The upside of being maximum risk

Plus Microstrategy continues to pile on leverage and the ongoing consequences of El Salvador's legal tender bill.

In this issue:

  • Microstrategy is happy to keep adding leverage

  • Sometimes you adopt Bitcoin, sometimes Bitcoin adopts you

  • The upside of being maximum risk


Microstrategy is happy to keep adding leverage

Over the weekend the price of Bitcoin rose ~11% to a high of ~$41k/BTC before settling down to ~$40k/BTC at time of writing. Some people attributed the move to another will-he-won’t-he tweet from the boy king of Tesla, but I think the much more obvious explanation is that Microstrategy raised yet another $500M in debt to buy more Bitcoin starting this week:

Microstrategy claims there was ~$1.6B worth of interest in this offering, so there seems to still be plenty of appetite to fuel this trade. In spite of that level of interest the terms for this round of debt are not as favorable as previous rounds. The bonds yield a more typical 6.125% interest rate rather than the 0% coupon the last few rounds have paid. More importantly this debt is secured against the Bitcoin directly rather than against equity in the company - which is bad news for previous bondholders since these new claims are senior in the event of a default.

The previous bondholders have what is known as convertible debt - basically debt that will be paid back in equity in the company. Microstrategy raised two rounds of convertible debt - one at an effective stock price just under ~$400/share and one at an effective stock price of ~$1430/share. At time of writing $MSTR is trading at ~$600/share, meaning the first round is comfortably in profit but the bondholders from the second round of debt are holding a ~27%* loss. These bonds don’t "mature" for a few years, but as of right now they look like pretty bad investments - which is probably why Microstrategy had to offer better terms to raise another round of debt.

Editor’s Note: I originally wrote the bondholders are trading at a ~60% loss, but at time of writing the bonds are actually trading at ~73% of face value. The difference in value is because I was neglecting that bondholders have the option receive face value in cash at maturity instead of being forced to convert into shares. Thanks to reader TO!

At this point Microstrategy has made such a levered bet on Bitcoin that it may create systemic risk for the Bitcoin market itself if it collapses and needs to unwind. There is a concept in corporate law called the "zone of insolvency" that basically says if a company is close enough to bankruptcy then management has a fiduciary responsibility not just to shareholders but to creditors as well. A collapse in the market for Microstrategy’s bonds could create a legal obligation to sell their bitcoin to protect their credit rating (and implicitly, their creditors). In other words a crash in the illiquid markets for Microstrategy bonds could potentially ripple back outwards into the market for Bitcoin itself.

Michael Kao has a long, technically dense but thoughtful discussion of the risks:

None of this seems to keep Michael Saylor up at night - the man is the very definition of all-in. On Monday he announced an at-the-market offering of up to $1B of new Microstrategy stock - diluting the existing equity holders (and holders of convertible debt) to raise more money for: "general corporate purposes, including the acquisition of bitcoin." At time of writing $1B would be enough to buy ~24.6k BTC or ~27 days worth of newly mined bitcoin.


Sometimes you adopt Bitcoin, sometimes Bitcoin adopts you

Another possible explanation for the rise in Bitcoin’s price of course is El Salvador’s newly passed legal tender law. The literal impact of the law will likely be small, since El Salvador is a small economy, but we have already seen a wave of politicians signalling support for Bitcoin and in turn the first voice of significant opposition from the International Monetary Fund (IMF). El Salvador has been in ongoing talks with the IMF for a ~$1B loan, and the IMF is generally uncomfortable with the whole Bitcoin thing for obvious but not especially specific reasons, or as they put it:

"Adoption of bitcoin as legal tender raises a number of macroeconomic, financial and legal issues that require very careful analysis," - Gerry Rice, IMF Spokesman

We talked last week about the fact that Bitcoin being legal tender in El Salvador also made it a foreign currency in other jurisdictions. In most countries Bitcoin is still taxed and regulated as a commodity (like oil) rather than as money, so a backdoor precedent allowing it to be treated as a foreign currency would have a lot of mechanical implications for Bitcoin globally.

