Desk Commentary: Jumanji

Crypto markets’ baleful coiling just above 29,000 and 1,800 support, with its palpable feeling of dreadful anticipation, turned out to be more than just a premonition. Set against several potentially attributable catalysts ranging from Chinese economic woes to SpaceX unwinds to gamma-driven considerations, cryptocurrency prices teleported lower on Thursday evening in gratuitous fashion. With that cascade, the inveterate predilection of sitting short variance risk premia at any price faced a most violent rinse; notwithstanding some covering of shorter-dated optionality during the week amidst a slight preemptive uptick in IVs, there had still been, until just after 5:30 PM EST, a concomitant propensity to sell volatility with vigor.

Case in point, minutes before the collapse in prices, sharp taker activity saw a prominent player scoop the better part of a 1,000 units of1-week ~10 delta puts at just over 40% IV, barely half a point from mids, as makers eagerly parted with precious gamma, convexity and skew, which will surely be remembered as one of the all-time punctual lifts of mispriced optionality, much to the detriment of complacency.

The deluge that ensued just after was nothing short of spectacular; spot bitcoin traded from 27,700 to 27,000 to 25,300 in an evaporative flash, with ETH plunging from 1,720 to 1,550 before recouping the entirety of those losses (briefly). It could be scarcely imagined that in the same trading week, 2-day ATM IVs in BTC and ETH traded as low as 13% while they surged over 100 points higher in a cataclysmic whoosh.

The trading tape that followed had pain and disarray writ large, with an endless barrage of exchange liquidations along with gamma and vega driven stop-losses. Those closeouts drove the implied volatility surface to levels not seen since the FTX debacle; notable prints included overnight ATM strikes paid at 117%, June 2024 40,000 strikes paid at 75% (and above) and~1-month ~quarter-delta calls lifted in size at close to 60%, only to be given down some 20 points lower just hours later.

The wholesale destruction was equally evident in linear derivatives markets where basis plunged with equally dramatic splendor, negative funding momentarily touching well into the double-digit percentages (and in some cases triple-digit percentages) across the curve.

Suffice it to say, moves in spot, basis, vol, skew and convexity pricing were as extreme as this market has witnessed. Yet it occurred at a time when, at least ostensibly, all has been reasonably well for the digital asset ecosystem. Unlike comparable dislocations during COVID or over the course of 2022, the cryptocurrency market has experienced, to the eyes of most, a renaissance in 2023, with a healthy rebound in prices and a secular decline in volatility, attributed to the maturation of the asset class.

Some, such as crypto detractor Nassim Taleb, may say ‘BlackSwan.’ But in truth, there had been, ex-post-facto, certain telltales that all may not have been typical in the digital asset derivative markets leading up to this moment. Particularly after the third quarter’s flush in IVs, it was noteworthy that 2-day vols doubled in days, and even though spot markets merely ground lower from 29000 toward 28000 in an orderly fashion with similarly controlled moves in ETH, IVs and skews had begun to disconnect from spot moves.

Throughout the current bullish recovery regime, the established custom has been one of entrenched positive spot:vol correlation.Yet, in the two days before this week’s crypto crash, we saw that relationship violated as IVs rose on static or indeed lower spot, particularly for shorter-dated IVs. Front-end risk reversals similarly repriced briskly from calls over to puts over, even while longer-dated risk reversals remained firmly bid for calls. All the while, in the face of a notably steep term structure that suggested a market content to sit short underperforming gamma and skew, both ATMs and fixed strike vols had begun to gyrate with increasing instability, suggesting that liquidity in the street was drying up.

In summary, crypto options markets remain a place for professional investors to test their mettle and potentially capture huge moves. Still, as was demonstrated this week, the digital asset derivatives game can be ‘fun for some but not for all.’

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