Dan Hillery on BMTV: Inside the Digital Credit Market

We are excited to introduce our very first installment of the Allocator's Edge presented by UTXO Management, where we bring on experts from UTXO, a Bitcoin-native asset manager allocating across public markets, venture capital and structured credit while providing institutional financial research. Now, just a disclosure here: UTXO Management, just like Bitcoin Magazine, is owned by Nakamoto, Inc., but with all that said, let's welcome in Dan Hillery now, VP of Credit at UTXO Management. Good morning to you, Dan.

Good morning. It's great to be here. Thank you.

So you've said that digital credit is the fastest-growing segment of the Bitcoin capital structure. And this market was essentially nonexistent two years ago. Today it's around $16 billion. How big do you think this market can become?

Yeah, I think there's a long-term scenario in which it actually grows to be a meaningful portion of the total Bitcoin network. And so financialization layers on top of traditional equities can even grow larger than the equities themselves, right? The options markets on a lot of publicly traded securities are larger than those public security market caps. So I'm not going to say the derivatives market and the digital credit market on top of Bitcoin will grow larger than Bitcoin itself, but certainly a possibility a long way down the road.

Yeah. And forecasting out, you described STRC as a kind of market rate for short-term Bitcoin-backed credit because it allows the market to price in the risk of Bitcoin collateral in real time. What do you think investors are actually pricing when they buy something like STRC and then what makes that desirable to build a fund on top of?

Yeah. I think STRC is a unique instrument because it's one of the first variable rate preferred securities, which is based off market pricing, like you said, and that means they use the traded volume-weighted average price of the security to benchmark the rate at which you receive a dividend payment. And they also have open market activities like buybacks and then sales above $100, which stabilize the price around that par value. And that's unlike any sort of preferred security that's ever been created in history. And so that means that the market's going to have fluctuations and the changes in its expectation of those dividends.

And so building a fund on top of STRC is important because while STRC is almost perfect, it's not perfect, right? It's traded down to $73 over the past couple of months, and there is volatility because people get a little too aggressive, they lever up. And sometimes the open market activities, the capital market activities don't exactly peg it at $100. So we tranche the two different kind of investor classes on top of STRC, those looking for a lower return, but almost exact principal protection or zero volatility.

And there's also investors who are looking for a higher return, a higher yield, but are willing to take on some of that principal fluctuation, understanding that over a long period of time, STRC is going to trade around $100.

Strategy and Strive are essentially arbitrages between their cost of capital and the performance of Bitcoin. So if that's the model, what does a prolonged period of flat or declining Bitcoin prices look like for these companies? And what does that mean for funds or instruments built on top of these?

Yeah, and I think that's the exact risk profile that you need to consider when looking at digital credit versus digital equity, right? And so Saylor is famous for saying that Bitcoin only needs to go up 3% per year for us to pay our dividends on our preferred equity obligations forever. And that number is similar for Strive, it's a little bit higher. And so if you're worried about Bitcoin's performance in the near term, then a digital credit instrument is a lot safer, you're more likely to get that return in the principal protection.

Whereas, again, like you're saying, if the Bitcoin performance does not outpace the cost of capital for the common equity holders or the digital equity holders, then you're going to get significant underperformance in the case of effectively dilution to pay the dividends or decrease Bitcoin per share while Bitcoin's underperforming the cost of capital. However, I don't expect that to happen in the near term. So I think it's balancing your expectations and figuring out how long you're willing to hold the instrument. If you're not willing to hold it for four years, then the digital equity is probably not for you.

So you're at the frontier of structured digital credit products. From your vantage point, what do you think this market looks like and this ecosystem looks like in, say, five years, in terms of vol, in terms of dividends, in terms of size and what products do you think might eventually get built in this space?

Sure. I think it will centralize around the main players. So I think Strategy and Strive have a head start in a way that there won't be many meaningful competitors on a large, large scale. I think one part of the market that's underdeveloped is short duration secured Bitcoin credit. So I think there will be a lot more shorter duration notes and bonds backed by Bitcoin and that will be part of this digital credit market that we're yet to see. In terms of the total size, roughly in five to 10 years, it's very difficult to predict out how large the market will be, but I expect it to grow significantly.

I think rates across the digital credit instruments, with STRC at 12% and SATA at 13%, I think they'll actually stay high for a longer period of time than people are considering because simply, markets take a really, really long time to mature and they want to keep the interest rate high, Strategy and Strive, in order to bolster adoption and to stimulate adoption. So expect high interest rates for a long period of time, expect massive growth. And I think there's going to be a whole host of ETFs and different products that are built on top of these.

We're seeing double-digit yields attract investors into these Bitcoin-linked preferred securities. From a credit analyst perspective, what does an investor still need to understand about the risk they're taking to earn that yield? What are some of the biggest misconceptions you're seeing around digital credit right now?

Yeah, I think some of the misconceptions are just the misunderstanding of what a preferred security is. Historically, preferred securities haven't been very attractive instruments. And traditional debt has been a much safer form of investments, really because you get your principal back over a fixed duration of time and you can discount the cash flows and the principal into the future. And with these preferred securities, they're very novel in their construction. And so I think people are discounting or not considering the fact that one, they're backed by the good faith of the company, the credit, and all the assets in the balance sheet as opposed to cash flows.

