BTC Denominated Portfolio Management & the Structure of Bitcoin Interest Rates by Nik Bhatia
Since Google’s IPO in 2004, its stock is up over 2,000% while the S&P 500 is up less than 200%. This type of relative outperformance is nothing new to bitcoin investors, many of whom have seen astronomical returns no matter what performance benchmark is used, as long as that benchmark is in dollars. But what happens if your home denomination isn’t US dollars? In this research piece, we examine what happens when investors start to think about bitcoin in relation to itself rather than in relation to dollars.
The stock market index is a century old invention by the financial press in order to track a basket of companies with one value. Benchmark indices became ubiquitous because every corporate executive and portfolio manager wanted to measure performance versus their competition. But the benchmark for Bitcoin fund managers shouldn’t be anything USD related like the S&P 500, Russell 2000, or Bloomberg Barclays US Aggregate Bond Index. The benchmark is now BTC.
What’s your denomination?
Investing in Bitcoin will always have fluctuating performance when converted back to USD, but what about for an investor who has switched his or her home denomination to BTC? While you might not see Wells Fargo offering a toggle feature for viewing USD deposits in a BTC denomination today, the prospect of entirely BTC denominated investors is now a reality.
Here’s an example: Alice is an early investor in Bitcoin. She buys 500 bitcoin for $50,000 in 2013. As the price reached an uncomfortable level for her in late 2017, she decided to liquidate half her position, 250 BTC, at a price of $12,000 for a capital gain of nearly $3 million. She uses the $3 million to pay off debts and taxes, and sets up a steady income stream using a USD bond portfolio. She is now free from any dollar debt, has dollar inflows to cover monthly expenses, and also still has 250 BTC. Should she be thinking of her remaining bitcoin wealth in dollar terms? No. Her USD balance sheet is now stable, so she can start to think about a portion of her overall portfolio in bitcoin denomination.
BTC is a home denomination for a growing population
At Tantra Labs, we argue that Alice should be looking at her bitcoin holdings as a standalone investment portfolio granted her USD balance sheet is completely sound. Alice has already diversified away from her bitcoin wealth by setting up a USD fixed income portfolio. Her next step should be to diversify her bitcoin portfolio by altering her current allocation of 100% cold storage.
Remove yourself from the shackles of a USD denominated world, for Alice’s sake. How can Alice maximize her BTC denominated wealth? Can she balance security and risk appropriately? With her USD portfolio properly allocated, Alice is ready to turn her attention to her Bitcoin wealth. She should use some principles from traditional portfolio management, but many of them don’t apply to Bitcoin. Tantra Labs introduces a new framework for BTC denominated portfolio management and the overall structure of bitcoin interest rates.
The structure of bitcoin interest rates
We have identified five main types of Bitcoin portfolio allocations currently available in the BTC denominated investment universe. Each sleeve has Bitcoin-native attributes and characteristics completely unique to this new cryptography-based asset class. We will make analogies to traditional investing with the caveat that not all analogies are complete or sufficient to describe Bitcoin.
The first Bitcoin allocation type is bitcoin held in cold storage. This investment is holding bitcoin without any counterparty risk and likely with a marginally negative return when factoring hardware and software wallet solutions, multisignature key signing services, and storage and redundancy costs.
The second and third Bitcoin allocation types carry varying levels of counterparty risk: exchange lending and depository instruments. Exchange lending of bitcoin is very similar to the concept of securities lending of bonds and equities to facilitate short selling. Bitcoin deposits work similarly to bank deposits; Bitcoin banks will profit by capturing a spread between borrowers and lenders. The interest rate in each transaction represents a combination of the time value of bitcoin and any risk premiums associated with the borrowing party, whether bitcoin exchange or bitcoin bank.
The fourth Bitcoin allocation type is bitcoin allocated to payment channels in the Lightning Network, a high-velocity routed network of Bitcoin nodes. Currently, nominal returns from routing fees still are outweighed by bandwidth and electricity costs because Lightning Network is in a nascent stage. Importantly, however, counterparty risk does not exist for the individual Lightning Network node operator; payment channels in Lightning Network use Bitcoin’s blockchain as its security anchor. The ability to earn bitcoin without taking explicit counterparty default risk is truly novel in monetary history.
The fifth Bitcoin allocation type is represented by Tantra Labs and its BTC denominated debt instruments. Returns are achieved by using algorithmic trading strategies with an explicit bitcoin benchmark. The objective is to outperform bitcoin held in cold storage. While cold storage bitcoin will have dollar returns dependent on bitcoin’s USD price performance, its bitcoin returns will essentially be zero. Tantra Labs is trading to outperform bitcoin itself, giving the investor access to an entirely new way of earning bitcoin.
