Bitcoin ETFs, Custodians, and Collateral
Verifiable NAVs via public key disclosure are essential for a symbiotic relationship between bitcoin and traditional financial institutions.
Let’s get one thing straight before we dive into the financialization of bitcoin: bitcoin doesn’t need any ETFs or legacy custodians in order to survive. In fact, bitcoin thrives because it didn’t closely interact with traditional financial institutions in its early years and thus cemented its decentralization. The relationship between bitcoin and traditional financial institutions, however, is about to change in a big way. 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.
I know there are many owners of bitcoin that will never relinquish the responsibility of private key management to a trusted third party; I am one of them, and I encourage everybody to practice private key management. Unless you do so, you don’t own real 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.
Fast Money versus Real Money
Fast money and real money are generic terms used to describe two distinct investor types in the asset management industry. 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. These investors are hopefully quite familiar with the risks of owning bitcoin as a claim given past exchange hacks.
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. They have quarterly board meetings and countless consultants that slow down the investment decision-making process. They do extensive review of all counterparties and use large custodians such as State Street, Bank of New York Mellon, and Northern Trust to house their assets. 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.
Net Asset Value describes the value of underlying assets in an investment vehicle. For example, if a fund owns 1,000 BTC for its investors, its NAV would be $6.7 million assuming a price of $6,700 per bitcoin. But how does somebody owning shares in this fund know that the balance of 1,000 BTC is real? There is one way: the fund discloses its public keys to investors on a regular basis. This would allow the public to observe, but not spend, the fund’s holdings. If investment vehicles continuously disclosed public keys and developed a reputation of doing so honestly, we would see a huge leap forward in the relationship between bitcoin and traditional financial institutions. I do believe that in addition to fraudulent fractionally reserved custodians, good actors will disclose public keys in an honest and transparent way. 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.
The growing probability of an eventual bitcoin ETF approval from the SEC has brought out some strong opinions from owners of bitcoin. I’ll quickly summarize the two primary fears expressed. Firstly, some are opposed to ETFs because bitcoin is designed to provide people with financial sovereignty, and any display of third party reliance is unwelcome. This argument ignores the fact that millions of people already hold their bitcoin on exchanges and therefore only own claims on bitcoin and not real bitcoin. Secondly, some are opposed to ETFs because of fears of fractionally reserved bitcoin and artificial supply inflation. This is a valid fear and theoretically can never be assuaged. ETF managers can do only one thing to convince the market they are good actors: verifiable NAVs via public key disclosure. It is important to remember that an ETF manager can still get hacked or mismanage private keys, a risk that will likely be insured by yet another counterparty. I anticipate ETFs will be used by both retail and institutional investors. Retail investors can invest through their already-established brokerage accounts; institutional investors generally already have allocations to a variety of equity ETFs and have a high degree of familiarity with the asset type.
Institutional investors looking for increased privacy and control will elect to hold bitcoin at an established custodian rather than invest in an ETF. This type of activity will be reserved for investors that prefer to have a single counterparty separating themselves from their bitcoin (ETF investors are two counterparties removed from their bitcoin because they own shares in a trust that stores bitcoin). Typically, large institutional investors will hire asset managers to structure portfolios and will separately hire a custodian to house those assets. The relationship between the institution and custodian is independent from the relationship between institution and asset manager. For example, let’s say a central bank wants to purchase bitcoin but doesn’t have the necessary infrastructure or expertise yet to hold bitcoin in cold storage. The central bank will hire two separate entities, a broker and a custodian. 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. I believe that large institutions will eventually choose this method of buying and storing bitcoin over ETF purchases to reduce, but not eliminate, counterparty risk. The custodians will have an immense responsibility of security and a fiduciary duty to protect the client’s private keys at all costs. Custodians may choose to comingle bitcoin balances or they may choose to keep the bitcoin allocated in specific public keys corresponding to individual clients. For heightened transparency, they should choose the latter. I am unaware of any large traditional custodian offering bitcoin custody services at the moment, although announcements from Fidelity, Northern Trust, and Goldman Sachs over the past several months suggest that bitcoin custodial services by traditional finance might be only a year or two away.
Collateral and Securities Lending
Once custodians and ETFs have custody of large quantities of bitcoin, they will have powerful collateral in their hands. In the traditional financial system, US Treasuries are considered pristine collateral. For example, if a company owns US Treasuries and needs to unlock liquidity to invest in a project, it can post the Treasury as collateral to a bank and borrow against it. If the company defaults on the loan, the bank is indifferent because they hold the Treasury as collateral and can just sell it to recoup their money. Bitcoin can be used as collateral in a similar manner. Companies such as BlockFi are taking bitcoin as collateral and lending US Dollar liquidity against it.
Institutional investors should demand that custodians don’t use allocated bitcoin as collateral to borrow money without explicit authorization. If a custodian defaults on a loan secured by a client’s bitcoin, the client won’t recover its holdings. Clients however can choose to allow custodians to conduct such activity to earn some extra return, a process traditionally called securities lending. Institutional investors need to be made aware of the risks of bitcoin lending by custodians in the context of traditional securities lending. This type of activity again can be policed by a system of public key disclosure by the custodian and monitoring of bitcoin’s blockchain by the investor. Investors should run watch-only full nodes just to continually audit their custodian.
Institutional investors will not be engaging in private key management for their bitcoin allocation for many years to come. Custodians and ETF managers that have been investing time and money in bitcoin education and infrastructure will hold private keys on behalf of clients. I envision a scenario in which custodians and ETFs might become some of the largest holders of bitcoin in the world, necessitating a continuous and rigorous audit process by anybody interested in the sanctity of bitcoin’s 21 million supply cap.
Assets Under Management rankings can be found at https://www.ipe.com/Uploads/k/x/x/Top-400-Ranking.pdf