Amid the current crypt resurgence there is a new wrinkle, crypto points. I am reminded of the Gold Bond Stamps that my mother collected for purchases at our favorite grocery store and used to reduce the cost of more groceries or to receive a nice setting of silverware or plates when she had filled an entire book full of stamps. Likewise, crypto points are the new digital version of loyalty rewards for being a patron of a given entity in the blockchain or crypto world. These points are earned via specified transactions such as purchasing benefits, services, or goods using a specific cryptocurrency. So, like Gold Bond Stamps, are crypto points worthwhile or a gimmick meant to ensnare more unwary folks into parting with their hard earned money?
Crypto Points Are a New Version of an Old Story
Bonds have for a long time been a favorite investment vehicle for folks who distrust the fluctuations of the stock market, real estate, or commodities. The rationale is that you put your money in a bond or US Treasury bill, earn interest, and aways get your original money back in its original dollar value. However, you need to pay taxes on that interest throughout the duration of the bond until maturity. A procedure or gimmick that arose in the bond market years ago was to buy a whole host of bonds and then reissue “zero coupon” bonds that sold at a discount to their price at redemption and did not pay interest along the way. The issuer of such bonds kept the interest on the original debt and structured the whole thing so that they were always guaranteed a profit.
This process of stripping out the interest from interest bearing investments or in other ways repackaging such investments has arrived in the crypto world. Like with the gimmick in the bond market, the folks who set this up and do the repackaging are doing it for a profit. So, is this a safe way to invest in crypto or are you being taken for a ride like in the days running up to crypto winter when there were shenanigans behind the scenes before the FTX collapse.
Yield Stripping in the Crypto World
Bloomberg wrote about how yield stripping has become a billion dollar deal in crypto. The instigator in this case is Pendle Finance. They are taking yield-bearing cryptocurrencies and breaking them down like the bond guys have done for years. Pendle started this in 2020 and attracted about $250 million in investments. Then they added the loyalty points aspect and it took off. Now about $6.4 billion is invested in this scheme. The gimmick part is that unlike my mother’s Gold Bond Stamps, these loyalty points are tradable. The money rushing into this niche is being used to buy and sell assets that have very little intrinsic value. Our concern is that folks are paying real money to get and trade “funny money.” This feels like a scam, a pyramid scheme, or what the Romans warned about when they said, “caveat emptor” which meant “let the buyer beware.”
Beware Derivatives of Derivatives
An understandable rationale for buying a zero coupon bond issued by a reseller or by the US Treasury is that you are not paying interest over the ten year period of the bond, know exactly the dollar amount that you will receive at maturity, and will pay taxes on long term capital gains instead of regular tax rates on the interest and not until the bond reaches maturity. These investment vehicles, especially the US Treasury issued zero coupon bonds, are a conservative investment with a solid basis. The US government has never, so far, defaulted on its debts.
Nevertheless, an investment vehicle based on the performance of another investment vehicle is a derivative. Options are derivates as are futures. So are tradable reward points based on stripping out the interest from interest-bearing crypto investments. The reasons that people use derivatives are either to hedge risk or to leverage their investment and trading capital. To the extent that one is using a derivative vehicle to leverage capital and increase their profit potential they are also increasing their risk. As a rule the greater the potential reward of a derivative vehicle the greater the risk that the investor will not only lose all of their investment capital but they will go into debt when losses far exceed their expectations.
The folks who run Pendle describe their vehicle as a way to bet on the direction that crypto is moving. Critics say that this vehicle is simply multiplying risks inherent in crypto and the DeFi realm. To the extent that the current crypto boom continues, this will likely be a profitable niche for many. A genuine concern is that crypto has a history of wild price swings in which some get rich and others get wiped out. The way in which trading derivatives of derivatives magnifies potential price swings puts the unwary crypto investor at what we consider to be an unacceptable level of risk when the next downward inflection hits the crypto world.
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