“That’s Our 2 Satoshis” — Pricing Bitcoin Using a CDS Framework

What Happened This Week in the Digital Assets Markets?
Week-over-Week Price Changes (as of Sunday, 10/16/22)

Week over Week Price Change

Source: TradingView, CNBC, Bloomberg, Messari

Pricing Bitcoin Using a CDS Framework

The yield on 10-year U.S. government bonds ended the week over 4.0%, delivering an 11th consecutive weekly jump—the longest stretch in 38 years. Yields in the U.K. (Gilts) also jumped week-over-week back to near YTD highs (10-year at 4.35%) but were more volatile and erratic as the length and transparency of the Bank of England buy program remains in flux. Meanwhile, 10-year Japanese government bonds (JGBs) have basically stopped trading as the Bank of Japan price fixes the 10-year at 0.25%.

As the market fixates on sovereign yields, it’s important to remember what government bond yields really represent. While the term “risk-free rate” gets thrown around for government bonds, this often conflates academic theory with reality, as 2022 has shown that these bonds are anything but risk-free. Instead, the yield represents the return an investor needs to earn to warrant taking the risks associated with holding these government obligations. And while default risk is low for bonds issued by nations that can print their own currency, it is not zero.

A better way to see this is via the credit default swaps (CDS) market, which tends to more accurately price “risk” than bonds themselves, since they are less heavily manipulated by central banks’ direct intervention. While most people would say the U.S. can never default on its bonds, the cost to insure principal loss on U.S. government bonds for 5 years costs 32 basis points per year. With roughly $23 trillion of U.S. government bonds outstanding, if every single bond owned was insured, it would cost $73 billion annually. That’s hardly pricing in a zero percent chance of default.

And, of course, the U.S. is the best house in a bad neighborhood. Sovereign CDS has blown out this year worldwide, indicating the risk of default has risen, or at least, the cost to insure this low probability outcome has increased significantly. Many South American countries are now 100-200 bps wider, while European and Asian nations are 15-50 bps wider.

CDS Market

Source: Bloomberg [SOVR]

Which brings us to bitcoin. No digital assets enthusiasts have been tougher on bitcoin than we have as it has failed to live up to any of its billings this year: it’s not defensive, it’s not an inflation hedge, it doesn’t get used for transactions, and there is no natural buyer to offset the inflation. That said, bitcoin has always been a call option on anarchy if citizens begin to lose faith in their banks and local governments. In fact, in February 2022, when Russia’s Ruble tanked and Canadian banks froze citizens’ accounts, we highlighted that it would not be surprising if demand for bitcoin skyrocketed. This prediction is even more relevant now with European banks imploding, England’s currency and bond market eroding, and Japan’s yield curve control flummoxing investors.

But how do you value that call option? In the past, we’ve utilized Black-Scholes’ options model to value bitcoin—a technique that favorably prices bitcoin due to the infinite time horizon and high volatility. But that is an imperfect model given the variance and low confidence of the inputs. Perhaps looking at the sovereign CDS market makes more sense. If bitcoin is a call option on the risks of sovereign anarchy, then shouldn’t bitcoin be much higher YTD to reflect the rising levels of sovereign and bank risk, in line with the moves we’ve seen in sovereign and bank CDS? After all, they both represent the same end game. Greg Foss, bitcoin enthusiast and former credit trader, is the mastermind behind pricing bitcoin using the sovereign CDS framework. Foss argues that bitcoin is default insurance on a basket of Sovereigns/Fiats. If you just look at the U.S. by itself, by buying bitcoin, you are buying default insurance on the USA for an 85% discount to fair value as indicated by the cost of bitcoin compared to the cost to insure against all U.S. liabilities. But equally important, buying bitcoin as insurance also covers you against defaults on ALL other government obligations. Not to mention, it’s not just government debt that seems to be on shaky ground. European bank CDS is at 2008-like wides as the market has lost faith in Credit Suisse and a handful of other European banks.

There is roughly $88 trillion of combined global government debt, plus trillions more if you include off-balance sheet and unfunded long-term liabilities. Add in global bank debt (Credit Suisse alone has $128B of unsecured debt), and the numbers become staggering.

Suddenly, paying a 1-time fee of just under $20,000 for bitcoin doesn’t seem that expensive. Perhaps we should stop looking at bitcoin as an inflation hedge or store of value and start valuing it as wealth and livelihood protection. It’s certainly counterintuitive that bitcoin and sovereign CDS serve the same purpose, yet one is more expensive due to very real increased risks (CDS) while the other is on sale for 70% off its recent all-time highs.

Bitcoin vs Sovereign CDS

Source: Twitter

And That’s Our Two Satoshis!
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The Arca Portfolio Management Team

Jeff Dorman, CFA - Chief Investment Officer

Katie Talati - Director of Research

Hassan Bassiri, CFA - Portfolio Manager

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Alex Woodard - Research Analyst

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Kyle Doane - Trader

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Michael Dershewitz - Principal, Venture Investing

Michal Benedykcinski - Research Analyst

Andrew Masotti - Trading Operations

Topher Macpherson - Trading Operations

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