Get Your Bitcoin and Get Out

The year 2020 was an important one in economic history. Covid hit and shit down the global economy. What happens when governments are faced with crises of this magnitude - they print money in order to inflate a collapsing economy. So how much money was printed? The United States Federal Reserve printed approximately $3.3 trillion in 2020 which equated to one-fifth of the entire money supply. In other words, they printed 20 percent of all the money that has ever been printed, and they did this in the space of less than one year.

The reason why money printing is seen as a panacea for a financial crisis is that it injects money into the economy which is supposed to be used to encourage borrowing for financially viable projects such as new businesses, factories, and projects. Consumers also use this money to buy goods and services which contributes towards the gross domestic product of the economy. That is what is supposed to happen in theory.

To understand what actually happened, we need to go back to the 2008 financial crisis and how this caused a bifurcation in the US banking industry. The regulation that followed the crisis created two kinds of banks. The first was the large systematically important banks labeled "too big to fail". This list was then extended to global banks and to date there are thirty-two banks whose size and tole meant that any failure could cause serious systemic problems. Those banks include Agricultural Bank of China, BBVA, Banco Santander, Bank of America, Bank of China, Bank of New York Mellon, Barclays, BNP Paribas, China Construction Bank, Citigroup, Credit Agricole Group, Credit Suisse, Deutsche Bank, Goldman Sachs, Groupe BPCE, HSBC, Industrial and Commercial Bank of China, ING Group, JP Morgan Chase, Mitsubishi UFJ, Mizuho, Morgan Stanley, Nordea Bank, Royal Bank of Canada, Royal Bank of Scotland, Societe Generale, Standard Chartered, State Street, Sumitomo Mitsui, UBS Group, UniCredit and Wells Fargo.

These banks are so large and interconnected that their failure would be disastrous for the greater economic system and they, therefore, need to be supported by governments. Some critics have argued that this classification of select banks can lead to moral hazard in that banks are able to enjoy the profits when their trades are successful but taxpayers can be left to pick up the tab if their bets turn out to be wrong. This in turn encourages these banks to act irresponsibly. Regardless of whether you buy into this, one thing that emerged from this protection of large banks is that it is one of these banks that came with it many other benefits. They had access to very cheap money and it made it very easy for them to make money. The most important input of any bank is funding. If they have access to money that is almost free, it means that their biggest input has almost no cost. Imagine if Toyota could build cars for free and then sell them at a market price. How easy would it be for them to make money? They could be as inefficient and lazy as they wanted and they would still make money. This is what happened to these 32 largest banks in the world - they lived a pampered life while all other banks had to work their fingers to the bone in a gold hard competitive world where they did not enjoy the same support.

Let's now go back to the money printing brought on by COVID. Approximately $1.8 trillion of the money printed went to individuals and families and another large chunk went to businesses. The problem is that instead of spending and investing this money in the real world economy, they plowed a large portion back into the financial system. In other words, they deposited the cash into banks. Why did they do this? Human beings have a strong sense of self-preservation. In the middle of a global pandemic, when you receive a windfall check (ie money you were not expecting), you are going to pop that into the bank because you don't have a clue how long the pandemic is going to last.

What did the bank do when they suddenly received all this money? Banks are also risk averse. They only like to lend money to people and entities that don't need the money. In the middle of a global pandemic, what are they going to do? They are going to lend the money to the entity that is most likely going to pay them back - and that is the United States Government. They invested in treasury bonds but now you need to understand what is a yield curve.

