SEC Goes After Crypto, Why the Low Vol?

SEC bears down on crypto

The sheriff is in town. The US Securities and Exchange Commission (SEC) has rounded on the cryptocurrency market with lawsuits against Binance and Coinbase, two of the largest and most prominent digital exchanges. Following the news of Binance yesterday, the SEC said it was also suing Coinbase for operating “as an unregistered broker … an unregistered exchange … and an unregistered clearing agency”.

“Coinbase has for years defied the regulatory structures and evaded the disclosure requirements that Congress, and the SEC have constructed for the protection of the national securities markets and investors,” the SEC said in its complaint. Back in March, the SEC issued a Wells notice to Coinbase, warning it had identified potential violations of US securities law, so we kind of knew this was coming. In March the US Commodity Futures Trading Commission sued Binance for “wilful evasion of US law”. In fact, the SEC itself has launched over 30 enforcement actions since last year – it is taking a very assertive approach. Some argue that it has failed to provide a path for digital asset exchanges to register – but it’s absurd to think it is the duty of the SEC to change the rules to suit the crypto crowd.

Unsurprisingly, many in the crypto community are not impressed. Binance founder and chief executive Changpeng Zhao, known as CZ, pointed out that the SEC didn’t sue FTX. The point is that it probably wasn’t a massive priority until FTX blew up and exposed the business model underpinning many if not all these exchanges – comingling of client money and business functions in a way that would not be permitted anywhere else in finance. Among other things, Binance is accused of mixing “billions of dollars” in customer funds and sending them to a separate company controlled by CZ. According to SEC chief Gary Gensler, the whole industry is “built on non-compliance" with US securities laws.

All lots of legal stuff – crypto exchanges are clearly all kinda of dodgy in some way or another. Tokens are meaningless and have no value IMHO, and they are clearly unregistered securities. Suing the main exchanges does not spell the end of crypto. What Gensler said about the industry as a whole is more interesting. Speaking to CNBC he said we don’t need any more digital currency. “We already have digital currency. It’s called the U.S. dollar. It’s called the euro or it’s called the yen; they’re all digital right now. We already have digital investments.” This tells you a lot about how the current SEC views the industry: pointless.

Bitcoin first dropped around 5% or so on the Binance news but then rallied to recover the losses. Ultimately, you get the sense that the wild west is being tamed by the SEC with all its railroads and barbed wire. This, you would expect, will leave an industry facing higher costs, fewer and more respectable actors and only a handful of coins viable. For now the industry looks shaken – if Binance were to suffer a major exit of client funds (already a lot has been taken out), then it will reverberate around the sector.

China fear and disappointment

Stocks were treading water a bit again early on Wednesday after China’s May trade data was not as good as hoped – exports fell for the first time in three months, down 7.5% on the year. Imports also declined by 4.5%. This comes after data showed manufacturing activity in the country contracted in May. In Europe, German industrial production didn’t recover as much as hoped and UK house prices registered their first annual fall in a decade. Key data coming up later is the US trade deficit and consumer credit data for April.

Market reactions dull

The FTSE 100 slid about 0.2% to test the 7,600 area, whilst the DAX also fell by a similar margin, held under by the 16,000 resistances. US indices ended the day a bit higher, led by financials. Coinbase fell 12%, but MicroStrategy rallied on an AI tie-up with Microsoft. Yields are steady with the 10yr Treasury at 3.68%, gold a bit lower as the dollar gains ground. Crude oil keeps lower on the soft China trade numbers. In FX, the Turkish lira fell to a new all-time low as markets speculate that the country’s finance minister will loosen controls that helped to stem the currency’s depreciation.

Bank of Canada rate decision later – RBA maybe is the green light to hike again? It was always a coin toss after the April inflation data – my hunch is the BoC hikes. Lots of ECB speakers – remember Fed blackout period now ahead of the Jun 15th rate decision. RBA’s Lowe said “Some further tightening of monetary policy may be required”.

What's going on with all this low volatility?

It feels like the dog days of summer have already arrived. After last Friday’s monster jobs report the Vix fell to its lowest level since February 2020 – the calm before the Covid storm – as the S&P 500 finally made a concerted break above 4,200 to hit its highest in nine months. Bank of America's MOVE index, a measure of Treasury market volatility, is at its lowest since March and FX volatility has also notably declined recently, hovering around a roughly 1yr low.

