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1/ I wrote an accessible analysis on the risks involved in investments such as the @TheRealBlockFi Interest Account. I find legal ToS documents difficult to parse so sought to explore the mysterious world of risk and finance at a basic level: zanepocock.com/blockfi-and-th…
2/ Before I go on: this is not a hit piece. I defend @TheRealBlockFi's right to build their business as well as market participants' right to assess whether it's a fit for their own needs. But I don't feel like there is clear enough information out there to do this.
3/ BlockFi's foray into the market last year with their Crypto Loans offered an opportunity for hodlers to make a calculated custodial risk if they needed liquidity. They could hypothecate bitcoin against a fiat loan and avoid realising a capital gain blockfi.com/taxes/cryptocu…
4/ The biz model for these loans is simple: BlockFi charges 4.5% interest and plans to hold on to as much forfeited collateral as reasonable to play the Bitcoin long game, as @BlockFiZac and @MartyBent discuss here: stitcher.com/podcast/marty-… The fiat cash for lending comes from VCs
5/ BlockFi's second product, an Interest Account, was announced a few weeks ago and caused some commotion. Through this product, hodlers can deposit bitcoin (or ether) and earn an initial 6.2% annualised interest, paid out monthly, though this rate is likely to change.
6/ Responses varied b/w 3 main positions: 1) 'yay, interest!'; 2) 'the ToS document is hella frightening, don't use this product!'; & 3) 'welcome to finance'. My goal is to take the concerns of 2 and explain what 3 knows so 1 can make an informed decision
7/ The short thesis for investing in a BlockFi Interest Account is to earn interest against the risk of BlockFi defaulting. As @matt_odell put it on RHR, you should see these as high-risk 'junk bonds', not 'savings accounts' which culturally carry a lot of low-risk assumptions.
8/ Rehypothecation is the loudest perceived risk, though probably not the most significant. Rehypothecation means that an asset you post as collateral against a loan is used in turn by the custodian as their own asset for a further loan. It creates 2+ claims on a single asset.
9/ To me it's a fallacy that this phenomenon even exists; the collateral is never the custodian's asset. But leaving that aside, let's first accept that there is not yet any *systemic* risk to Bitcoin from rehypothecation. Financialization is just too early and small for now.
10/ But there is individual risk from rehypothecation: you need to trust that the debt BlockFi takes on against your collateral is at a risk level you're comfortable with. If BlockFi defaults, you might have to defend the seniority of your right to the collateral or else lose it.
11/ All this said, rehypothecation appears to be a meaningless concept within the context of the Interest Accounts. They function more like a loan *to* BlockFi, not from them, and thus no collateral is involved. So why is this in the ToS?
12/ In its defence, BlockFi claims to over-collateralize its loans, requires short termination windows for its lending contracts to other institutions, monitors positions, models risk pricing appropriately and so on. There's no verification option on this: you have to trust them.
13/ The possibility of fractional reserves was the next loudest concern. In 'The Mystery of Banking', Murray Rothbard explores something that is particularly pertinent here: the traditional separation of roles between deposit banking and loan banking mises.org/library/myster…
14/ With gold and other commodity moneys there was a need to store wealth in a warehousing facility — a deposit bank for this conversation’s purpose. These were separate to loan banks that looked much like the term deposits/CDs/time deposits we’re familiar with today.
15/ One of the reasons we ended up with the riskier fractional reserve banking system of today is that these functions became co-mingled. If banks noticed they only ever needed 20% in reserves at any time there was every incentive to owe more than they were owed (create money).
16/ @BlockFiZac is right to observe that it's hard to see how fractional reserves could be built by BlockFi at this point in time; we're told that all activity occurs on-chain. Again, you're required to trust this.
17/ But while BlockFi might not inflate the supply of Bitcoin receipts, the mix of bank functions does expose the risk of a bank run. Despite their best intentions I contend that if most current debts were simultaneously called upon, BlockFi might struggle to meet obligations.
18/ This is why higher-risk lending tends to have a well defined loan period (time deposits). A solvent loan bank would manage their books in a way to ensure that they always, predictably have the debts owed to them due before the debts they themselves owe could be called upon.
19/ BlockFi offers instant withdrawals in theory but its terms stipulate it may take seven days to meet obligations. It requires the same seven-day notice period (or shorter) from the institutions it lends to, which on the surface might give the appearance of solvency.
20/ But this doesn’t account for the shock of a short notice period. BlockFi lends crypto to institutions and individual futures investors who may be unable at any given moment in time to unwind their investments. Sudden big market moves that expose gap risk also compound here.