A yield is the term structure of interest rates. You need to remember that when people talk about interest rates generically they are making out as if there is only one interest rate in the world. The reality is that each country has its own interest rates and different maturities have different interest rates. People also give you the impression that the central bank control interest rates - the truth is that they only control short-term interest rates - the market (also known as the forces of supply and demand) controls longer-dated interest rates. So let's start at the short end of US/dollar interest rates. These are set by the Federal Reserve and it is an overnight rate. It is known as the Fed Funds rate. The Fed Funds rate is the interest rate at which banks lend reserve balances to other banks overnight on an uncollateralized basis. It is the overnight interbank rate that is set by the Federal Reserve. But what happens if borrowers/lenders want to do longer deals - like 1 month, 3 months, 1 year, or even 30 years? Advanced economies have interest rate points designated in months, years, and decades. The world's biggest lender is the United States government. It borrows money for as short as a few weeks and months to numerous years. The market sets these borrowing rates or interest rates in a yield curve, and under normal circumstances, the yield curve has a positive slope. As the maturity extends, the interest rate increases because the risk is higher. For example, if investors demand 2 percent to lend the government money for a year, it may require 3 percent for a 10-year loan and 4 percent for a 30-year loan. This yield curve will look different for Brazil than it would for the United States government because lending to the Brazilian government is riskier than the US government - so investors may demand 5 percent for 1 year, 7 percent for 10 years, and 12 percent for 30 years. Super risky countries may have a yield curve that only goes out a few months because no one is prepared to lend them money for longer.

Ok, now we need to go back to 2020. Banks received this flood of COVID money and they need to find a way to lend it out with the lowest level of risk. At the time the curve was relatively flat on the short end so the banks had to invest in longer-dated treasury bonds in order to get yield. Now you need to understand duration.

Duration is a bit like jumping into a rabbit hole so you will need to loosen your brain. Take a deep breath, a swig of tequila and let the crazy begin. The prices of bonds that pay fixed coupons move in the opposite direction to interest rates. When interest rates decline, bond prices increase. So why the hell does this weird inverse relationship exist? You buy a bond that matures in five years and pays a coupon of 10 percent. If you hold that bond until maturity, you will receive a steady flow of coupons of 10 percent and then your principal when the bond matures.  You paid 100 for the bond. One month after getting behind the wheel of this fine specimen of financial engineering, 5-year interest rates decline from 10 percent to 8 percent. You are stoked.  You have locked in a fixed cash flow of 10 percent and everyone who buys 5-year bonds will only earn 8 percent.  Let's assume that no one is issuing 5-year bonds at the moment and your neighbor has a strong hankering for some 5-year action. He leans over the fence and catches you attending to your beloved bonsai.  He offers to buy your 10 percent bonds at the same price you paid - 100. You feel tempted to take your miniature tweezers and ram them through his eye but you are on probation for a previous incident also involving pruning equipment. The only way in which your neighbor will be able to convince you to part with your bonds is if he sweetens the deal by offering you a premium above 100. You propose to sell at 108 and after some haggling, you agree on 105. Notice how interest rates have decreased and the price has increased. If interest rates on 5-year bonds increase to 12 percent, the tables are turned. You are now stuck with a bond that is only paying 10 percent. The only way that you will be able to sell the bond is by offering it at a discount.

This relationship between bond prices and interest rates is duration. Duration assigns a number to this relationship. It explains how bond prices move for every 1 percent change in interest rates. Duration of 7 means that for every 1 percent increase in interest rates, the bond price will decline 7 percent. The higher the duration, the greater the sensitivity of the bond to changes in interest rates. What factors influence the duration of a bond? We are going to use a simple agricultural definition of duration, a definition you will never find on a Harvard whiteboard. Duration is the time taken to recover half the price paid for the bond. Short-maturity bonds will have a low duration because you will soon receive the price paid for the bonds.  Bonds with high coupons have lower durations because a high coupon means that you will receive half your money quicker. Zero-coupon bonds have durations that are equal to the term of the bond because they have no cash flows before maturity. Bonds with coupons linked to a floating rate index such as LIBOR or SOFR move in line with interest rates. If the interest rate increases, the coupon will increase. The new coupon will reflect this new interest rate and the price of the bond is likely to stay the same unless there is scarcity in floating-rate bonds. This could cause the price to increase but there is no mathematical formula to calculate this increase. The price change will be subject to the wilds of the open market and the forces of supply and demand. Floating rate notes have minimal duration.