Other countries (like the US) might take steps to avoid that unintended side effect - but those steps might be harder to take if El Salvador is joined by other countries. Consider this research report from JP Morgan:

So the big question is which countries (if any) may follow El Salvador’s lead. So far we have seen Bitcoin-friendly posturing from politicians in 🇨🇴 Colombia, 🇵🇾 Paraguaya, 🇵🇦 Panama, 🇦🇷 Argentina, 🇲🇽 Mexico, 🇪🇨 Ecuador, 🇹🇴 Tonga and 🇹🇳 Tunisia - but no concrete steps towards any formal adoption. Talk is cheap.

One country that is almost certainly considering adopting Bitcoin is 🇳🇬 Nigeria. Nigeria has banned cryptocurrency since 2017 but it still has the highest self-reported ownership rate of any country (>20%). We talked a few weeks ago about how the government was starting to grapple with the fact that Bitcoin was rendering the Nigerian naira worthless:

NFL Star, Bitcoin enthusiast and Nigerian-American Russell Okung wrote a passionate open letter this weekend to the Nigerian government urging them to adopt a Bitcoin standard. That would be a more dramatic move than it was for El Salvador because Nigeria actually has a local currency that would be displaced - but that may be happening already whether the government approves of it or not.

Bitcoin adoption in Nigeria seems to be accelerating. One way to see that is in remittance trends where Nigerians are increasingly abandoning traditional banking channels in favor of Bitcoin. From January 2020 to September 2020 inbound remittances to Nigeria through traditional banks fell ~98% - from ~$2.5B to only ~$55M. Bitcoin appears to be outcompeting the naira - if enough of the Nigerian economy moves to Bitcoin the government may have no choice but to recognize Bitcoin as a legal tender or risk driving the entire economy underground.

Sometimes you adopt Bitcoin. Sometimes Bitcoin adopts you.


The upside of being maximum risk

Banks are required to keep a certain amount of money (called the capital reserve) around in case their investments go sour. How much money banks are expected to keep on hand varies depending on how volatile the bank’s investments are - if they are stable, boring investments capital requirements will generally be lower. If they are exciting, high-volatility investments capital requirements will be higher.

The Basel Committee on Banking Supervision (BCBS) in Switzerland is a global banking organization that (among other things) sets standards for capital reserve requirements. On Thursday they released a public consultation on the "the prudential treatment of cryptoasset exposure by banks." The language is suitably dry and dusty but it basically establishes two things:

  1. If you wrap a traditional asset in some kind of blockchain-based tokenization, you can apply the same capital reserve requirements as the underlying asset.

  2. Bitcoin and other cryptocurrencies should receive "conservative prudential treatment" based on the maximum risk weight (1250%)

At first glance that sounds like bad news, but having a formal risk weighting moves Bitcoin from the realm of inconceivable to the realm of expensive - which is actually a huge step forward in normalization.

I think Matt Levine summarized this best in his recent Money Stuff column:

"Banks try not to own cocaine, and the reason that they don’t own cocaine is not that it has a very high risk weight; the reason they don’t own cocaine is that if they owned cocaine their prudential supervisors would have some very stern questions that would not be about capital requirements. Cocaine does not have a 1,250% risk weight; it has a “no no no this is not what banks do” risk weight. Moving Bitcoin from “absolutely not, what on earth” to 1,250% is a positive." - Matt Levine


Other things happening right now:

  • As we predicted when we spoke about it a few weeks ago, the Taproot upgrade has locked in for Bitcoin and will activate in mid-November. Taproot is an immediate improvement to privacy and efficiency but also an important stepping stone towards future improvements. It took about four years from conception to final launch on the main network.

  • The original DOGE meme photograph was auctioned as an NFT over the weekend and sold for 1696.9 ETH, ~$4.3M at time of sale. The winner of the auction is @pleasrdao, a decentralized autonomous organization (DAO) formed to invest in NFTs. We wrote about them last when they purchased an NFT from Edward Snowden for ~$5.5M. You can see @pleasrdao’s entire collection here.

  • We’ve talked before about how boxer Floyd Mayweather was fined in 2018 for "unlawful touting" of ICOs - but you don’t get to be where Floyd Mayweather is without learning to take a punch and get back up. Mayweather is right back in the ring promoting another small-market coin called Ethereum Max, this time with the support of Kim Kardashian. Apparently no one mentioned to her how this played out for him the first time? If anyone knows Kim please help her subscribe to Something Interesting and tell her to charge her phone.1

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One free NFT to anyone who recruits a Kardashian to the mailing list. Even Khloé.