Other BTC denominated return opportunities are coming online, all with their own idiosyncratic and counterparty risk. Derebit and LedgerX, online exchanges, allow writing options and collecting premium directly in bitcoin. Time value, risk premium, and volatility can all be theoretically determined from observing these transactions. A fund by Wave Financial started to capture this option premium and turn it into an income stream for investors.
Within bitcoin portfolio management, opportunities currently have varying degrees of liquidity, preventing a true comparison of interest rates right now. Lending bitcoin on BitMEX, for example, is a much higher capacity avenue to invest bitcoin versus payment channel routing in the Lightning Network.
Cold storage
Management of a bitcoin portfolio demands a first principles approach because the underlying money does not conform to what is currently considered money: central bank liabilities. Bitcoin is more comparable to gold or land than dollar deposits, as dollar deposits are liabilities on banks’ balance sheets. Bitcoin is a bearer asset much like a physical gold coin — once final delivery occurs, counterparty risk is eliminated.
This distinguishing characteristic between dollars and bitcoin alone should mandate an entirely different portfolio management approach, particularly in what the investor considers as the risk-free sleeve. Dollar investors buy US Treasury securities as the risk-free asset due to its dramatically reduced risk in relation to dollar deposits at individual financial institutions. Reserve assets are not held in dollar deposit form, they are held in government securities.
On the other hand, bitcoin held by investors using a variety of cold storage methods does not need a US Treasury equivalent as a risk-free security. The holder of bitcoin using his or her own cold storage does not have a counterparty like a dollar deposit has, and therefore the bitcoin holder does not demand a liquid asset equivalent to US Treasuries. Bitcoin’s underlying nature as an asset eliminates the need for the asset/liability security/deposit tradeoff existing in traditional portfolio management. The bitcoin asset itself has deep liquidity and fungibility. Holding BTC is logistically superior to the USD process of earning dollars, depositing them at a bank, and purchasing US Treasuries to negate any counterparty risk to that bank.
Exchange lending
Exchange lending was the first example of bitcoin exhibiting time value. Exchanges wanted to allow customers to go short bitcoin. Mechanically, shorting bitcoin requires borrowing bitcoin at an interest rate and then selling it. Customers with bitcoin deposits accrued interest on their holdings by lending to short sellers.
Bitcoin exchange lending works in a similar way to securities lending in traditional capital markets. Investors with custody of securities can lend them to short sellers. Bitcoin exchange lending transactions carry an interest rate comprised of some combination of bitcoin’s time value and the default probability associated with the borrower and exchange.
BitMEX, for example, offers lending rates across multiple timeframes; rates fluctuate depending on market conditions. Earning interest by lending to short sellers is currently the most relevant example of bitcoin interest rates because exchanges like BitMEX see billions of dollars worth of daily volume. We’re able to see bitcoin’s collateral-like traits most clearly in this setting.
Deposit rates
Companies such as Unchained Capital, BlockFi, and Celsius offer deposit rates on bitcoin in order to capture a spread on lending activity. The source of interest is similar to exchange lending: the depositor is being compensated for the time value of bitcoin and any counterparty risk associated with the borrower.
BlockFi offers insured deposits at attractive rates, but the most interesting aspect of its current rates offerings is the stark difference between interest offered on small versus large deposits. On large balances of bitcoin, deposit rates are materially lower than on small balances. Tiered rates are an indication of insufficient market depth.
Insured deposits also carry denomination risk. If bitcoin are lost or stolen from an insured fund, the depositor should be aware that insurance payouts might occur in dollars instead of bitcoin. Payouts can also occur with some delay, leaving the depositor exposed to price movements if payouts aren’t denominated in bitcoin.
Lightning Network routing
In 2017, the Bitcoin protocol’s Segregated Witness upgrade allowed Lightning Network to become a reality, forever affecting the way we think about settlement of money. Anybody with bitcoin could now join a peer-to-peer network and settle transactions instantly, without having to wait for block confirmations. Bitcoin simultaneously demonstrated two powerful traits as money when Lightning Network adoption began: velocity and native time value. A most welcome byproduct was a new way to allocate bitcoin: productive Lightning Network payment channels.
