This chapter details ways to invest and store Bitcoin while the next chapter will address Bitcoin counterarguments before the book delves into Ethereum and Altcoins. I separate Bitcoin from other cryptocurrencies for reasons that will become clear in later chapters. When purchasing Bitcoin, investors have several options: (1) traditional brokerage account options such as a trust, trading futures contracts, or investing in companies with high exposure; (2) an online Bitcoin wallet typically held with an exchange; (3) an offline Bitcoin wallet that physically stores the asset through methods such as a hard drive, thumb drive, or paper wallet. The terms hot and cold wallets are synonymous with online and offline storage. Between hot and cold wallet options involve multisignature wallets—those that are held online but have added security because they require multiple keys to authorize any transaction. Each option provides trade-offs between ownership of coins, ease of use, and security. The choice in method of investment usually stems from an investor’s personal beliefs regarding the trade-offs above and level of subscription to the principles of Bitcoin purists.
Traditional Brokerage Account Options
Currently, the simplest way to add Bitcoin exposure to an investor’s portfolio is through the Grayscale Bitcoin Investment Trust, ticker $GBTC. Though an ETF option does not yet exist, it surely will in the coming years as regulations become solidified. The trust privately owns and stores over 600,000 Bitcoin at the time of this writing and continues to buy at a breakneck pace as demand for the trust increases. There are some advantages to purchasing shares of a publicly traded Bitcoin Trust as opposed to actual Bitcoin. For one, an investor can hold it in retirement accounts such as a Traditional Individual Retirement Account (IRA) or Roth IRA, which they cannot do with the actual asset. This comes with the inherent tax advantage of Bitcoin exposure disguised as a tradable equity in a tax deferred account. Meanwhile, selling Bitcoin in a hot wallet will incur capital gains similar to any other asset.
For investors that desire Bitcoin as a portfolio hedge against inflation or an uncorrelated asset that complements a portfolio of stocks, bonds, commodities, and the like, it helps to have one account managing these positions as opposed to transferring back and forth between a digital wallet and brokerage account. For new investors in the space, a publicly traded fund also eliminates the security versus ownership dilemma that many Bitcoin investors face. There is no need to make a decision about a hot wallet, cold wallet, or multisignature storage. There is also no need to memorize or store private keys. These decisions are pawned off to the experts at Grayscale who secure their Bitcoin offline for a fee—just as a gold trust would with physical storage of gold.
Investors should understand that $GBTC is a grantor trust, not an ETF. The fund is not registered with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 and trades over the counter. For many in the Bitcoin community, an SEC-approved ETF is the holy grail given that it provides seamless on-ramps for institutional investors. For example, Merrill Lynch has banned clients and advisors from purchasing the fund since 2018, citing “concerns pertaining to suitability and eligibility standards of this product.”1 Though barring exposure to Bitcoin for its clients will likely backfire by condemning clients to underperformance, the concerns given the trust’s status as unregistered with the SEC and traded over the counter does serve as a major obstacle for some would-be institutional investors.
The SEC rejected the first Bitcoin ETF proposal in 2013 and continued to reject proposals citing various reasons. In the 2017 rejection of the Winkelvoss twins’ proposal, owners of the Gemini exchange, the SEC cited lack of regulation and the potential for “manipulative acts and practices in this market.”2 As more experienced institutional investment management and ETF firms file applications with the SEC, such as the VanEck proposal that will see a decision in 2021, I believe a fully registered Bitcoin fund or ETF is inevitable. To address previously stated SEC concerns, increasing price action will visit increased regulation. Additionally, increased market capitalization will prevent market whales from creating volatile price action by entering and exiting the market. Until an ETF proposal becomes fully registered, Grayscale’s Investment Trust best solves the desire for Bitcoin exposure in traditional brokerage accounts. However, this option also comes with disadvantages.
Grayscale charges an annual fee of 2 percent. While exchanges may charge a fee for transactions, they do not have annual fees for simply holding Bitcoin. The second disadvantage is that the fund oftentimes trades at a premium to the Bitcoin spot price that varies depending on demand. Though the premium tends to remain between 1 and 15 percent, it can rise to extraordinary levels. Near the 2017 peak, $GBTC traded at nearly a 100 percent premium to the spot price. That constitutes buying one Bitcoin for the price of two. On the other hand, $GBTC will trade at a discount to the spot price under heavy selling pressure, and this acts as a barometer for oversold conditions. An ETF that tracks the price would reduce the premium and discount arbitrage. Potential investors to the fund should take fees and the premium into account before making a purchase.
