[Archive - 05/18/18] The Hunt for State-Sovereign Yield
“If you owe the bank $100,000, that’s your problem. If you owe the bank $100 million, that’s the banks problem” — J. Paul Getty
Note 01/26/22: Consolidating my previous writing here, in many ways its funny to look back at my 21 year old self and the way I wrote, thought, and expressed views. Things have evolved since then, nonetheless here is a blast from the past.
Original Article Link (Medium.com)
ARCHIVED POST BEGINS:
The Hunt for State-Sovereign Yield
“If you owe the bank $100,000, that’s your problem. If you owe the bank $100 million, that’s the banks problem” — J. Paul Getty
Note: If you’re already convinced we’re in a global credit bubble and Bitcoin is relatively undervalued, feel free to skip ahead to the section “Bitcoin Credit”
Capitalism 101
A 20th century factory owner producing manufactured goods at 10% market share is happy sliding to 5% as long as the total size of the market doubles. Successful industry does not cannibalize a fixed market pie given new participants — it grows the pie. Over the Industrial Age, markets proved they could grow at unprecedented rates and kicked off the largest expansion of credit in human history. The capitalist mantra became clear — borrow to invest today, profit tomorrow, repeat.
Stock entitles shareholders to earnings and are considered “productive” assets. Capitalism dictates profits generated from productive assets should be reinvested as the value of these assets will always rise due to growth. Short term market whims are irrelevant — dividends, compounded interest, and growth over years assemble quite the powerful investment cocktail. This reality ensures that leveraging up on the future is a lucrative endeavor and fuels the global credit market.
Global Credit Bubble
I won’t rant on about credit bubbles — this Twitter post by Brendan Bernstein contains some great charts and captions for your viewing pleasure if you need any conviction that we’re in a global credit bubble.
To summarize, extended periods of low interest rates dictated by the most credit-worthy governments have swelled global debt. Investors are seeking yield in every corner of the world, causing a massive rise in global bond prices. Debt is not inherently bad, debt that can’t be paid back becomes problematic. Since it’s accepted amongst all market participants that the United States never defaults on its debt, the line between bubble and acceptable feels subjective.
Where do we go from here
Looking forward to the next 5 years, it’s entirely possible credit simply continues to expand from here. We’ve become so indifferent to debt that it arguably doesn’t matter if the United States owes $20 trillion or $100 trillion, it’s just a number. Albeit a dangerous line of thinking, it’s sadly not unreasonable. After all, the United States can’t default, right?
The scarier scenario involves global deleveraging, where the profits from productive assets are not invested in business for the future, but instead go towards interest payments. This can kick off a vicious cycle of decaying expected growth, damaging the core tenant of capitalism by forcibly drying up demand for credit and investment in the future.
State-Sovereign Assets
A state-sovereign asset is one that is as exogenous as possible to fluctuations, and potentially systemic shifts, in state-sensitive currency, interest rates, and general well-being. Owning a state-sovereign asset alongside a basket of state-sensitive assets, like stocks, bonds, and fiat, serves as a hedge against both increased credit expansion and deleveraging. The expected use case is market participants will pile into the asset as a haven as the bubble expands, and if there is an eventual bust via deleveraging or black swan, the state-sovereign assets performs relatively well. The notion becomes a psychological phenomenon — if I believe everyone else will not sell this asset in a crisis, I won’t sell as well. Like a commodity, the near-term value of this asset should increase if there is more short term demand than supply. The long-term equilibrium should be strictly positive and a function of how much the market values state-sovereignty in an asset.
State-sovereign assets by definition must have as little to do with the health of any single nation, including the United States, as possible.
20th Century Assets
Arguably real estate, especially with infrastructure like homes, buildings, canals, and bridges built upon it is fairly state-sovereign in the sense that there is an intrinsic value floor associated with owning real estate. When credit markets tighten, mortgage demand dries up and land might be less desirable and liquid in the moment. However, there is always a minimum price someone is willing to pay and an expectation of eventual recovery. Even consider the extreme tail scenario when an entire state defaults and reboots its economy, possibly even with a new currency — real estate will hold value in this new economy. Real estate is effectively an eternal put option. The same cannot be said for U.S. dollars, Apple Stock, or treasury bonds. There are always tail scenarios where those assets can be worth nothing and their livelihood is tied to the state.
The crack in the state-sovereignty of real estate lies in the title deed — the state accepts and enforces ownership of land. In the extreme tail scenario above, the state can convert your land ownership to a 100 year lease and you can’t really do anything. Or worse, it can easily be taken with violence. Presently this seems unlikely in the United States or Amsterdam, yet a tangible concern in Venezuela or Colombia, where there is less security in state policy stability. It’s sometimes surprising to find what tomorrow holds for the state — Americans got a taste of some political volatility with the Trump White House. Other nations have seen magnitudes worse.
