute performance. The extreme characteristics of those considerations are, at least in part, exacerbated both by the gravity-defying, sustained gains of some of these very same meme-tokens, as well as several self-referentially labeled straight-to-zero wipeouts like BTRST (BrainTrust), KLIMA, and to a certain extent, names like ICP (Internet Computer). Meme coin ownership embodies many philosophical concepts, but perhaps most chiefly it confers upon hodlers an inherent perceived optionality. Scooping tokens with three, four, five (or more) zeroes seems to suggest to some participants that set against ‘good support at 0’, there is the prospect of a geometric rise towards unitary par, which in the case of DOGE, nearly occurred.

In short, risk-oriented recycling out of majors, eschewing L1s, and going straight to memes is considered a fashion of buying optionality. And as a thematic bent, it’s difficult to argue against the possibility of further fat-tailed outcomes for this asset class. With the banking sector staring into crises and majors stalling at significant thresholds, there’s more than a touch of Gresham’s law afoot in the recent meme move, which serves as a reminder that volatility doesn’t necessarily evaporate in this asset class so much as it migrates.

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