Blogs

Beyond Abstraction: Bitcoin Practicalities

So you’ve read our first blog, educated yourself on protocols and hash rates, heeded the advice of doge-owning friends and family, and have made the decision to dip your toes into the crypto ocean. At this point, the mechanics of ownership deserve some attention (surprisingly, we have received more questions of the “How do I buy?” rather than the “Should I buy?” variety).

Here, we look at the lifecycle of a bitcoin purchase, covering the frequency of buys, the ways to access bitcoin, considerations when choosing an exchange, and how to securely store your coins post-purchase. What follows (mostly) generalizes to other crypto assets, such as Ethereum.

Should I dollar-cost average into crypto?

Dollar-cost-averaging is the practice of buying at a fixed frequency over a period of time, e.g., $100 every two weeks, rather than investing the full principal up front. If the asset in question exhibits a positive long-term trend, dollar-cost-averaging will underperform a lump-sum purchase in the long run. However, the answer to the question above is behavioral; investors should assess their risk tolerance and ability to withstand sudden corrections without capitulating and selling at just the wrong moment since bitcoin can drop 10-15% in a matter of hours. For example, as of 6/28, BTC sat 45% off its April all-time highs:

Source: Gemini

While we believe that lump sum purchases are generally the optimal route for most assets, investments should be sized appropriately at the portfolio level, such that investors are not tempted to sell at the wrong moment. If you are unsure as to how you will react seeing the value of your portfolio cut in half, start with small, recurring buys to better understand your own behavior in times of market duress.

How can I access bitcoin?

While there are bitcoin exchange-traded funds in both Canada and Brazil¹, and six outstanding requests to the Securities and Exchange Commission (SEC) for Exchange Traded Fund (ETF) approval at the time of writing, there is not yet a US-listed ETF. Consequently, investors currently have four primary methods to gain exposure to bitcoin:

  1. Futures. The bitcoin futures market is relatively robust². However, capital requirements per contract specifications can be limiting to investors (although this is changing with the introduction of CME Group’s Micro Bitcoin Futures). We caution against the use of bitcoin futures given the costs to roll the position and keep it live, the necessity of a view on the timing of the trade in addition to its direction, and inherent leverage that accompanies futures exposure and the potential for untimely margin calls.
  2. Separately managed account offerings. Typically only offered through advisory platforms, separately managed accounts involve third-party managers who buy bitcoin directly or who gain access via bitcoin futures. The manager handles custody, reporting, and tax-optimization for an annual management fee which may range anywhere from 1.5%-2.0%.
  3. Closed-end funds. Here, there is one dominant player, Grayscale, who offers the well-known Grayscale Bitcoin Trust (GBTC). The closed-end structure invites certain investors who meet income and net worth requirements to buy shares of the fund directly through private placements. After a lockup period, investors can sell shares on secondary markets to non-accredited/non-qualified investors, who can access the secondary listing using platforms such as Fidelity, Schwab, and the like. However, supply/demand imbalances can create large premiums or discounts to the net asset value (NAV) of the fund, meaning that there exists “basis risk” between the price of the fund and what it tracks (bitcoin). In December of 2020, this premium reached roughly 40%. More recently, the fund has traded at a discount to NAV of as much as 12%. While GBTC gives the feel of a more traditional public markets investment, its basis risk alongside steep management fees (2% annually) make it an inefficient if not subpar method to access bitcoin.
  4. Direct ownership. This involves buying bitcoin through an exchange, such as Coinbase, and storing the coins yourself. For now, we feel that direct ownership is the best method to access bitcoin.

Some investors may opt for the indirect method of owning publicly-listed companies whose revenue largely depends on the health of the crypto space, such as Coinbase (NASDAQ: COIN) or MicroStrategy (NASDAQ: MSTR). While tempting given the ease with which publicly-listed equities can be bought and sold, we caution against buying proxies whose prices can be affected by a myriad of unrelated factors.

What should I look for in a crypto exchange?

If you opt for direct ownership, the next step involves the acquisition of bitcoin and the use of an exchange. Crypto exchanges come in two varieties: centralized and decentralized. Centralized exchanges are owned and operated by a single entity and serve as “on-ramps” to the crypto ecosystem by facilitating the conversion of “fiat” currencies ( government-issued currencies like U.S. dollars, into crypto assets like bitcoin). You simply deposit your assets and then place orders as you would with an online brokerage platform. Centralized exchanges have evolved into highly regulated entities, complying with Know-Your-Customer and Anti-Money Laundering laws, and generally provide a familiar feel and painless experience for the end user. For U.S. investors, the most well-known of these exchanges is Coinbase.

