Beware of the Bitcoin Balance Sheet

Tesla made news earlier this month when the release of their 2020 annual report revealed the firm had purchased $1.5 billion in bitcoin and would begin accepting bitcoin as a form of payment for their “products in the near future.” Following this revelation, Tesla’s CEO Elon Musk tweeted:  “Having some Bitcoin, which is simply a less dumb form of liquidity than cash, is adventurous enough for an S&P500 company.” CNBC’s Jim Cramer agrees with Musk, recently stating on television that “it’s almost irresponsible not to include” bitcoin on corporate balance sheets and that “every treasurer should be going to boards of directors and saying, ‘Should we put a small portion of our cash in bitcoin?’”

Tesla is the most prominent public company to invest in bitcoin, but they are not the first. In 2014, Overstock.com began accepting payment in bitcoin through a partnership with cryptocurrency exchange Coinbase, and in 2017, the firm announced it would be holding on to half of all bitcoin payments as an investment. More recently, software company MicroStrategy announced last year that it was adopting bitcoin as its primary treasury reserve asset, a move that no other publicly-traded company has emulated.

Tesla’s announcement combined with the recent spike in bitcoin’s price has left corporate treasurers wondering whether they should follow suit. Speaking on CNBC, Twitter CFO Ned Segal said:  “We’ve done a lot of the upfront thinking to consider how we might pay employees should they ask to be paid in bitcoin, how we might pay a vendor if they ask to be [paid] in bitcoin and whether we need to have bitcoin on our balance sheet should that happen.” 

Other CFOs are less sanguine about the prospect of adding bitcoin to their balance sheet. In a recent Wall Street Journal article titled, “CFOs Hesitate to Invest in, Handle Bitcoin Due to Volatility,” the CFOs of Verizon, Cisco, Mozilla, and several smaller firms said they had no intention of investing in bitcoin, mainly due to its volatility.  These CFOs are prudent corporate stewards, and companies considering investing in bitcoin and other digital assets would be wise to follow their lead. While the allure of handsome investment returns is hard to resist, the bitcoin balance sheet presents too many risks and challenges for corporations to overcome.

Investors can buy bitcoin on their own

Cryptocurrencies are notoriously volatile. Therefore, public firms invested in cryptocurrency are unnecessarily risking wild swings in earnings. The current accounting treatment of cryptocurrency exacerbates this problem. Following their recent investment, Tesla indicated they would classify bitcoin as an indefinite-lived intangible asset. This means that any decrease in bitcoin’s fair value below Tesla’s carrying value will require the company “to recognize impairment charges” and they can “make no upward revisions for any market price increases until a sale.”  Put simply, if the price of bitcoin declines below the price Tesla paid for it, earnings will be hit immediately, whereas earnings will only increase if Tesla sells its bitcoin for more than it initially paid. This accounting treatment is particularly problematic for an illiquid asset like bitcoin – intangible assets are nearly always illiquid – because large buy and sell orders can quickly and significantly move bitcoin’s price. This creates asymmetric risk for Tesla: earnings go down anytime bitcoin goes down but earnings don’t go up when bitcoin goes up, unless they sell their holdings. In addition, transaction fees and Tesla’s notoriety will make it difficult for the company to exit large bitcoin positions.

Dramatic swings in earnings that are tied to cryptocurrency may not sit well with investors, who generally prefer stable earnings. Presumably, Tesla shareholders bought their shares because they believed the company would successfully produce and sell lots of electric cars, not because they thought the company was particularly good at investing in speculative assets like bitcoin. If Tesla’s investors want to speculate in bitcoin, they can do so on their own, as can Elon Musk. If a company has excess cash on its balance sheet, it can buy back stock or pay a dividend to shareholders who can then use the funds to invest in cryptocurrency should they wish. As Cam Harvey said, the purpose of any company’s corporate treasury is “to provide some insurance in crunch time” or to deploy funds “for strategic opportunities where “strategic” means opportunities that are aligned with the business model of the company.” Holding bitcoin on the balance sheet accomplishes neither of these goals.