Is the market complacent about what’s coming around the bend? Maybe investors are content that the Fed is near the top and will either skip or pause in June – maybe one more hike this month, maybe delay it until July. Whether the Fed goes for a couple more hikes or not there is a definite sense that it is near the end of its hiking cycle – whether this is true or not remains to be seen. Certainly, the debt ceiling deal removes one worry – the tail risk of a default. And the banking crisis in the US appears to have calmed down – for now.

But volatility has been squeezed lower since March; and the main reason is probably technical. We have a seen a volatility crush that has mechanically driven stocks higher – funds buying when vol is low. This gamma trap is neatly described as a market dominated by options sellers, which encourages mean reversion, spurring mechanical buying by low vol strategy funds. Dealers are long gamma, and the path of least resistance is to drift up on the lower vol squeeze.

As per a JPM note of late April: “We believe the reasons for low volatility are technical in nature with the market dominated by option sellers. Selling of options forces intraday reversion, leaving the market price virtually unchanged many days. This in turn drives buying of stocks by funds that mechanically increase exposure when volatility declines.”

Long gamma means that option market-makers buy S&P500 on dips and sell on rallies – low vol. Short gamma means they sell when it falls and buy when it spikes. So, the market is more volatile when gamma goes negative. Right now it’s long and is allowing SPX to drift up. But why so low and can it last?

Against the decline in implied volatility measured by the Vix etc we have seen the SKEW index shoot higher – which may be down to dealers protecting short volatility positions with longer out of the money options. This happened in 2021 when the Fed was doing QE and this latest appears to be correlated to the Fed’s banking crisis pump since March. SKEW measures tail risk – a change in the S&P 500 that would move it to either of the tail ends of a normal distribution curve.

Part of the reason for the long gamma vol crush is that there has been a lot of liquidity provided by the Fed over the last 2-3 months. And the market may be about to see a sudden spike in volatility as the Treasury issues a huge volume of T-bills which pulls liquidity out of the system. In the wake of the debt ceiling deal something like half a trillion dollars' worth of these bonds may be needed in June alone, with a little more over the course of the year – about $1.3tn in total for the rest of 2023 according to DB. Issuance may lead to a major drain on liquidity, which has been buoyed up by the Fed’s bank lending since the banking crisis blew up in March. The impact of the liquidity drain will depend on how much money market funds can absorb as they shift out of the Fed’s overnight reverse repo facility (RRP).

Elsewhere...

Meanwhile the S&P 500 looks over-extended on its current run. Bespoke says that after Friday’s rally, the S&P 500 closed 2.47 standard deviations above its 50-DMA, which was the most ‘extreme’ overbought reading for the index since July 2021. Nasdaq positioning is also at its ‘most extended ever’, according to Citi. "Positioning is the most extreme in Nasdaq futures where investors also are sitting on very extended profits. This could lead to rounds of profit-taking in the near term," says Citi.

Driving the market has been a mix of the anticipated Fed pivot on disinflationary trends, liquidity injections, megacaps picking up bid and delivering fresh leadership on a flight to safety and, of course, AI bubble tailwinds...loss of liquidity and exhaustion of the megacap bull run looks like conspiring with a failure to find fresh leadership from cyclicals and lower ‘quality’ shares amid persistent recessionary indicators from most of the surveys we are getting from the US. The lack of breadth in the rally has been stunning – it's like an upside pyramid.

GS’s Brian Garrett has some interesting reading on gamma positioning for SPX. He’s highlighted a rare occurrence in in the S&P options market, noting that if the market keeps drifting higher "things get very interesting for dealer community." If the S&P goes up another 4% to 4,390, dealer gamma flips from positive to negative – the sort of flip that almost never happens in a rally...presumably that sort of flip could see dealers chasing the market higher...? Risks are building on either side – we saw the Vix tick up a touch in the last couple of days so maybe the bottom is on for volatility.

Net-net, I sense that stocks overbought + liquidity drain = higher yields and equity volatility spike incoming + this rally can’t last. Plus, this is still a bear market rally, albeit a heck of a long one. Pain trade remains equities up, vol down and continued crush but this will not last forever.