wyoming bitcoin

How To Keep The Bitcoin Strategic Reserve From Morphing Into A Bailout Fund

In October 2022, I cringed while listening to FTX’s Sam Bankman-Fried advocate for a government crypto bailout during his keynote at D.C. Fintech Week 2022, viscerally but silently screaming “NOOOOOOOO.”

No bailouts. 

Please, no bailouts.

But bailouts implicitly loom over the debate about a Bitcoin Strategic Reserve (“BSR”) in the U.S., because – if not expressly prohibited upfront – the BSR could someday be hijacked during a market panic to become a bailout fund for politically-connected parties. 

It is crucial that the authorizing legislation for any BSR be carefully drafted to prohibit the BSR from ever being used as a bailout fund. Why? Because there will never be more than 21 million bitcoins. Consequently, anyone who becomes leveraged more than 1:1 to bitcoin is insolvent, by definition. Precisely because there is no lender-of-last-resort for bitcoin, it is fundamentally unsafe ever to leverage bitcoin more than 1:1. 

A Bitcoin Strategic Reserve must ‘neither a borrower nor lender be.’

But politically-connected interests could pressure politicians to convert a BSR into a bailout fund, unless the BSR’s enabling legislation expressly prohibits that upfront. Hijacking the BSR to make it a bailout fund would not only socialize losses, but it would also defeat the purpose of a BSR. 

Accordingly, all such BSR legislation, whether at the federal or state level, must: 

  1. prohibit the BSR from ever being used as a lender-of-last-resort to bail out private-sector speculators, akin to the role of a central bank; 
  2. prohibit the BSR from ever lending, leasing, pledging, hypothecating, rehypothecating or engaging in derivatives transactions with the BSR’s bitcoins, or holding the BSR’s bitcoins in a margin account or omnibus (commingled) account at a custodian; 
  3. publish proof-of-reserves to enable taxpayers to verify at any given moment that the BSR actually holds and controls the bitcoins, and
  4. if the BSR invests in exchange-traded products that own bitcoins (such as ETFs or closed-end funds), and if the exchange-traded products enable lending, leasing, pledging, hypothecating or rehypothecating the underlying bitcoins, to avoid exposure to leverage the BSR must immediately sell the exchange-traded versions and invest in on-chain bitcoins held in self-custody. 

Two questions you might ask:

A. Governments engage in securities lending all the time, so why not with bitcoin?

Yes, but bitcoin lending is far riskier than securities lending. 

During the 2008 financial crisis, securities-lending strategies that were marketed as low-risk suddenly lost ~80% of their value in some cases. They “picked up pennies in front of a freight train.” Two things went awry: asset managers invested the cash raised from lending the securities into high-risk investments that defaulted (e.g., AIG in 2008); but, more importantly and far more subtly, long before the strategies failed catastrophically, their smaller losses got bailed out many times by various loss-absorbing facilities – which enabled them to keep building more and more risk. By analogy, they put out small fires without clearing the underbrush, so that when the conflagration hit it was catastrophic. These loss-absorbing facilities pushed the attachment point for losses out to the tail end of their probability distributions; they included unsecured credit lines from dealers, repo markets, collateral substitution, clearinghouses, the Fed’s lender-of-last-resort facilities, etc. But such loss-absorbing facilities won’t similarly exist for bitcoin (see below) – which means the attachment point for losses on bitcoin lending strategies will always be much closer to the spot bitcoin price. Translation: losses in bitcoin lending will be far more frequent than losses in securities lending. That makes bitcoin lending far riskier than securities lending. The 2022 blowups of bitcoin lenders such as BlockFi and Celsius are “Exhibit A” and were predictable.

You’ve heard me previously support leverage in bitcoin PROVIDED THAT it never exceeds 1:1, and only for those that can afford to lose their bitcoins to margin calls or counterparty defaults. But I do not support leverage of any form involving a BSR

Remember: the policy goal of the BSR is for the government to hold bitcoins for their price appreciation to defease government debt, as well as for strategic reasons, based on the expectation that bitcoin will outperform the U.S. dollar over time due to bitcoin’s relative scarcity. The annual inflation rate of bitcoin (currently 0.83%) is far lower than that of the US dollar (CPI is currently reported at 2.9%), and this differential in inflation rates is the key to understanding the BSR as a policy idea. (Note: since the Bitcoin protocol guarantees scarcity and, consequently, a lower inflation rate than the US dollar, bitcoin makes sense as a reserve asset. Any crypto-asset with an actual or potential inflation rate higher than that of the US dollar makes no sense as a reserve asset. Because the consensus mechanisms of other crypto-assets can be too easily changed to permit higher inflation, I do not support including them as reserve assets.)

