Since Strategy (formerly MicroStrategy) restructured its business model to focus on acquiring Bitcoin in August 2020 as its primary reserve asset, digital asset treasury companies (DATCO) have significantly risen in notoriety.
What seemed impossible and traditional has become a notion that most publicly listed companies have adopted: managing not just cash or bonds, but also digital assets.
Strategy’s fortunes have dramatically increased since this decision.
As companies continue to inject liquidity into Bitcoin, Ethereum, and BNB into their balance sheets, a pivotal question remains unanswered.
Is the swelling interest in digital asset treasury a long-term strategy or speculative bet? On the surface, this might seem a genius approach to treasury management – substituting cash with cryptocurrencies, but this optimism may present systemic risks and fragilities.
This blog breaks down the major hidden risks behind the digital asset treasury hype and why this new corporate playbook may not be all that it seems.
What DATCOs Are All About?
Basically, these are companies that hold a significant amount of cryptocurrencies on their balance sheet as a primary reserve asset. You can liken it to traditional companies that hold cash or commodities like gold in their balance sheet. DATCO’s core business model is centered on accumulating and managing cryptocurrencies, but that’s not all.
DATCOs provide direct exposure to cryptocurrencies, offering a compelling alternative to owning the asset through a crypto exchange or exchange-traded fund (ETF). This means you can invest in a DATCO and own a part of the company in the form of equity.
This model can both be favorable and unfavorable to investors. For instance, during crypto bull markets, when the price of that particular asset typically increases, DATCO’s equity value trades at a premium to its net asset value.
This allows companies to raise new capital by issuing shares above NAV (a measurement of a company’s market cap to the value of its digital asset holdings), essentially borrowing against future appreciation. The proceeds from the share issuance and convertible bonds are then used to acquire more of the crypto asset, leading to an increase in the asset per share for existing investors.
Strategy is a leading example of this model, as its share price once traded at a premium of over 50% to Bitcoin NAV, and its debt now represents 11% of its Bitcoin NAV due to the issuance of convertible notes.
Other companies, such as Metaplanet and SharpLink, used this same model to acquire over 150,000 Bitcoins valued at over $15 billion. Consequently, their share prices soared against the underlying crypto asset.
Another funding model used by companies to acquire digital assets is credit expansion. Rather than convert part of their cash reserves to cryptocurrencies, these companies take out loans against the crypto asset they plan to acquire and then layer leverage on top.
Regardless of whatever model is used, it exposes the company to significant risks. Of course, the crypto market is volatile, and what happens to these companies in a bear market?
How do they respond, and what consequences do they face? We will explain the risks of this operating model and others below.
Risks Behind Digital Asset Treasury
The reflexive loop of trading at a premium is obviously the most significant risk. In a bear market, it’s possible for the company’s mNAV value to drop below the value of its crypto holdings. Recently, Strategy and Metaplanet saw their mNAV drop below 1 due to Bitcoin’s dump.
What does this mean? Firstly, it means their market valuation is now lower than the crypto they hold. Secondly, investors’ enthusiasm is affected. They will be wary of the company’s long-term stability. It essentially creates fear and fright in their minds, often with the feeling that the company might be forced to sell its holdings soon to survive the market.
For holders, this spells doom as they will experience greater losses. If the price decline is too rapid, a premium to NAV can turn into a discount, and this becomes a catastrophe. This is a clear sign of fragility that mustn’t be ignored.
What about companies that rely heavily on borrowed money? When conditions tighten, refinancing becomes difficult. And what do these companies do?
Credit markets freeze assets; loan-to-value ratios spike; Lenders’ requirements increase; and these companies are forced to unwind positions immediately to repay debts with assets that are losing value, similar to what happened during the 2022 lending crisis.
The impact of forced liquidation will reverberate on the broader crypto market, with prices of cryptocurrencies plummeting further. Other DATCOs holding similar collateral or digital asset exposure dance to the tune as well, and might be forced to liquidate. This creates a sell-off loop that could quickly spread contagion across the entire crypto market.
Some companies, in a bid to avoid the drawdown associated with mainstream digital assets like Bitcoin, often bet recklessly on illiquid altcoins and low-cap tokens.
However, this move is as risky as concentrating on mainstream assets because these tokens are far more prone to flash crashes and market manipulation. Moreover, these tokens are harder to liquidate during crises, which leaves the company in a terrible state of destabilization.
Other risks associated with digital asset treasury include:
- Systemic Contagion: Digital-asset treasuries are intertwined with lenders, custody partners, liquidity pools, etc. One DAT failure can spark sector-wide liquidation, just like the FTX exchange contagion in 2022. A single collapse can lead to chain reactions – lender distress, price shock, and insolvencies.
- Weak Business Fundamentals: Few DATCOs have minimal revenue, weak cash flow, or lack a diversified business line. Their only strategy is betting on the appreciation of crypto. When the market is favorable, everything looks good, but when it isn’t, they might declare bankruptcy or liquidate their holdings to pay their creditors.
- Regulatory Shocks: Digital asset treasury is a relatively new phenomenon that operates at the intersection of corporate finance, cryptocurrencies, and securities law. As a result, they are vulnerable to taxation laws, audit and reporting policies, custody standards, capital requirements, etc. Regulatory clarity is slowly building, as institutional confidence rises globally. This means more structured frameworks for digital assets, including DATCOs, will be developed. A regulatory shift targeting any of the aforementioned policies could force DATCOs into potential solvency, rapid restructuring, and forced asset sales, if they aren’t properly structured. Regulations hit hard when they arrive.
What DATCOs Can Do To Mitigate the Risks?
In a bear crisis, a DATCO can do either of the following:
- Wait: By waiting, it means the company should continue to hold onto its assets and wait for a rebound. However, this is only practical if the company has sufficient reserves to cover operating expenses. This strategy preserves the crypto holdings, but it could worsen stock price declines and shareholder dissatisfaction. Strategy, for example, has held onto its Bitcoin holdings through several bear market cycles.
- Sell Assets to Repurchase Shares: Another solution is to sell some of the digital assets to repurchase shares to restore the share price to parity with NAV. This strategy balances the premium and discount dynamics, where the share price stays afloat, but part of the digital assets are sacrificed.
Final Thoughts
The future isn’t bleak, despite the risks behind digital asset treasuries. Companies and investors who survive are those that evolve beyond the simple “buy and hold” strategy.
They will be companies that have strong business fundamentals and generate sustainable yields through their suite of products or services and active participation in DeFi protocols, such as lending and staking.
The true strength of a DATCO will not be measured by the size of their digital asset portfolio but by how they can navigate volatile markets and manage costs prudently. Market downturns are inevitable, and companies that master the balance of thriving and survival will cement their place as true pioneers of digital asset treasury in the future.
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