So that's one misconception. And then two, now that we're seeing buybacks on STRC, people are not understanding that while you don't get a principal repayment like you do with a bond, you do have the company guaranteeing the price or bolstering or supporting the price near that $100 price point, that's par value. And that's a really important point. Although the preferred security isn't a bond, it's not a debt, Strategy is managing their capital markets activities to make it behave like a debt that you get your principal back.

So I think people need to look at them in their entirety, not just as preferred securities, but as preferred securities with a full capital markets suite of tools to make them trade closer to short term debt.

And obviously the space is still very young and it's hard to predict out with too much accuracy. But you mentioned the novelty of these instruments, and that creates a system where it's really just one type of instrument. It's a perpetual preferred equity. That is sort of the extent of this digital credit landscape. Will more instruments be built out to this that will allow more market participants to come in and buy digital credit? In other terms, will the basket of investable assets and will we have additional baskets of digital credit that more entities can come in and actually touch and broaden that user base of people who are engaging daily with digital credit?

Yes, there's a few different investment classes that can't even touch digital credit right now. Actually, the return-of-capital dividend treatment, it's not a qualified dividend. So for a lot of mutual funds and larger funds that have aggregate dividend mandates across their entire suite of investments, equity investments, the ROC treatment doesn't count towards that total dividend income. So it's not attractive to put STRC in that portfolio. That's something a product built on top of digital credit will fix. And then also for different investors that actually can't invest in equities but have to invest in debt, I think there will be some form of debt-secured note backed by digital credit that's more attractive to fixed income allocators.

And that's what my fund at UTXO is attempting to do in a hybrid format of credit-like equity.

And let's talk more about the fund that you're leading over at UTXO. How exactly are you structuring this?

Yeah, it's kind of like a CLO, or a tranched credit fund, structured credit fund. There's simply an underlying portfolio of STRC and SATA that can employ leverage. And there's two tranches of investors. There's a senior class of investor and a junior class of investor. The junior class of investors, the first-loss capital, they experience all the volatility and fluctuations. The senior class of investors gets a 7.5% return, which is less than STRC, obviously, but they have the 40% extra equity buffer of the junior class of investors.

So their principal is generally stable over all forms of STRC volatility. If STRC trades down to $80, generally their principal will be stable, but they don't get any return above that 7.5%. The junior investor, on the other hand, if STRC trades down, he'll experience a capital loss in the short term, right? Your principal will fluctuate down, but you're getting more of a 17, 18% yield on that instrument over long periods of time. So if you expect STRC to trade at par, then you're going to get really levered outperformance of STRC, whereas the senior has that principal protection.

And where does that leverage get introduced? Is this external leverage or is this something where you're using the common or the preferred equities instead to generate that leverage to then buy additional?

Sure. Well, the main form of leverage is really the risk tranching, right? So the senior class of investor only gets 8% of the STRC return underlying the entire portfolio, with 50 basis points of fees. And then the 400 basis points, or the 4% above that 8%, which the senior didn't receive is allocated to the junior who's taking on more volatility risk. So the junior is getting that 12% STRC plus that 4% the senior's giving up in exchange for taking on first loss capital and volatility.

I see. And then how are the allocations decided? And is there any active rebalancing? When you're allocating to STRC or other preferred products, are you trying to keep that constant? Are you actively managing that?

Yeah, the underlying portfolio of security is actively managed. And as new issuers come to market, there's going to be a lot more diversification between issuers and balance sheet risk, which I think is really, really attractive for this type of vehicle. But then also, you have to think about pool composition, how much senior relative to how much junior. And that's something we actively manage as we take subscriptions or meet with withdrawals or redemptions over time.

And how do you manage the withdrawals and redemptions? Is that on a quarterly or monthly schedule?

The senior has monthly withdrawal cadence, or monthly liquidity, whereas the junior has quarterly liquidity.

And who do you think are the ideal customers or individuals that might want to engage with a fund like this rather than just buying the pref themselves?

Well, the main value proposition of the senior is, one, the return-of-capital tax treatment, which is very advantageous for anyone comparing this against municipal bonds or other forms of short-term Treasury bonds. And two, it doesn't have nearly as much mark-to-market risk as STRC. If you mark your credit fund's books quarterly and STRC is at $80 when the end of the quarter comes around, that's very problematic as an investor. Our senior protects against that because of the junior first-loss capital. As long as STRC is fluctuating somewhere between 70 and 100, you can mark that on your books as $100 invested and you get that 7.5% return.

The junior is more of a special situations credit vehicle, opportunistic credit fund. And so you're getting these high double-digit returns with more principal volatility, but ideally still a very high Sharpe ratio. So this would be more of a high-yield credit bucket.

Dan, I just want to ask for the everyday investor, the 60/40 investor or someone who's a little bit new to the space, what should they know about digital credit? How relevant is this to their portfolio?

Yeah, I think it's a tool you now have in your fixed income bucket when looking to allocate for income. And the fact that it's very liquid, very tradable means you can allocate to it and then change your mind and you can add it to your retirement portfolio. And it's generally a lot easier to handle than a traditional bond or fixed income instrument. So I think you should look at it as a positive addition to the 40% of a traditional 60/40 portfolio, but you don't need to fully go all into it right away.

All right, Dan Hillery, VP of Credit at UTXO Management. Thanks so much for joining us today.

Thanks guys. This was great.