I recently completed an assignment for an International Economics Policy class which entailed designing a carry trade. A carry trade is a financial transaction that involves borrowing (short) in a low interest currency, and lending (go long) in a high interest (yield) currency. For instance from Bloomberg's rates for bonds, this would involve borrowing in Swiss francs (rate is -0.15 percent) and lend in New Zealand dollars (rate is 2.83 percent). All else remaining equal, the carry trade would yield a rate differential of 2.83+0.15 = 2.98 percent. Note: this is an unusual case where the interest rate we are borrowing from is negative; usually, this would involve subtracting the first interest rate from the second. For instance, borrowing in Japanese yen (0.04 percent) and lending in Kiwi dollars (at 2.83 percent) would yield 2.79 percent as profit.
My carry trade in this case involves borrowing in USD at a rate of 2.33 percent, and buying bitcoins. But, what, you may ask, is the interest rate for bitcoins? Well, bitcoin does not have an interest rate, because it is not a central-bank-issued fiat currency. But we can still make money. How? Well, a carry trade can also make money by leveraging exchange rate differences between the two currencies. The rule: we always want the currency we go long on to appreciate relative to the currency we short. Why? Well, because it means that we require less of the loaned currency to pay back our borrowed funds. For instance, if we borrow USD 100 and lend in NZD when the rate is 1USD=1.5 NZD, and the NZD appreciates against the USD such that 1USD=1.4NZD, then we require fewer NZD to pay back USD; i.e. we borrowed the equivalent of 150 NZD (1.5*100) but only have to return 140 NZD + interest (1.4*100). This leaves us with a higher profit!
Therefore, our carry trade of USD to bitcoin (BTC) would involve borrowing in USD and buying BTC in the bitcoin market. The expectation is that BTC would appreciate against the USD, and yield us a profit. And indeed it has. In 2017 alone, BTC has appreciated from 1BTC = 997.69USD in January to 1BTC=7,380.7USD on Nov. 4 (as at the time of writing), a rise of almost 650 percent! If you had borrowed USD 1,000 to buy a bitcoin in January, you would have paid back and made a cool USD 6,000 and change! No other asset class comes even close! Did I just call BTC an asset? Yes, it's an asset in the sense that it stores value. Of course all this is in hindsight, which is 20-20.
You may be concerned though, is this meteoric rise sustainable? Is BTC too expensive right now to go into? Are there other options? What about liquidity? Who controls it?
(Almost) All these are sensible questions. If you want to make money on any market, you want to buy low, and leave when price is high. But what do these mean when a currency rises 600 percent in ten months? Is this a bubble that's going to burst soon? Well, who knows?! Answers to some of the above questions. On liquidity: for instance, in today's (Nov. 4) trading so far about 2 percent of the 16,000,000 plus bitcoins in circulation were traded. Is that high or low enough for an investor? It depends.
Is BTC too expensive right now? Again, it depends on where the currency is going. First, the currency has a limited supply. According to the snapshot below, the maximum supply of bitcoin is 21 million. This means that as we get closer to that theoretical number, it becomes more difficult to increase supply of the coins by mining power. A decreasing growth in supply of bitcoin leads to an increase in price, if the demand growth is higher. Which means that the price is going to keep rising until an inflection point. Second, there are other alternatives to bitcoin like Ethereum. But Ethereum and the other 1200 plus coins are not as popular as bitcoin which commands about 60 percent of market capitalization, and liquidity. In matters currency and money, "everyone wants what everyone else wants, and has". However, these new coins are introducing new applications of the underlying technology such as smart contracts, which could make them even more attractive.
What does this mean for our proposed carry trade? Should we do it or not? Like many things in life, the answer is "it depends". First, there is volatility risk. Bitcoin has suffered crash scares, losing between 10 and 20 percent of its value in a matter of minutes in a trading day. This is generally true for Ethereum and other coins as well. Some of the crashes remain unexplained, and this is something to keep in mind. Second, there's the matter about supply. It is limited, at least for bitcoin. Which means that the prices will go up and up, until they cannot go up any longer. To what level, it's a wait-and-see game. Third, other coin offerings may impact upward pressure on bitcoin to appreciate. This may stabilize it as demand goes to other coin options. Fourth, government policy is mixed. Some governments have recognized bitcoin and the value of blockchain technnology, and are putting in place guidelines. Other governments have cracked down on cryptocurrency miners and traders. Everyone is gingerly about cryptocurrencies, mainly because governments have not figured a way to regulate and control it. But that is the whole point of these currencies anyway, to remove power from central banks and to the masses.
