Why do American companies want to allocate Bitcoin?

Original title: "The real motivation for American companies to buy Bitcoin"

Original source: FT Chinese

Bitcoin broke the milestone of $1 trillion in total market value on February 19, mainly due to two driving factors: one is that Canada launched North America’s first Bitcoin exchange-traded fund ETF on the 18th; the second is that MicroStrategy used convertible bond financing to increase its Bitcoin holdings for the second time in three months.

In Clubhouse, the new darling of social media, there was a special session encouraging listeners to "flash buy" Bitcoin in a carnival to celebrate the continued surge in Bitcoin's value.

Purpose Bitcoin ETF gathered $421.8 million in assets under management in two days, and Bloomberg estimates that the scale may reach $1 billion within a week. Another Evolve Bitcoin ETF opened on the 19th with a market value of approximately $14.5 million.

In early February, Tesla disclosed in a filing with the U.S. Securities and Exchange Commission that it had purchased $1.5 billion worth of Bitcoin. As of the fourth quarter of 2020, this investment accounted for approximately 7.7% of Tesla's $19.384 billion in cash holdings. Tesla also claimed that it would accept Bitcoin as a payment currency for its products in the future, but industry insiders believe that due to the large fluctuations in Bitcoin prices, it is currently difficult to use Bitcoin as a medium of exchange.

Tesla's bitcoin investment certainly set off a wave of speculation, but MicroStrategy is the only public company actively using debt to acquire more bitcoin. Chairman and CEO Mike Saylor once tweeted in 2013: "Bitcoin's death is imminent. It seems only a matter of time before it suffers the same fate as online gambling." Yet he is now the most fervent bitcoin evangelist in corporate America, including in a Twitter conversation to get Tesla CEO Elon Musk to join the game.

According to data from asset management company CoinShares, inflows into Bitcoin and other crypto investment products reached $1.3 billion so far in January 2021. But I think the current story about Bitcoin is dominated by "store of value" rather than "medium of exchange" as a currency.

Why has the narrative about Bitcoin changed? In addition to financial service institutions as asset allocation or providing financial products, more importantly, a wave of American companies are considering restructuring their balance sheets by purchasing Bitcoin and cryptocurrencies. What kind of anxiety and risks will this bring to the capital market?

To encourage other companies to follow MicroStrategy's lead, MicroStrategy hosted a two-day Enterprise Investment Cryptocurrency Summit in early February and provided a series of tactics based on its own experience. The summit attracted industry insiders and more than 1,400 company representatives from at least 16 countries.

Saylor compared Bitcoin to "superb monetary engineering", a system with "monetary energy" that can prevent "energy leakage" caused by inflation. He even publicly announced that he personally holds 17,732 Bitcoins, currently worth more than $1 billion.

As of February 2, MicroStrategy has nearly 72,000 bitcoins, making it the leading bitcoin holder in the US corporate world, with a value that exceeds the value of its core business. MicroStrategy originally planned to issue $600 million in convertible bonds in early February to purchase bitcoins with net proceeds. Due to investors' rush to buy, the issuance scale was expanded to $900 million, with an option to increase by $150 million. At the time of delivery on February 19, the fundraising requirement of $1.05 billion was fully met.

MicroStrategy began using company cash to buy cryptocurrencies last summer, announcing in August that it would invest 85% of its cash reserves in Bitcoin, and then issued $650 million in convertible bonds for the first time in December to buy Bitcoin. Citibank immediately downgraded MicroStrategy's rating to a "sell" recommendation. However, since the announcement of the first purchase on August 11, the price of Bitcoin has increased fivefold, and MicroStrategy's stock price has soared by more than 700%. Obviously, the market is bullish on MicroStrategy's Bitcoin strategy.

MicroStrategy's selling point for Bitcoin's narrative is that the massive money printing by the US government will make holding cash very risky. Under the leadership of the Federal Reserve, coupled with the support of other central banks, global quantitative easing asset purchases will reach a staggering $6 trillion in 2020 alone, accounting for more than half of the cumulative value of global quantitative easing from 2009 to 2018. The US M2 money supply has grown by more than 25% in the past 12 months.

In response to the COVID-19 pandemic, the Federal Reserve has expanded its balance sheet by more than 75% ($3.25 trillion); the U.S. Treasury has accumulated $3.7 trillion in debt since the end of fiscal 2019, while the European Central Bank has added more than €2 trillion. Such a massive expansion of financial assets has led many to question the long-term value of fiat currencies and look for alternative assets such as commodities and cryptocurrencies as a hedge against inflation.

Saylor believes that macroeconomic headwinds will affect $400 trillion of capital trapped in depreciating fiat currencies. He also argues that inflation depends on the goods to be purchased, not the consumer price index. For example, high tech stock prices mean lower purchasing power for cash, and the real cash yield in 2020 is -30%.