Traders can use the futures market to gain Bitcoin exposure as well. Billionaire hedge fund manager Paul Tudor Jones went public with his support for Bitcoin in mid-2020. In his published Market Outlook, Jones first begins by stating his belief that there will be a “great monetary inflation” caused by unprecedented Fed balance sheet expansion and the unquestioned “direct monetization of massive fiscal spending” following the COVID-19 pandemic.3 Based on this thesis, he graded several stores of value on four criteria: retaining purchasing power over time, perceived trustworthiness, liquidity, and portability. Assets studied included gold, the 2s30s yield curve, Bitcoin, TIPS breakevens, the tech heavy NASDAQ exchange, U.S. cyclicals, and more. Based on this criteria, Bitcoin scored a 43 compared to gold’s 62 based mostly on its liquidity and portability premium. While admittedly less proven than gold to Jones, Bitcoin’s market capitalization was only 7 percent of gold’s at the time of Jones’s report, demonstrating immense upside potential. Due to the low market cap, Jones also states that investing in Bitcoin is akin to investing early in one of the infamous FAANG stocks—Facebook, Amazon, Apple, Netflix, and Google.
I convey Jones’s story because the legendary fund manager gains exposure through trading Bitcoin futures. The Chicago Board Options Exchange (CBOE) began offering Bitcoin contracts on December 10, 2017. Again, this option trades asset ownership for price exposure on traditional brokerage accounts through brokers such as TDAmeritrade and Interactive-Brokers. For experienced futures traders, this may well be the best option. However, there is a third option for gaining Bitcoin exposure that does not involve the futures markets and non-SEC approved funds—purchasing shares of companies with known Bitcoin exposure.
Individual equity exposure to Bitcoin varies depending on the company. At the end of 2020, 5.79 percent of all Bitcoin, or 1,216,188 coins, are held on the treasury accounts of companies. Many of these companies are publicly traded. Therefore, the most circuitous route to gain Bitcoin exposure, and less risky route for skeptics, involves purchasing publicly traded shares of a company that has allocated a percentage of its treasury balance away from dollars and into Bitcoin. Companies do this because inflationary policies act as a tax against cash holdings. They also desire exposure to the massive upside potential that Bitcoin offers while only sacrificing a small percentage of the balance sheet. This trend of companies moving small portions of their balance sheets to Bitcoin will accelerate in the future. The companies that I will name shortly have the first-mover advantage.
This section will focus on companies listed on U.S. exchanges, although Canada and Europe have several companies with high Bitcoin treasuries as well. The figures listed were gathered at the end of 2020 and the balance sheets of these companies have surely changed since. Investors can focus on percentage of the balance sheet allocated to Bitcoin or number of Bitcoins outstanding. Square Inc. ($SQ), a commerce-based financial services platform and parent company of CashApp, has the second largest Bitcoin treasury for companies listed in the United States with 4,709 Bitcoin but only 0.2 percent of its balance sheet. The listed company with the third largest Bitcoin treasury is Riot Blockchain, Inc. ($RIOT), a Bitcoin mining operation out of Montana. It has 1,175 outstanding, though a larger 2.7 percent of its treasury in Bitcoin.
The company that has wholeheartedly adopted the Bitcoin Standard as its reserve asset is Michael Saylor’s MicroStrategy Incorporated ($MSTR). MicroStrategy owns over 70,000 Bitcoin and roughly one-third of 1 percent of all Bitcoin in existence at the end of 2020. Given Saylor’s unwavering conviction, I expect this number will continue increasing. Many investors will buy MicroStrategy as a proxy for Bitcoin, without knowing anything of its business intelligence services. For investors who choose this route, I highly recommend understanding the company itself and the service it provides. MicroStrategy’s CEO, Michael Saylor, has laid out his reasoning in several written works and podcasts. He did not want to hold a large cash balance due to the macroeconomic factors reiterated throughout this book and he did not feel compelled to make a large acquisition or hastily use his cash when he saw little opportunities in the market. His solution was to put his treasury on the Bitcoin Standard to keep his reserves from depreciating while he awaited opportunities.4 Investors in MicroStrategy are investing in a business analytics software company that made the decision to adopt Bitcoin as its reserve asset—they are not directly investing in Bitcoin. The market has rewarded the company greatly. Less than six months after the announcement, the company’s stock surged nearly 200 percent.