21/ Venture Capital. BlockFi appears to be running on generous venture capital injections. This is no small detail, with the Silicon Valley boom since 2008 being a textbook example of the malinvestment that arises from an easy monetary environment
22/ This doesn’t necessarily mean that BlockFi has any undue risk, but if they’re reliant on VC to maintain their operations or incentivize new clients to reach a critical mass then this tap running dry is certainly a tail risk to price into your decision to engage with them.
23/ On that, BlockFi has admitted to strategically positioning these interest-earning accounts as a loss-leader for up to 18 months and intends to launch new products every six months, backed by extra venture capital to help them achieve their growth aims coindesk.com/25-million-in-…
24/ Alt coins. You might think that you understand Bitcoin well, but BlockFi is playing with Ethereum as well. The caution is self-explanatory here: do you have faith in the BlockFi team to adequately understand both of these markets in the long run?
25/ Insurance. You have no insurance and no way to get it. FDIC insurance would not cover you; you are solely exposed to any losses that BlockFi incurs on your funds. FDIC insurance is the Central Bank’s way to cover depositor funds held with a bank. This is not a savings account
26/ Exchange risk. I hate to state the obvious, but all the above risks are on top of those you’d expect with any other custodial solutions: mis-managed keys, exit scams, leaked/sold data, etc. BlockFi uses @Gemini for custody, a third party with a good track record, but beware.
27/ Tax. As @alphaazeta pointed out, it appears that returns from BlockFi will be taxed as ordinary income. At a 37% tax rate (the highest bracket for personal income tax in the U.S.), this leaves you earning a real yield of 3.9%. Is this worth the downside risk?
28/ Risk premium. What we’re really interested in when evaluating Block-Fi’s Interest Account as an investment is the risk premium over hodling your keys. This is initially a predictable 6.2%. But what does that mean? Assuming a 50% annual BTC price appreciation as measured in $:
29/ Option 1 — Your Keys, Your Bitcoin
In this scenario our self-sovereign hodler, Hal, sees a 50% appreciation in his initial investment of 2.5 BTC, or $10,000 in USD, netting himself a tidy $5,000 pre-tax fiat profit without any counter-party risk.
In this scenario our self-sovereign hodler, Hal, sees a 50% appreciation in his initial investment of 2.5 BTC, or $10,000 in USD, netting himself a tidy $5,000 pre-tax fiat profit without any counter-party risk.
30/ Option 2 — BlockFi Investment Account
Our BlockFi investor, Mark, sees the same price appreciation as Hal, but also gets a 6.2% return in BTC. At year-end, Mark has 2.655 BTC worth $15,930, a gain of $5,000 from price appreciation and $930 from interest ($585.90 after tax).
Our BlockFi investor, Mark, sees the same price appreciation as Hal, but also gets a 6.2% return in BTC. At year-end, Mark has 2.655 BTC worth $15,930, a gain of $5,000 from price appreciation and $930 from interest ($585.90 after tax).
31/ The question for Hal and Mark is, “Is Mark's extra $585.90 after tax worth the additional risk?” Bear in mind that BlockFi’s posted interest rate is changeable month-to-month. As @BlockFiZac explained, the interest rate will be inverse to price action and drop in bull markets
32/ Default risk. The umbrella risk over all of this is that BlockFi is a start-up founded in 2017, and start-ups are risky. Question whether the quoted premiums are the return you’d expect from taking on the same default risk as an early stage VC and balance exposure accordingly
33/ An open market for banking/money is known as a free banking system and it seems likely this will develop around Bitcoin. Free banking means banks are free to issue deposit notes and financial instruments, governed by forces of the free market without intervention/protection
34/ Over enough time, risk will be priced appropriately with risky products balanced by incentives to avoid them. As Rothbard observes, “the day-to-day constraint on banks under free banking is the fact that non-clients will, by definition, call upon the bank for redemption.”
35/ It follows that without extreme regulatory capture, fractional reserves and other forms of inflation on top of the base money supply shouldn’t be expected to grow much larger than an omnipresent but small group of institutions and investors willing to take on that risk.
36/ Financialization is inevitable and important. As @CaitlinLong_ illustrates, financialization allows for better liquidity, debt structures, and other benefits that mean institutional custody/lending can be good for Bitcoin. But be cognizant of the risks forbes.com/sites/caitlinl…
Thanks to @mrcoolbp, @thibm_ & @Tom_Harned for the epic help working this out. h/t to @alphaazeta, @ObiWanKenoBit & @CaitlinLong_ for the inspiration and @MartyBent, @matt_odell & @BlockFiZac for being prepared to jump into the frenzy. Plz correct me if I've misrepresented things
