Is Bitcoin Underperforming Because a Hedge Fund Blew Up? Here's the Theory

I literally think this time around it's the massive growth in Bitcoin derivatives and a giant fund taking advantage of it. It's actually a pretty simple story. There's some complexities there, but I kind of think that's all that happened here.

And it has nothing to do with the Bitcoin having or the market just deciding it's time to go down. Today's topic is the crypto market meltdown of February 5th and whether or not it relates to 1010. Here to discuss is Parker White, COO and chief investment officer at Defi Development Corp. Welcome, Parker.

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You had a series of tweets that went viral this weekend in which you gave some explanations for why Thursday, February 5th, we saw the Bitcoin price drop from 70K to 63K and why it was also the highest volume day on the Black Rockck Bitcoin ETF IBIT. Tell us what you noticed about that day and a little bit about what your theory is.

Yeah. So, you know, looking at that move, obviously that was outsized. And whenever you see something that's off the charts, that abnormal, that's typically the place to start the investigation on what went wrong.

So, we looked at spot Bitcoin, even the pers, and the volumes weren't off the charts. It was in IBIT. And so that's where some of the guys over here at DFTV we started looking into it and kind of came up with this theory that it was actually due to the options market on IBIT which have become the fourth largest options market in the world only behind spy spx index options and the QQQ ETF options.

So the IBIT options market is massive. Bitcoin is no longer this niche asset. It's no longer this magic internet money. It is a core part of global finance, at least on the derivative side.

And so this led us to believe that there was some kind of blow up in the options market that kind of triggered things. And if you looked at the VSS, the implied V on the early expiry contracts, you saw them just absolutely blow out. And so that typically indicates stress specifically in the options market.

And so that's kind of what led to this dive down the rabbit hole and ultimately to the kind of the the theory around, hey, somebody blew up, somebody that was trading options that was shorting V. And that probably actually started that the problems probably started back on 1010 and ultimately the fund was blown up on February 5th.

So a and another piece of it was that you thought maybe they're based in Hong Kong. So talk a little bit about those pieces of the hypothesis because you have a number of observations that you've made about Asian traders about some of the other things that have been happening in markets that aren't related to crypto but but now of course because crypto is just becoming part of the broader markets that there can be connections there.

So, you know, talk about like what led you to that piece of it, you know, a non-crypto hedge fund in Hong Kong potentially being, you know, what's behind this big price drop.

Yeah. So, you know, we've been racking our brains like everybody else over the last four months. Like, what is going on? Crypto is deping from global risk assets. Everything's ripping. Metals are ripping, which is like the debasement trade. Like, this is supposed to be Bitcoin. What's going on?

And nobody seemed to know. So this led me to believe that somebody was pushing the move or creating the move that was somewhat insulated or very good at hiding their tracks potentially, but somewhat insulated from the broader crypto market. So they weren't doing a lot of flows with OTC desks where like chatter would start to happen.

Hey, this shop just like keeps selling or keeps buying this thing over and over, right? And so this led me to believe that it might be a non-crypto fund or maybe a crossover fund that is able to like you know is really good at hiding their tracks and is able to execute a lot more on the traditional side.

So maybe they picked up a lot of their exposure through IBIT which you know the flows aren't seen by your standard crypto names, your desks, your exchanges so on. And then the kind of the Hong Kong based hypothesis came from the fact that you know a couple of these large holders of IBIT single entity holders right where they have a fund and the only asset in the fund is IBIT which you the only reason you would do that is to create isolated margin right you don't want that fund or that position rather to blow up and spread to the other assets in your firm and so you would just set up a special purpose vehicle to only run this one strategy and isolated margin is a common construct that everyone in crypto knows about, right?

So, you see a couple of these funds are all based in Hong Kong. Like interesting. And then we also know that the metals trade has really been big in Asia. You know, there's been some reports coming out about some of these like bucket shops that have blown. I think there was one that blew up in Shanghai doing gold trading.

