As institutional demand for productive bitcoin positions has grown, a market for so-called bitcoin yield has emerged alongside it. No risk-free rate exists for bitcoin. Any strategy marketed as bitcoin yield generates return by transferring identifiable risk to the investor.
This article examines how each major category actually generates return and what risks are being taken in exchange for that return. What honest alternatives look like for institutional allocators is the question it closes on.
By Alexander Blume
Co-Founder and CEO of Two Prime
The Problem with Bitcoin Yield
As bitcoin becomes increasingly institutional, more firms are seeking ways to make their BTC productive. Corporate treasuries, private hedge funds, and DeFi-based products have all begun marketing “BTC Yield” over the past 12 months. Unfortunately, if using the common financial meaning of “yield,” a risk-free rate for providing capital, like a T-bill for USD, does not exist. Groups are motivated to sell “yield” products because the market wants them. Digging into the complexity of how the return actually gets produced adds friction and alerts clients to risks they may not realize they are taking. This article will examine how “yield” is produced and what realistic alternatives exist.
Why the Term Matters
First, one should ask, why does this matter? The biggest issue stems from an impression that BTC return can be achieved with zero or minimal risk. This is simply not the case. Bitcoin has no native yield. To gain more bitcoin, someone else must lose it.
In bitcoin, and crypto in general, technical jargon often gets used to obfuscate standard financial operations, hidden risks, and methods for producing returns. Investors, both retail and institutional, can fall for the trap of deferring to authority, thinking that they must not understand something obvious. However, in reality, they are ceding knowledge of significant risk, often technical and tail risk, that deviates far from their conservative goals.
The three primary sources for “yield’ are in corporate treasuries, hedge funds, and DeFi products. Each comes with tradeoffs and is not the standard meaning of yield.
How DATs Manufacture BPS
Taking Strategy as an example, the firm measures bitcoin per share (BPS). In this metric, the company divides the amount of bitcoin by the number of shares. Over time, if Strategy buys more bitcoin above NAV, the BPS increases; this change in BPS is called “yield.” While it is true that bitcoin per share has increased, it does not address two main issues. One, it is increasing because new investors, by definition, are entering into a discounted bitcoin position relative to the share price they paid. And two, shareholders have zero claim on the actual bitcoin. The price of bitcoin does not necessarily correlate with the share price. Shares can not be redeemed for bitcoin. A host of secondary-market dynamics can have negative consequences for shareholders.
The price of the stock depends on supply and demand dynamics, independent of the BTC price. If the CEO says something concerning, changes in corporate policy, regulatory changes, macroeconomic news, new products, or failing products, and a slew of other issues can all harm shareholders. The same thing occurred previously in Grayscale Trust shares, before the trust was converted to an ETF. Investors entered thinking they could arbitrage a premium between primary share creation and secondary markets, but when demand dried up, investors sat in shares at a discount to NAV for many years, effectively trapped in what they thought was a risk-free investment. Rescue only came upon ETF conversion, which Strategy and other DAT shares do not offer as a potential solution. In the end, Strategy shareholders can end up in situations where bitcoin “yield” is up, and they have lost USD in the end.
Hedge Funds and Short Volatility
Hedge funds also market bitcoin yield products. There are several methods used to achieve the supposed yield. Often, it stems from simplistic short volatility strategies that do very well until they fail, the most common being selling covered calls. The volatility premium is collected monthly in a static strategy, but can be completely destroyed in a single month if realized volatility exceeds implied volatility. Especially over the past year, as institutions have crowded into this trade, the risk-reward has grown worse and worse as implied volatility has decreased. However, because these strategies are easy to explain, have high Sharpe ratios, and can work for months or years at a time, they often appear appealing to investors. Any static, short strategy on a high-volatility asset like bitcoin will eventually blow up.
"To gain more bitcoin, someone else must lose it."
DeFi and Unsecured Lending
There is demand for unsecured BTC borrowing. BTC can be lent at 3 - 6% APR to hedge funds and other bitcoin-related financial firms. Investors like the consistency and simplicity of this style of income generation. That said, unsecured lending can pose significant systemic risk. We saw this occur in 2020 and 2021 as many of the leading lenders - Genesis, BlockFi, Celsius, and others - all blew up due to FTX and Three Arrows Capital’s fraudulent behavior. What appeared to be a low-risk strategy, lending to large counterparties, became a complete loss of principle, nearly instantly, and years of bankruptcy claims as a reward. Further, the BTC being lent is often traded in high-risk or exotic ways by borrowers to generate much higher returns. A lender is therefore taking equity-style risk but being paid credit-style returns, with limited information about the risk being taken. Credible counterparties do exist, but they can not borrow limitless amounts of BTC.
Lastly, a slew of DeFi strategies claiming to offer BTC yield have also emerged. In these cases, often you’re effectively lending BTC, but with added technology risk and to low-quality counterparties. What appears to be an on-chain yield is often manual lending to institutions on the backend. This technical obfuscation can create a sense of safety where one should not exist.
What Honest Bitcoin Return Looks Like
If we can accept that “BTC Yield” does not exist in the traditional sense, we can focus on ways to achieve a similar result with clear eyes. Amongst the risks available to take - counterparty, technology, tail, volatility, systemic, macro, etc - one should want to take known risks that have controlled downside. To me, this means avoiding anything with DeFi, unsecured lending, or directional bets. What remains are delta-neutral derivative strategies. For example, a persistent return exists in arbitrage between the funding costs of perpetual futures and dated futures. It does not always exist, but people and systems can observe its fluctuations and determine when it is best to enter a trade. In this case, a 3-6% return can be achieved with controlled losses and complete transparency into performance and risk. Further, assets can remain off-exchange with a qualified custodian. A number of other delta-neutral arbitrage strategies like this can be found as well. They wax and wane, and new ones emerge over time. The benefit here is that returns and volatility can be defined based on specific client goals and risk tolerance. For those looking for simplistic and guaranteed alternatives, this can appear overly complex, but what they are seeking simply does not exist.
In conclusion, “Bitcoin Yield” has emerged, largely in response to market desires. The analogs to staking on other assets have also crossed over to BTC, where holders want consistent ways to grow their stack without risking principal. Unfortunately, with no native yield, BTC holders seeking returns must take some risk. Often, they are short some risk they do not realize, with massive tail risk on the other side. BTC Total Return that contains risk to known variables with regulated, institutional custody and counterparties, is the closest one can get to BTC yield. If you hear something else, I recommend you turn the other way.
This article originally appeared in Forbes.
