Counting Your Crypto Amidst Currency Wars
A new currency war is on the verge of being waged, providing ample opportunities for cryptocurrency arbitrageurs and risk-on traders.
Juan Emanuel Ortega looked up from his goblet of wine. The 15th century trader and huckster from Spain’s capital Madrid was well outside his realm and hunting down his fortune in the warring city states of Italy.
Seated in one of his favorite taverns or “taverna” Ortega kept one hand on his goblet and the other ready to reach at a moment’s notice for his cinqueda, a long dagger developed in the Lombardy region in what is today northern Italy — and very effective in close quarter combat.
His head on a swivel, Ortega was constantly on the lookout for danger, even in the “taverna.”
Because 15th century Italy consisted of several constantly warring city-states, each city-state had a demand for gold to raise armies — typically made up of mercenaries. Italians of the Renaissance were far too “sophisticated” to indulge in the pedestrian act of waging war.
But war cost gold and because information in the 15th century neither traveled freely or far, there was often an arbitrage trade to be made simply by buying gold from one region and selling it at a handsome profit in another region.
The main risk from this arbitrage trade in gold was that transporting the gold itself was dangerous and the waging of war fickle. Demand for gold could dry up faster than Ortega’s goblet of wine.
To add to the mix, across the Italian countryside, brigands and bandits were lying in wait to pounce on the gold caravans led by Ortega and his men.
Yet for lifelong hucksters like Ortega, who were just as skilled in swordplay as wordplay, a dagger at the handy and a swift word where needed — the rewards of arbitraging gold, far outweighed the risk.
And for cryptocurrency traders, that window of opportunity for arbitrage may be opening yet again.
Because while the world has had more than a decade to prepare for the next serious financial crisis, we have not used that time well at all.
Like the college student who’s got perpetual manyada (tomorrow) syndrome and waits till the last day to finish their term paper, the world’s financiers, central bankers and regulators have kicked the bucket for financial reforms down the road, juiced with liquidity like a college freshman is juiced with energy drinks.
And like the college hookup who’s told you that she’s missed her period, the world has gotten a heavy dose of the coronavirus shock at a time when the world’s largest economies are divided by trade disputes.
The coronavirus would have been hard to deal with even with a unified and global policy effort — but since policy makers can’t even meet anymore because of social distancing, much will be lost through video calls and telephone conversations.
And a globally uncoordinated policy response that prolongs economic weakness and triggers a new round of currency wars, is a real danger.
Let’s Get Together
In an ideal world, the stuff of policy simulations and think tank conferences, central banks would be confronting the coronavirus crisis with a healthy level of inflation and interest rates above 5%.
At least if the coronavirus outbreak were to hit domestic demand (it already has, at least in the short term), central bankers could cut rates as needed, with plenty of breathing room.
Unfortunately, we’re not in the oak-paneled conference rooms of central banks running simulations.
The world confronts what could potentially be a crippling recession, if not depression, on the back of an increasingly intractable pandemic.
In large swathes of the rich world, interest rates are already below zero, something which had hitherto been deemed impossible and other easing tools such as asset purchases are close to the limit.
And while the United States has more leeway than it’s Atlantic cousins, it’s not by much.
The U.S. entered this crisis with policy rates between the range of 1.5% and 1.75% and has already cut rates by 50 basic points, whereas emerging markets such as Russia and Mexico have rates at 6% and 7% respectively, providing more headroom.
But it is precisely this asymmetry in rates that is a recipe for what Brazilian finance minister Guido Mantega once called “currency wars” — not outright currency manipulation in pursuit of competitive advantage, but rather divergences in monetary policy that leads to sharp foreign exchange movements, with threats of retaliation by those who lose out.
To illustrate, if the the U.S. Federal Reserve cuts rates when the European Central Bank and the Bank of Japan cannot follow, the dollar is likely to weaken against the euro and the yen, making American exports cheaper as compared to the other two.
And it’s not just theoretical.
About a week and a half ago, the Fed’s emergency rate cuts sent the yen plummeting to ¥101 against the dollar at one point, a level which hurts Japanese exports and has in the past prompted threats of currency intervention.
Because the euro and the yen don’t have much room to cut rates, further cuts by the Fed could easily strengthen the yen and the euro, in a beggar-thy-neighbor policy that would dramatically affect the economies of those two regions.
But it’s not as if currency wars are a one-sided battle.
The Fed also has limits to how far it can cut rates because while the dollar may be falling against the yen and the euro, it’s been rising against the Mexican peso, the Indian rupee and other emerging market currencies, especially those most affected by Saudi Arabia’s decision to pump more oil out of the ground, crashing oil prices.
And despite the Fed cutting rates, the coronavirus pandemic has seen a flight to safety in the U.S. and the dollar, instead of higher yielding emerging markets as happened in 2010, when Mantega gave his warning of “currency wars.”
Yet that could all change very quickly — especially if the U.S. is unable to contain the spread of the coronavirus within its shores and if investors become jittery at the feckless response of the Trump administration, which has done little to engender itself to calming markets.