And so we know that trade is really big there. And the moves, they seem to be coinciding a little bit. It could be perfectly coincidental, but that seems to be another little breadcrumb that, you know, whoever blew up may have been a Hong Kong based fund because of, you know, what's going on in the metals trade.

So, again, I don't have like hard documented proof, but there's just a whole bunch of breadcrumbs that would all point to a Hong Kong based fund being involved here and potentially being non-crypto or at least certainly a TRFI crypto crossover.

Yeah. And another factor you mentioned was this Japan yen carry trade that's kind of been unwinding. So it's like another piece of it. So yeah, it's just a, you know, that would just be a kind of a slow burn like the funding costs are just getting more and more expensive slowly.

May have been involved, may not have been involved, but you know, it's another piece. Okay. So talk through, you know, what you So again, I know we're hypothesizing about things, although you did say after you wrote your tweet that you talked to a bunch of people and you became even more convinced of it.

We can get to that in a second, but just walk us through like what exactly this hypothetical hedge fund could have done that would have ended up in, you know, them blowing up and that steep price drop on Thursday.

Yeah. So, I think that was the culmination Thursday was the culmination of some bad choices along the way. And so if you look at this past summer, you saw realized and implied vault collapse. In fact, realized vault at one point, 30-day trailing realized vault fell to like 10% on Bitcoin, which like what?

I mean, that's like a utility stock or something. I mean, it's like, you know, a short-term bond. Like, how is that possible? And I think that was because V had been massively compressed by people shorting V. It's a common strategy, right?

Covered call covered calls are one side of shorting V, but you can also short a straddle where you sell calls and you sell puts and you double up on your V short. Um, and that's a way to harvest harvest this V, generate income off your Bitcoin stack. So you can generate 10 20% even more annualized depending on how aggressive you want to go u by shorting V which for Bitcoin that's great and if you're you got a big stack of Bitcoin you're trying to generate income Bitcoin's institutionalizing you know V's definitely going to continue to go down you could easily see how somebody would have put this trade on you know shorting calls shorting puts whether it's a straight straddle or some kind of strangle or something and then I think on 1010 it blew up.

Obviously, lots of things blew up on 1010. But you looked at realized vault or well and implied vault, but specifically implied vault, it just I mean ripped on 1010. And so I think what likely happened is a bunch of these short V shops you know had a problem, right?

They had a big loss on their balance sheet. But V typically mean reverts. And so a common strategy is just like, all right, well, we're just going to roll the position. You're going to like not book a loss now and you're just going to hope that fall subsides.

Bitcoin, you know, dropped, but it's going to kind of slowly work its way back. You're going to work your way out of the position over time. Ball's going to come down. It'll all be fine. You just got to you got to wait a little bit longer to like get back into the into the green.

But then things just snowballed and prices just kept coming down and down and doll down. involved didn't subside that much and then potentially I hypothesize that the fund may have gotten a redemption request sometime in October and so if they had a big redemption request in October then they basically have to pay out all that cash and book a loss and if it's a big LP and it's a big loss then it could be the end of the fund right these LPS are going to talk hey these they push the price you know I lost 20% % on my lowvall high income bitcoin strategy and it could create a bank run and like fund you know over and so if you look in Hong Kong financial regulations funds are required to meet redemption requests within 90 days max length is 90 days so if the fund received a redemption request sometime in October say mid to late October they would have had until mid to late January to pay out the redemption request.

And so you could easily see a scenario where these guys are like, "All right, well, V's going to come down. We're just going to wait. We're going to sit on the cash. Prices are going to come back up, and then we can meet the redemption request, book a profit or maybe a tiny loss, and like it's not going to be the end of the fund. We can save face, whatever."

And so this was a 1010 created a problem, but rather than just admitting the problem, dealing with it, tried to paper it over, hope it would go away, and it just got worse and worse. And this parallels to actually wild situation, but a scenario from back in 2018 So when I was on the buy side at an investment adviser about a $2 billion investment advisor, liquid alternative funds were becoming a a exciting thing at the time.

