If bitcoin and traditional financial institutions are to have a successful relationship, then certain rules will need to be followed.
Bitcoin analyst Nik Bhatia discussed the issue in a recent blog post titled, “Bitcoin ETFs, Custodians, and Collateral.”
In that blog post, Bhatia discussed how verifiable net asset values via public key disclosure are essential for a symbiotic relationship between bitcoin and traditional financial institutions. Institutions will need to verify their assets via the bitcoin blockchain to ensure a healthy relationship. Otherwise, we could run into problems with firms lending out more bitcoin than they actually own – which defeats the point of bitcoin.
The blog post discusses a number of issues with the financialization of bitcoin, including problems that need to be solved. Let’s dive into some of the things that Bhatia found in his research.
Bitcoin Doesn’t Need ETFs Or Custodians To Survive
First, Bhatia clarifies one thing. Bitcoin doesn’t need ETFs or custodians to survive. In fact, bitcoin has been designed from the ground up to avoid traditional financial institutions and systems. Bitcoin has survived – and prospered – since 2009 without the need for traditional financial institutions.
Bhatia, however, claims this is all about to change in a big way. The financialization of bitcoin is coming, and that means we need to develop some rules.
One Of Bitcoin’s Biggest Threats Comes From Fractional Reserve Banking
One of the key features of bitcoin was its ability to defeat fractional reserve bitcoin: the practice of lending money you don’t have. Today, banks rely on fractional reserve banking. The entire financial institution rests on this idea. We can lend money that we don’t actually have because it’s unlikely that everyone is going to withdraw their money from the bank simultaneously.
As financial institutions start getting involved with bitcoin, this could become more and more of a problem:
“It’s worth taking a step back and assessing some pros and cons, as well as strategize the ideal outcome for bitcoin so that the 21 million supply maximum isn’t diluted by a fractionally reserved overabundance of claims masquerading as real bitcoin.”
Institutions Will Not Let You Keep Your Private Keys
The best way to store your bitcoin is to keep your private keys in a safe place. If someone else holds your private keys, then you don’t truly own your bitcoin.
Financial institutions won’t play along with this game. Instead, they’ll use traditional financial systems to store your bitcoin.
“But institutions will not choose this route. They will use custodians, ETFs, and insurance. These solutions are layers on top of bitcoin that carry significant counterparty risk. Bitcoin’s integration into the traditional financial system of counterparty risk is arriving as we speak.”
The Difference Between Fast Money And Real Money
The financial ecosystem is home to two broad types of money, including fast money and real money.
“Fast money generally refers to billion dollar hedge funds, some of which are already dabbling in bitcoin. These funds are likely using exchanges for custody, although some might be using robust multisignature self-custody solutions.”
Real money, on the other hand, is a far bigger playing field:
“Real money encompasses over a hundred asset managers with at least $100 billion under management, including a dozen with over $1 trillion each, absolutely dwarfing the size of fast money. Real money managers act as fiduciaries for governments, central banks, and corporations. These clients have strict investment guidelines and thick bureaucracy preventing short-term flexibility of investment strategy.”
Before investing in an asset, for example, these real money funds are required to have board meetings. They need to hire consultants. They need to do an extensive review of all counterparties involved with the process. They’re managed trillions of dollars: they can’t afford to be fast with their money. All of these steps can slow down the investment process.
We already know how fast money firms will invest in bitcoin. They already are investing in bitcoin. Real money. Here’s what Bhatia believes, citing past experience in the industry:
“My experience in the asset management industry tells me that institutional investors will use current financial rails to access bitcoin. They will entrust the purchase and storage of bitcoin to third parties that demonstrate expertise. They do not custody bonds and equities themselves, and they won’t do so with bitcoin either. They will hire custodians that have robust insurance mechanisms against loss and theft. Hopefully, and most importantly, they will hire custodians offering verifiable NAVs.”
The Importance Of Verifiable Net Asset Values
Verifiable net asset values, or NAVs, will help bitcoin integrate into the existing financial system.
If a fund owns 10,000 BTC, then the NAV of the fund would be $65 million – assuming a price of $6500 per bitcoin.
When someone buys a share of this fund, they want to know their share is directly linked to the asset value of the fund. They want a way to verify that value.
Bitcoin already has a solution for that: the fund can disclose its public keys to investors, allowing the public to observe – but not spend – the fund’s holdings. You get read access to the fund, allowing you to verify that the fund does indeed have 10,000 BTC.
If bitcoin is to successfully integrate with financial institutions, then we need to urge financial institutions to be transparent with their bitcoin.
“I specifically encourage Bakkt and VanEck, two entities that have recently announced products that will require private key management, to prove to the highly scrutinizing public that bitcoin holdings are genuine and bitcoin claims are fully reserved. Owners of bitcoin and fully validating node operators must hold Bakkt’s and VanEck’s feet to the fire and demand maximum possible transparency.”
If an institution holds customers’ private keys, then it needs to be transparent with its net asset value. No exceptions.
What About Established Custodians?
Custodial services safely store funds. In the bitcoin world, investors could use custodians to hold bitcoin rather than investing in an ETF. With this system, investors have a single counterparty separating themselves from their bitcoin.
Let’s say a central bank wants to buy bitcoin but doesn’t have the expertise or infrastructure to create a secure cold storage system. this central bank could rely on a custodian to store bitcoin. Here’s how this could work with bitcoin:
“The broker will source the bitcoin and deliver to a public key provided by the custodian on behalf of the central bank. The central bank only has counterparty risk to the custodian going forward.”
Bhatia believes that large institutions will eventually choose this method of buying and storing bitcoin over ETF purchases to reduce – not eliminate – counterparty risk.
Financial Institutions Can Lend Collateral – But They Need to Do It Transparently
Eventually, we’ll reach a point where custodians and ETFs have a large quantity of bitcoin. These funds will have powerful collateral in their hands. They’ll want to use that collateral to make more money.
Companies like BlockFi are already showing it’s possible to use bitcoin as collateral.
Nevertheless, customers of these institutions will need to “demand that custodians don’t use allocated bitcoin as collateral to borrow money without explicit authorization,” explains Bhatia.
“If a custodian defaults on a loan secured by a client’s bitcoin, the client won’t recover its holdings.”
Nevertheless, clients may choose to allow the institution to lend their bitcoin, and they can expect a return for that – similar to how traditional securities lending works. A system of public key disclosure would facilitate this system.
Ultimately, the sanctity of bitcoin’s 21 million supply cap is at stake. If financial institutions continue operating as normal and practice fractional reserve banking with bitcoin, then we could face troubles. Nik Bhatia outlined those issues – and explained how to avoid them – in a recent blog post.