In their Q3 2020 quarterly report, MicroStrategy was explicit about the risks of investing in bitcoin:

The price of bitcoin has historically been subject to dramatic price fluctuations and is highly volatile. Any decrease in the fair value of bitcoin below our carrying value for such assets at any time since their acquisition requires us to incur an impairment charge, and such charge could be material to our financial results for the applicable reporting period, which may create significant volatility in our reported earnings and decrease the carrying value of our digital assets. For example, in the third quarter of 2020, we incurred an impairment charge of approximately $44.2 million related to our bitcoin. Any decrease in reported earnings or increased volatility of such earnings due to impairment charges related to our bitcoin holdings could have a material adverse effect on the market price of our class A common stock.

The extreme example of MicroStrategy

MicroStrategy is a bitcoin investment fund masquerading as a software company. In fact, one of the firm’s two corporate strategies is acquiring bitcoin when their “cash, cash equivalents and short-term investments exceed current working capital requirements.” In their 2020 annual report, MicroStrategy reported $1.05 billion worth of digital assets on their balance sheet – up from zero in 2019 – which represents a whopping 72% of total assets. And yet, they want even more: “[W]e may from time to time, subject to market conditions, issue debt or equity securities in capital raising transactions with the objective of using the proceeds to purchase bitcoin.”  The firm must believe that “market conditions” are ripe because they recently completed a $1 billion private placement of convertible debt, the proceeds of which were used to buy bitcoin. In a sign of how frothy markets are right now, the notes pay a 0% coupon.

MicroStrategy has tied their fortunes to bitcoin. In doing so, they have effectively created a publicly available bitcoin investment vehicle. Why buy bitcoin on Coinbase when you can buy MicroStrategy on E-Trade? However, as Crystal Kim and Tom Contiliano at Bloomberg pointed out, this would be a bad investment since investors in MicroStrategy “are paying a 53% premium over the market price of Bitcoin.”

MicroStrategy is an extreme example of the bitcoin balance sheet and I suspect it will not end well for them – for the same reason I would not predict long-term success for a hedge fund that invests in just one asset. But for firms like Tesla and others that are considering investing in bitcoin, there are significant risks that extend well beyond price volatility.

Security and operational challenges

Security breaches and cyberattacks have been a feature of the cryptocurrency market from its inception. Tesla acknowledges that “digital assets have been, and may in the future be, subject to security breaches, cyberattacks or other malicious activities, as well as human errors or computer malfunctions that may result in the loss or destruction of private keys needed to access such assets.” Unlike the traditional corporate treasury asset of cash, which is deposited at a bank, maintaining “control” over bitcoin is far more complicated. The only way for a user to access their bitcoin is through their private key, an alphanumeric cryptographic code. If a malicious actor obtains access to this private key, they can send your bitcoin to an address they control. A less sinister possibility is for an employee to accidentally sign a transaction with the firm’s private key, thereby sending the firm’s bitcoin to a digital wallet they do not control. If this seems farfetched, look no further than Citigroup accidently wiring $893 million to Revlon’s creditors last year. If this can happen with fiat currency at one of the world’s largest and most sophisticated financial institutions, then surely a fat finger bitcoin error is possible. And unlike dollars deposited at a bank, there is no regulatory framework that provides remedies to victims of cryptocurrency fraud or protects users from erroneous cryptocurrency transactions. As Tesla says in their annual report: “[D]igital assets have been, and may in the future be, subject to . . . human errors or computer malfunctions that may result in the loss or destruction of private keys needed to access such assets.” 

Tesla does not disclose how they store their bitcoin, other than to say they “intend to take all reasonable measures to secure any digital assets.” MicroStrategy claims they have “ownership of and control over” their bitcoin and that they use “third-party custodial services at multiple locations that are geographically dispersed to store its bitcoin.” However, without more information, it is hard to assess how secure MicroStrategy’s bitcoin holdings really are. The Catch-22 is that revealing more information around their bitcoin custody may assure investors while at the same time provide a roadmap for potential hackers. In their recent annual report, MicroStrategy acknowledges the dangers inherent in cryptocurrency custody: “In light of the significant amount of bitcoin we hold, we are continuing to seek a greater degree of diversification in the use of custodial services as the extent of potential risk of loss is dependent, in part, on the degree of diversification.”