These and many other issues make answering the question "To trade or not to trade?" difficult to answer. However, if you have some spare USD lying around, you might try it. It will be clear, soon enough whether your decision was right or wrong. Risk aversion notwithstanding, we are living in great times. Do not feel bad if you feel like you missed the train. Yours is not as bad as one developer who bought two pizzas for 10,000 BTC in 2010, which would be worth USD70 million today. We are likely to see such and many more blunders in coming days. In the end, someone makes money and someone loses money.
My carry trade in this case involves borrowing in USD at a rate of 2.33 percent, and buying bitcoins. But, what, you may ask, is the interest rate for bitcoins? Well, bitcoin does not have an interest rate, because it is not a central-bank-issued fiat currency. But we can still make money. How? Well, a carry trade can also make money by leveraging exchange rate differences between the two currencies. The rule: we always want the currency we go long on to appreciate relative to the currency we short. Why? Well, because it means that we require less of the loaned currency to pay back our borrowed funds. For instance, if we borrow USD 100 and lend in NZD when the rate is 1USD=1.5 NZD, and the NZD appreciates against the USD such that 1USD=1.4NZD, then we require fewer NZD to pay back USD; i.e. we borrowed the equivalent of 150 NZD (1.5*100) but only have to return 140 NZD + interest (1.4*100). This leaves us with a higher profit!
Therefore, our carry trade of USD to bitcoin (BTC) would involve borrowing in USD and buying BTC in the bitcoin market. The expectation is that BTC would appreciate against the USD, and yield us a profit. And indeed it has. In 2017 alone, BTC has appreciated from 1BTC = 997.69USD in January to 1BTC=7,380.7USD on Nov. 4 (as at the time of writing), a rise of almost 650 percent! If you had borrowed USD 1,000 to buy a bitcoin in January, you would have paid back and made a cool USD 6,000 and change! No other asset class comes even close! Did I just call BTC an asset? Yes, it's an asset in the sense that it stores value. Of course all this is in hindsight, which is 20-20.
You may be concerned though, is this meteoric rise sustainable? Is BTC too expensive right now to go into? Are there other options? What about liquidity? Who controls it?
(Almost) All these are sensible questions. If you want to make money on any market, you want to buy low, and leave when price is high. But what do these mean when a currency rises 600 percent in ten months? Is this a bubble that's going to burst soon? Well, who knows?! Answers to some of the above questions. On liquidity: for instance, in today's (Nov. 4) trading so far about 2 percent of the 16,000,000 plus bitcoins in circulation were traded. Is that high or low enough for an investor? It depends.
Is BTC too expensive right now? Again, it depends on where the currency is going. First, the currency has a limited supply. According to the snapshot below, the maximum supply of bitcoin is 21 million. This means that as we get closer to that theoretical number, it becomes more difficult to increase supply of the coins by mining power. A decreasing growth in supply of bitcoin leads to an increase in price, if the demand growth is higher. Which means that the price is going to keep rising until an inflection point. Second, there are other alternatives to bitcoin like Ethereum. But Ethereum and the other 1200 plus coins are not as popular as bitcoin which commands about 60 percent of market capitalization, and liquidity. In matters currency and money, "everyone wants what everyone else wants, and has". However, these new coins are introducing new applications of the underlying technology such as smart contracts, which could make them even more attractive.
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| Snapshot of bitcoin. Source https://coinmarketcap.com/currencies/bitcoin/ |
What does this mean for our proposed carry trade? Should we do it or not? Like many things in life, the answer is "it depends". First, there is volatility risk. Bitcoin has suffered crash scares, losing between 10 and 20 percent of its value in a matter of minutes in a trading day. This is generally true for Ethereum and other coins as well. Some of the crashes remain unexplained, and this is something to keep in mind. Second, there's the matter about supply. It is limited, at least for bitcoin. Which means that the prices will go up and up, until they cannot go up any longer. To what level, it's a wait-and-see game. Third, other coin offerings may impact upward pressure on bitcoin to appreciate. This may stabilize it as demand goes to other coin options. Fourth, government policy is mixed. Some governments have recognized bitcoin and the value of blockchain technnology, and are putting in place guidelines. Other governments have cracked down on cryptocurrency miners and traders. Everyone is gingerly about cryptocurrencies, mainly because governments have not figured a way to regulate and control it. But that is the whole point of these currencies anyway, to remove power from central banks and to the masses.
These and many other issues make answering the question "To trade or not to trade?" difficult to answer. However, if you have some spare USD lying around, you might try it. It will be clear, soon enough whether your decision was right or wrong. Risk aversion notwithstanding, we are living in great times. Do not feel bad if you feel like you missed the train. Yours is not as bad as one developer who bought two pizzas for 10,000 BTC in 2010, which would be worth USD70 million today. We are likely to see such and many more blunders in coming days. In the end, someone makes money and someone loses money.
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