How can the bitcoin bonds influence the future of financial instruments?
El Salvador is working on the release of bitcoin bonds, designed by Samson Mow, founder of Jan3. This new financial instrument could change the future of our financial world. Not because asset backed bonds are a new thing, but because of how their validity and backing can be confirmed by investors.
When we think of government bonds , we usually think of the bonds that are backed by the government directly. These assets are attractive to investors based on the trust that they can have in the government. If the future of said government is doubted by investors, the value of the bond will fall. These were originally invented to finance wars and allowed investors to choose a side for a given conflict, and even influence the outcome.
The Italian cities were the first to create such bonds around the fourteenth century. They raised money by forcing their wealthy citizens to lend this money to the government, that was then used to hire mercenaries to fight the wars instead of the city’s residents. In exchange, these wealthy residents were paid an interest that was directly correlated with the price of this bond, that could be sold through a secondary market. The big Italian cities used these instruments to fight each other during most of the fourteenth and fifteenth century.
The second type of bonds are the asset backed bonds. As the name suggests, these bonds are directly linked to a kind of asset. Rather than trust in the future of a government, investors can trust an industry or a product.
A great example of the use of such bonds was seen in North America. War was raging between the Union and the Confederate States of America. The Confederacy was seen as the losing side, and as history showed, ended being the case. They were not considered a good credit risk, which meant private and foreign investment in their bonds was very limited. They decided to create cotton-backed bonds that allowed investors to profit from the profits from the Confederacy’s cotton industry. It benefited them very much, with the price of the bonds doubling from December 1863 to September 1864. It was of course helpful that they were the biggest producers of cotton at the time and controlled the supply and price of the global cotton industry. This allowed them to lower the supply, thereby increasing the price of cotton, which allowed them to get richer even though they were losing battles against the Union and losing credibility as to the long term prosperity of the government.
Of course, as markets tend to self regulate, the high price and limited supply of cotton attracted others to enter the market more aggressively. The textile industry found new sources of cotton and the Confederation lost its majority market share. Following this, investors lost faith in the cotton bonds, that started to sell off and drop in price. The confederate government resolved to printing unbacked paper dollars irresponsibly (as it often happens) and created a 4000% inflation during the civil war, while it was at 60% for the Union.
So how does this relate to the bitcoin backed bonds that El Salvador wants to issue?
The bitcoin backed bonds would allow for the same benefits that the cotton-backed bonds had:
1. Investors do not need to put their faith in the government directly
2. The nation benefits from the purchase of the bonds as long as the price of the asset keeps going up
There are two major differences with the cotton-backed bonds, though:
1. The government cannot control the supply of bitcoin (as a reminder: no one can). They cannot manipulate the underlying asset, which increases the trust in the bonds.
2. Bitcoin’s blockchain allows for proof of asset holdings. Anyone can audit the blockchain and verify that the addresses backing these bonds do hold the bitcoin they are supposed to. Of course, this assumes the addresses are public information - which they should be, because it increases investor confidence in the bonds.
These new bitcoin bonds have the potential of changing the bond market as we know it. There is more profit to be made by trusting a decentralised asset rather than trusting governments. Governments can go bankrupt whereas bitcoin cannot. There are fluctuations in the price of bitcoin but not in the way it works. Thanks to this security and because of the inflationary world we live in, the price of bitcoin is likely to continue going up in the long term. Furthermore, if there is any change in the way the government manages these bonds, investors would be able to tell instantly because of the transparency that the bitcoin blockchain provides. The Salvadorian government will have to be very careful and responsible about how it manages these instruments or it may risk losing a lot.
We don’t know yet when these bonds will be available. My guess is that they are waiting for the price to stabilise in order to confirm that they have bought all the dips in price possible. With the price of bitcoin at a 75% discount, it is fair to assume that there are more chances the price will start going back up. If these bonds are released at the right time, it will allow for a greater income potential for investors and will increase the returns El Salvador can make.
We’ll see what the the president Nayib Bukele has prepared for us and how it may impact the legacy financial world. It definitely is an interesting time to be alive.