A CIRIous look at the markets

If traditional asset classes are any guide, fixed income markets in crypto will be orders of magnitude bigger than the spot market. However, healthy fixed income markets require well-known reference interest rates. In the absence of such a benchmark, it is difficult for market participants to fairly price various fixed income instruments.

This is why in May we rolled out the Crypto Interest Rate Index (CIRI).

To reiterate, the version 1.0 of CIRI is a reference rate for Bitcoin, published on business days at 1pm UTC. It’s computed by averaging the Bitmex futures implied rate, the CME futures implied rate, the Bitfinex lending rate, and the Poloniex lending rate.

It’s been about 30 business days since the release. So let’s take a look back!

When I first plotted the above chart, I was pleasantly surprised to see a clear inverse relationship between CIRI and the spot price of Bitcoin.

The direction of the relationship wasn’t surprising, as I will explain below, but the magnitude was. In my career, I have rarely seen this high of a correlation between two financial time series.

• Pearson correlation between CIRI and the price: -0.8.
• Pearson correlation between CIRI change and price change: -0.4.

So what are some plausible explanations for this negative relationship?

The most obvious explanation is that shorting simply crushes the spot market. When you short Bitcoin on Bitfinex, you need to borrow Bitcoin, thereby pushing the lending rate up on Bitfinex. When you short using a CME futures contract, you push the future price down in relation to the spot price, thereby increasing the interest rate implied by the future contract. CIRI increases as a result.

Conversely, when the spot market rallies, shorts may get liquidated, or become more inclined to stay out of the market. Either way, that reduces demand in the lending market, thereby driving CIRI down.

Another plausible explanation is that the initial release of CIRI coincided with the Bitfinex/Tether probe. The Bitfinex lending rate priced in the legal risk of Bitfinex and was well over 20%. But as the perceived risk diminished, not only did the lending rate dropped, but also the spot market became more bullish.

It’s important to note that everything we discussed so far is correlation, and not causation. The empirical relationship between CIRI and the spot price is not necessarily a causal one. All the subsequent theories may explain the correlation, but not necessarily the causation.

For instance, CIRI rising and price falling may be effects of a common cause - that there are simply more shorts - but one does not necessarily cause the other.

Many crypto traders seem to take a causal relationship for granted. I routinely see people make market calls on Twitter based on lending rates and short levels. As I have written many times before, this type of stuff is extremely dangerous, and sooner or later people will get rekt™.

To firmly answer the question of whether or not there is a causal relationship between rising rates and falling prices, in such a way that you can use past CIRI to speculate on future prices, we probably need more granular data and a longer history. So we’ll certainly revisit this topic in the future.

But if I had to guess, I would say that more likely than not there is a causal relationship. A few years ago, I backtested the statistical relationship between the level of short interest and the future 7-day price change on thousands of equities. It was extremely strong.

The theory here is that shorts are generally more informed than longs. They pay a nontrivial amount of interest, and they have to accept unlimited downside with limited upside. So they must have more conviction than longs.

I would not be surprised that a similar causal relationship also exists in crypto.

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