The total return on equities is generated by a change of price in the stock in addition to any dividends paid. So, in one year, if the stock price gains 20 percent and the stock pays a dividend of 3 percent, the total return for that year will be 23 percent. Bonds work in the same way but to confuse everyone, different terminology is employed. In the bond world (a world of Maseratis, beautiful women, Omega watches, and tailored British suites) we speak about curve return and carry return. Bond is all about the curves. Curve return is the return generated from the price change of the bond on account of interest rate changes (duration) and any change in the perception of the credit risk in the issuer. If you buy a bond at 100 and the price moves to 110, your curve return is 10 percent. If the bond carries a coupon of 6 percent, you need to add 6 percent to the curve return and that is the carry return. In the bond world, prices are either dirty or clean. Don't get too excited - it is not even close to what you think. A clean price does not contain accrued interest. An AT&T bond pays an annual coupon of 7 percent in December. Your neighbor buys the bond for 100 on January 1st and holds the bond for six months. He is entitled to half the coupon which is 3.5 percent.  If he sells you the bond in June and you hold it until December, you will receive the full coupon of 7 percent. Because you are not a douchebag, you will make good that money owed. This AT&T bond trades clean and you buy it in June for 100.  At the time of settling or paying for the bond, you will pay your neighbor 103.5 which is the dirty price. The dirty price includes accrued interest. Some bonds also trade dirty. If this bond in question was dirty, it would trade and settle at 103.5.

Tell me how much I will make if I hold this bond until maturity. You buy a 10-year Chesapeake bond with an 8 percent coupon for 100. Rates increase to 10 percent and suddenly your bond isn't so pretty compared to new bonds paying 10 percent. The price of your Chesapeake bond will need to decline to reflect this new relative unattractiveness.  You live in a remote Amazonian village and you are the best-looking guy in the village. Half the men have a bone through their nose and the other half have no teeth. You are boneless but are blessed with all your molars and all the girls want to dance with you. Brad Pitt then decides to move to your village because he wants to save the rainforest. Your relative attractiveness plummets and all the girls now want to dance with the gringo. You need to recalibrate your skills to stay relevant in the market. You, therefore, discount the price of your full-body deep tissue massages. The same is true in the Chesapeake bond. You need to discount your bond to below par to let's say 95. The person who buys that bond will receive a coupon of 8 percent payable on the par value of 100. He, however, bought that bond at 95 and when the bond matures the issuer will pay him 100. Taking this discount into account, his effective return will be 10 percent which is the new interest rate. This return of 10 percent is known as the bond's yield to maturity. Here are the rules that summarize all this: If you buy a bond at par, the coupon is equal to the yield to maturity. If you buy a bond at a premium to par, the yield to maturity is below the coupon. If you buy a bond at a discount to par, the yield to maturity is above the coupon.