Gold is the other ideal candidate, it’s value derives largely from the psychological store of value associated with holding gold in times of toil. It’s hard to fake, limited in supply, and beautiful. The crack in the state-sovereignty of gold, similar to real estate, lies in its ownership — you must physically own the gold thus it can be taken with violence. If you own a note that entitles you to gold in a vault you rely on someone to enforce your claim otherwise your note is as valuable as the paper.
21st Century Assets
I would argue digital assets are the best state-sovereign asset class available today. Of these, Bitcoin is the frontrunner for the one that fits the role best. It’s strictly better than gold or real-estate due to its decentralized nature — no state can dishonor your title deed to Bitcoin or forcibly take it from you(with proper storage precautions), and it was created largely in response to the global credit bubble we see today. Of course, Bitcoin is contentious. You have many people arguing whether state-sovereignty is a valuable feature for an asset. Those that accept the usefulness of a state-sovereign hedge might believe gold, real estate, or something else is better than Bitcoin. This spectrum of viewpoints gives rise to a new market: Bitcoin credit.
Thinking in Bitcoin
Before diving into Bitcoin credit, it’s important to realize many think of value in terms of Bitcoin.
There are a subset of people in the world that hold digital assets. Of this subset, most evaluate their position based on the dollar value of their assets. However, there are a few within the group of holders who simply evaluate their digital asset exposure in terms of Bitcoin. To these people, 100 BTC is worth 100 BTC.
Crypto traders realized evaluating any alt/USD cross is futile when what really matters is alt/BTC followed by BTC/USD. This two step mentality forced traders to get comfortable evaluating their positions against Bitcoin. Long term holders who do not plan to sell for at least a year are also comfortable with this mentality, as they would lose their mind if they checked BTC/USD everyday knowing they plan to hold through the volatility.
Bitcoin Credit
Alongside the professional appetite for spot Bitcoin and thanks to the help of gateways like CME and CBOE Futures, we are naturally seeing the rise of a sister market to Bitcoin spot — Bitcoin credit.
Once a Bitcoin holder crosses the threshold of “thinking in Bitcoin”, they should rationally seek yield on their Bitcoin, denominated in Bitcoin. Anyone planning to hold for years should loan out their inventory at anywhere from 9% to upwards of 20% annually, accumulating interest in Bitcoin. The realized yield against the dollar will be poor if BTC/USD falls over the entire holding period or it will be significantly higher than the rate achieved from simply longing BTC/USD if BTC/USD rises.
The demand for these loans largely comes from short-selling speculators, but can also come from arbitrage traders and businesses looking to leverage their inventory of digital assets to operate at scale. Genesis Trading launched an OTC lending group in February. Within two weeks of opening, they had nearly $100 million outstanding in loans.
Juthica Chou of LedgerX stated recently in Coindesk — “”We’re seeing more and more demand for people who want to earn some sort of interest off their bitcoin and lending is not exactly natural to people — especially lending where they earn their interest back in bitcoin. So we’re seeing participants come back to trading.”
LedgerX is launching a new covered calls platform, where Bitcoin holders can easily sell upside calls, giving someone the right to purchase Bitcoin from them at a price higher than it is today to lock in gains if the price does reach that level. If it doesn’t, the calls expire worthless and the seller effectively earns interest on their long Bitcoin position.
I expect more firms and the likes of Goldman to eventually get involved in this blossoming credit market as more people realize there is significant demand for Bitcoin yield.
Speculative Spectrum
What makes the credit market for Bitcoin so exciting is the wide spectrum of opinions on Bitcoin itself. On one hand you have the Bitcoin benchmarked traders, believers, and long-term hedgers, attempting to accumulate as much as possible over many years. On the other hand you have the skeptics, extremely confident in the inevitable eventuality of $0 BTC. There really isn’t room for opinions in between — Bitcoin will eventually be worth a lot more than the $8,000 its trading at today or near $0. It most certainly will not lose volatility and stabilize anytime soon.
Many confident in the $0 case include Warren Buffet, Bill Gates, and others with significant capital. At a certain point, they have to put their money where their mouths are and go short. Bill Gates even said, “I would short Bitcoin if I could.”
As Bitcoin trickles up with volatility and becomes an increasingly attractive short, short interest will balloon. It will be a battle between the bulls and bears on all timeframes. If you fall into the long term bullish category, capitalizing on this battle by loaning inventory can be one of the more profitable trades of the 21st century.
The hunt for state-sovereign yield in response to the largest expansion of fiat credit in history has started with Bitcoin. Its contentious nature amongst many with plenty of money and risk appetite ensures the credit market will be a lucrative endeavor. Shorting Bitcoin at the peak of it’s ultimate bubble will be massively profitable. So will the margin calls on the way up.