When interest in blockchain peaked three years ago, most companies had a plan (or at least a PR announcement) for force-fitting what Dennis Howlett called "the most over-hyped yet least understood technology shift I've ever seen" into their operations, whether it made sense or not. Little did anyone know that perhaps the most promising corporate blockchain application might be the one that made the technology a household name: digital currency.
Until recently, Bitcoin's immature financial ecosystem, extreme volatility and legal ambiguities made it inappropriate for anyone but speculators. Since falling from its first peak in December 2017, the financial infrastructure for cryptocurrency has significantly matured, however, a recent price spike has seen a return of the volatility that spooked investors three years ago. Nevertheless, the COVID-19 response by central banks and sovereign treasuries is even more worrisome to some, including a small list of companies trading their dollars for Bitcoin.
The governmental response to the calamities of 2020, which saw the U.S. Federal Reserve expand its balance sheet by more than 75 percent ($3.25 trillion), the U.S. Treasury accumulate $3.7 trillion in debt since the end of FY2019 and the European Central Bank add more than €2 trillion is unprecedented. Such a massive expansion in financial assets has many questioning the long-term value of fiat currency and looking for alternative assets such as commodities and cryptocurrencies as hedges against inflation. Wealthy individuals have started using cryptocurrencies to supplement other alternative investments and several corporations, notably MicroStrategy have chosen to hold Bitcoin on their balance sheets. Since adopting Bitcoin as a primary holding in its treasury, MicroStrategy's share price has quadrupled, significantly outperforming Bitcoin itself. Although the company had some strong earnings reports since then, cryptocurrency enthusiasm and significant appreciation of its Bitcoin assets undoubtedly contributed to the rise.
CEO Michael Saylor explained the company's rationale this way (emphasis added):
This investment reflects our belief that Bitcoin, as the world’s most widely-adopted cryptocurrency, is a dependable store of value and an attractive investment asset with more long-term appreciation potential than holding cash. Since its inception over a decade ago, Bitcoin has emerged as a significant addition to the global financial system, with characteristics that are useful to both individuals and institutions. MicroStrategy has recognized Bitcoin as a legitimate investment asset that can be superior to cash and accordingly has made Bitcoin the principal holding in its treasury reserve strategy.
Investment or gamble?
MicroStrategy didn't take the decision lightly, deliberating it for months before concluding that Bitcoin mitigates several macroeconomic risks to its reserve holdings. These primarily stem from the continued uncertainties due to Covid and subsequent policy response I illustrated above, or as Saylor put it, "unprecedented government financial stimulus measures including quantitative easing adopted around the world." He shares concerns about a potentially inflationary financial policy and still struggling economy that investors traditionally hedge against by purchasing precious metals, but now have some turning to cryptocurrencies (emphasis added):
We believe that, together, these and other factors may well have a significant depreciating effect on the long-term real value of fiat currencies and many other conventional asset types, including many of the assets traditionally held as part of corporate treasury operations. In considering various asset classes for potential investment, MicroStrategy observed distinctive properties of Bitcoin that led it to believe investing in the cryptocurrency would provide not only a reasonable hedge against inflation, but also the prospect of earning a higher return than other investments.
Indeed, Saylor proceeds to call Bitcoin "digital gold," adding that its value will further increase as network effects create a virtuous cycle of greater innovation and adoption. Saylor and other MicroStrategy execs reiterated their Bitcoin stance when discussing the company's recent Q4 2020 earnings. The CFO said MicroStrategy purchased 70,469 Bitcoins for an aggregate price of $1.125 billion, making its average price $15,964 per Bitcoin with an unrealized (paper) gain of $1.27 billion based on a recent price of $34,000. When asked if MicroStrategy was simply using Bitcoin as a "buy low, sell high" investment vehicle, Saylor stressed that it's not, but rather sees Bitcoin as a strategic investment, saying (emphasis added):
Our belief is that Bitcoin is the first effective digital monetary network, and it's going to grow over time. We're early adopters, the early Bitcoin holders or adopters. It's the solution to every company's problem and every individual investor's problem. And so as more and more corporations adopt the Bitcoin's standard and they use it as a store of value, as more investors and mutual funds and hedge funds use it as a store of value, as more individuals use it as a store of value, the overall amount of monetary energy, the total amount of capital flowing into the network is just going to increase in time. And because there's a fixed amount of Bitcoin, that just means the price is going to go up. And as I've said to many people, the nature in the free market is in a free market capital flows from the weakest assets to the strongest assets...We're strategic buyers, and we're looking out a decade or longer, which we think is the right way to think about this.
