The Bitcoin Backstop

January 11, 2022
Steven McCormack
4 mins

A strong start to 2022, folks. I've just digested Greg Foss's thoughts on Bitcoin as insurance for fixed income investors. Greg is a battle hardened money man with over 30 years in the field, so his comments carry a little extra weight in my book. And boy did they expose gaps in my finance knowledge. Whilst I have a fairly decent grasp on Bitcoin's technical credentials, prior to reading I didn't fully understand what he meant by fixed income. In short, it is the type of debt instrument (or bond) that Corporations and Governments use to raise capital. Fixed income represents a 'contractual obligation that agrees to pay a stream of fixed payments from borrower to lender'. At the end of the contract term, or maturity date, the original loan is repaid in entirety. As an example, an entity may issue a 5% bond with $1,000 par value. An investor (lender) can buy the bond, receive 5% ($50) 'coupon payments' for the following 5 years, and then collect the original $1,000 at maturity. Simples.

But what does this have to do with our magic internet money? By diving in a little further, we can really begin to understand Bitcoin's place in the wider financial ecosystem. It also helps to further differentiate this asset from other proof-of-stake projects in the blockchain arena. First up, let's see how fixed income shapes up against its cooler sibling, the equity market. Note; from here I'm regurgitating Greg's work in rather basic terms, so refer back to the original piece for the real detail.

Priority of Psychology

Consider the risk profile of a bond. Payments are contractually set in stone (i.e. you know what you are getting in advance). Payment streams cannot be changed to reflect the underlying health of the borrower. This cuts both ways. If a Corporation (or indeed, a Government) becomes fiscally irresponsible, a fixed income investor cannot demand a higher return to account for the additional risk. The mispricing will also be reflected in the secondary market, with a reduced contract value. In contrast, the benefit of better performance accrues to the borrower, who is under no requirement to share extra spoils with the lender. Greg also notes that 'if the risk profile has changed for the better, the borrower will likely pay down the obligation and refinance at a lower cost'. So the poor investor cannot even flog his risk-adjusted (i.e. more attractive) contract to other prospective buyers!

Ultimately, fixed income is a static, seemingly dour endeavour. The risk is asymmetric - to the downside. And against the more dynamic appeal of equity, why would you bother? What could possibly trump exposure to explosive capital growth or ever juicier dividends? The answer lies in a simple phrase; priority of claim. Y'see, going long on equity is generally a warm and optimistic affair (unless you take a short position - you horrible bastard). You put your faith in a given company, and they reward you with a share in their incredible performance. Rinse and repeat. But what happens when that illusion is shattered? You soon learn that dividends are not cast iron - they are merely a voluntary distribution. And those gravity defying valuations, that were justified by, y'know, momentum or a new paradigm? Up in smoke.

Now in this scenario, when a company is marching towards a default, it is the pessimistic fixed income chaps who can sleep better. Remember; priority of claim. Lenders are king of the capital stack. Should the worst happen, they are entitled to 100% of their principal (and accrued interest). In default a settlement can include equity (if it ain't worthless) or other assets pledged as security against the contract. High flying equity bozos simply have to wait in line, behind those waving their contractual obligations. And usually there isn't much left by the time they get their turn at the carcass.

To be super clear here, I'm not pissing all over equities - you gotta take (calculated) risk and accept (sometimes wild) volatility in life to make outsized returns. But once you got something to protect, the fixed income worldview begins to make much more sense. And the true value of security is only revealed when you need it most. To illustrate, observe this example; prior to the GFC you could buy default insurance on Lehman Brothers for 9 basis points. As Foss clarified, 'you could insure $10 million of debt against $9k per year. Two years later that same contract was worth millions of dollars'. Now that's what you call risk-adjustment.

Bitcoin's Backstop

So where does BTC fit in this long established duel between protection (bonds/credit), and accumulation (equity)? With my sharpened fixed income knowledge, I see the overall framework like this. Equity investing is (or was!) the poster boy for capitalism. Traditionally, our spare capital has worked best in this arena, by allocating it to listed companies with the best looking prospects, business models, leadership, you name it. Once you benefited from compounding dividends, or found the next GEICO or Amazon, you then found calmer waters and regular income via bonds. Finally, you reached the nirvana of the 60/40 portfolio, and sailed off into the sunset. There is a problem however; everything in this happy little scenario is now corrupted by ever-flimsier fiat currency.

The juice that flows through this entire framework has been soured; a sorry outcome of rampant 'money printing' by central banks (to service ever spiralling sovereign debt). This in turn is a response to many interwoven factors, such as demographics, GFC bailouts and our recent pandemic measures. And then there's Jeff Booth's main argument, that technology induced deflation (think iPhone capability) is incompatible with an economic architecture that demands expansion. We have let loose a secular, almost unstoppable force - and it is duly strangling the life out of price discovery through our limitless monetary system. The imploding value of fiat denomination (whether dollars, euros or yen) is exactly what Greg is insuring against with Bitcoin.

Do you remember Deden's preferences? Bitcoin is the scarce, enduring and independent asset that offers the ultimate wealth protection for our digital age (in my humble opinion). And just like pre-GFC Lehman Brothers insurance, it is really rather mispriced for its role. That is why the big boys (Dalio et al.) are now sniffing around and kicking the tyres. Just one thing, however. Foss contends that there is no counterparty risk with BTC, which only adds to its appeal. That doesn't quite ring true for me; we ultimately rely on energy flow (as expended by miners through proof-of-work) to secure transactions in perpetuity. It is the whole damn point!

Living, Breathing Value

Walk with me. Bitcoin, the asset, is the purest store-of-value we have ever seen. It is the simple conversion of energy (via math and code) into verifiable truth, whether via hydrocarbons, renewables, nuclear reactions or even god damn volcanoes. Bitcoin also carefully evolves to offer greater utility over time, as we see with lightning and taproot. Real estate is stale in comparison; you may expend energy to form static bricks, aluminium or concrete. But it just degrades without active maintenance. Gold, whilst durable can be centralised or even confiscated. And don't forget the high initial cost of extraction. So where does this leave our good friend fiat?

Stand still and ponder this. Fiat backstopped by government is old skool proof-of-stake. It simply isn't fit for protecting accrued time and effort over time. As our collective attention is concentrated on (low time-preference) politics, we fail to notice the byproduct of monetary manipulation and fiscal abuse. The outcome is predictable; gradual, systemic corrosion and sudden collapse. With Bitcoin, we're backstopped by continuous energy, an unemotional resource outside of our control or influence.

For as long as energy exists, Bitcoin can exist. And energy ain't going anywhere.

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