This week markets have been trading between $620/BTC and $650/BTC. A relatively calm period after the mtgox storm. Given the current market sentiment, I see a rally in the near future, perhaps the very beginnings of a fourth great bitcoin bubble. The type of news coming out about bitcoin this week suggests signals organic growth and awareness of bitcoin and reminds me of earlier periods of bitcoins history which were followed by strong market rallies. The news has a flavor of being "disperse" in the sense that there are many things happening in many unrelated areas. For example,
- Xapos is coming out with a bitcoin vault with built-in insurance.
- Bitcoin surpasses Western Union in transaction volume.
- Overstock.com emailed a pro-bitcoin article to its users.
- Congressman Jared Polis also wrote a pro-bitcoin email that's been getting passed around.
- New York is in the final stages of creating Bitlicense regulation.
- Conan O'Brien mentions bitcoin on his show.
- Warren Buffet says bitcoin is a mirage. (negative news)
- Arguably all news is good news and as normal Americans see more about bitcoin and cryptocurrency in the media, they become more comfortable with the idea. At least it begins to seem less and less foreign/alien.
- Wikipedia founder, Jimmy Wales, receives a good deal of bitcoin donations after publishing his personal bitcoin address.
- Ebay files a patent for a bitcoin currency exchanger.
- Rumors of a big wall street firm hosting an internal (employees-only) event about bitcoin that gets completely booked within 10 minutes.
- Dorian Nakamoto's story continues to hit the mainstream news.
This pattern of news where it is very disperse and sort of self-propagating has historically signaled a change in market sentiment from neutral to positive. Also, the boom and bust cycles of the bitcoin markets have gotten shorter and less severe (i.e. the cycles have shorter periods and lower amplitude). The market now overreacts both up and down to a lessened effect and also more quickly "resets" back to normal market conditions. In less than a week after the largest exchange in the world goes bankrupt, the market has settled on a relatively stable price in the current range and volatility has almost dropped to normal levels. All of this leads me to believe that we are at the beginning of a steady rally.
Today I also wanted to talk about bitcoin storage solutions backed by insurance (e.g. Xapos, Elliptic Vault). To me, this doesn't make sense. While it's great for marketing and plays well into the consumer's perspective, logistically, any company which underwrites insurance on a bitcoin vault is taking on a type of risk that requires the insurance premium collected for underwriting it to be unreasonably high. This is due to a few reasons.
- The information is strongly asymmetric between the vault storage company (VSC) and the underwriting insurance company (UIC). What expertise does the UIC have on cryptography and best practices in this emerging industry? The VSC knows much more about just how secure their vault is. So for the UIC to price the risk premium of underwriting the vault, they have to add an additional premium for adverse selection. What they lack in expertise, they must pass on as extra cost to the insurance buyer.
- The actual tail risk of losing bitcoins in a vault has historically been significant. A VSC like Xapos charges 16 basis points per year which implies a risk-neutral expectation of losing the whole vault (assuming the whole vault was insured) of 1 in 625. So if the actual risk of losing the vault was 1 in 625 per year (is it?) and Xapos paid their underwriter the entire 16 bps premium (took no profit margins themselves) and their underwriter was fine with that (the underwriter also has no profit margins), then they all break even in the expected value sense which brings me to...
- Considering expected value by itself is not how companies subject to limitless downside, like UICs, think. When you make a million every day and lose $364m once a year, your expected value is near zero and slightly positive but your skew risk is very high. If you have $100m in assets, you would much rather prefer making a million plus a thousand every other day and losing a million every other day than the previous situation since, in the previous situation, if you go bankrupt, you cannot continue business. So the UIC has to charge an additional premium for skew risk over the risk-neutral premium, and their profit margins.
- UICs for retail markets like life insurance and health insurance can collect premiums from largely independent parties thus diversifying their risk. UICs for bitcoin storage vaults cannot since there are only a few VSCs that exist.
- Finally, if bitcoin truly goes mainstream and the vaults get huge, the insurance loses effectiveness due to the counterparty risk of the insurance company. If the vault is lost and the losses are more than the equity of the insurance company, the insurance company defaults and the claims are not fully paid out. What insurance company could underwrite the gold at Fort Knox?
To summarize, (1) the insurance company knows a lot less about security than the vault company causing there to be asymmetric information in the underwriting process, (2) the actual risk of losing the vault implies a rather high insurance premium (would you pay, say 10% yearly, for that kind of insurance?), (3) insurance companies have to be compensated for skew risk causing the premium to be even higher, (4) insurance companies cannot diversify since there are very few vault storage companies, (5) if the vault gets big enough, who insures the insurance company?
Ultimately, Elliptic Vault does not insure the whole sum of their customer deposits, only a fraction for a hefty cost. Rumors are that Xapos also is only insuring up to a certain limit and that they are underwriting it themselves which would then explain why the premium is only 16 bps. In that case, the structured product these companies provide is a hybrid between full insurance and no insurance. There might be a market for this; I just happen to think the premiums will be too high for the amount covered.
Kevin & Team Buttercoin
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After re-reading my last update, I feel compelled to clarify one point. I may have come across as against the idea of insured vault storage solutions but that isn't the case.
A fully insured vault storage solution would be good for the bitcoin ecosystem, and any company that can make the numbers work will do very well. The solution isn't obvious to me, and anyone looking to use such a service should make sure to do their own due diligence.
That said, Wences Casares is one of the smartest and most capable people in the bitcoin space. Of companies that could figure out a good solution to the insurance problem, Xapos would be at the top of the list.