Investors should take note of Lightning Network not just for its unprecedented settlement characteristics but also for its Hashed Time-Locked Contracts (HTLCs). Lightning Network contracts can be compared to zero-coupon fixed income instruments, making Lightning Network essentially a web of financial agreements all with embedded time value. In order to use Lightning Network, users pay for the right to use others’ channel capacity; the fees incurred by users are fees earned by network routers. Time value can be calculated from three observable metrics: channel capacity representing principal, routing fees earned representing income, and the measurement period representing time.
In a previous work, I introduced the idea of a Lightning Network Reference Rate (LNRR), an average of interest rates that Lightning node operators earn from providing liquidity to the network. Large node operators such as BitMEX Research have already published realized interest rates for their routing activity. We don’t know their exact calculation metrics, nor are we able to audit them, but the fact they are disclosing an interest rate is a promising sign that LNRR might become a reality one day. With LNRR, Bitcoin will have a native time-value component free from centralized decision makers, such as LIBOR panels or central banking monetary policy committees.
Lightning Network routing is not yet a profitable endeavor. Fees in Lightning Network are extremely low, and the size of the network isn’t big enough to offer a material return to even the largest capacity node operators. The fact that routing has a positive nominal return, however, is monumental for Bitcoin’s capital market because LNRR can theoretically function as Bitcoin’s reference rate. A reference rate should be free of counterparty risk so that borrowers can offer lenders a risk premium instead of an absolute value. Lenders use risk premiums to determine the quality of investment, and on goes the debt capital market. LNRR offers Bitcoin an opportunity to take the traditional debt capital market’s first principle, the structure of interest rates, and make it its own.
Tantra Labs
Tantra Labs has created a brand new type of BTC denominated instrument, one which sources return from the volatility of bitcoin’s price. The instrument is structured as a debt vehicle paying quarterly interest, with an additional performance-tied dividend.
Tantra Labs uses algorithmic trading strategies programmed to capitalize on one of Bitcoin’s inherent characteristics, price volatility. We’re of the few, but not alone; Wave Financial recently launched a fund with a bitcoin option writing strategy designed to accrue BTC yield to investors.
Bitcoin price volatility is a robust source of income for arbitrage, market making, and speculative strategies, and it shouldn’t be expected to decline until adoption has increased materially. If Bitcoin follows an internet-like adoption path, it will become the worldwide standard for value transfer online, its terminal market value is magnitudes higher than today’s; adoption waves will lead to massive price swings as more investors and savers coalesce around Bitcoin’s terminal value.
Tantra Labs’ mission is to deliver BTC denominated investors more bitcoin by taking advantage of that unpredictably volatile path forward. Additional performance-tied BTC payouts will help provide optionality to the current yield landscape and attract capital looking to invest in instruments with proper risk compensation.
Portfolio management
Bitcoin investors should be keeping the majority of holdings in some form of cold storage. Custodians are starting to offer robust solutions, and some with enough multi-signature features to mitigate any counterparty risk. Whatever the storage method, the age-old adage of Bitcoin should be held paramount: “not your keys, not your coins.” Bitcoin flourishes because of the paradigm shift it created in securing wealth and protecting it from confiscation. No matter how much financialization of Bitcoin takes place, people will always hold their own keys to ensure their financial sovereignty.
Bitcoin denominated investors now have many options to invest in order to earn more bitcoin and should consider part of their portfolio to be allocated away from cold storage. Exchange lending of bitcoin is definitely the deepest market; returns can be made on very large balances. Depository institutions are growing in popularity, but tiered rates are a sign that the market for deposits is immature. Lightning Network routing is fascinating, exciting, and the source of swells of Bitcoin enthusiasm, but the rates are extremely low and the liquidity is relatively non-existent today.
Tantra Labs and its new BTC denominated debt instruments have a unique opportunity to find a home with the bitcoin-benchmarked investor. Opportunities to use bitcoin to make more bitcoin are growing by the day, creating a bitcoin structure of interest rates complete with term structure and credit spreads. Any investment that requires signing a transaction, sending bitcoin, and receiving a BTC denominated return needs to be thought of in its own category, and soon we’ll have a robust BTC denominated interest rate market.
Written and researched by Nik Bhatia @timevalueofbtc
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Author’s opinion only. The views and opinions expressed in this article are those of the author and do not necessarily reflect the position of Tantra Labs Inc. or any other company. Examples of analysis performed within this article are only examples. They should not be utilized in real-world investment decisions as they are based only on very limited information. Assumptions made within the analysis are not reflective of the position of Tantra or any company.
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