Ok, let's now bring this all together. When COVID hits in 2020, the Federal Reserve scraps the reserve requirements for banks which means that banks are literally able to create new money out of thin air. This creates $3.3 trillion in new money in 12 months which is 20 percent of all the money that has ever been created in the history of the United States. Half this money arrives in the bank accounts of individuals and families. Also remember, when we talk about money being printed, most of it is not physically printed. You need to remember that 90% of all money does not exist in physical form - it exists in the form of a bunch of numbers on your bank account. This goes back to the point of money being created out of thin air. What do people do with this money? They don't spend it - they are so spooked by COVID that they leave it in the safest place they know - their bank. In a recent CBS news poll, it was found that 75 percent of respondents say they have confidence in their banks. This is kind of crazy given the recent meltdown of banks like Silicon Valley Bank and Signature, but we will get back to this a little later. So banks see a massive increase in deposits from 2020 as all this stimulus money comes rushing through their doors. This is not only coming from families and individuals but also from businesses who also received a good chunk of this stimulus money. From 2020 until 2022, there is an increase in total bank deposits from $13 trillion to $18 trillion. In 2020, interest rates were close to zero which means that banks were paying almost nothing for this money. Why were people prepared to receive zero interest on their deposits? Firstly, they received this money for free from the Federal Government, and secondly, they were so spooked by COVID that all they wanted was a safe place to store their money, so a zero interest rate was not the end of the world. What did the banks do with all this money? Traditional banks act as conduits - they receive money from depositors and they lend that money to people and businesses that will put that money to sound economic use through new projects and investments. However, given the mood in the COVID economy, banks were far too spooked to lend all this money out, so they also parked it in a safe place. What is the safest place for a banker to park his money - in the safest investment known to man - United States Treasury Bonds? The problem was that their yield curve at that time was flat. The only way the banks could earn a return above 1 percent on these treasuries was to buy longer-dated treasuries maturing beyond 10 years. We already know that although these bonds have low credit risk because they are issued by the United States Federal Government, they have plenty of duration risk. Duration risk is a function of two things - the maturity of the bond and the size of the coupon. Long-dated bonds with low coupons have lots of duration. Duration risk works in your favor when rates go down, but it will bite you in the bottom when rates go up. In 2020, interest rates were at record lows which means that one of two things could happen - rates could either stay the same, or they could go up. Banks were hoping the former scenario would play out, and in the worst-case scenario, if the second scenario played out, they were hoping that interest rates would not increase too dramatically.

Now we need to take a closer look at the Federal Reserve. The odd thing about the Federal Reserve Bank is that it is not Federal, it holds no reserves and it is not a bank!! The Federal Reserve System (often shortened to the Federal Reserve, or simply the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act, after a series of financial panics (particularly the panic of 1907) led to the desire for central control of the monetary system in order to alleviate financial crises. Over the years, events such as the Great Depression in the 1930s and the Great Recession during the 2000s have led to the expansion of the roles and responsibilities of the Federal Reserve System.

Congress established three key objectives for monetary policy in the Federal Reserve Act: maximizing employment, stabilizing prices, and moderating long-term interest rates. The first two objectives are sometimes referred to as the Federal Reserve's dual mandate. Its duties have expanded over the years, and currently also include supervising and regulating banks, maintaining the stability of the financial system, and providing financial services to depository institutions, the U.S. government, and foreign official institutions. The Fed also conducts research into the economy and provides numerous publications, such as the Beige Book and the FRED database.

So who owns the Fed? The Fed is made up of 12 regional banks - the most important of which is the Federal Reserve Bank of New York because that is where the major banks are domiciled. Each regional Fed is owned by its member banks. As of 2018, the biggest shareholder of the New York Fed was Citibank, holding 87.9 million New York Federal Reserve Bank shares – or 42.8 percent of the total. The No. 2 holder stockholder was JPMorgan Chase Bank, with 60.6 million shares, equal to 29.5 percent of the total. In other words, the two banks together control nearly three-quarters of the regional bank’s capital shares.

Ok, now we know that the Fed is not owned by the Federal government - it is ostensibly owned by the banks, and the big banks hold the biggest influence over the Fed. It is believed that every Sunday, top Fed officials meet with the top 4 banks to discuss the strategy for the week. Who is the Chairman of the Fed? His name is Jerome Powell - known as Jay to his friends. In order to understand Jay, you need to understand his hero, Paul Volcker. Paul Volcker was the 12th president of the Fed. Volcker is widely regarded as one of the most important figures in modern central banking. During his tenure at the Federal Reserve, he implemented a series of policies aimed at reducing inflation, which had been a persistent problem in the US economy for more than a decade. He raised interest rates to unprecedented levels, which helped to curb inflation but also contributed to a severe recession in the early 1980s.

When Paul Volcker went for his interview with President Jimmy Carter to get the job of Fed chair, he said, “You won’t like anything I do in this job. I’m going to push interest rates high, I’m going to hurt the economy, and I’m going to bring down inflation.” From the very outset, Volcker envisioned a Fed that was unpopular, that was doing things that the populace didn’t understand or wouldn’t welcome. And that was certainly true: People really hated Paul Volcker. We now look at him as this historical, almost heroic figure, but at the moment, people resented him deeply. They sent him 2x4s for houses they couldn’t build and keys to cars they couldn’t sell because of his very high interest rates, which were aimed at taming inflation.

