After the Great Financial Crisis, when the market got worried about the cost to governments of bailing out the global banking system, the CDS market expanded from insuring corporate debt to insuring sovereign debt.
“I’m standing in front of a burning house, and I’m offering fire insurance on it.”
—Ryan Gosling, The Big Short
BTC as CDS
In 2007, you could buy credit default swaps (CDS) on Lehman Brothers at about 10 bips (0.1%). Which is to say, it would have cost you just $10,000 a year to hedge the default risk on $10 million of Lehman debt.
CDS on subprime mortgages was a similar bargain.
Both proved to be incredibly cheap insurance policies against huge risks the financial system had built up during the housing bubble.
Not many availed themselves of that insurance, unfortunately.
There were plenty that should have — the systemically important financial institutions, who were long mortgage debt and counterparty risk — but not many did.
They were more likely to be multiplying their risks by selling CDS than hedging their risks by buying.
Fortunately, CDS is a type of insurance where you don’t have to own the thing that’s being insured — like taking out a home-owners policy on your neighbor’s house because you think someone (Not you, I hope) might burn it down.
And that’s mostly what it’s used for. As Selena Gomez explains in The Big Short, the side bets in finance are many times bigger than the underlying.
After the Great Financial Crisis, when the market got worried about the cost to governments of bailing out the global banking system, the CDS market expanded from insuring corporate debt to insuring sovereign debt.
Now, with the cost of pandemic bailouts piled on top of the cost of banking bailouts, that, too, may be an underutilized form of insurance. Perhaps more so because while it’s mostly just big banks that are exposed to subprime and counterparty risk, everyone is exposed to credit risk inherent to fiat currencies.
If you’re concerned that fiat-issuing governments are on a slippery slope to default, sovereign CDS is however not much help to you: It’s only available to institutions big enough to sign ISDA agreements with investment banks.
Fortunately, there’s a better form of insurance available to hedge the risk of sovereign default: Bitcoin.
Insuringa Bit ofYourCoin
What’s better about bitcoin?
For thing one, it’s available to all: no ISDAs required.
For thing two, there’s no carry cost to pay — not even the 10 bips it cost to hedge Lehman debt in 2007 — and it never expires.
And for thing three, there’s no counterparty risk: In 2008/9, the CDS on Lehman and subprime nearly proved worthless, because the sellers were themselves in danger of going under. Your insurance isn’t worth anything if your insurer goes bust.
When the movie version of Michael Burry told Goldman Sachs he was worried they wouldn’t be able to pay out on the CDS he wanted to buy from them, he got laughed out of the room.
He was right to worry, of course. And if you’re buying insurance on sovereign debt, you’re betting on a scenario where every counterparty will be highly suspect — even the US government.
I, personally, am not losing any sleep over it. I don’t think the fiat currency house is on fire.
But hedges are for when you’re wrong. You don’t buy fire insurance because you think your house is going to burn down, but because you know there’s some probability it might.
Bitcoin is a hedge against the probability that I’m wrong about fiat currencies.
And, like Lehman and subprime CDS in 2007, it’s cheap.
Tangible Valuation
Crypto is mostly narratives still. There’s not much valuation support to go on.
The bull cases you hear for bitcoin are mostly things like Michael Saylor’s thesis that it’s the “purest form of monetary energy.”
I find that formulation inspiring, except for the fact that I don’t know what it means.
In reading Greg Foss’s work, however, I’ve learned that thinking about bitcoin in CDS terms can make things more tangible.
Foss uses CDS prices to calculate what the market is currently paying to hedge sovereign debt credit risk and argues that bitcoin is similarly valuable.
Bitcoin, he argues, should be worth at least $110,000 on that basis. (And presumably more now, as the stock of government debt is ever rising).
So, at today’s bitcoin price of $22,000, you are being offered insurance on your fiat exposure at a bargain rate.
That does not mean you’ll be able to sell your BTC at $110,000 any time soon. There’s no reason why it can’t trade at a big discount more or less forever.
But as with all insurance, you don’t actually want it to pay out: The world will be a better place if the doomsday scenarios on fiat currencies don’t come to pass.
What Are the Odds
It’s easy to dismiss Bitcoin at the moment because it hasn’t been a hedge against 9% inflation.
That’s a fair criticism: If Bitcoin is only going to be a higher-beta version of Nasdaq, then it’s not particularly useful. The financial world doesn’t need another levered bet on interest rates; we have plenty of those.
And, as discussed yesterday, as long as M2 money supply stays within normal bounds, Bitcoin may not be much more than that.
But the real value in Bitcoin is for the eventuality that M2 gets out of normal bounds.
BTC is a put option on USD with asymmetric upside.
Judging by the low cost of CDS on US government debt, there may only be a 1-in-500 chance of that put option paying out.
But the odds of your house burning down are even longer, and you wouldn’t go without fire insurance, would you?