Thaler believes that the Fed's massive money printing policy has sown the seeds of hyperinflation, causing cash in fiat currencies such as the euro and the dollar on corporate balance sheets to lose about 15% of its purchasing power each year. Since the most important job of every CEO is capital allocation, the most important decision every CEO must make in the next 10 years will be: whether and how to adopt Bitcoin, because cash has become a liability.

Saylor pointed out that in the face of a world where money is being printed in large quantities, every company must choose one of two options: either it must reduce capital, which is like self-destruction... or it must switch to assets that appreciate faster than the expansion of the money supply, which is Bitcoin.

From Saylor’s perspective, the dollar will not remain the world’s reserve currency. He also believes that bonds, stocks, and real estate are just placeholders for fiat currencies, and as long as the base fiat currency continues to depreciate, the returns they generate will become increasingly diluted. The solution: convert them all to Bitcoin.

“Every company on the planet can do this because every company has a certain amount of reserve assets.”

This radical Bitcoin strategy includes: "If you want to maximize shareholder value, if you want to preserve or create shareholder wealth, then companies can develop a Bitcoin balance sheet strategy or a Bitcoin-driven income statement strategy." Companies can start by developing Bitcoin tools, building Bitcoin software, and providing Bitcoin services for Bitcoin infrastructure, because Saylor believes that "all of these will drive revenue growth and will drive cash flow."

Musk explained in an interview with Bloomberg on February 18 why Tesla bought Bitcoin instead of the playful cryptocurrency Dogecoin that he hyped up: "Owning some Bitcoin, which is just slightly less stupid liquidity than cash, is risky enough for S&P 500 companies."

Musk also tweeted: "When fiat currencies have a negative impact on real interest rates, only a fool wouldn't look elsewhere... Bitcoin is almost as shit as fiat currencies. The key word is 'almost'."

For many institutional investors, buying MicroStrategy's convertible bonds is equivalent to "almost free Bitcoin call options ."

The interest rate of convertible bonds issued by MicroStrategy at the end of last year was 0.75%, and the interest rate of convertible bonds issued again in February was reduced to 0%, reflecting that some or all of the following conditions may have occurred between the two issuances:

The newly issued convertible bonds will mature on February 15, 2027, and the initial conversion rate of the bonds is initially 0.6981 shares of MicroStrategy Class A common stock for every $1,000 of note principal, equivalent to an initial conversion price of approximately $1,432.46. This is a premium of more than 50% over the closing price of MicroStrategy Class A common stock of $932.72 on February 19. The conversion rate will be adjusted according to the terms of the bonds.

As with typical US convertible bonds, conversion into shares is not allowed until close to maturity unless certain circumstances occur, such as a company merger or market failure. In fact, no investor will convert before maturity, and in a normal market, the trading price of convertible bonds is always higher than the shares it can be converted into, so anyone who wants to convert is actually just selling a convertible bond.

Debt-to-equity swaps are the investor's choice, and MicroStrategy can choose to deliver stock, cash equal to the value of the stock, or a mixture of the two.

For convertible bond investors, if MicroStrategy's stock performs poorly, they can at least get their principal back, but they also have room to rise above the conversion price, and they can make money by trading options on volatility. If MicroStrategy owns a lot of Bitcoin, or its "performance" is closely related to Bitcoin's success, then it can be considered a call option on Bitcoin, but this "call option" is not actually "free" because if the bondholder buys a non-convertible bond, the interest will be higher.

However, the appeal of convertible bonds is obviously that investors have the opportunity to participate in the appreciation of MicroStrategy's stock price that may be brought about by the rise in Bitcoin, which means that they are optimistic about MicroStrategy's Bitcoin narrative.

Catherine Wood, the leader of ARK Investment Management, said on February 17 that if all U.S. companies put 10% of their cash into Bitcoin, this move alone would increase the value of Bitcoin by $200,000.

Digital financial services company BCB Group announced on February 19 that it will launch a reserve fund management service to help companies purchase and manage cryptocurrencies such as Bitcoin.

At present, MicroStrategy's stock price is obviously the biggest beneficiary of the debt-funded purchase of Bitcoin. However, even Wood, who strongly supports Bitcoin, has repeatedly questioned in public whether MicroStrategy is a technology company or a Bitcoin ETF fund.

Before MicroStrategy, it was unusual for companies to take risks with corporate cash, as most companies put safety first, with liquidity and yield as secondary considerations.

Shareholders are generally more tolerant of the risks a company faces in conducting its business, but are relatively less willing to take risks when investing cash. If Bitcoin were to experience a similar drop from approximately $20,000 to $3,000 from December 2017 to December 2018, such losses could cause the balance sheets of Tesla and MicroStrategy to collapse, resulting in the company's earnings estimates failing to meet expectations. How would the capital market respond?

