How to Value Bitcoin Using Financial Principles? | CatcherVC Research

Author: Kit, Researcher at CatcherVC

Introduction

Greg Foss has 35 years of experience in high-yield bond management and was one of the first managers of open high-yield bonds in Canada. His friend appealed to the Ontario provincial court and passed the first BTC spot fund. In finance, high-yield bonds, also known as junk bonds, have different ratings ranging from AAA to B. The history of high-yield bonds in Canada is similar to that of Bitcoin, evolving from a few private asset management companies to being adopted by Canadian banks and opening up high-yield bond trading.

BTC as CDS for Multiple Currencies

Today, the long-term debt and credit markets have become the largest financial assets. However, if we compare the credit market to a dog and equity to a dog's tail, the movements in equity prices will shake the credit market. Greg points out that ignoring the equity valuation of the credit market is very foolish. During the Latin American debt crisis in the 1980s, if it weren't for the Brady Plan, the book value of RBC, Canada's largest bank, would have evaporated instantly.

In finance, Credit Default Swap (CDS) is a financial derivative that allows the buyer to sell bonds to the defaulting party at the bond's face value to avoid credit risk. If Bitcoin's goal is to be a hard asset and store of value, then its intrinsic value should fluctuate with the negative spread of various countries' currency CDS.

Valuing BTC through the Credit Market

The total valuation of global financial assets should include the credit market, which amounts to $900 trillion. The credit market accounts for $400 trillion, $300 trillion is real estate, $120 trillion is the equity market, and the remainder consists of gold, commodities, etc. Sovereign debt or government bonds make up a quarter of the credit market, which is $100 trillion.

First, Greg suggests that BTC's valuation should be calculated similarly to Leverage Enterprise Value, where debt is an important part of the asset structure. Without debt valuation, there is no market value for the credit market. Therefore, although there may be double counting, the leveraged real estate valuation should be included in the total valuation of global financial assets. The following are the differences between equity analysis, EV analysis, and credit analysis, clearly showing that ignoring the credit market for equity valuation is very foolish, as credit dominates the entire market. When tail risk occurs, bondholders will receive compensation first during liquidation, followed by equity holders:

• Equity Valuation: Market Value = Share Price x Shares Outstanding
• Enterprise Value: Includes DCF model, cash flow analysis, bondholders, EBITDA book analysis
• Credit Valuation: Non-public market debt, default rates, credit ratings

Source: Investopedia

As the leader of the credit market, the U.S. accounts for nearly $200 trillion of the credit market. Since the 2008 subprime mortgage crisis opened the floodgates for quantitative easing, and the issuance of $10 trillion in federal bonds due to COVID-19 in 2020, the current scale of U.S. federal bonds (excluding municipal or state government bonds) has reached $30 trillion, while the scale of unsecured bonds (including federal Medicare and Medicaid programs) has reached $162 trillion. By now, you should understand why researchers who ignore the credit market when discussing equity valuation are foolish.

Source: U.S. Department of the Treasury

In summary, although BTC is often presented as a competitor to gold, its valuation remains low compared to the $12 trillion gold market cap, especially when compared to $800 billion.

Valuing BTC through Probability

When considering BTC's status, the first reaction might be to see it replace the U.S. dollar as the new global currency for trading natural gas and crude oil, becoming a new global reserve asset. Michael Saylor, founder of MicroStrategy, said: "Energy sellers want to exchange their energy for BTC rather than the depreciating petrodollar, as BTC indirectly represents the world's energy costs."

Let's make a simple assumption: if BTC's share is equal to gold's share in global financial asset valuation, or even 3.7 to 5% of gold, we can multiply the share by the total circulation to find that each BTC's value is in the range of $200,000 to $50,000. However, this is not 100% certain, so we can calculate the expected return based on the probability of events occurring.

It can be seen that if there is a 10% chance BTC can reach gold's market value or 3.7 times gold's market value, then its valuation should be between $57,000 and $214,000 per BTC. However, at the current valuation of $40,000, people believe the probability of reaching gold's market value is only 7%, and the probability of reaching 3.7 times gold's market value is only 2%. These figures do not consider the assumption that hard assets will appreciate due to future dollar depreciation.

More importantly, unlike in 2017 when BTC was at $4,000, the Beta (risk-return ratio) has become more reasonable based on the global context and the pandemic's aftermath. Furthermore, after the start of the Ukraine-Russia war, all dollar reserves from energy trading profits were frozen and sanctioned by the U.S., forcing more countries to escape the petrodollar sanctions. The history of continuous dollar depreciation over the past 30 years indicates that the future probabilities are far higher than the current 2% or 7%.

Who Will Take the First Step?

Currently, the first step should be taken by those engaged in fixed-income bonds or bond discount premium trading. If bonds are issued when the yield is 1%, their face value will be severely devalued by the 2.9% yield on U.S. Treasuries currently being sold in the open market. These bonds have already depreciated by over 20% compared to their face value two years ago. Therefore, considering BTC as insurance for these asset portfolios is the best asymmetric trade opportunity. According to Greg, this is the best non-liquidating asymmetric trading opportunity he has seen in 35 years.

Ray Dalio, founder of Bridgewater Hedge Fund, began building his hedge fund through balanced all-weather risk parity financing when the 10-year U.S. Treasury yield was 14% 30 years ago. However, in the last quarter, as both the stock market and U.S. Treasuries fell simultaneously, and U.S. Treasury yields dropped to a low of 1%, we saw for the first time in history that U.S. Treasury yields and the Nasdaq experienced double-digit percentage fluctuations. In simple terms, the rising U.S. Treasury yields and the declining face value of U.S. Treasuries are equivalent to the decline in the Nasdaq index, indicating that the risk of the Risk Parity asset portfolio has not been effectively hedged or balanced, leading to negative impacts on the performance of assets using these strategies. Therefore, there are currently no effective traditional asset portfolios to cope with systemic risks.

