The upscaling of STRC and SATA has drawn in many critics.
Recently, Onramp published a paper highlighting some issues with Digital Credit. There were some errors and the paper was clearly AI generated in most places. My favorite error actually had little to do with Digital Credit and appeared in the foreword of the report (imagine you haven’t even started reading the paper itself and you already see a factual error, that’s the level of AI we’re dealing with).
Onramp writes on page 3: “Strategy has released AI-generated advertising featuring a young, attractive model in a tropical setting”
But a quick view of the 30-second ad they refer to shows the woman was working “hard as an engineer”, not a model. This is literally 10 seconds into the ad, which is about as long as it took me to spot the error in Onramp’s foreword.
I just thought this anecdote was funny. To my main point.
Their core argument was that Digital Credit could be better replicated by combining US Treasuries with BTC. (This is what Onramp calls “the simpler trade”, but I also don’t see how this is simpler given that buying digital credit only involves a single ticker, while “the simpler trade” involves a dynamic re-ladder of expiring Treasuries combined with BTC held in a separate location.)
This conclusion is wrong. It is trivial to show that it is wrong empirically (one only needs to look at the daily return time series of Digital Credit instruments vs. a portfolio of IBIT and SGOV or IEF). But this letter will present several economic arguments for why we can know in advance that the claim is wrong.
Reason 1: Security
Digital credit is over-secured by companies’ bitcoin holdings. This cannot be replicated with one’s own equity because there is no committed external capital in the case of owning BTC and Treasuries – it’s all your own money and no one else is on the hook. Credit is different. Although the principal is yours, there is external capital in the form of the issuer’s assets, which is committed to making sure you are made whole. This capital is “external” because it existed before you ever put in your principal, and it remains well after you’ve sold your position.
To be precise, an unencumbered bitcoin balance is not security in the strict sense, but it serves as security in a flexible sense. For example, a BTC-backed margin call loan is secured in the strict sense because the collateral is separate from the debt. Digital Credit gives the issuer more flexibility with collateral, but it also gives the investor more flexibility because the collateral is fungible and liquid. This is an understanding that both parties agree on.
The presence of the collateral is protection for the investor. This coverage is expressed in the BTC Rating metric, which is the ratio of Bitcoin NAV to the sum of the nominal value of a particular credit series and all more senior series.
A portfolio of BTC and government bonds has no external capital. This fact alone makes it financially impossible to replicate what is going on in Digital Credit with BTC and Treasuries.
Before I go any further, I should address the Treasuries. It is true that these are backed by the full faith and credit of the federal government and this can be considered a form of security. Some might even call this infinite security coverage. However, this implicitly assumes that the US will not default on its debt. Onramp mentions that because the government can print money and it is constitutionally illegal not to pay the debt, the Treasury’s position is therefore a sure thing.
This does not account for a case where the government revises its policy and defaults on some debt obligations but not others. Such a move should not be considered impossible given the growing influence of modern monetary theory, which argues that government debt is a pure construct limited only by inflation. MMT views debt as a redistribution of society’s resources across time to generate the highest social benefit in the present. This mindset is really the final destination of fiat finance where everything is relative and based on high time preference decision making.
But under this logic, a move to “cancel” the debt of some parties while paying off the debt of others, assuming the parties are chosen correctly, would constitute a partial debt jubilee that would still allow currency stability to persist. Is the treasury’s risk worth taking? Everyone must decide for themselves. If this happens STRC will be fine (as the dollar would be fine because we already said currency stability continues) but the Treasuries and BTC portfolio could see some big losses.
Combining BTC with government bonds therefore introduces the risk option that Digital Credit, which is a fully structured oversecured bitcoin position, does not have.
In other words, the real difference between Digital Credit and a synthetic replication is the type of risk that the investor bears. Remember this point because it is a recurring theme.
Reason 2: Correlation
Markowitz portfolio theory shows diversification as the only free lunch in finance. When several uncorrelated things are stacked together, they can create higher risk-adjusted returns.
Digital credit is fairly uncorrelated to bitcoin and other assets. STRC is at 0.63 correlation to BTC and 0.33 correlation to SPY and a 0.33 correlation to S&P preferred stock index.