So, the Fed, after creating all this new money in 2020, watched how all this new money flooded into the banks instead of being allocated to reviving the economy. Banks, battling to find a low-risk home for this new money, plowed it into long-dated treasury bonds and they prayed interest rates would not go up. The problem is that their prayers were not heard. All this money printing is inherently inflationary. The world then witnessed Russia’s invasion of Ukraine. This invasion caused a surge in commodity prices for two reasons: the physical impact of blockades and the destruction of productive capacity; and the impact on trade and production following sanctions that were placed on Russia in protest to the invasion. Russia is the world's largest exporter of wheat, pig iron, natural gas, and nickel, and it accounts for a significant share of coal, crude oil, and refined aluminum exports. Russia and Belarus are important suppliers of fertilizers. Ukraine is a key exporter of food commodities such as wheat and sunflower seed oil.

In the face of this rising global inflation, Jay Powell sees the opportunity to take a page out of his hero Paul Volcker's playbook and sets on a path of hiking interest rates like a ninja. He takes the Fed Funds rate from effectively zero in March of 2020 to 5 percent in the space of three years and causes havoc in the long-term treasury market. The shares of 20-plus year Treasury Bond ETF which tracks the performance of long-dated treasury bonds declined almost 40 percent over that period of time, and the banks are left with massive mark-to-market losses in their balance sheets.

Now we need to go back to the bifurcation of the banking system. You need to remember that not all banks are created equally. You have 32 global banks that are too big to fail. We already know the big US banks effectively own the Federal Reserve, but it may come as some surprise that foreign banks also have their filthy fingers in the Fed. HSBC Bank USA, which is part of the London-based HSBC Holdings PLC (and before that HSBC was based in Hong Kong - the name stands for Hong Kong Shanghai Bank Corporation) owned 6.1 percent of the New York Fed as of 2018. Deutsche Bank owns 0.87 percent. Mizuho owned 819,344 shares and the Industrial and Commercial Bank of China held 221,278 shares. The list goes on but now you can understand the importance of this concept of too big to fail. Which banks are most likely to weather this banking crisis? The banks are too big to fail. Which banks are most likely to benefit from this banking crisis? These banks that are too big to fail because depositors are going to take their money out of smaller banks and put their money in these bulletproof banks.

So, do the big banks want to get rid of the small banks? In order to answer this question, it is worthwhile going back to the panic of 1907 which was also known as the Knickerbocker Crisis. It took place over a three-week period starting in mid-October when the New York Stock Exchange fell almost 50 percent from its peak the previous year. Panic in the stock market spread throughout the nation and people started to withdraw money from their banks and trust companies. The biggest loser was the Knickerbocker Trust Company which was one of America's largest trusts at the time. When the panic started, the most powerful banker in New York was John Piermont Morgan - known as JP Morgan to his friends. He was in Richmond Virginia and eagerly returned to New York. He seemed untroubled by the chaos and was seen with "no suggestion of care nor anxiety on his part, indeed rather the contrary. He was in the best of spirits". Later upon arrival in New York, he was heard "singing lustily, some tune that no one could recognize".

As the panic got underway, Morgan formed a committee to determine which institutions could be saved after the panic and which would be sacrificed. That seems a little odd that the most powerful banker was able to decide the fate of his competitors. Initially, three banks were left off the list to save - the Hamilton Bank, the 12th Ward Bank, and Empire City Savings Bank. Morgan ended up taking over Hamilton Bank in what I am sure was no coincidence. He then swooped in and acquired seven more banks including the two largest banks that were the hardest hit. The most tragic story was that of Knickerbocker Trust. The trust company was headed by Charles Barney. Morgan promised Barney he would help him and then withdrew his support at the last minute. Barney later committed suicide. Morgan used this crisis to eliminate competition. It is possible that large banks today are taking a page out of the JP Morgan playbook and are using the crisis to consolidate their position on top of the banking food chain.