Current Bitcoin options for a traditional brokerage account include the Grayscale Bitcoin Investment Trust, trading on a futures account, or investing in Bitcoin-friendly companies. These options provide the greatest ease of use for traditional investors. However, disadvantages include service fees, premiums paid, and the fact that you do not own these Bitcoin as you would with a personal wallet. I would equate this to a Gold Trust or having real estate exposure through a Real Estate Investment Trust (REIT) as opposed to owning gold and renting homes yourself. If owned through a fund, the asset truly belongs to the fund and the investor has a claim to that asset. The next option, an online custodial wallet, is both easy to use and provides more of a sense ownership to the investor.
Hot Wallets—Custodial and Noncustodial
Investors draw a multitude of parallels between Bitcoin and physical gold—storage is no different. Custodial wallets connected to the Internet is equivalent to trusting a third party to store your gold. For purists who want personal custody of an asset outside of the financial system, trusting a third party defeats the purpose of owning Bitcoin and gold alike. Why? Because a security breach could occur in the gold vault, the storage company could go rogue and take off with your gold, or the government could outlaw the storage of physical gold and the vault will be forced to comply. Though I would handicap these as low probability events with Bitcoin, they exist within the realm of possibility. An individual who stores his or her physical gold at home in a personal vault does not have such concerns. The same logic applies to Bitcoin storage.
Exchange wallets serve as examples of popular custodial wallets. Popular exchanges include Coinbase, Kraken, and Gemini. They are exchanges that allow users to purchase Bitcoin or other cryptocurrencies and store their assets on a wallet held with the exchange. Both the user and the company have access to the private keys. The phrase “not your keys, not your coins” is popular among Bitcoin purists to signify that these companies are in fact the owners of your Bitcoin. Why would a Bitcoin investor allow a trusted third party to own their coins? For the lay investor with only a few Bitcoin or a percentage of a Bitcoin, for those who regularly trade crypto, or those who use it for purchases, custodial storage makes sense. It also makes sense if you do not trust in your own ability to store your Bitcoin offline or wish to transfer some coins offline when the wallet value reaches a certain amount. Cold storage is undoubtedly more secure but investors risk losing their private keys—just as a gold bar kept at home could be physically lost or stolen.
Having a custodial wallet is similar to a regular brokerage account. Users have a username, password, and typically a second-tier verification system such as a pin or randomized authenticator code. They can link their debit or credit account to make purchases instantaneously from a mobile phone or computer. Verifying one’s identity also provides extra benefits such as increased spending limits and the ability to send or receive crypto with other wallets. As opposed to a share price, these wallets show the number of coins held in your wallet and the entire portfolio value. Similar to a brokerage account, a third party getting access to your username, password, and code can withdraw your funds. The exchange may also become bogged down with high activity and prevent immediate settlement of trades. Lastly, and most importantly, users of custodial wallet risk exchange hacks.
While a Bitcoin held offline cannot be hacked, exchanges that hold Bitcoin can. In 2019, the popular Binance cryptocurrency exchange witnessed hackers steal $40 million of Bitcoin in an orchestrated attack that used phishing, viruses, and other sophisticated methods. I remind readers of two facts to mitigate the likelihood of losing Bitcoin. Firstly, know the security and storage system of the exchanges. Large exchanges will typically hold most of their coins in cold storage, have multifaceted authenticity measures, and sophisticated firewalls. The latter two can be said of any brokerage account. I recommend that individuals with large Bitcoin balances use both hot and cold storage—in a similar manner to a checking account readily available for spending and a savings account held offline for emergency situations. Secondly, much of the Bitcoin infrastructure is unproven. Though not the wild west of yesteryear where hackers stole 7 percent of the entire Bitcoin market capitalization from the Mt. Gox exchange in 2014, the threat of hackers stealing through exchanges is still real. Exchanges become more secure with each passing year and most exchanges have had zero security issues. Mt. Gox is short for Magic: The Gathering Online Exchange. The exchange was initially created for customers to buy and sell cards of a fantasy card game. Today’s exchanges are not repurposed trading card websites but sophisticated systems that use a balance of hot storage, cold storage, firewalls, and more.
Custodial wallets provide incredible ease of use and a greater sense of coin ownership than traditional brokerage methods. Investors do not see a ticker and price but own a number of Bitcoin custodied by an exchange. They can easily buy, sell, and spend Bitcoin, but this option requires trust in a third party similar to trusting your online broker or a physical gold vault company. This is the most common option for Bitcoin investors; however, noncustodial software and multisignature wallets are both held online and do not require trust in an exchange.
