Arbitrage, the secret to the success of the first Bitcoin long positions strategy

Author: Dio Casares

Compiled by: White55, Mars Finance

In the past 5 years, Strategy has spent $40.8 billion, equivalent to Iceland's GDP, purchasing over 580,000 bitcoins. This accounts for 2.9% of the bitcoin supply or nearly 10% of active bitcoins (1).

The stock code of Strategy, $MSTR, has increased by 1600% over the past three years, while Bitcoin's increase during the same period was only about 420%. This significant growth has pushed Strategy's valuation to over $100 billion and has been included in the Nasdaq 100 Index.

This enormous growth has also brought about skepticism. Some claim that $MSTR will become a trillion-dollar company, while others have sounded the alarm, questioning whether Strategy will be forced to sell its Bitcoin, potentially triggering a massive panic that could depress Bitcoin prices for years.

However, although these concerns are not entirely unfounded, most people lack a basic understanding of how Strategy operates. This article will explore in detail how Strategy works and whether it poses a significant risk for Bitcoin acquisition or represents a revolutionary model.

How did Strategy purchase so many bitcoins?

Note: Due to new financing and other reasons, the data may differ from that at the time of writing.

Broadly speaking, Strategy acquires funds to purchase Bitcoin primarily through three means: revenue from its operational business, selling stocks/equity, and debt. Among these three methods, debt is undoubtedly the most scrutinized. People tend to focus heavily on debt, but in reality, the vast majority of the funds Strategy uses to purchase Bitcoin comes from issuance, that is, selling stocks to the public and using the proceeds to buy Bitcoin.

This may seem somewhat counterintuitive; why would people buy shares of Strategy instead of buying Bitcoin directly? The reason is quite simple, it goes back to the most favored business type in the cryptocurrency realm: arbitrage.

Why do people choose to buy $MSTR instead of directly buying $BTC?

Many institutions, funds, and regulated entities are subject to restrictions from "investment mandates". These mandates specify which assets a company can and cannot purchase. For example, credit funds can only buy credit instruments, equity funds can only buy stocks, and long-only funds can never short, and so on.

These authorizations allow investors to be assured that, for example, a fund that invests solely in stocks will not purchase sovereign debt, and vice versa. It forces fund managers and regulated entities (such as banks and insurance companies) to be more responsible, only taking on specific types of risks rather than being able to take on any type of risk at will. After all, the risk of buying Nvidia stock is completely different from the risk of purchasing U.S. Treasury bonds or investing funds in the money market.

Due to the highly conservative nature of these authorizations, a significant amount of capital remaining in funds and entities is "locked in," preventing it from entering emerging industries or opportunity areas, including cryptocurrency, particularly unable to directly access Bitcoin, even if the managers of these funds and related personnel wish to engage with Bitcoin in some way.

Michael Saylor, the founder and Executive Chairman of Strategy (@saylor), recognized the gap between these entities' desire for asset exposure and the actual risk they can bear, and capitalized on it. Before the emergence of Bitcoin ETFs, $MSTR was one of the few reliable ways for these entities, which could only purchase stocks, to gain exposure to Bitcoin. This meant that Strategy's shares often traded at a premium, as the demand for $MSTR exceeded the supply of its shares. Strategy continuously leveraged this premium, which is the difference between the value of $MSTR shares and the value of the Bitcoin contained in each share, to purchase more Bitcoin while increasing the amount of Bitcoin per share.

In the past two years, if you held $MSTR, your "return" in Bitcoin terms reached 134%, which is the highest among scaled Bitcoin investment returns in the market. Strategy's products directly meet the needs of entities that typically cannot access Bitcoin.

This is a typical case of "Mandate Arbitrage". Before the launch of the Bitcoin ETF, as mentioned earlier, many market participants were unable to purchase non-exchange-traded stocks or securities. However, as a publicly traded company, Strategy was allowed to hold and buy Bitcoin ($BTC). Even though the Bitcoin ETF has recently launched, it is completely wrong to think that this strategy is no longer effective, as many funds are still prohibited from investing in ETFs, including most mutual funds managing $25 trillion in assets.

A typical case study is Capital Group's Capital International Investors Fund (CII). This fund manages $509 billion in assets, but its investment scope is limited to equities and cannot directly hold commodities or ETFs (Bitcoin is largely considered a commodity in the U.S.). Due to these restrictions, Strategy has become one of the few tools that CII uses to gain exposure to Bitcoin price fluctuations. In fact, CII has such high confidence in Strategy that it holds about 12% of Strategy's shares, making CII one of the largest non-insider shareholders.

Debt terms: binding for other companies, but a boost for Strategy

In addition to a positive supply situation, Strategy also has certain advantages regarding the debts it undertakes. Not all debts are the same. Credit card debt, mortgages, margin loans—these are all distinctly different types of debt.

Credit card debt is personal debt that depends on your salary and repayment ability, rather than asset backing, and the annual interest rate is usually over 20%. Margin loans are typically loans issued against your existing assets (usually stocks) as collateral; if the total value of your assets approaches the amount you owe, your broker or bank may seize all your funds. Mortgages are considered the "holy grail" of debt because they allow you to purchase assets that typically appreciate (such as houses) using a loan, while only paying the monthly interest on the loan (i.e., mortgage payment).

Although this is not completely risk-free, especially in the current interest rate environment where interest could accumulate to unsustainable levels, it is still the most flexible compared to other types of loans, as the interest rates are lower, and as long as the monthly payments are made on time, the assets will not be forfeited.

Generally speaking, mortgages are limited to housing. However, business loans can sometimes operate similarly to mortgages, meaning that interest is paid over a specified period, and the principal (i.e., the initial amount of the loan) is only repaid at the end of that term. While loan terms can vary greatly, typically as long as interest is paid on time, the debt holder does not have the right to sell the company’s assets.

Chart source: @glxyresearch

This flexibility allows corporate borrowers like Strategy to more easily respond to market fluctuations, which also makes $MSTR a way to "harvest" the volatility of the crypto market. However, this does not mean that risks are completely eliminated.

Conclusion

Strategy is not in leveraged trading, but in arbitrage trading.

Although there is indeed a certain amount of debt at present, the price of Bitcoin would need to fall to about $15,000 per coin within five years to pose a serious risk to Strategy. With the expansion of "Treasury Companies" (referring to companies that replicate Strategy's Bitcoin accumulation strategy), including MetaPlanet and Nakamoto by @DavidFBailey, this will become a key focus of another topic.

However, if these vault companies stop charging premiums in order to compete with each other and begin to take on excessive debt, the entire situation will change and could have serious consequences.