So we had a small liquid alternative a liquid alternative fund as part of a allocation inside of our liquid alt sleeve. And this fund was shorting V, right? It's an income fund, pretty stable. They'd been running for like 10 years, generating 8 to 10% a year. Yield with very few draw downs. Pretty stable fund.

They did the same thing. And funny enough, it was actually on February 5th, 2018, exactly eight years ago. Wild timing when I went and looked back at this like, holy Um, you had what's called AR or Volmageddon. The VIX spiked, I believe it was 117%, the largest intraday move in like 40 years on the VIX.

And this fund blew up. We're down 80% in one day. The Prime Brokers came into the office. Well, Wellelss Fargo came to the office, closed the fund down. The fund was LJM Advisors. You can go look it up. And we one day on the screen had a mutual fund. It was trading at like, you know, let's call it $100. and the next day, boom, it's down to $20, 80% loss overnight.

And so the events kind of reminded me of that situation, and that's exactly what they did. They had some problems. They kept doubling down, hoping it would get better, and it didn't, and then they eventually were blown up. And so I kind of think that's what happened here.

Wow. Okay. That That's so funny that the dates were the same. I mean what's yeah what's interesting is it's like again we're talking about hypothesis you don't have you know like actual data although I I am going to ask you about the conversations you had after your tweet but you're like pattern matching and um you know because of what we talked about how everybody in crypto has been like you know like everybody's trying to figure out who blew up and nobody's hearing about anything and so That's that's the part of it where like this hypothesis I think kind of um you know resonated with the community because everybody could tell like the the the markets have been very strange since October.

So um you know your hypothesis is something where it would account for all of those sort of irregularities or kind of you know um just unexplainable things. Um, so after you because your tweet went very viral. So after you tweeted it, you then followed up with another tweet saying, quote, "After talking to multiple folks, I'm much more convinced now that a Hong Kong-based fund who is a large holder of IBIT blew up, moving from hypothesis to strong theory at this point."

So, you know, I don't know what you can reveal about those conversations, but I'd love to hear, you know, why it is that you became even more convinced that this was um a plausible explanation.

Yeah, you know, I just did some poking around. You know, I have some buddies in different parts of the world that are pretty connected and they started asking around some people knew some people at, you know, some funds and it just heard some things. I don't want to get like too specific because I don't want to, you know, the worst thing is is a fund gets like incriminated and actually they're fine, but then it creates a bank run and that like causes a problem, right?

So, I don't want to do that. But just talking to some people who know some people at, you know, these funds or used to know people at the funds, you know, whatever. They're no longer there. It's pretty clear that at least one blew up.

And so again, I don't want to say a name, but I feel pretty confident and you know, if people start asking around, like I think more pe more uh, people could have this evidence kind of corroborated. And as I've highlighted and actually there's a polyarket up now for it. There's four fund names on there. uh one or two of those may or may not be, you know, some of the obvious ones, but these funds have to file 13F reports at the end of the quarter.

So in on May 15th, so 45 days after the end of Q1, all the funds are going to have to file their holdings or lack of holdings of IBIT, their change in holdings. And so that'll be the kind of smoking gun if we don't see something earlier when we know one or more of these highly concentrated IBIT holding funds is no longer holding IBIT. I think that'll be the uh the smoking gun that one of these guys blew up.

So May 15th is a drop deadad date to know. Some of these guys can file earlier and who knows there might be more evidence that comes out before that too. Okay. Okay. So yeah, I I think people will probably be like counting the days till then.

So you then followed up with another post about how you thought that this past summer it wasn't that OG Bitcoiners were selling, but you thought that they were taking their spot Bitcoin and putting it into IBIT where they could e more easily access the IBET options market, which you said is the fourth most liquid options market in the planet. So talk a little bit more about that hypothesis and you know however it relates to to what you've been discussing.