Software wallets downloaded to your desktop exist to allow the owner to have sole custody his or her private key. Essentially, your private key serves as your login information to access your Bitcoin. The software encrypts and stores your private key, but the company does not have access. This trades convenience for greater individual responsibility and safety. In this option, your Bitcoin are as secure as your personal security practices. Multisignature technology is another trustless way to store Bitcoin online. As opposed to a single private key, users can have three keys stored on three different devices. They will need two of the three keys to access their account. If one gets stolen or compromised, their coins are still safe assuming they have the other two keys.
I believe that for the average investor entering the Bitcoin landscape, using a custodial wallet with an exchange will suffice because it provides greater ease of use and optionality if the owner one day wishes to transfer to a more secure wallet. Transferring to cold storage is not possible through shares of a Bitcoin trust. Noncustodial wallets require a greater degree of individual responsibility and some technical knowledge. Only those with a significant amount of net worth wrapped in Bitcoin or traditionalists who want a truly bankless experience have reason for self-custodied wallets. Twenty-first-century custodial practices are secure, though I believe that the reader should know his or her options when it comes to buying and storing Bitcoin. If the investor trusts an online brokerage account, they will likely trust a custodial wallet or third-party trust.
Cold Storage
The process of storing your Bitcoin offline begins with choosing a method. The most popular method is purchasing a hardware wallet such as Ledger Nano or Trezor and transferring your Bitcoin to the physical wallet. Other methods include paper wallets, desktop wallets, or a USB drive. These hardware wallets must be stored in a safe, secure location. Additionally, some physical wallet options are not waterproof, fireproof, and cannot be restored if destroyed. If maintaining physical custody of your Bitcoin sounds stressful, perhaps a custodial wallet serves as your best option. Though cold storage is undoubtedly the most secure storage method because it does not involve a third party, it risks physical destruction, loss, and theft. The owner substitutes digital and counterparty risk for physical risk. Truly, the trade-off is that simple. As previously mentioned, those with a significant number of coins should diversify their storage methods between self-custody and custodial wallets.
Conclusion
The emphasis on private key ownership among Bitcoin circles originates from its anarcho-capitalist origins. Bitcoin was created in January 2009 as a trustless currency and digital analog to gold. Though the gold narrative has surpassed the trust narrative with the introduction of valuation metrics such as the SF ratio, the trustless feature is what drew early Bitcoin adopters. In the words of Bitcoin’s founder, Satoshi Nakamoto:
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.5
Satoshi also differentiates Bitcoin from previous Internet currencies when he focuses on the decentralized and trustless nature of blockchain technology and proof-of-work.
A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990’s. I hope it’s obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we’re trying a decentralized, non-trust-based system.6
The genesis block, the first ever Bitcoin block mined by Satoshi, contained a political message on it. It said, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” Bitcoin’s origin was more of an anarcho-capitalist political movement than an asset class. It was created in the wake of the bank bailouts of the 2008 Global Financial Crisis and sold as the ideological antithesis to Central Banking. It was against monetary debasement, fractional reserve banking, and rent-seeking practices of governments and banks. It was pro sound money, independence, and privacy. Due to this, it shares an ideological link with physical gold investors and has a market in the investment world. As monetary debasement accelerates, Bitcoin becomes a more attractive asset because Bitcoin was created to counter monetary debasement.
Today, early Bitcoin investors constitute the loud minority. Satoshi created an investable asset based on an ideological movement. However, there is a constant tension between the original ideology and price appreciation. Price appreciation invites more government regulation and institutional adoption from Wall Street. This invites less privacy and independence. My guess is that as the price appreciates and more stakeholders get involved, the “not your keys, not your coins” ideology will become less prevalent. Though an ideological loss for early adopters, they will certainly gain monetarily.
Introductory crypto investors who want a portfolio hedge or exposure to an asymmetric asset class should stick to traditional brokerage options or custodial wallets with a trusted exchange. Those who have completely adopted the Bitcoin Standard as their modus operandi or early investors who have a large amount of their net worth in Bitcoin should rely on a mix of hot and cold storage. Before moving funds to cold storage or any form of self-custody, the investor should research best security practices in order to avoid losing a hardware wallet or private keys. Losing a hardware wallet or keys means losing access to funds. Though the options can make a new investor’s head spin, they are essentially the same as gold. Investors can choose paper gold, self-custodied physical gold, or third-party custodied physical gold based on their personal and ideological preferences. Any other conceptualization overcomplicates the matter.