Companies looking to invest in bitcoin need to conduct significant due diligence before settling on a custodian, as the large banks that provide traditional treasury and cash management services have been reluctant to enter the cryptocurrency space. However, that may be changing. Earlier this month, the Bank of New York Mellon announced they will begin to “hold, transfer and issue bitcoin and other cryptocurrencies on behalf of its asset-management clients.” As institutional investors continue to embrace cryptocurrency as a legitimate asset class, expect more Wall Street firms to roll out secure cryptocurrency custodial solutions that can be integrated into existing treasury and transaction services. But even with Wall Street wading into the crypto waters, the lack of an established track record in cryptocurrency custody means firms should think twice before putting bitcoin on their balance sheet.

Moreover, even the most secure custodial arrangement may not be able to withstand the dedicated efforts of nation state hackers. On February 17th, the U.S. Department of Justice unsealed a sweeping indictment against three North Korean computer programmers for “participating in a wide-ranging criminal conspiracy to conduct a series of destructive cyberattacks, to steal and extort more than $1.3 billion of money and cryptocurrency from financial institutions and companies, to create and deploy multiple malicious cryptocurrency applications, and to develop and fraudulently market a blockchain platform.” According to the indictment, the hackers stole cryptocurrency worth $1.9 million from a financial services company in New York that was held at two cryptocurrency exchanges. The hackers also stole $75 million from a cryptocurrency company in Slovenia and $24.9 million from an Indonesian cryptocurrency company.

While security protocols at cryptocurrency firms will likely improve over time, the SolarWinds hack reveals that no system, no matter how secure, is truly impenetrable. In addition to compromising numerous government networks, the SolarWinds hackers were able to access Microsoft source code.

Auditing

Bitcoin balance sheets present novel challenges for auditors. The Big Four accounting firms all have their own blockchain/cryptocurrency practice, but these services haven’t been fully vetted and tested, and history provides little comfort that auditors will be able, or willing, to fully account for a firm’s bitcoin holdings. As we have seen many times, from Enron and WorldCom, to Luckin Coffee and Wirecard, auditors’ financial incentives may limit their willingness to faithfully fulfill their responsibilities. 

In MicroStrategy’s most recent annual report, their auditor, KPMG, acknowledges that “whether the Company controls the digital asserts” is a “critical audit matter.” However, “the nature and extent of evidence required” to assess the company’s control over digital assets was based on “subjective auditor judgment” – a phrase that does not inspire confidence (emphasis added). KPMG goes on to say that they compared the “Company’s records of digital assets held to the custodial records” and that these records were compared “to the records on the public blockchain using a software audit tool.” Exactly how this tool was used, and what specifically was compared, is left unsaid. Investors in companies with bitcoin balance sheets would be wise to take no assurance in auditors’ attestations on bitcoin holdings.

ESG incompatible

Investing in bitcoin or other cryptocurrencies that rely on the proof of work (PoW) consensus mechanism is incompatible with sustainability goals. Broadly, users running a special mining variant of the bitcoin software expend a great amount of computing power to win the right to add another block to the blockchain, which is accompanied by a reward of bitcoins. The concept of proof-of-work mining ensures an adjusted amount of work and computing power must be expended to solve a block, with a block reward of a certain amount of bitcoin providing an economic incentive for honest mining. Importantly, this mining process requires tremendous amounts of energy, most of which comes from fossil fuel sources. As Tim Swanson recently noted, “the energy consumption of Bitcoin is ​more​ than the ​combined​ energy use of Amazon, Google, Microsoft, Facebook, and Apple. And the e-waste that is generated annually from discarded​ mining equipment is roughly ​equivalent​ to what ​Luxembourg​ throws [away] in the trash each year.” According to the University of Cambridge’s Bitcoin Electricity Consumption Index (BECI), the bitcoin network consumes 119.87 terawatt-hours in electricity annually, which, if bitcoin were a country, would rank it 32^nd in annual electricity consumption.