Yeah. So I didn't realize this. I mean this was a a rapid descent down the rabbit hole for me but I just I didn't realize the sheer magnitude of the IBID options market how quickly it had grown. So, IBIT options are only eclipsed by SPY, S&P index options, and the Q's, QQQ, ETF, index or ETF options.

So, really, it's S&P options and NASDAQ options are more liquid than IBIT. That's it. So, like gold options, all the other index options, like the treasury market, you treasury bond options. I mean none of these come close to the liquidity in IBIT options which is staggering to me.

So, I think the obvious we we know a lot of these well I personally know some of these OG Bitcoiners who one in particular runs a family office and the whole reason for existence behind the family office is to generate income off of a substantial stack of Bitcoin and then deploy that income into other cash flow generating businesses to kind of slowly diversify without selling that stack of Bitcoin.

And so it's no surprise that harnessing or rather harvesting volatility off of Bitcoin is a very common income generation strategy. It's done for single stocks. It's been done for single stocks since options are around. It's one of the key reasons options exist.

So if you have a giant Apple holding or a giant Google holding or what have you, you can harvest premiums and harvest income off that volatility without selling the asset itself. And so because of this massive growth in liquidity, it would make sense that a Bitcoiner would rather than trying to trade in the less liquid spot Bitcoin options market, they would move to the IBIT options market.

But the challenge there is for a while it was only cash creation and redemption. So, you would have to go sell a bunch of Bitcoin, take the cash, wire it over, or just buy in the open market. There's slippage there. There's probably tax issues there. There's this mental hurdle of like actually selling Bitcoin.

There's the potential bad looks of like, oh, these Bitcoin are moving on chain. It's being sold. Like, what the hell? Which I guess we got anyways. I know some of these like one of the Bitcoiners that was being flagged as like a massive OG holder selling billions. I'm like, I know this guy. He's not all of a sudden like losing faith in Bitcoin. What is he doing?

But he's a trader. You know, he was a real early like pre7 2017 Kraken like OG market maker. Like he's very act very active trader. like he's also probably running this um you know options trade and he sees IBIT much more liquid options you can do a lot more size less slippage all these great reasons to trade in IBIT instead of spot Bitcoin so it would make logical sense that once inind creation and redemption was allowed these guys would pursue that path to just move their Bitcoin into the ETF rapper rather than having to sell and then reby by and the timing kind of lined up, you know, the in kind creation and redemption being turned on this summer.

So coincidence maybe or maybe a cause, I don't know. Okay. And that led you to conclude that instead of it being one of these non-crypto hedge funds in Hong Kong that it could actually be like an OG Bitcoiner that had blown up. like that was like another kind of, you know, potential second hypothesis. Did I get that right?

Yeah, I think they kind of converging the two. I think probably what happened was um it was a some kind of either family office or maybe a little more tradoriented fund or at least having some trad capabilities that maybe took a either an LP contribution from a some OG Bitcoiners or maybe it was actually the OG Bitcoiners themselves very private and this fund.

So they the fund certainly was some kind of crossover fund. They definitely had crypto roots. This is not like a pure trades. So they had a standard prime brokerage account. You know, it's a Goldman Sachs prime brokerage account or it's a Nura prime brokerage account. I'm making up names. I don't know.

But it's a standard prime brokerage account and they have standard margin agreements with a very standard TRDFI ETF rapper and they're trading very Tradfi standard options. But the people on the other side and where the capital came from maybe came from some OG Bitcoiners and maybe these were, you know, crypto traders or crossover traders that had experience on both sides.

And because they were trading primarily in IBIT and IBIT options, the flows, they didn't hit, you know, a winter mute or one of these crypto desks. And so word didn't really get out. it was kind of insulated to the prime broker and the um you know exchange options market.

Okay. I did see Devy Juan responded to that tweet with some skepticism. She was saying that um I I guess you know her organization is due diligencing some of the biggest Bitcoin option strategy funds in Hong Kong right now. And she said because it's kind of a small community that people like would have heard something.

