Arthur Hayes, co-founder and former CEO of BitMEX, published the report essay titled “Persistent Weak Layer” on October 16, which examines the potential impact of escalating tensions between Israel and Iran on cryptocurrency markets. Drawing an analogy from the science of avalanches, Hayes examines how the geopolitical situation in the Middle East could act as a “persistent weak layer” (PWL) that could trigger significant shocks in financial markets, affecting Bitcoin and cryptocurrency prices.

How will the cryptocurrency market react?

Hayes begins the essay by recalling his last ski trip and states. “One of the most terrible conditions is a persistent tender layer (PWL), which, when stressed, can cause a lasting avalanche from the slab. He compares this to the geopolitical situation in the Middle East after World War II, suggesting that it serves as the PML on which the state-of-the-art global order rests.

“The starter usually has something to do with Israel,” notes Hayes. It emphasizes that the main concern of financial markets is the reaction of energy prices, the impact on global supply chains and the potential for a nuclear exchange in the event of an escalation of hostilities between Israel and another Middle Eastern country, in particular Iran or its proxies.

Hayes outlines two scenarios. In the first case, the Israeli-Iranian conflict turns into minor military actions based on the “tit for tat” principle. “Israel continues to murder people and behead dicks, and Iran’s response is telegraphed, non-threatening missile attacks,” he describes bluntly. No critical infrastructure was destroyed and no nuclear attacks occurred; therefore, PML applies. In the second scenario, the conflict escalates dramatically and culminates in the destruction of the Middle Eastern oil infrastructure, the closing of the Strait of Hormuz or a nuclear attack, which leads to the collapse of the PML and causes an “avalanche in the financial markets.”

Expressing his concerns, Hayes states, “As they say, you can’t invest in war.” He faces a strategic choice regarding his investment portfolio: whether to continue converting fiat currency to cryptocurrencies or reducing his exposure to cryptocurrencies in favor of cash or US treasury bonds. “I don’t want my allocations to be under-allocated if this truly is the beginning of the next bullish stage in the crypto bull market,” he explains. “Still, I also don’t want to burn capital if Bitcoin drops 50% in one day because Israel/Iran caused a sustained avalanche in financial markets. Forget about Bitcoin; always bounces back; I’m more worried about the absolute crap I have in my portfolio…meme coins.”

Buy or sell now?

To deal with this dilemma, Hayes conducts a scenario analysis, focusing on how a second, more sedate scenario might affect cryptocurrency markets, in particular Bitcoin, which he calls a “cryptocurrency reserve asset.” It considers three primary threats: the physical destruction of Bitcoin mining rigs, the dramatic augment in energy prices, and the financial consequences resulting from the conflict.

In terms of physical destruction of mining infrastructure, Hayes identifies Iran as the only country in the Middle East with significant Bitcoin mining operations, accounting for up to 7% of the global hashrate. Reflecting on the scenario for 2021, when China banned Bitcoin mining, he comes to the conclusion that even the complete elimination of Iranian mining capacity would have a negligible impact on the Bitcoin network and its price.

Addressing the risk of dramatic increases in energy prices, Hayes considers the potential consequences if Iran retaliated by destroying major oil and natural gas deposits or closing the Strait of Hormuz. Such actions would cause oil prices to skyrocket, driving up energy costs around the world. Hayes argues that this scenario would actually augment the value of Bitcoin in fiat terms. “Bitcoin is energy stored in digital form. Therefore, if energy prices increase, Bitcoin will be worth more in terms of fiat currency,” he explains.

It draws historical parallels to the oil shocks of the 1970s. During the Arab oil embargo in 1973 and the Iranian revolution in 1979, oil prices rose significantly. “Oil rose 412% and gold almost matched the 380% gain,” notes Hayes. It illustrates that while gold has retained its purchasing power relative to oil, stocks have lost significant value relative to energy prices. Hayes suggests that Bitcoin, as a form of “hard money”, would similarly retain its value and even augment in value relative to rising energy costs.

Finally, Hayes examines the monetary implications, particularly how the United States could respond financially to the conflict. He emphasizes that US support for Israel includes the supply of weapons, financed by increased government borrowing, not savings. “The US government buys goods on credit, not from savings,” he emphasizes, referring to data that show net domestic savings in the US are negative. He asks who will buy this debt and points out that the Federal Reserve and the U.S. commercial banking system will likely step in, effectively expanding their balance sheets and printing more money.

Hayes notes historical instances in which negative domestic savings corresponded with a surge in the Federal Reserve’s balance sheet, such as after the 2008 global financial crisis and during the Covid-19 pandemic. “The Fed and the U.S. commercial banking system will buy this debt by printing money and expanding their balance sheets,” he says. He suggests that this monetary inflation would significantly strengthen the price of Bitcoin. “Bitcoin outperformed the Fed’s balance sheet growth by 25,000%,” Hayes points out, pointing to Bitcoin’s forceful performance relative to the expansion of the monetary base.

However, it warns investors of the potential for intense price volatility and uneven performance across different crypto assets. “Just because Bitcoin will rise over time doesn’t mean there won’t be intense price volatility, nor does it mean every shitcoin will get its share of the glory,” he warns.

Hayes reveals that he invested in several meme coins, but reduced his number dramatically after Iran launched missile attacks. “When Iran fired its latest barrage of missiles at Israel, I dramatically distanced myself from that position. “My size was too large given the unpredictability of how crypto assets will react to increased warfare in the short term,” he admits. He currently holds only one meme coin and notes, “The only meme coin I have is the Church of Smoking Chicken Fish (symbol: SCF). Ramen.”

At the time of publication, the BTC price was $66,907.

Featured image created with DALL.E, chart from TradingView.com