Source: TradingView

Fidelity Investments once published a study on virtual currencies, categorizing them into two types: one is BTC, and the other lacks the value represented by BTC. According to data, Fidelity Investments, the fourth-largest asset manager globally, has allowed its clients and retirement benefit plans (401K) to provide BTC services. It seems that other large asset managers that do not offer BTC services will lose a significant portion of their client base. Thus, Greg points out that just like the development of high-yield bonds in Canada, it is only a matter of time before BTC becomes a service option for other institutions, and everything will accelerate, whether it is BlackRock or Vanguard Group.

Source: Advrating

When Will Large Funds Enter the Market?

Currently, BTC has not yet reached a total market cap of $1 trillion, which is too small for large funds like Bridgewater or even the $35 trillion pension funds in the U.S. Therefore, this period is very suitable for small asset management teams, while the risk for large funds to enter is very high. So when will these large funds enter the market? It may not be realistic to judge the timing of entry, so let's calculate it from a probability perspective.

Currently, U.S. pension funds generally promise an average annual interest rate of 10% over 40 years, investing with a traditional allocation ratio of 60% in equities and 40% in bonds. We can assume that without any global debt default risk, the 40% bond investment and the average coupon rate of bonds at 5% yield 2% of the 10% pension return. Another 2% comes from fixed income and investments made by these pension investors. As a result, we find that the remaining 6% return needs to be maintained by ensuring that equity investments always yield 10% annually for pension investors. Greg says that with the current historically highest equity valuations and cash flow valuation multiples, all pension fund managers must be feeling overwhelmed, as they either continue to leverage to push the stock market higher or find ways to insure against inflated valuations, or they can just wait for the expanding bubble to burst.

Let's imagine a scenario where systemic risks of defaults and liquidations cause stock prices to plummet by 50%. The most affected would be pension fund investors. First, these firefighters, police officers, municipal workers, etc., will find that their lifetime savings in pensions cannot be fulfilled as per the contract or can only pay half of what was promised, and then market volatility will rise with social instability.

Spot ETF vs. Futures ETF

Currently, BTC's price is influenced by historically high futures interest rates and the opening of futures ETFs, which have been artificially compressed to low prices like a spring in the short term. However, in the long run, BTC is the only derivative insurance that shorts the debt market while going long on long-term market volatility characteristics, and there is currently no recognized product that serves as long-term bullish insurance on market volatility. In simple terms, the world believes that the economy will develop more steadily after the pandemic, while BTC is the only index that opposes this view and can be purchased. Ultimately, those who are optimistic about economic development and short BTC will have to pay for their shorts in the long run.

Greg points out that many hedge funds treat BTC as a fan stock of the Nasdaq, bundling it together to short these overheated sentiments, but they do not realize that it is actually a hedge insurance product that is bullish on long-term market volatility. VXY is a fund that can be used to bet on VIX volatility, and when volatility rises (VIX), asset stocks generally experience significant declines. No one believes the market will always be negatively volatile, but having extra insurance during periods of high market volatility is also reasonable.

Overall, regardless of the type of ETF, legal and compliant regulation will attract more interested investors, referring to asset managers in trillions rather than just billionaires currently in the market.

Source: Crypto Quant

Correlation with Stock Indices

Many people point out that BTC's price is highly correlated with indices like the Nasdaq, with a correlation of up to 0.8; however, historical data is generally for reference only. Moreover, we can see even higher index correlations in the corporate bond trading market, as AI trading algorithms have a significant weight in short-term correlation decision-making. However, these algorithms can easily fail due to some artificial manipulation of long-term risk indicators, specifically the continuous refreshing of high-yield bond interest rates. Currently, BTC is more attractive for investment compared to 2016, as many unknown macro and micro factors have settled.

From a macro perspective, we can almost be certain that fiat currencies will 100% continue to depreciate. Originally, in 2018, the U.S. could have rescued the death spiral caused by the subprime mortgage crisis with technology development. However, with the onset of the COVID-19 pandemic, quantitative easing has begun to form a death spiral in trillions. If Americans mistakenly believe that their government will safeguard their assets for the next 40 years, will they give the government another chance to believe in the next 40 years, or even make a 180-degree turn in 2022? The possibility is extremely low. From a micro perspective, BTC's positioning, including the decision on block size and even the trend of technological development, is clearer than it was years ago.

Will Interest Rate Hikes Really Have an Impact?

So, will interest rate hikes really slow down the depreciation of the dollar and affect BTC's price? First, we have understood that the printed fiat currency is the root of this death spiral, so this becomes a middle school algebra problem. This equation needs to be satisfied through the following points:

• The global economic growth rate is insufficient to pay bond interest (Economic Growth < Bond Interest)
• Printing money to support the credit market (Slow Economic Growth + Infinite Money Printing = Bond Interest)

In summary, the entire credit market is in chaos. Because no matter how much interest rates are raised, it does not change the fact that the global economy is slow and needs to continuously print fiat currency to repay the bond interest generated from selling bonds. Worse still, equity holders are the last to receive compensation during default risks. In simple terms, the current market is not suitable for lending money; instead, one should borrow as much as possible.

Conclusion

Peter Schiff started engaging with BTC when it was at $10. He could have achieved a 40-fold return on his total assets by investing 1% of his total assets, but he has never learned from asymmetric trading and instead continues to obstruct traditional investors. Although it seems that fiat currency will likely continue to depreciate or even decouple, we may still have a parallel universe option where BTC becomes a treasury reserve while fiat currency continues to nominally serve as global reserve currency.