Note: As of January 10, 2024 the US Bitcoin Spot ETF(s) have been approved.
Disclaimer:
I come from a software development background, not a financial, investment and/or accounting background. However, I subscribe to the idea of life long learning and enjoy delving into topics of interest to me that may have future implications. The thoughts expressed in this blog post are that of my own(influenced by many other sources) and not that of my employer SAP. Nothing expressed here is to be taken as financial advice or recommendation. You should these topics for yourself and also seek to know yourself before taking any action.
Prologue:
If you attend a Bitcoin meeting, you'll inevitably be asked how you came to know about Bitcoin. Each person's "origin story" is different and helps to establish where the discussion goes from there. Here is an abbreviated version of mine. If you're in a hurry you can skip to the introduction.
My wife, dog and I live in Atlanta somewhat near the east coast of the US. About 10 years ago, we went on a beach vacation to a dog friendly beach called Jekyll Island Georgia. While we were there we took one of those
horse drawn historic tours of the island. Near the end of the tour as we passed the historic
Jekyll Island Club our driver leaned over his shoulder and casually stated.
"That's where the secret meeting that formed the Federal Reserve was held." I remember thinking what an odd thing to say on a historic tour that seemed to have nothing to do with anything we'd been talking about. I just filed it back in my mind as something weird. A couple years later while listening to a podcast
"The Creature From Jekyll Island" book title was mentioned. Again, I remember thinking what an odd title for a book. I've been there and maybe it had something to do with that thing the tour guide mentioned. I picked up the book and read it cover to cover. Needless to say, it was the start of a lot of reading about monetary systems and policy that continues to this day. On one trip to Germany for work, I arrived early in Frankfurt and spent a whole afternoon at the
Bundesbank Money Museum of which I can't recommend enough for those with the inclination. Learning about sound money eventually leads to Bitcoin. In 2009 my wife said I should read about this new thing called Bitcoin. I picked up the
whitepaper and realized thought that it would be a great innovation
"if anybody cared". I figured I'd keep an eye on it and see what happened. My eyes wandered to other things in life and a dozen+ years slipped by. A few years ago the blockchain topic became part of my work focus and with that the crypto topic came along with it. Since then, the more I've studied sound money principals, the more Bitcoin seems to be one of the best expressions of it.
Introduction:
Just to repeat myself, I'm offering my thoughts on one aspect of Bitcoin that I think is getting glossed over in the excitement in the US over the pending approval of a Bitcoin Spot (Electronically Traded Fund(ETF)s.
None of this is financial or investing advice and the views expressed here are my own and not that of my employer SAP.
Even as I write this(an quite possibly by the time you're reading this) in
articles today it seems that the approval is
all but a done deal. Why is there so much anticipation stored up in these announcements? Many feel it's because there is a lot of enterprise and institutional money sitting on the sidelines waiting to get into Bitcoin, but has not been allowed to because of restrictions imposed by the governance rules to which they are bound. As the pension fund manager, you probably can't just plunk down a credit card and buy crypto without getting process and allocation rules changed by a committee of some sort. I expect there is also the huge reputational risk that many treasury and asset managers face should they go out on a limb with a small allocation to Bitcoin just to have it drop
(May 2021: -53%) . On top of that the jurisdictional, regulatory, taxation and legal standing of Bitcoin has been and continues to be murky with legislation in the US just getting introduced and/or starting to make it's way through committee. It's no wonder large entities have been hesitant.
That will change significantly when "buying Bitcoin" is as easy as logging into a brokerage account and clicking a few buttons. But what are you really "buying" and "who" is selling it?
Thoughts:
One of the hardest concept surrounding money is that of
counterparty risk. In simplest terms it's the risk that somebody else fails to keep their end of an agreement. If I loan my neighbor $20 and he moves away having never paid me back, I've lost my $20. If I put $20 in my bank account and my bank fails, the government insures my $20 and I'll get it back at some point in the future. If my $20 is in my wallet I don't have to worry about anyone else for me to use it. Each of these situations expresses a different level of counterparty risk. You can think of the amount of counterparty risk on a scale like so.