To add to currency volatility, 2020 is an election year, which means that it is entirely possible for U.S. President Donald Trump to tolerate currency depreciation across a large spectrum of America’s trading partners.
Whether or not Trump believes that U.S. trading partners are gaining an advantage this year because of currency devaluation — he may still decide to resort to currency intervention or punitive tariffs to solidify or pander to his base — simply because it makes for good headlines (in his determination).
Already, U.S. Federal Reserve chairman Jerome Powell has done his utmost to prevent central banks from taking their currencies downwards in a race to the bottom.
Before the rate cut, Powell liaised with his G7 (a grouping of the world’s seven most industrialized economies) counterparts.
To understand the circumstances, it’s helpful to frame a currency war in the context of mathematician John Nash’s Game Theory.
In Game Theory, each player’s payoff or outcome is contingent on the strategy implemented by the other player.
Say for instance we have two suspects who have been accused of committing a robbery. If they both implicate each other of the robbery, they will each serve 2 years in prison.
If one implicates the other of the robbery and the other remains silent, the accuser will be set free, while his partner will be sentenced to 3 years in prison and vice versa.
And if both don’t admit to the crime, they will each serve 1 year in prison on reduced charges.
So what would a presumably rational criminal do?
It is implied that the suspects will have no opportunity to reward or punish their partner other than the prison sentences they get and that their decision will not affect their reputation in the future.
Because betraying a partner-in-crime offers a greater reward than cooperating with them, all purely rational self-interested prisoners will betray the other, meaning the only possible outcome for two purely rational prisoners is for them to betray each other.
Reality differs somewhat.
In reality, humans display a systemic bias towards cooperative behavior in this and similar games, despite what is predicted by simple models of “rational” self-interested action, a bias that was first tested by the RAND Corporation several decades ago.
And for the most part, that is why currencies have remained relatively stable — central banks know the destructive nature of a race to the bottom in devaluing currencies and the U.S. central bank has withstood countless conflicts and crises to stand out as a bastion of independence and stability.
But a New York minute can change all previous assumptions about a systemic bias towards co-operation the way a New York-born U.S. president can upend all previous assumptions about America.
Whereas the U.S. could previously have been assumed to be a partner in ushering the world towards cooperative behavior, the erosion of multilateralism, through a rules-based global system has since tended towards isolationism, nationalism and self-interest.
The reliability of multilateral institutions such as the United Nations, NATO and the WTO have all been undermined by the current U.S. administration — it would be naïve for any central banker outside of the U.S. to believe that a currency war is beyond the Trump administration either.
What does that leave us with?
If nothing else, the coronavirus pandemic has brought out both the best and the worst in humans.
The world has witnessed numerous examples of both generosity and societal concern as well as selfishness, hoarding and self-interested behavior.
Because a currency war is entirely possible, that leaves us with Game Theory — meaning that if push comes to shove, central banks can and will engage in a race to the bottom.
The potential for currency wars creates two distinct opportunities when it comes to another type of currency — cryptocurrency — specifically Bitcoin.
During periods of foreign exchange volatility, particularly in emerging market currencies, an arbitrage trade occurs for Bitcoin.
For instance, in 2017, there was what was colloquially known as the “Kimchi premium” — where the achievable price of Bitcoin on South Korean exchanges was as much as 20% more than on cryptocurrency exchanges elsewhere — due in large part to Chinese demand for Bitcoin that could not be satiated from local sources.
That disconnect created substantial arbitrage opportunities for Bitcoin resellers, picking up Bitcoin cheap elsewhere to offload it on South Korean exchanges.
That opportunity looks to be arising again in a variety of locations.
Already, thanks to foreign exchange volatility, there has been a “Tom Yum” premium for Bitcoin on Thailand’s numerous regulated cryptocurrency exchanges and that’s not the only place such a premium can be found.
On lesser known cryptocurrency exchanges (regulated and otherwise) in both Vietnam and Indonesia, to the plucky arbitrageur go the spoils as arbitrage opportunities exist aplenty.
But that’s not to say that there are no risks to participating in such a trade. For starters, liquidity on many of these exchanges is not what one would hope for, nor is the speed of settlement.
Yet for those able to manage those risks — it is literally the definition of a “free lunch” — and when faced with a “free lunch” the only logical thing to do is eat.
To say that global economic co-operation is fragile is to put it mildly.
But at a time when central banks can’t afford to turn off the liquidity taps, a race to the bottom seems almost inevitable — meaning there will be substantial lag, disconnect and opportunity, trading foreign currency pairs with Bitcoin, especially because countries differ in their willingness to bottom out the barrel.
The eurozone and Germany in particular are usually reluctant to spend more.
Japan and the eurozone may simply not be able to cut rates any more to match the Federal Reserve and depending on the tact that Jerome Powell and his friends take, easing could be done to other countries instead of with.
The coronavirus crisis has brought out the best and the worst in humanity.
From hoarding to helping, selfishness and selflessness, the entire spectrum of human capacity has been on display.
It will take time for an equilibrium to settle and expect central banks to be no different.
Against the backdrop of such volatility, a swashbuckling trader like Ortega, with a strong will to survive, can forge their fortune.