For companies without sustainability objectives – a dying breed at this point – the bitcoin network’s energy consumption is of little concern. But for the vast majority of companies that do care about sustainability and addressing climate change, it is hard to reconcile these goals with investing in bitcoin. As a corporation founded upon the promise of a sustainable future, Tesla’s motivations for investing in bitcoin are particularly difficult to justify. Tesla’s stated mission is to “accelerate the world’s transition to sustainable energy” and the firm believes that “the faster the world stops relying on fossil fuels and moves towards a zero-emission future, the better.” Given these professed beliefs, how can Tesla and Elon Musk justify their bitcoin investment? While the firm has been silent on the issue, The New Republic pointed out that in 2020, Tesla sold roughly $1.58 billion in carbon credits, almost exactly the value of bitcoin they purchased. It appears as though the firm is monetizing the environmental benefits of producing electric cars, in the form of carbon credits, to fund its not-so-environmentally friendly bitcoin purchases.

Legal and Regulatory Risks

It is a near certainty that bitcoin balance sheets will result in shareholder lawsuits; as my colleague Emily Strauss points out: “Securities litigation is a virtually inevitable fact of life for any public company.” It is easy to imagine a scenario where shareholders sue MicroStrategy or Tesla after a large decline in bitcoin’s price, which, as mentioned above, would directly flow through to earnings that belong to shareholders. To forestall such lawsuits, MicroStrategy discloses the risks inherent in bitcoin in terms so blunt, it makes you wonder why they invested in bitcoin in the first place:

Fluctuations in the price of bitcoin, which may be influenced by highly uncertain regulatory, commercial, and technical factors, may significantly influence the market price of our class A common stock.

Our historical financial statements do not reflect the potential variability in earnings that we may experience in the future relating to bitcoin holdings.

Our bitcoin holdings could subject us to regulatory scrutiny.

The concentration of our bitcoin holdings enhances the risks inherent in our bitcoin acquisition strategy.

Our bitcoin holdings are less liquid than our existing cash and cash equivalents and may not be able to serve as a source of liquidity for us to the same extent as cash and cash equivalents.

If we or our third-party service providers experience a security breach or cyberattack, or if our private key is lost or destroyed, we may lose some or all of our bitcoin.

The legal and regulatory environment surrounding cryptocurrencies is complex, uncertain, and subject to change on short notice. The Commodity Futures Trading Commission, Securities and Exchange Commission, Financial Crimes Enforcement Network, and the Internal Revenue Service all lay claim to some aspect of cryptocurrency depending on its use. And that is just in the U.S. Any changes to this regulatory regime could induce steep declines in the price of bitcoin and other cryptocurrencies, and create new headaches for CFOs, corporate treasurers, and auditors. It would also prompt new lawsuits from shareholders who would argue that executives should have known better than to invest in an asset whose regulatory status was so uncertain.

Conclusion

There may come a time when it makes sense for corporate treasurers to put bitcoin on their balance sheet. If bitcoin became an active medium of exchange used by consumers and businesses to sell and buy goods, then companies would justifiably want to hold on to at least some bitcoin to facilitate bitcoin-denominated transactions and avoid costly fiat conversion fees. This scenario is conceptually no different than a multinational company with revenue and expenses in various foreign currencies, bitcoin being one. The problem, of course, is that this scenario is entirely fictional, and the likelihood of it ever becoming reality are slim. Bitcoin is simply far too volatile to be used as a medium of exchange. As a merchant, why would you accept payment in an asset that could decline in value by 5 or 10% the next day? Stablecoins are cryptocurrencies that were created to overcome this volatility by maintaining a stable value through the backing of a reserve asset, usually dollars. But even stablecoins have failed to gain attraction outside of allowing users to buy and sell other cryptocurrencies more quickly and cheaply.

Bitcoin is a speculative asset, and any public company that puts bitcoin on its balance sheet is doing nothing more than speculating with shareholders’ money. Shareholders expect companies to take informed risks, not gamble on meme assets. Moreover, should investors wish to speculate in cryptocurrency, they can do so directly, without paying a premium for a publicly traded stock masquerading as a bitcoin fund. Tesla may view its bitcoin investment as in keeping with its image as a forward-thinking tech-savvy company, but in doing so it has ignored multiple red flags and every principal of working capital management. Companies considering following Tesla’s lead should think again.

Lee Reiners is the executive director of the Global Financial Markets Center at Duke Law