Re-hypothecation & Fractional Reserves

Good Morning Everyone,

Caitlin Long, founder and CEO of Avanti, a US bank focussed toward digital assets, and a major Bitcoin proponent in the US, highlighted something yesterday that I had not given much thought to, and think has largely gone unnoticed for the most part up until now.

In a really powerful twitter thread, which i encourage you to read for yourself, she highlighted the impact of derivatives markets, specifically the impact to supply and demand, through the issuance of “paper bitcoin” and the way in which this distorts price. Paper Bitcoin meaning “bitcoin” that are not part of the 21m fixed supply - rather a contract via an intermediary for a claim on the value of bitcoins current market price (ie futures or options derivatives).

The thread was in relation to why MVRV ratio (market value to realised value) may not be useful in valuing bitcoin, due to the fact that RV is not an accurate number because of the issuance of all the paper bitcoin contracts as she claims many likely run fractional reserves.

I’ve attached the MVRV chart below so you can take a look.

The basic idea here is that due to the injection of an artificial supply via paper or fake bitcoin, people holding the real pristine asset ie: on-chain bitcoin, are having their asset devalued, and not by one factor, but two fold.

* Price drops due to fake supply being created and also, and perhaps more critically;

* Price drops or is impacted further, due to demand for the real asset dropping as demand is catered for via the artificial supply instead of the scarce bearer asset.

So this phenomenon is not just increased supply, but also decreased demand.

The fact that this impacts Bitcoins price in the short term, is not what is most i found most interesting however.

What really stood out to me was the level of fragility this creates and how much more pristine holding the real asset actually is. The risk of a run on the market where there is insufficient bitcoin held by exchanges to satisfy the claims being made by market participants could lead to a number of failures, or blow ups. The only way to be insulated from this is to hold the true bearer asset.

So basically a number of players are falling into the same traps that in part leads us to this new system. That is re-hypothecation and fractional reserves.

At the end of the day, the market has a way of working these things out, although it can take much longer than you think and often creates a lot of pain in the process as the market educates participants on risk, and risk management.

One of the primary reasons Bitcoin is so powerful is the fact you can securely hold it yourself, without any need to trust an intermediary to store and secure it for you. Unlike when you store money in a bank, or own stocks via an exchange or gold, silver or diamonds in a vault - in these instances you are trusting that when you want to take possession of these commodities, that the 3rd party will oblige.

Bitcoin is a bearer instrument or asset. Fully secured by proof of work, whereby no one can create a counterfeit. It is fully secured via unbreakable SHA256 cryptography and you do not need to seek anyones permission to access it. Forfeiting these properties and essentially handing over ownership of your assets and trusting an institution carries significant risk, and for most people should likely be avoided in my opinion. As to do so dissolves the very qualities that makes Bitcoin so powerful in the first place.

As the saying goes, “Not your keys, not your coins”.

The simplest thing is often the hardest when it comes to investing. Lowering your time preference. Let time do the heavy lifting. Let your winners ride, and allow them to compound over time.

Where there exists opportunities for what seems simple often carries significant hidden risk. Storing your keys offline in a secure way is a process that every bitcoin holder needs to go through for themselves.

My hope is that it’s in a proactive way because they understand the asset, it’s qualities and what’s at stake, as opposed to being reactive and learning the hard way.

Hope everyone has a great start to the week, and I look forward to chatting to you tomorrow.

AK

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