Bitcoin’s Growing Pains

Here’s a chart you never want to see in your portfolio

Here’s a chart you never want to see in your portfolio.

This is the Iron Titanium token, which after gaining 500% in a week, proceeded to lose 100% in little more than one day.

Titanium was part of the Iron finance ‘stablecoin’, tokens that are supposedly pegged to another asset, ideally a real currency like US Dollars, thereby offering more stability compared to the volatility of the underlying cryptocurrency. Stablecoins clearly does not live up to their name.

Ever since writing two articles on bitcoin, I’ve become fascinated with the potential upside of the technology, while trying to identify the downside risks. This has led me to the Decentralised Finance movement, abbreviated to DeFi. DeFi is an interesting concept, attempting to bring concepts of traditional finance, like interest, lending, and insurance, to the crypto world. Anyone who has investments in crypto should understand the developments in DeFi.

DeFi tries to address the fact that cryptocurrencies are too volatile to be used as currencies for the exchange of goods. If you own a business with a 20% profit margin that accepts bitcoin for your widget, what happens when bitcoin falls -30% after your sale? You’ve just made a loss, so the only way your business can survive such a drop is if you constantly adjust the price of your widget in bitcoins. Cue stablecoins, which act as a go-between to act as a lubricant for the transaction.

Other than addressing the volatility of crypto, stablecoins also attempt to give investors confidence that there are real assets behind a token, thereby giving it quantifiable value. In addition, while you earn near-zero interest rates in traditional currencies, if you’re willing to lock up your crypto investment for a period like you would do in a one-month fixed deposit in a bank, DeFi can pay you yields of 20%. Your crypto will then be used by the platform and lent out for interest, much like a bank. This lending improves liquidity and can use for insurance and other similar financial transaction. It’s already become a big market, with over $80 billion in DeFi programs, up from $1 billion a year ago. The primary function is to take crypto deposits to make loans to people looking for leverage on their crypto bets. You can also ensure your crypto stash against hacks, though there would be some clear questions about the counterparty risk of the insurer, as none of these entities are regulated.

The Iron family of stablecoins were touted for their stability during bitcoin’s -50% fall in May. All until the fateful day in mid-June. The Iron Titanium debacle could be dismissed as an obscure part of the crypto world. However, if you own Bitcoin and are bullish on its prospects, you should know that bitcoin is partially underpinned by two stablecoins: Tether and Circle. Both of these are supposedly backed by hard cash at a 1:1 ratio. However, a deeper dive into Tether raises many questions.

Tether has raised $60 billion that has gone into bitcoin. With the supposed 1:1 ratio backing, Tether would be holding US$60 billion in US dollars, or as they claim in multi-currencies and in US commercial paper. An audit scheduled for 2018 on Tether’s reserves never took place. The New York Attorney General’s office announced an investigation soon after, accusing Tether’s parent company of hiding a loss of $850 million dollars. While there is no audit, there is an attestation to the reserves. The next time you meet an accountant at a party, instead of looking elsewhere to find a more interesting conversation partner, ask them the difference between the two.

Crypto fans have countered that they’re aware of Tether’s issues and that it’s probably a Ponzi scheme but only makes up 10% of bitcoin’s market capitalisation, so bitcoin will survive this. They’re right, but they’re ignoring market structure. In the early days when no entity would lend against crypto, you could simply hold on for the long term. The DeFi movement introduces tremendous amounts of leverage into the system, with companies like Binance offering leverage of 125 times your investment. Old hands like me may not fully understand bitcoin, but we understand leverage.

The 2008 financial crisis was precipitated by Lehman Brothers’ collapse, and Lehman commercial paper made up less than 2% of the total. The amount of leverage that has been built up in the crypto infrastructure has introduced more finance-like instruments but at the cost of stability of the overall system.

Tether has a sister company, Bitfinex, which is an exchange for cryptocurrencies. New York court filings alleged that Bitfinex took at least $700 million from Tether’s cash reserves to hide a loss after the money was missing, giving the money to a Panamanian entity called Crypto Capital Corp. And this is just the tip of the iceberg in red flags.

Tether is the biggest stablecoin, and yet in traditional finance, no one has seen transactions by it, and even in this age of free money $60 billion isn’t exactly chump change. If Tether’s reserves are legitimate, one of the ironies of bitcoin is that it is propping itself up by self-printing its own money, just like a central bank. If they’re not, the leverage in the system is likely to one day cause significant downward pressure on bitcoin’s price, more than what we have seen so far this year.

Despite questions around tether, bitcoin’s journey to becoming a real asset just got much closer to reality, as it has just been adopted by a Central American country as legal tender.

On 9 June, El Salvador’s 39-year-old president Nayib Bukele succeeded in getting Congress to pass a law making bitcoin legal tender. You will be able to pay taxes with bitcoin, and businesses will be required to accept bitcoin as payment for goods and services. El Salvador plans to mine bitcoin using volcanic energy.

Bukele thinks this will bring all sorts of benefits to his country in investment, tourism, innovation, and economic development. The country would also offer citizenship to anyone who showed evidence they have invested in at least three bitcoins.

El Salvador will guarantee convertibility to US dollars by committing US$150 million of its own money to buffer its citizens from bitcoin’s volatility, out of the country’s $3 billion in foreign exchange reserves. Supporters are hailing this as a legitimisation of cryptocurrency, confirming its role as a store of value, a means of transaction, and an investment asset class.

Unless bitcoin’s volatility subsides, the $150 million set aside may be insufficient. My economics 101 training suggests that the country’s deficits will increase, and its bitcoin experiment will cause its US Dollar reserves to dwindle, causing problems for the economy. The value locked up in bitcoin will see an exit to US dollars to the tune of $3 billion in El Salvador’s reserves, assuming the experiment is successful and bitcoin becomes the transaction currency of choice. Daily bitcoin fluctuations will influence consumer behaviour: ever-higher bitcoin prices causing people to put off spending them, or falling prices causing hyper-inflationary behaviour, where people rush to spend a currency that is devaluing each day. It will be fascinating to see what happens in El Salvador and if they end up reversing this legislation.

Or maybe my economics 101 training will be proven wrong. After all, it taught me that massive government spending leads to massive inflation. The US is up to 130% debt-to-GDP with little sign of inflation. Japan, which has been at this much longer than any other country, is at 260% debt-to-GDP (compared to 60% when its asset bubble burst three decades ago) and has not seen any inflation. Maybe I should ask for my tuition fees back.

I was discussing all of the above with a hedge fund manager who has been quoted in media as having an interest in bitcoin. Rather than outright buying bitcoin with all the potential downside risk, the crypto-related assets that are coming to the stock market (the second largest stablecoin, Circle, has filed to go public via a SPAC merger with Concord Acquisition Corp, following Coinbase’s successful IPO) provide a way to hedge some of the downside risks via traditional crypto-linked stocks. When hedge fund managers say they’re in bitcoin, they’re likely to be involved in ways such as this, rather than outright long with no protection.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.