Bitcoin Financialization and the Minsky Cycle
Bitcoin has been around for more than a decade and its total “market capitalization” passed $1 trillion, making it the fifth largest currency in the world by some base money measures (USD, EUR, JPY and CNY are the top four, in that order).
And yet, Bitcoin has yet to become the “world currency” that some of its early acolytes had hoped.
Bitcoin as a store of value has been well established. A UTXO, or unspent transaction commonly referred to as a coin, can be acquired, stored, transferred and spent with ease. In some countries, bitcoin is a better store of value than the national currency because it is not subject to capital controls, devaluation or inflation.
Despite its global nature, size and appeal, bitcoin’s use as a financial asset is still constrained.
To understand why, we can borrow the framework that Hyman Minsky established to explain the connection between the economic and financial cycles.
In his hypothesis, there were three types of financing which he called hedge, speculative and ponzi. He posited that economies would naturally cycle through each stage. While the actual mechanisms of finance remained similar, the character of each stage was unique. It was a cycle because eventually there would come a moment, later dubbed a “Minsky Moment”, when the house of cards from the Ponzi stage would grow large enough to fall in on itself. The financial institutions that survived would rebuild themselves from a very conservative starting point and the cycle would build anew.
For the purpose of this article, I will simplify the stages.
“Hedge finance” describes lending in which the cashflow of the underlying asset alone is sufficient to repay principal and interest. This type of financing is considered the least risky and priced accordingly.
“Speculative Finance” refers to a situation where the income produced by the asset being financed does not cover all the interest and principal. The equity holder has confidence that the asset will increase in value. By leveraging, the equity holder seeks to boost the potential rewards because the obligation to the debt holder is fixed. If things go in the wrong direction, the resolution is that the asset will be liquidated (in a bankruptcy or restructuring procedure) and that the debt holder will be largely or wholly compensated while the equity holder takes all or most of the loss. Speculative debt financiers put more weight on the loan to value (LTV) ratio than the expected cash flows of the underlying asset. With the higher risk, providers of this type of financing expect a higher return.
The final stage is called “Ponzi Finance”. This is financing in which repayment hinges entirely upon the appreciation of the underlying asset. The asset does not produce much or any cash flow on its own and certainly not enough to support the interest and principal payments of a normal loan. So long as the asset appreciates faster than the cost of financing, ponzi financing can last for a surprisingly long period of time. However, once the momentum fails, asset liquidation will wipe out the equity holders and a potentially large proportion of the debt financing portion along with it. The subprime housing crisis followed the script perfectly. These financings provide the highest risk and command the highest margins.
While it might seem that the progression from hedge to speculative to ponzi financing is driven entirely by the greedy equity side of the finance equation at the expense of the gullible debt side, that would be an oversimplification large enough to distort the picture entirely. Financial institutions are always trying to grab extra bits of return because their shareholders demand competitive returns on investment. It would also be misleading to think of these stages as mutually exclusive. In 2007/2008 subprime crisis, there were still plenty of dull project finance deals being structured. The problem was the credit destruction at the ponzi end of the spectrum was large enough to require financial institutions to pull resources from even their most conservative endeavors, causing a system wide credit squeeze.
Using this framework, it is easy to see where the center of gravity is in terms of Bitcoin Financing as it is practiced today. When ‘ponzi” epithets are hurled at bitcoin, they are channelling Minsky rather than Madoff, even if many have not fully thought it through.
There are currently only two sources of natural BTC cashflows today which could be financed as “hedge financing”. And they are not huge relative to the overall stock of currency or current financing activity.
The first is in bitcoin mining. A bitcoin miner turns on their rigs and participates in the roughly every 10 minute lottery game that yields newly minted bitcoin and the fees that we attach to our proposed bitcoin transactions. The variables are the cost of electricity and the computational difficulty of winning the right to form the next block in the blockchain. For the places on earth where turning wind, solar, hydro, coal, natural gas or potentially nuclear energy into electricity is cheap enough, turning that resource into enough electricity to win the right to mine the next block can be a viable business venture. The metrics are transparent to all players and the parameters can be easily encoded into operations using readily available software tools.
An example of this in West Texas can be found here. There are also stories of companies doing similar exercises with solar in Texas where it is reported that a company mines bitcoin for 10 months and sells electricity to the grid for two months during peak air conditioning times. This article suggests that more than a few Texas bitcoin miners are looking to jump into the fray.
The other smaller but interesting source of natural BTC cashflows comes in the form of Lightning network fees. Well established nodes on the Bitcoin Lightning Network can sell access to interested parties through an auction system run by Lightning Labs called Pool. The nodes are a way to build something similar to a correspondent banking system within the bitcoin network that allows for private bitcoin transactions at speeds and transaction costs unachievable on the main network.
The next layer of financialization can be categorized as “speculative finance” and it appears to be the most prevalent financialization activity in crypto currencies today. There is an active market in lending bitcoin to companies that fund the margin lending activity of financial players to short bitcoin. Shorting bitcoin can be done as a straight bet that the value of bitcoin will fall or as part of a more complex pair trading strategy to match BTC with cryptocurrencies that may outperform the shorted BTC. While this is the bread and butter of “hedge funds” in the space, it is important to distinguish between their “hedge fund activities” and what Minsky would characterize as “hedge financing”. These activities fall squarely in the “speculative financing” realm as market driven returns rather than income streams will determine the success or failure of the activities being financed. Carry trade opportunities, where the borrow on one currency is cheaper than the interest one could earn on the other cryptocurrency in the pair trade, may present themselves from time to time but given the volatility of crypto currencies, the rapid dissemination of pricing information and the lack of underlying economics to drive disparities, those arbitrage opportunities are not large and frequent enough to yield steady cashflows.
The final category, “ponzi finance” happens when the “speculative finance” gets “over its skis”. This has already resulted in a few business collapses and defaults but so far nothing systemic enough to cause a crisis in the bitcoin market.
How will Bitcoin Financialization develop from here?
There are two ways in which bitcoin finance could nudge the center of gravity from its current position somewhere between “speculative finance” and “ponzi finance” back towards “hedge finance”.
The first way relies on the adoption of bitcoin in a real economic setting. The more that spending, investment in real assets and wages become denominated in bitcoin, the more likely that sources of natural cashflows of bitcoin can develop. Once natural cashflows develop, financial institutions will scramble to find ways to finance the flows. A whole fleet of decentralized finance (DeFi) projects have been launched to find pathways to creating these sources of economic activity across a broad spectrum of crypto currencies.
The second way depends on using bitcoin as a savings vehicle in a hybrid model that bridges the gap between the worlds of fiat currencies and crypto currencies. By combining the collateral aspect of bitcoin and fiat cashflows from real world activities, financial institutions will start to introduce programs that allow savers to accumulate crypto savings. The insurance industry and the fund management industry both have deep experience in transforming current cashflows into future savings pools of capital. The tools are available on both the crypto and fiat sides of the divide. Building the bridges to cross that divide will create a new market that will allow bitcoin to develop from its current position as a store of value and speculative plaything into a legitimate “world currency” deep pool of capital that savers can use as a mainstream financial planning tool and borrowers can leverage to drive future economic activity.
Flux has developed a regulatorily compliant method to build a “perfected security” out of bitcoin. We will use that methodology to develop retail and institutional tools to bridge the gap between the fiat and crypto worlds of currency. This will allow bitcoin holders to financialize their holdings and build the deep pools of capital in bitcoin that the markets crave and HODLers have been holding out for. Once the road towards deep pools of capital in bitcoin is apparent, the financial world will happily welcome its newest “world currency” and bitcoin will reach the potential that many had hoped it could achieve.