Although MicroStrategy is holding Bitcoin for the long term, one analyst raised an pertinent accounting question about how the volatility of Bitcoin's dollar price affects MicroStrategy's quarterly balance sheet. Its CFO answered that the company treats Bitcoin as an intangible asset and that GAAP requires it to mark its digital wallets to market every quarter, creating balance sheet fluctuations that showed up between Q3 and Q4. However, the company also reports non-GAAP financials that better reflect the underlying book value of its holdings, adding " there's transparency into both means, the book value and a potential market value."
Bitcoin proponents refer to it as a digital currency, however, the designation is more aspirational than actual since Bitcoin isn't widely accepted as a medium of exchange, with the dollar volume of Bitcoin payments about 1/2000th the size of annual U.S. retail sales. The other significant critique of Bitcoin is its volatility. Even when priced using another popular inflation hedge, gold, Bitcoin's value has spanned a 4:1 range over the past year.
Some investors counter that such volatility makes Bitcoin a more efficient hedge against other assets since it means you don't need much to diversify a portfolio. For example, the VP of research at Morningstar estimates that a 5 percent share in Bitcoin diversifies a balanced portfolio as effectively as a 25 percent allocation in an 'alternative' Hedged Equity mutual fund that uses options to reduce volatility. Bitcoin as a portfolio hedge also has the advantage of being almost completely uncorrelated to both equities and gold.
Another recurring critique is that Bitcoin's price is artificially inflated by purchases from other crypto currencies, particularly Tether, that can create (rather than mine as the case for Bitcoin) new tokens on demand. However, the Tether fraud argument has been debunked by crypto analysts who point out that at 4 percent that of Bitcoin, Tether's market capitalization is far too small to move the price.
Corporate Bitcoin beyond MicroStrategy
MicroStrategy is the largest and most prominent, but several other companies now hold Bitcoin on their balance sheets. MicroStrategy remains unique as the only non-financial firm, since others with significant Bitcoin portfolios operate Bitcoin funds or are investment managers. A site that tracks corporate Bitcoin holdings shows an aggregate value of about $44 billion, with MicroStrategy accounting for almost six percent of the total.
MicroStrategy is promoting Bitcoin as a financial asset with a Bitcoin for Corporations track at its MicroStrategy World conference this week, which includes sessions on Bitcoin:
- Macro strategy
- Corporate strategy and playbook
- Legal and financial considerations
- Marketplace with presentations from Binance, Coinbase, Kraken, NYDIG and others
I'll have coverage in my next article should significant news emerge from the event.
Ditching dollars for Bitcoin is a bold move that instantly turned MicroStrategy into an influential force in the crypto currency world. Given Bitcoin's volatility and recent price appreciation (and pullback) it also significantly muddled its financial reporting and corporate strategy to the point that one analyst asked Saylor whether MicroStrategy is still a software company or merely a Bitcoin investment vehicle. Saylor's reply, that the company's primary focus is software but that it plans to continue acquiring Bitcoin to bolster its balance sheet, implies that the company is both, a factor sure to confound financial analysts attempting to value the company.
While there's a good case for Bitcoin as an inflation hedge and vehicle for portfolio diversification, the ecosystem for distributed finance, aka DeFi, is too immature to allow Bitcoin to be broadly used for B2B transactions. However, it behooves corporations wanting to be on the cutting edge of DeFi and smart contracts to include some Bitcoin on their balance sheet and gain experience using Bitcoin as an alternative to wire transfers for B2B payments. More committed DeFi advocates can start playing with Ethereum and wrapped Bitcoin to combine the former's advantages as a smart contract platform with Bitcoin's security and financial ecosystem.
Bitcoin and other crypto currencies have survived stages of euphoria, despair and derision to emerge as a viable, albeit still unstable, financial asset. With AT&T, Microsoft, Overstock soon to be joined by Paypal in accepting Bitcoin payments, MicroStrategy won't be the last major corporation holding Bitcoin on its balance sheet. Organizations that want to be ready for the mainstreaming of crypto-enabled DeFi should start preparing now.