Bonds backed by bitcoin are emerging as innovative ways to repackage bitcoin exposure and monetise crypto-holdings, but a risk management framework is vital.
For better or for worse, bitcoin and other cryptoassets are finding their way into the mainstream. The institutional acceptance of bitcoin is a well-established fact. A growing proportion of traditional investors now reserve a small portion of their portfolios for cryptoassets.
There are a few different ways they can take this exposure. The first is the most obvious: actually buy and hold cryptoassets. While conceptually simple, this is not necessarily easy for many asset managers. Although their mandates may permit them to hold these assets, taking custody of cryptoassets in a safe and responsible manner is a technically complex task. Even if they use wallet providers and cryptoasset exchanges to take the burden of custody away, they are still exposed to new risks that must be assessed by committees.
Exchange-traded products have emerged to give these investors an easy way to get exposure to the performance of cryptoassets with a traditional wrapper that they are comfortable handling. These work well, but they are limited in scope and flexibility. Traditional investors are used to sophisticated tools to hedge and manipulate their exposure to various assets. Leveraged ETFs and short positions can provide some of the necessary functionality, but traditional asset classes have a much broader toolkit.
Crypto-debt products
Much of this innovation will come in the form of structured debt products and these are starting to emerge in cryptoasset markets as well.
Bitcoin-backed securities are growing in scale and popularity. The propositions range in complexity but the essence of the structure is to monetise bitcoin or other cryptoassets that do not generate income, leveraging them as collateral to unlock their value without liquidating them.
OMFIF hosted a roundtable featuring an organisation in the process of structuring an instrument like this, and the potential utility for both issuers and investors was discussed. It was pointed out that government bodies frequently end up holding bitcoin as the result of seizures of illegal goods. Some states also accept payments denominated in cryptoassets. El Salvador is an extreme example, having made bitcoin legal tender, but US states like Colorado and Utah as well as the Canton of Zug in Switzerland accept crypto payments for taxes.
State entities that end up with bitcoin in their portfolios might choose to auction them off, but such auctions tend to be slow and must be done carefully so as not to move the market excessively. The entities might also wish to hold on to the bitcoin for strategic reasons. If so, they would be in a position of holding a valuable asset that does not generate income.
Accordingly, they might consider borrowing against the asset, unlocking its value without losing its potential performance. Since they would be borrowing on a secured basis, this might enable them to achieve a lower cost of funds than they would otherwise achieve in capital markets.
Assessing and managing risk
As these instruments grow in popularity, it becomes vital to assess the risks that such structures pose. Fitch, which also participated in the OMFIF roundtable, has produced a paper detailing the novel risks that such instruments present and the appropriate strategies to mitigate them.
Perhaps the most important is that, because of the historical volatility of bitcoin, 1:1 collateralisation is not enough. Fitch recommends a coverage ratio of 2:1, which would mean borrowing $50 for every $100 of bitcoin collateral. Other possible approaches include smaller levels of over-collateralisation protected by mandatory liquidation floors.
Fitch also highlights that some transactions include provisions that allow sponsors to post additional collateral to avoid mandatory liquidation and protect investors. However, Fitch points out that these provisions are only as valuable as the credit quality of the sponsor.
As well as traditional assessments on the stability of the collateral, there are also crypto-specific factors that present risks and need to be assessed. Holding cryptoassets as collateral requires using crypto custodians. Although such custodians have specialist expertise, they necessarily have much shorter operating histories than their counterparts in traditional markets. Fitch points out that additional caution is warranted when purchasing instruments whose robustness relies on these counterparties.
New products are emerging
These instruments are an indication of the growing links between traditional markets and crypto. The cryptoasset market, since its inception, has been a byword for volatility. In the last few years, its much-vaunted lack of correlation has begun to erode and the bitcoin price has lost its immunity to overall market sentiment. When US stock markets sneeze, crypto can often catch a cold.
But so far, this contagion has gone only one way. A sell-off affecting cryptoassets is unlikely to put much of a dent in appetite for traditional assets. However, as cryptoassets become more regulated and accessible to mainstream investors, this might begin to change.
As the sophistication of the average bitcoin investor grows, a new product set is emerging, giving investors the opportunity to monetise their cryptoasset holdings without triggering tax events or relinquishing ownerships.
As well as demand for bitcoin holders to borrow and monetise their holdings, bitcoin-backed securities provide a means for investors to get exposure to bitcoin. While the lenders do not get true upside exposure to the performance of bitcoin, they are making a bet that bitcoin’s value will not drop enough to compromise their collateral and are compensated for the risk by the interest on the lending product.
Lewis McLellan is Head of Content, Digital Monetary Institute, OMFIF.
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