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
If you hold something in your hand like a nugget of gold, you don't have to worry about anyone else keeping up their end of an agreement. You bear(hold) it and is thus called a bearer asset. Your counterparty risk is none. One of the most novel attributes of Bitcoin is that with proper use of your private cryptographic key, you have the same sovereign ownership as if you were physically holding(maintaining custody of) it. Due to the nature of cryptography and the blockchain it is the first truly electronic bearer asset.
Self
Custody
On-Chain
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
As mentioned above, enterprises can share the responsibility of controlling their Bitcoin by engaging a 3rd party custodian. This can be done by sharing some of cryptographic keys when more that one is required to transfer the Bitcoin. Since there is more than party, there is more counterparty risk.
3rd Self
Party Custody
Custodian On-Chain
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
If as an enterprise, your governance allows you to keep your Bitcoin on an exchange it is really just an entry in the exchange's ledger(similar to your bank account balance) and isn't converted into actual Bitcoin until it needs to be sent out of the exchange(to a custodian). If the exchange fails(like the
recent FTX failure) your assets go along with it.
Crypto 3rd Self
Currency Party Custody
Exchange Custodian On-Chain
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
Until now an enterprise could do the things it's always done from an asset investment standpoint, buy securities. Bitcoin Heavy Securities companies (like
MicroStrategy) which are shares in a company that has a large allocation in Bitcoin itself, but is again a counterparty risk that could be affected by mismanagement or maybe not getting a big contract or maybe face regulatory action. Another option in the US has been futures ETFs like
Grayscale but these are shares in a pool of bets on the future price of Bitcoin and are getting away from the underlying asset itself. What happens if the fund goes defunct, or your broker? I put the futures a bit further on the risk scale, but I think it could be debated which is risker from a counterparty risk basis.
Bitcoin Bitcoin Crypto 3rd Self
Futures Heavy Currency Party Custody
ETF Securities Exchange Custodian On-Chain
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
This leave the (potentially)new kid on the block, the Bitcoin Spot ETF. The ETF is required to purchase on hold actual Bitcoin as the underlying collateral for it's ETF shares. The ETF will have to compete for the limited quantity of Bitcoin just like everyone else due to the Bitcoin's built in limited supply of 21 Million. While 93% (see
circulating supply) has already been created(mined) the remaining will become available at a slower and slower rate as time goes by. Seems like the best of both worlds, easy to buy, don't have to worry about crypto keys, fewer parties (and risk)....but.
Bitcoin Bitcoin Bitcoin Crypto 3rd Self
Futures Heavy Spot Currency Party Custody
ETF Securities ETF Exchange Custodian On-Chain
<====o============o===============o=============o=============o============o====>
Most Greater Counterparty Risk Lesser None
What are you buying and from whom? All securities are held in a national
Central Security Depository (CSD)
which operates a book entry system for electronic settlement of trades and maintains a record of “ownership.” And while it's often assumed that you are purchasing shares in an ETF or other security, it's actually a note in your broker's bookkeeping ledger(risk) for a "
security entitlement" to shares of an a entity that custodies(risk) Bitcoin. So while a spot ETF may bring you closer to the actual underlying commodity, it doesn't remove as much counterparty risk as may be assumed. If there is a monetary crisis and the counterparties involved start to fail, the collateral assets flow to the "secured creditors" and not those holding "security entitlements".
Conclusion:
For an enterprise to be truly sovereign in it's holding of crypto assets like Bitcoin and to reduce or eliminate counterparty risks, it should consider taking on the time and responsibility of self custody of those crypto assets if their governance allows. Those that have rules and policy that prohibit this should consider starting the process of changing them if they wish to diversify their asset investment treasury to include crypto assets. In time SAP will likely develop tools and guidance for this sort of investment activity but for the time being the Bitcoin spot ETF may be an enterprises' only realistic option to gain exposure to Bitcoin despite the continuing risks.
Would love to hear your thoughts/comments on this constantly evolving topic.
