#writing MicroStrategy is scaling one of the most complex volatility harvesting strategies ever seen. --- **December 9, 2024** MicroStrategy, the software turned "Bitcoin Treasury" company, recently raised $3 billion in a convertible bond offering that featured a 0% coupon effectively enabling MicroStrategy (MSTR) to fund further purchases of Bitcoin (BTC) for free. MSTR currently owns 402,100 BTC worth approximately $40 billion at current market prices. There has been a fair amount of buzz around this offering and two notable articles by Matt Levine of Bloomberg and Alec Campbell of Rose.ai (formerly Bridgewater) that helped explain the complicated nature of MSTR's trade. What these articles only briefly touched on was the counterparties to the MSTR trade and how the risk was being laid-off in the markets. This is important because what happened before has a lot to do with what will happen in the future. In other words, we can get a better handle on the future impact of MSTR's trade by understanding how the risk it is warehousing or putting into the market is being down streamed in the financial markets. This is the primary function of the financial markets: to distribute risk to the investors who are best equipped to hold and pay for that risk to aid in the capital formation process; aka financial intermediation.  The first thing to point out is the point that Alexander Campbell drove home in [Convert of Doom](https://open.substack.com/pub/campbellramble/p/convert-of-doom), which is that MSTR is monetizing it's high volatility by funding with low-coupon convertible bonds. The way this works is that the convert buyers forgo a higher fixed-rate coupon in exchange for exposure to the levered volatility of the MSTR stock. By issuing these converts MSTR is exchanging the right tail for a lower cost of capital today. ![[Pasted image 20241209104011.png]] After this recent offering MSTR has approximately $7.5 billion in debt which is roughly two turns of equity (2.0x debt/equity) which gives the equity holders levered exposure to BTC. Alex pointed out that this isn't the only source of volatility for MSTR, the premium that their stock trades at to the Bitcoin it holds adds even more volatility that they can sell to convertible bond investors. Through the premium and the leverage MSTR transforms BTC vol of 75% into MSTR vol of 105% and uses that to fund at zero percent. In [MicroStrategy Has Volatility to Sell](https://www.bloomberg.com/opinion/articles/2024-12-05/microstrategy-has-volatility-to-sell), Matt Levine shows how delta hedging the convert allows convert holders like Calamos to profit off the high MSTR realized volatility. He also describes how the combination of the levered MSTR ETFs and the converts allows MSTR to scale this trade by essentially transferring a short vol position on MSTR from the ETFs to the convert holders. Using some back of the envelope math we can figure out that MSTR is selling their vol to convert holders around 45% while the stock is realizing around 105%. This discount implies that delta hedging the converts over the life of the bond will earn approximately $316 per share of MSTR. Since each $1,000 of convert gives you 1.4872 shares then the discount is worth $471, or $94 annually over five years, which works out to a 9.4% annualized yield. Roughly 500 over Treasuries seems about right for where MSTR unsecured credit would trade, and we can see how instead of paying that in actual cashflow MSTR sells its vol to sophisticated investors so it can fund at zero. What could go wrong? MSTR is left holding the bag if BTC drops below their reported cost basis of $58,263. The convert holders have a claim on the assets of MSTR, which is basically just the BTC holdings, struck at the total face amount of debt outstanding. This works out to roughly $18,825 per BTC. ![[Pasted image 20241209112637.png]] Since MSTR is a self-described "Bitcoin Treasury Company" let's look at their risk profile in terms of BTC. They are long BTC at $58,263 and have sold puts (the converts) at $18k. Instead of taking in premium for those puts they got interest free financing and have about two turns of leverage on their BTC. They are zeroed out at $18k and breakeven at $58k. The upside is gravy, but they also get diluted as the converts come into the money. MSTR had 197 million shares outstanding as of Q3 and the debt can convert into an additional 12 million shares (rough approximation as I'm not sure if I captured all the issues correctly) which is roughly an additional 6% of the outstanding float. Selling puts by issuing debt and selling calls embedded in that debt basically turns MSTR common stock into a short straddle position on BTC. Looking at the term structure of MSTR vol we find strong backwardation, meaning long dated vol is lower than near-term vol, whereas the term structure for BTC vol is much flatter. This might be evidence that MSTR convert holders are selling long-dated risk vol to hedge their convert holdings. ![[Pasted image 20241209115933.png]] ![[Pasted image 20241209115939.png]] As we peel back the layers, we can see how complex the MSTR position is; it is leverage on leverage, derivatives on derivatives, complexity on complexity. What has led us to this point in history where we have one of the most complex financial structures ever built in the form of a publicly traded former software company? First off, the innovation of Bitcoin is a huge enabling factor in all of this. The concept of a digital asset, something intangible, decentralized and largely free of regulatory oversight that can be easily transacted across borders with the click of a button has taken hold of the public consciousness. The ability for BTC to capture imaginations dramatically increases its [[Price - Value Framework|extrinsic value]]. Then you have the personality of Michael Saylor himself, the so called "Bitcoin Jesus", dumping fuel onto the fire that is the collective imagination and hopes of the "Bitcoin Faithful." The fact that we are using religious terms when talking about Bitcoin demonstrates how the value of Bitcoin has moved well beyond just the intrinsic value of cryptocurrency. Saylor has therefore found himself in a position where he can be a key promoter of Bitcoin and his company so that his company, which is merely a derivative position on Bitcoin, commands a significant premium to its Bitcoin holdings. It is extrinsic value on top of extrinsic value. Since extrinsic value realizes volatility at a higher rate than intrinsic value the implied volatility of Bitcoin is higher than equities and MSTR's implied volatility is even higher than the implied volatility of its underlying holdings. This vol-on-vol exposure has created a virtuous cycle for MSTR where they can monetize that magnified vol through convertible bond issuances plowing the proceeds right back into BTC which keeps the whole thing going in a complex financial perpetual motion trade. This is why many have labeled MSTR a pyramid scheme. As MSTR continues to scale this trade more and more importance is placed on the MSTR premium to its BTC holdings. The more that is scaled, the more fragile the trade becomes since it is increasingly dependent on the extrinsic value which is inherently more fragile than intrinsic value. As complex as this trade is, it is not much different than the [Tulip Mania](https://en.wikipedia.org/wiki/Tulip_mania) of the 17th century Dutch Republic. BTC's intrinsic value is probably greater than that of a flower, but the social dynamics fueling the extrinsic value are very similar. The difference is today they are further fueled by three centuries worth of financial innovation that has enabled the wide scale monetization of an abstract financial commodity (volatility) based on an abstract digital asset (Bitcoin). Indeed, we live in interesting times.