And she also said that she thought some of the OG Bitcoin whales in Asia had already swapped into IBIT long before she said um before uh in kind redemptions were turned on that this was actually something you could do via Galaxy. Uh what was your uh what's your response to her skepticism?

Sure. So on the due diligence side, you know, I think the fund finally blew up in obviously February 5th and I think even the week leading up to it, I think the fund was like probably somewhat okay. I did some, you know, modeling on it, like a a hypothetical position, and I showed that like in late January, the position actually started would have started to look a lot better.

Market started to move up and V came way back down most importantly. And so I was like, "Hey, look, like things are mostly back to normal." And so I think it's been only in the last week or so that, you know, it's been the death nail for this fund. Um, it may not have been the death nail for the whole firm, right?

I mean, the whole point of isolating the uh position into a single vehicle is that if that vehicle blows up, the firm itself is safe. So if somebody was due diligent a firm, they might not see, you know, the firm blow up, right? It might just be like, hey, this strategy, this fund blew up.

But I think also the important thing to note is it is a matter of life and death for this firm to keep things under wraps. And I say life, you know, it's life and death for the firm, not, you know, actual life and death for the people. But it's a matter of life and death to keep this under wraps because if it gets out that they had a giant blow up, a giant hole in their balance sheet, there's no more LP money.

All the LP money is going to flow out. Like it's just completely over and your reputation. And you know, she highlighted, hey, the Hong Kong hedge fund space is really a tightlyknit community. And so if you went and lost LPS a whole bunch of money on dumb trade, then you're a pariah. and you lose all that access for like the rest of your career.

And so it is absolutely imperative for a fund that's going to try to make it back, you know, whether in one trade or just letting things play out to keep this under wraps because as soon as it gets out, it's all over. And so it wouldn't surprise me that it wouldn't have been uncovered in any kind of due diligence because that's the kind of thing you definitely don't want to have come out in due diligence.

Um, but I think this week they finally died and the regulatory requirements, filing requirements will be such that it's going to have to come out. If Dovey comes back and it's May and is like, "We still haven't heard anything," then yeah, maybe she's right. But, um, I don't think you would have heard anything just yet.

Okay. So, in a moment, we're going to talk about another post that you made earlier today, which kind of fleshes out a bit more about what happened between 1010 and now. But first, we're going to take a quick word from the sponsors who make the show possible. Bits and Bits now has its dedicated feeds. We're spinning off from the Unchained feed and moving to a new podcast and YouTube channel.

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Go to cryptotaxgirl.com/chained to save $100. Once again, the link is cryptotaxgirl.com/unchained. Back to my conversation with Parker. So, Parker, earlier today you posted another tweet that kind of fleshes out more of your theory of what happened between 1010 and February 5th. And as you wrote, that was a time when Bitcoin underperformed the S&P 500 by 49% in 118 days. Unusual situation.

So, yeah. So explain um you know what what your theory is on that. Yeah. So, you know, I started digging into obviously what happened on the 5th and the options market and then hearkening back to the prior story about LJM and just thinking about like, okay, well, this maybe explains what happened this week, but like the typically something doesn't this catastrophic just happen because of market a confluence of market factors, especially this kind of DPEG, right?

I could understand if all risk assets had dumped, then it would make sense that, you know, Bitcoin was also down and then that just led to a blowup, but like that's not what happened. You have this decoupling and it just continued to widen and further widen. And so really starting to dig in, spent my whole weekend looking at this and kind of drawing from, you know, my CFA background, TRA 5 background.

And it became obvious that a powder keg was being set up in July with V way down. That meant options were really cheap. And if you were a large firm, and I listed out some criteria in my post on what this could look like or what this firm the criteria for this firm might have to be, but if you're a large firm who's been trading both crypto and trady markets for quite a while and you see this pattern where V drops to historically low levels, that means that taking the other side is historically cheap.