Given the policy goal behind the BSR, it should also be clear why the BSR should not be used for trading or to generate income. Bitcoin has no yield, so all yield-generating strategies are really just leveraged bitcoin strategies – 100% of which involve the risk of default. All such strategies, by definition, would put the BSR’s bitcoins at some degree of risk and should be prohibited upfront.

So, if BSR legislation does not expressly prohibit all versions of leverage, I will oppose it.

 

B. Couldn’t the BSR become a clearinghouse? What’s wrong with that?

Wall Street must be salivating over the BSR, knowing financial market history and understanding how politicians can easily become scared into creating bailout mechanisms during market panics. Big banks no doubt would love to turn a BSR into a clearinghouse that socializes their losses.

Clearinghouses are institutions that facilitate settlement between transacting parties. Functionally, by facilitating settlement they provide liquidity via collectivizing the impact of defaults – which they spread across clearinghouse members, backstopped by the Fed. 

The policy response to the 2008 financial crisis shifted many markets toward using clearinghouses and away from settling trades bilaterally. But here’s the problem: clearinghouses concentrate risk in institutions that are literally too-big-to-fail (“TBTF”). (I’ve long predicted that the next major financial crisis will involve clearinghouses, since leverage in the traditional financial system hasn’t really declined – it moved from the TBTF banks to the TBTF clearinghouses.) 

Bitcoin doesn’t need a clearinghouse, since settlement happens on-chain. Moreover, unlike every other financial asset – including gold – it’s not possible for traditional finance ever to control a majority of bitcoins to establish a clearinghouse akin to those in traditional markets. It’s already too late, since nearly 70% of bitcoins are held by long-term holders. Most HODLers don’t trade their bitcoins, as recent data show long-term holders make up only 4-8% of daily trading volume. For a clearinghouse to become a meaningful market backstop, it must continuously have access to an enormous quantity of the underlying asset – like clearinghouses do for stocks and bonds but also for physical gold, which they can obtain through central bank leasing programs, for example. But this won’t be the case for bitcoin. Good.

That said, a BSR could still be hijacked to start a small clearinghouse to backstop leveraged crypto traders if legislative drafters don’t carefully prohibit that outcome. A BSR should never be allowed to morph into financial market infrastructure. A BSR is strategic, and its enabling law should carefully protect it as such.

Final Note: Revealing An SBF Story

It was interesting to replay that October 2022 interview of Sam by Kate Rooney of CNBC (starting at 5:03 on the video link). The interview took place exactly one month before FTX failed – when Sam was still flying high, worshipped as the reincarnation of J.P. Morgan of 1907 (!). You can hear that D.C. audience gushing over Sam. 

But I knew better at the time. Here’s the context. 

On stage, Kate asked Sam whether crypto needs a “crypto TARP” and he was quick to say yes (at 5:11 on the video link). Months before that, I had already arranged for the FBI to receive evidence of probable crimes committed by FTX. To hear Sam publicly urging the D.C. audience to create a government backstop was, to me, more confirmation that FTX was in trouble. Privately, I wondered whether Sam was already worried about being arrested if he set foot on U.S. soil – because Sam, who didn’t miss many opportunities to spend time with D.C. bigwigs, curiously did his keynote on video from the Bahamas.

It is chilling to replay that interview today, knowing what happened one month later and understanding what Sam knew then – and concealed from the public. Kate and I privately chatted backstage after the interview, and I told her I thought something was very wrong at FTX. I couldn’t reveal everything I knew, but let’s just characterize our subsequent conversation as this: both of our heckles were up. One month later, FTX blew up. 

Thankfully, Sam didn’t get a bailout. 

Lesson: don’t let the future Sams – bankrupt but politically-connected – hijack the SBR for a bailout. Carefully draft the SBR legislation to prohibit all leverage, in any form.

Thank you for reading!

Thanks to Nik Bhatia and Andrew Parish for their helpful comments on the draft of this post.

Founder/CEO Custodia Bank. #bitcoin since 2012. 22-yr Wall St veteran. Not advice; not views of Custodia Bank!

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