What does Bitcoin have to do with all this? The price of Bitcoin has been surging on the back of the collapse of Silicon Valley Bank. This could be due to the loss in confidence in the global banking system. While one option is to move your money from smaller banks like Silicon Valley Bank to JP Morgan, another more extreme option is to move your money into Bitcoin. Speaking of JP Morgan, who is one of the most vocal critics of Bitcoin? It is Jamie Dimon. As far back as 2014, he called Bitcoin a "terrible store of value" and wondered aloud why regulatory bodies permit the trading of cryptocurrencies at all. In 2017 Dimon made headlines when he said that if he found a JP Morgan trader buying or selling crypto, he would "fire them in a second". In that same year, he compared cryptocurrencies to the 17th-century Dutch tulip mania: "You cannot have a business where people can invent a currency out of thin air and think that people buying it are really smart. It is worse than tulip bells". During the first major crypto rally in 2018, Dimon seems to soften his rhetoric on crypto saying that he regretted saying it was a fraud. He acknowledged that blockchain is real and seemed to imply that fiat-denominated currencies backed by governments would thrive, redirecting his past criticisms of Bitcoin. JP Morgan has since enabled crypto purchases for its clients saying they are adults and although JP Morgan disagrees with them, that is what makes markets. Testifying in front of Congress in 2022, Dimon doubled down on his dislike for cryptocurrencies saying "I am a major skeptic on crypto tokens, which you call currency, like Bitcoin. They are decentralized Ponzi schemes". He called for greater regulation of cryptocurrencies.

Now we need to go back to November 2022 and the demise of FTX. I like a good conspiracy theory as much as the next person but when I first heard of the collapse of FTX, I thought it was brought on by a toxic mix of greed, leverage, and the market moving against Sam Bankman Fried and his cohorts. I never entertained the idea that they could possibly have been used in an elaborate scheme to discredit cryptocurrencies. I then started to listen to interviews with Bankman Fried and his former girlfriend Caroline Ellison who was the CEO of Alameda Research, the trading arm of FTX. In the first couple of interviews, I could not help by being completely underwhelmed by both of them and I thought they were playing stupid, then I realized that no one could be such a good actor when so much was at stake. I am now entertaining the possibility that they were a bunch of idiots in the right place at the wrong time, and maybe they were puppets in a highly orchestrated scheme to discredit crypto and open the floodgates to a wave of new regulations that would be designed to destroy crypto. Who would have the resources and motive to do such as thing? How about a group of people that had the most to lose from widespread crypto adoption- the big banks?

Many argue that the Fed is the most powerful institution on earth, and that could potentially make Jerome Powell more important than the president of the United States. Think about how the Fed affects your everyday life. Interest rates affect everyone. They are at the center of economic life. They affect the cost of money, and the availability of credit, they are used to promote economic growth, and fight inflation. They determine how much interest you receive on your deposit, your monthly mortgage payment, the performance of the stock market, and the rate of growth in the real economy. The Fed controls interest rates in the United States and the rest of the world follows its leadership. The Fed regulates banks.

The chairman of the Fed is not an elected official and therefore is not accountable to anyone in theory. He or she is appointed by the president and confirmed by the Senate. You may also remember Trump saying he could remove the Fed chair. That was not entirely true. Legally he cannot. The Fed chair gets a four-year term which was renewed by Biden in 2022. So, given the influence of the Fed, given that the banks control the Fed, and given that the banks feel threatened by cryptocurrencies, it is not entirely crazy to believe that FTX was set up as the fall guys in an effort to destroy crypto.

It however seems to be doing the opposite. As this crisis is being used by the big banks to consolidate their positions, while some money is flowing into the big banks, we are also seeing a flow of money into Bitcoin and the crypto space. This could be the event that shoots the price of Bitcoin into the stratosphere.

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