Don’t Trust. Verify!

As the fall and contagion from the recent failure of the crypto exchange FTX and its associated hedge fund Alameda Research reverberates around Wall Street and the Crypto markets, I feel it would be helpful to reassure our clients of how we hold crypto in our investment strategy.

Most of the damage has been done to the US nonregulated offshore exchanges. Unlike for example the jurisdiction of Gibraltar which has developed a government backed robust regulatory regime for the licencing and regulating of Distributive Ledger Technology (DLT) exchanges and products. Still too early to know precisely, but it would appear that the demise of FTX was as a result of Fraud. However, that many large institutional investors from Pension Funds and Private Equity trusted a 23-year-old without conducting robust due diligence, is a result of greed arrogance and hubris. Whilst Wall Street have and will simply write off their losses as a rounding error, smaller investors will have lost their savings which they probably never be able to recover.

Before deciding to own bitcoin for my own family and clients I set about investigating the best way for us to hold Bitcoin and in the process carried out analysis as to the best available option to provide safe custody of Bitcoin and Ethereum. We were not intending to trade Bitcoin or use utility as a form of payment but to have an exposure to the price in the most secure and transparent way possible.

The requirement for us therefore was that we held Bitcoin in a securitized form in order that our custodian Bank would be able to take custody of the asset and quote a daily price to appear in a valuation. Our investment case for owning Bitcoin was as a store of value for the long term with no intention of trading or making transactions but building a position aligned to our strategic asset allocation by dollar cost averaging into the position. We therefore avoided the non-regulated offshore exchanges most of which use huge leverage which has been part of the problem contributing to lack of liquidity when prices decline and subsequent insolvency. The option of self-custody using a personal wallet was not viable as we required it to be held and valued by a regulated and licenced custodian.

We hold Bitcoin in two forms. Through an Electric Traded Note (ETN) XBT Tracker issued by issued by CoinShares PLC which tracks the price of Bitcoin. It is issued in certificated form as a debt obligation registered and listed on the Stockholm Stock Exchange. This provides scrutiny and transparency with regular audit something that has been missing from the offshore exchanges. A certificate is issued for each investment made and physical bitcoin is held to back each sales transaction. The Swedish regulator Financial Services Authority (FSA) (not known for a cavalier attitude to rules) has to approve all aspects of the product as described in the CoinShares prospectus before they will approve registration and listing on their national stock exchanges. The mission and principal role of any government regulatory authority is to protect the general public from losing money as a result of gross negligence and criminality.

The Guarantor to the obligation is CoinShares PLC a public limited company listed and regulated In Jersey Channel Islands by the Financial Services Commission.

CoinShares as the Guarantor have a strong balance sheet are subject to public audit and in addition hedge their assets and liabilities daily. By electing to own Bitcoin this way, we sacrifice some private confidentiality by not using personal custody, for the security of knowing that it is held in a robustly regulated jurisdiction with regular audit and increased security and transparency. None of these parameters applied to the exchanges that have filed for bankruptcy. Having an independent guarantor with its own balance sheet and as a public company under scrutiny from the regulator provides and extra layer of risk management designed to ensure in a worst-case scenario sufficient liquidity so that were all note (certificate) holders to cash in their certificates the issuer would be able to fulfil its obligation to note holders.

In addition, to diversify our business risk we also hold Bitcoin in another form of security which our custodian can hold and value daily through an Exchange Traded Fund (ETF) registered and listed in the Toronto Stock Exchange. In the same way as the ETN listed on the Stockholm Stock Exchange, the ETF in Canada by the giant US investment house Fidelity Inc. According to their prospectus (the legal document of the issuer) the ETF is not leveraged and is subject to public audit and the same scrutiny as stocks and Bonds held in exchange traded funds and listed on stock exchanges.

We believe that we have done our homework and whilst nothing may be guaranteed as certain, the risks associated with holding Bitcoin as a regulated security are largely contained in the speculative nature of the asset due to the uncertainty of definition which is reflected in the price. By owning Bitcoin as a securitized asset registered and regulated on a stock exchange, we mitigate much of the business risk seen in the unregulated or lightly regulated highly leveraged (borrowed capital) offshore exchanges,
It should be noted that by holding Bitcoin on a personal wallet in self custody, risks with a counter party are mitigated with the opportunity to transact utility, which is why many prefer to hold Bitcoin in this way.

A word on Bitcoin

As a result of the recent collapse of several main crypto exchanges beginning with Terra Luna and Celsius during the summer and now FTX, USD 15 Bn of crypto has been transferred from the exchanges onto personal wallets, in the last 5 days, most one of the main exchange Coinbase. The fortunate were able to make a transaction before the exchanges closed to withdrawals. 
In spite of the collapse of many crypto exchanges, the adoption (new acquisitions of Bitcoin) has risen to all-time highs!

Adoption on Bitcoin as measured by new addressed against the Bitcoin price. Yellow line Bitcoin adoption. Black line Bitcoin price.

This increase in adoption has happened as the price of Bitcoin has fallen 78% from the high in November 2021.

2014 – 2015 the price of Bitcoin fell 85% from the highs for 286 days until capitulation. 2018- 2019 the price of Bitcoin fell 84% until capitulation in 136 days.

Most of the early speculators have been cleaned out in the last price decline and a savvier investor is now buying Bitcoin as a long-term investment understanding that it is like Gold is a decentralised asset which is no one else’s liability. In the worlds FIAT financial system everything with that is not Gold is credit. This is also true of Bitcoin. As both Gold and Bitcoin are decentralized although their price can be manipulated in the short term by the futures markets, our investment case for holding Bitcoin is as a hedge against the collective stupidity of politically motivated central banks, and as a store of value over the long term. In addition, given a finite supply and huge unrealized potential demand, the opportunity for substantial price increase over time is compelling. It is a given that Blockchain technology and increased utility will continue to develop as long as entrepreneurs have access to capital.

What the collapse of the crypto exchanges has shown is that an entrepreneurial led industry is still crawling in ‘nappies (diapers) and needs to grow up. To the extent that institutional investors were driven offshore by the failure of the US to regulate and irrespective of their woeful lack of risk management shows the extent of the demand. What is now urgently needed is a regulatory standard definition for Crypto and Bitcoin. From the public remarks written and articulated by the US Security and Exchange Commission (SEC) and more recently the IRS (US Internal Revenue Service) Bitcoin is property (a commodity) and everything else is a security and will be subject to the already robust securities law. Under US law. an asset which has an issuer is a security which would include all crypto. Bitcoin does not have an issuer and is now recognised by the IRS as falling into the category of a hard asset a commodity not a security. However, this has not yet been defined formally by the US regulator.

When this definition is officially made then we will see increased legislation and regulation. This will be the catalyst for widespread adoption. With a market cap of around USD 10 – 11 trillion (current global amount of gold by capitalization) Bitcoin like Gold will exhibit less volatility and potential for a substantial increase in price over the long term. In addition, Bitcoin as a utility provides some 1.5Bn people who are unbanked around the world access to transactions and utility without needing a bank account which is beyond the reach of many for social, economic or political reasons. However, it would be remiss of me to close this note without the observation that the US corporate giants WorldCom and Enron were all subject to regulation as was Bernie Madoff. You cannot legislate away all Fraud.

Jeremy Blatch TEP
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