And if you look at the um you know if you're really good at playing the options market you understand how the Greeks um you know kind of work together not just delta but like the derivatives. So gamma is very important but speed and vanna are also very important here. Um, and so you know how these things move and you also know as a big firm how to push crypto prices around, right?

So you know about the CME gaps, you know about the weekend drops in liquidity. Um, you could totally see a setup for a short-term trade here where you buy V really cheap. So while these these funds are out there selling this vault, generating this income, you know, they move their Bitcoin into IBIT, they're selling the calls, this is and puts, this is all great, somebody on the other side is like, well, they're selling it way too cheap. This is mispricing. Go long.

Go long, V. So then October 10th happens and I think this firm made a bunch of money on that day. But then I think and maybe this was the plan all along or it materialized um you know over time kind of in real time but I think it became obvious that Bitcoin was going to trade off a little bit further and so I think this firm just decided to roll the profits and double down and just keep pushing and keep pushing and keep pushing.

Um, and that's what you saw with the huge pullback all the way into the end of the year, uh, where Bitcoin came down to, you know, almost to 80. Okay. And explain explain about that. Like what what you mean when you say they just kept pushing like you're saying that they actually started making money and then they just kept trying to to get more like profits out of that trade. Is that what you're saying?

Yeah. So if you look at and I threw an example and you can model this. It's pretty easy but you can get you know 100x or more leverage in the options market. And it's real easy. It's like I'll just take the example to the downside where you buy out of the money shortterm puts.

So these are going to be high what's called speed put options. So you've got delta, then you've got gamma, which is the change in delta, and you've got speed, which is the change in gamma for a move in the price. You've also got vanna, which is a change in gamma for the ch a change in vault. So gam uh sorry, vanna and speed, but speed's the most important one here.

And so you can buy options for let's say a penny. And if the price moves enough in a short enough window of time, that single option can control an entire share of IBIT or an entire Bitcoin, you know, depending on which market you're trading in. So, you can buy this these now. And the reason you can buy them cheap is because 99.9% of the time, a put that is 20% out of the money that will expire in a week or two is never going to go into the money.

And so it's just like it's throwaway. Like why would anybody buy this? It's never going to happen. But if it does happen, the leverage there is off the charts. And so what we saw post 1010 was spot markets uh liquidity come down, spreads widen. So this creates an environment where it's easier to push the price especially on the weekends.

And so by you can load up load up on these super cheap way out of the money short expiry puts that are high super high speed and then start pushing the price particularly over the weekends or overnight. You saw a lot of this Bitcoin was moving um spot the spot market was moving over the weekends and at night kind of coming down and then what happens is at the open the dealers the IBIT dealers they don't take risk they don't take directional risk and so now because the spot price of Bitcoin has moved over the weekend or at night they're the dealer is now um long delta because they've sold the puts moved against them they're now long delta they need to hedge So, right at the open, boom, they sell.

They're going to short IBIT immediately to bring that delta back to zero. Like, dealers don't take delta. And so, you saw this and this is just so weird. We I just remember watching all through November. It was like, oh, another day at the open, the price just nukes. What's going on?

Like, why is this nuking right at the open? And it's because the dealers were, you know, I think about it now, the dealers were programmatically hedging their delta that they picked up over the weekend or overnight. And so what was happening is whoever was moving the price over the weekend, they might have to I'm just making this up. They might have to short $10 million worth, but then during the day because of the leverage on the options, the dealers would go dump $50 million worth and move the price even further.

And so now the guy who shorted the 10 million over the weekend in the illlquid market or less liquid market made profit there. And so they can just take that profit and roll it into the next trade and just keep pushing it. Roll into the next trade. These options get into the money. They expire in, you know, in profit. Take that, move it to the next week, then weekend and overnight liquidity push and you just keep going down, down, down, and there was just no bid.

And so I think that's what happened. And this firm just kept pushing it. And then I think they wrapped up the trade in December because they would have a 13F filing requirement on December 31st. So any position they held open by December 31st, they would have to report.

And if you're a hedge fund, you don't want to do that. You don't