Bitcoin's growing pains

HERE'S a chart you never want to see in your portfolio. This is the Iron Titanium token, which after gaining 500 per cent in a week, proceeded to lose 100 per cent in little more than one day.

Titanium was part of the Iron finance 'stablecoin', tokens that are supposedly pegged to another asset, ideally a real currency like US dollars, thereby offering more stability compared to the volatility of the underlying cryptocurrency. Stablecoins clearly do not live up to their name.

Ever since writing two articles on bitcoin, I've become fascinated with the potential upside of the technology, while trying to identify the downside risks. This has led me to the Decentralised Finance movement, (or DeFi). DeFi is an interesting concept, attempting to bring concepts of traditional finance, like interest, lending, and insurance, to the crypto world.

DeFi tries to address the fact that cryptocurrencies are too volatile to be used as currencies for exchange of goods. If you own a business with a 20 per cent profit margin that accepts bitcoin for your widget, what happens when bitcoin falls 30 per cent after your sale? You've just made a loss, so the only way your business can survive such a drop is if you constantly adjust the price of your widget in bitcoins.

Stablecoins

Cue stablecoins, which act as a go-between to act as lubricant for the transaction.

Other than addressing the volatility of crypto, stablecoins also attempt to give investors confidence that there are real assets behind a token, thereby giving it quantifiable value. In addition, while you earn near-zero interest rates in traditional currencies, if you're willing to lock up your crypto investment for a period, like you would do in a one-month fixed deposit in a bank, DeFi can pay you yields of 20 per cent. Your crypto will then be used by the platform and lent out for interest, much like a bank. This lending improves liquidity, and can used for insurance and other similar financial transaction.

It's already become a big market, with over US$80 billion in DeFi programs, up from US$1 billion a year ago. The primary function is to take crypto deposits to make loans to people looking for leverage on their crypto bets. You can also insure your crypto stash against hacks, though there would be some clear questions about counterparty risk of the insurer, as none of these entities are regulated.

The Iron family of stablecoins were touted for their stability during bitcoin's 50 per cent fall in May. All until the fateful day in mid-June. The Iron Titanium debacle could be dismissed as an obscure part of the crypto world. However if you own Bitcoin and are bullish on its prospects, you should know that bitcoin is partially underpinned by two stablecoins: Tether and Circle. Both of these are supposedly backed by hard cash at 1:1 ratio. However a deeper dive into Tether raises many questions.

Tether has raised US$60 billion that has gone into bitcoin. With the supposed 1:1 ratio backing, Tether would be holding US$60 billion in US dollars, or as they claim in multi currencies and in US commercial paper. An audit scheduled for 2018 on Tether's reserves never took place.

The New York Attorney General's office announced an investigation soon after, accusing Tether's parent company of hiding a loss of US$850 million. While there is no audit, there is an attestation to the reserves.

The next time you meet an accountant at a party, instead of looking elsewhere to find a more interesting conversation partner, ask them the difference between the two.

Crypto fans have countered that they are aware of Tether's issues, and that it's probably a Ponzi scheme but only makes up 10 per cent of bitcoin's market capitalisation, so bitcoin will survive this. They are right, but they are ignoring market structure. In the early days when no entity would lend against crypto, you could simply hold on for the long term.

The DeFi movement introduces tremendous amounts of leverage into the system, with companies like Binance offering leverage of 125 times your investment. Old hands like me may not fully understand bitcoin, but we understand leverage.

The 2008 financial crisis was precipitated by Lehman Brothers' collapse, and Lehman commercial paper made up less than 2 per cent of the total. The amount of leverage that has been built up in the crypto infrastructure has introduced more finance-like instruments, but at the cost of stability of the overall system.

Tether has a sister company, Bitfinex, which is an exchange for crypto currencies. New York court filings alleged that Bitfinex took at least US$700 million from Tether's cash reserves to hide a loss after the money was missing, giving the money to a Panamanian entity called Crypto Capital Corp. And this is just the tip of the iceberg in red flags.

Tether is the biggest stablecoin, and yet in traditional finance no one has seen transactions by it, and even in this age of free money, US$60 billion isn't exactly chump change. If Tether's reserves are legitimate, one of the ironies of bitcoin is that it is propping itself up by self-printing its own money, just like a central bank. If they're not, the leverage in the system is likely to one day cause significant downward pressure on bitcoin's price, more than what we have seen so far this year.

Despite questions around Tether, bitcoin's journey to becoming a real asset just got much closer to reality, as it has just been adopted by a central American country as legal tender.

Legal tender in El Salvador

On June 9, El Salvador's 39-year-old president Nayib Bukele succeeded in getting Congress to pass a law making bitcoin legal tender. You will be able to pay taxes with bitcoin, and businesses will be required to accept bitcoin as payment for goods and services. El Salvador plans to mine bitcoin using volcanic energy.

Mr Bukele thinks this will bring all sorts of benefits to his country in investment, tourism, innovation, and economic development. The country would also offer citizenship to anyone who showed evidence they have invested in at least three bitcoins.

El Salvador will guarantee convertibility to US dollars by committing US$150 million of its own money to buffer its citizens from bitcoin's volatility, out of the country's US$3 billion in foreign exchange reserves. Supporters are hailing this as a legitimisation of cryptocurrency, confirming its role as a store of value, a means of transaction, and an investment asset class.

Unless bitcoin's volatility subsides, the US$150 million set aside may be insufficient. My economics 101 training suggests that the country's deficits will increase, and its bitcoin experiment will cause its US dollar reserves to dwindle, causing problems for the economy. The value locked up in bitcoin will see an exit to US dollars to the tune of US$3 billion in El Salvador's reserves, assuming the experiment is successful and bitcoin becomes the transaction currency of choice.

Daily bitcoin fluctuations will influence consumer behaviour: ever-higher bitcoin prices causing people to put off spending them, or falling prices causing hyper-inflationary behaviour, where people rush to spend a currency that is devaluing each day. It will be fascinating to see what happens in El Salvador, and if they end up reversing this legislation.

Economics 101

Or maybe my economics 101 training will be proven wrong. After all, it taught me that massive government spending leads to massive inflation. The US is up to 130 per cent debt-to-GDP with little sign of inflation. Japan, which has been at this much longer than any other country, is at 260 per cent debt-to-GDP (compared to 60 per cent when its asset bubble burst three decades ago) and has not seen any inflation. Maybe I should ask for my tuition fees back.

I was discussing all of the above with a hedge fund manager who has been quoted in media as having interest in bitcoin. Rather than outright buying bitcoin with all the potential downside risk, the crypto-related assets that are coming to the stock market (the second largest stablecoin, Circle, has filed to go public via a SPAC merger with Concord Acquisition Corp, following Coinbase's successful IPO) provide a way to hedge some of the downside risk via traditional crypto-linked stocks. When hedge fund managers say they are in bitcoin, they're likely to be involved in ways such as this, rather than outright long with no protection.

• The writer is co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund-management services to endowments and family offices, and wealth-advisory services.