But Saylor believes: "The choice between a volatile asset that could jump 200% and depreciating cash is simple," because "the nature of the free market is that capital flows from the weakest assets to the strongest assets."

Wall Street analysts believe that if a company buys financial assets for speculative purposes unrelated to its core business, it will be a red flag for investors. Chasing high-risk, high-return strategies like MicroStrategy may mean that if Bitcoin performs poorly, there will not be enough funds to meet its working capital needs.

Bitcoin’s price volatility isn’t the only risk, either. Bitcoin is also susceptible to hacking, fraud, and password loss, although institutional investors use custodial services to mitigate those dangers. Certain industries, such as financial services and utilities, may have a harder time adding Bitcoin to their balance sheets due to contractual requirements.

Some investors are also worried that investing in energy-consuming Bitcoin betrays Tesla's core corporate value of reducing carbon emissions, because energy consumption runs counter to Tesla's mission of "accelerating the world's transition to sustainable energy." Research from the Cambridge University Business School shows that the total electricity consumption for mining Bitcoin each year exceeds Argentina's annual electricity consumption and almost exceeds Norway's electricity consumption.

But Bitcoin supporter ARK Fund confirmed that the banking system uses 2.4 billion gigajoules per year and the gold mining industry uses 500 million gigajoules per year, while Bitcoin uses only a small fraction of both, 184 million gigajoules per year, and it is estimated that renewable energy accounts for 77.6% of Bitcoin's total mining electricity, so the impact of Bitcoin mining on the environment is "negligible."

MicroStrategy clearly doesn’t care about being seen as a “half” Bitcoin ETF. In its most recent annual report, it noted that it has two strategies in its business operations: one is to develop its enterprise analytics software business, and the other is to acquire and hold Bitcoin.

MicroStrategy will pursue its business strategy of acquiring Bitcoin when its cash, cash equivalents and short-term investments exceed current working capital requirements and may, from time to time, based on market conditions, issue debt or equity and use the proceeds to purchase Bitcoin.

MicroStrategy believes that its Bitcoin strategy is complementary to its analytical software and services business and that activities related to Bitcoin and supporting the Bitcoin network can increase awareness of the MicroStrategy brand and provide the company with opportunities to attract new customers for its products.

MicroStrategy is also exploring opportunities to apply Bitcoin-related technologies, such as blockchain analysis, to software products. From this point of view, although the original intention of American companies to buy Bitcoin may be to better manage their balance sheets and prevent the continued depreciation of cash, the huge profits of Bitcoin may drive more companies that are eager to use cryptocurrency investments to polish their income statements. The price of Bitcoin broke through the $55,000 level on February 19, which means that Tesla's book profit since January is about $930 million, which is nearly 30% higher than its electric vehicle profit of $721 million in the whole of 2020.

But at the same time, MicroStrategy also pointed out in its annual report that its aggressive Bitcoin strategy exposes the company to various risks related to Bitcoin, including: Bitcoin price fluctuations may be subject to highly uncertain regulation; historical financial statements do not reflect potential earnings fluctuations related to Bitcoin holdings that may be encountered in the future; Bitcoin held may be subject to regulatory scrutiny; the concentration of Bitcoin assets held increases the risks inherent in the Bitcoin acquisition strategy; the liquidity of Bitcoin held is lower than existing cash and cash equivalents, and therefore may not provide a source of liquidity for MicroStrategy like cash and cash equivalents; if MicroStrategy or a third-party service provider encounters a security breach or cyber attack, or loses private keys or is compromised, some or all of the Bitcoin may be lost.

What we should ask is: If the price of Bitcoin continues to move towards $100,000, how will the US government deal with an asset bubble that is now almost completely unrestricted? In an editorial on February 20, The Washington Post called on the Federal Reserve and US financial regulators to face up to whether the monetary and fiscal policies implemented in response to the new crown epidemic have directly or indirectly contributed to the risk of asset bubbles in cryptocurrencies?

If the US regulators are bold enough to take action, will the percentage of digital assets held by listed companies as asset reserves be subject to regulatory restrictions? The US currently has regulations restricting listed companies from repurchasing stocks that exceed 25% of the average daily trading volume. If US regulators implement similar regulations, this means that when the price of Bitcoin continues to rise, causing the digital currency in the asset reserves to break through the legal limit, it will force companies to sell Bitcoin, thus forming an unprecedented selling pressure in the cryptocurrency market.

In a sense, MicroStrategy has successfully stirred up collective anxiety in the American business community and stock market about hyperinflation by comparing the current United States to Germany during the Weimar period. But will this hysterical "herd effect" encourage companies to bet with their balance sheets in order to raise stock prices? Due to the lack of supervision, cryptocurrencies are more likely to become the target of market manipulation.

Global regulators should be concerned that volatility in digital asset prices could have the potential to spill over into traditional capital markets, bringing turmoil to stock markets and other asset markets.