Like anything else, it is true that it can be positively correlated in times of high stress. But the lower correlation most of the time means that Digital Credit can improve the diversification of portfolios.
In contrast, it is easy to show that bitcoin and Treasuries cannot do this because it is simply a diluted bitcoin position: bitcoin leveraged by a number between 0 and 1. For example, 20% BTC and 80% Treasuries are really just 0.2x leveraged BTC. 0.2x leveraged BTC still has a 1.0 correlation with BTC, so it provides zero diversification benefit to a larger portfolio that already has BTC. In finance jargon, we can say this has a 0.2 beta but a 1.0 correlation.
The reason why Digital Credit can generate a lower correlation is precisely because of the capital structure behind it. The company has many different options that are not available to the investor who only has BTC and government bonds. These options create idiosyncratic factors that are independent of and therefore uncorrelated with BTC.
And just to reiterate the earlier point, these idiosyncratic factors are also different risks that the digital credit investor accepts.
Reason 3: Tax
This is probably Onramp’s biggest mistake. Return of Capital is a tax benefit in case of STRC and SATA. Onramp claims that it is not an advantage because the company has no earnings and so the capital is really return on principal and therefore economically equivalent to the return on principal in their laddered treasuries model. While this is true for many cases of ROC, it is not the case for digital credit.
First, understand that the ROC tax rule of negative taxable earnings and profits was designed with the assumption that companies would make their money via fiat-denominated cash flows rather than taking advantage of fiat’s deterioration to accumulate increasing assets.
For a moment, I would like you to seriously consider why a distribution from a non-earnings business would be a cost base reduction. Why is this rule fair and why did it come about?
The answer is that a company that has no income but pays a distribution is liquidating itself financially, meaning that the principal (cost basis) of all equity investors should be reduced to reflect this partial liquidation. In most cases of ROC, the unit becomes smaller as the distributions occur because the distribution was literally part of the unit. You can see this for yourself in covered call ETFs that undergo brutal NAV erosion while paying out ROC distributions.
But again, this whole dynamic assumes as a premise that companies only make money with cash flow and not by investing in appreciating assets. If there really was a company that could make money by investing in asset appreciation, then it could easily take advantage of the ROC tax rule by making it look like it was partially liquidating when in fact it was growing bigger and bigger.
And if you look closely, that’s exactly what Strategy does. Its enterprise value increases as it pays out more ROC distributions. This is completely the opposite of what one would expect to see with ROC when thinking from first principles, or what one actually sees in other ROC cases. As BTC starts to rally, this difference becomes even more apparent.
This distinction alone should make it clear that Digital Credit offers something very unique. It has ROC, which we can think of as an accounting treatment of principal erosion without the financial reality of principal erosion being reflected by a lower share price. This is, in short, a structural arbitrage made possible by an oversight in the tax code (the oversight is that C-Corps do not make money by holding valuable assets). This is unique to Digital Credit and cannot be replicated by BTC and Treasuries.
But just as Digital Credit currently benefits from this tax rule, it could also stop benefiting if the rule changes. We should expect a repricing of Digital Credit in such events. This is a risk that Digital Credit investors accept and it is a risk that the BTC and treasuries portfolio does not have.
Reason 4: Value investing
Value investing is about buying undervalued assets. Assets are undervalued when the market does not assess risk correctly. It is possible that the risk associated with the corporate structure is not properly priced and therefore the Digital Credit investor earns a higher risk premium than is warranted. This could explain the double-digit returns on digital credit instruments.
Therefore, getting a potential trade is another advantage. It is of course true that the Treasury can be a bargain. And of course it is true that BTC is a bargain. But it is also undeniable that none of them can ever express the unique trade with a misunderstood capital structure that Digital Credit offers.
Conclusion
Finally, it is reasonable for an investor to believe that the risks of digital credit are not worth it. However, this would not be the point of the article, which should demonstrate that Digital Credit offers at least four unique advantages that a BTC and Treasury bond portfolio cannot duplicate.
The claim that such a portfolio can better replicate digital credit is false because such a portfolio does not replicate the underlying economics of Digital Credit at all.
The benefits of Digital Credit stem from a different set of risks associated with the unique capital structure of a Bitcoin tax company. Therefore, the economic facts prove that Digital Credit cannot be replicated without a similar capital structure.