For purists who already own crypto and wish to circumvent exchanges controlled by single companies, decentralized exchanges present a trustless option. Commonly referred to as DEX, decentralized exchanges use open-source software to interact with market-making smart contracts to exchange one type of crypto asset for another. As such, decentralized exchanges cannot currently facilitate the swapping of fiat currencies like dollars into crypto assets like bitcoin. Additionally, while the use of DEX is growing, they are more difficult to use and are historically more illiquid than their centralized competitors. Uniswap is the largest DEX by volume.

Beyond matters of centralization, a few key considerations when choosing an exchange for your first crypto purchase include:

  • Exchange Fees. What is the fee structure, i.e., are the fees fixed or variable? Some exchanges such as Coinbase Pro charge a fixed, percentage fee based on transaction size while others like Cash App charge a service fee plus a variable spread based on market conditions (see this breakdown for a comprehensive comparison of exchange fees). Note that maker and taker fees in crypto lingo refer to limit and market orders, respectively. Most users will receive taker fees.
  • Liquidity. For most major exchanges, volume is sufficient such that liquidity is a nonfactor. For all but the largest orders, users should receive adequate execution with tight spreads. See this list for a comparison of volume across popular exchanges, and click here for a live look at the Coinbase Pro bitcoin order book.
  • Deposit and withdrawal fees and limits. What are the daily account deposit and withdrawal limits? If the daily deposit limits are low, you may be forced to average into the position rather than making a lump-sum purchase. Users will also be interested to know if the exchange can facilitate recurrent buys through automatic purchases at a fixed interval.

How should I store my bitcoin?

So you made the leap and are now the proud owner of bitcoin. Congrats! But what exactly did you just buy?

There is no “coin” in the traditional sense; owning bitcoin means owning public/private key pairs that allow you to access and send bitcoin on the bitcoin blockchain. The keys are just long, alphanumeric entries with many digits, such as:

E9873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA33262

Rolls off the tongue.

While public keys can be exposed to the outside world, you should never expose your private key to others given that it is ultimately used to move funds on the bitcoin blockchain by “signing” transactions.

Private keys, since they are nothing more than strings of letters and numbers, can be stored anywhere, even within simple text files. More commonly, they are stored in wallets. Wallets provide the tools (through some sort of user interface) for users to communicate with a blockchain and perform actions like signing and broadcasting transactions to the network. For a quick yet coherent overview of wallets, see “What are Crypto Wallets.”

A common misconception is that the terms “exchange” and “wallet” may be used interchangeably. Exchanges are not wallets: Coinbase the exchange is distinct from Coinbase the wallet. If you buy bitcoin on Coinbase (or Cash App or Venmo or Gemini or whichever platform you choose) and never explicitly send your bitcoin off-exchange, you do not control your private keys. In this case, the exchange is functioning in a custodial capacity and generates public and private keys for you, retaining control of the private keys. With a wallet separate from an exchange, users control the private keys themselves.

Which leads to our final question: should you self-custody?

When considering how much autonomy and control over your private keys is necessary, it is helpful to consider the security vs. convenience tradeoff. In general, the more convenient it is to access your bitcoin, the less likely it is that your bitcoin is secure:

Source: Unchained Capital

For greater security and autonomy, users should transfer their crypto from an exchange to a wallet, opting for either “cold” or “hot” storage. Cold storage entails storing private keys offline, typically in USB-like devices such as the Ledger Nano S. These devices generate key pairs offline, never exposing your keys to the web, and are virtually unhackable given their lack of complexity. But beware: physical self-custody carries its own unique set of risks. In addition to inconvenience, hardware wallets rely on the user to safely store seed phrases, to remember things like pins (one journalist chronicled his forgotten pin journey here), and to simply keep up with the physical device. Fires, floods, and moves can lead to damage or lost hardware. As such, users who want to avoid these possibilities or who plan to frequently transact in bitcoin may want to keep a portion of their coins online for convenience. Desktop wallets and mobile wallets offer a compromise whereby users retain control of their keys, with minimal risk of private key exposure or compromise, and without the somewhat archaic physicality of cold storage.

It is estimated that roughly 20% of the existing 18.5 million bitcoin have been lost or stranded in accounts³. Ultimately, it is worth asking yourself which is more likely:

  • Key mismanagement, either through losing a device or through misuse of a hot wallet, or
  • Your exchange account being hacked/the exchange limiting access to your funds when you need them, either deliberately or through the site going down.

We are almost certainly past the days of entire exchanges being hacked, as in Mt. Gox in 2017. Most private keys held at exchanges are stored offline, in cold storage, and most exchanges are insured against theft and cybersecurity breaches. As mentioned above, the true risk with exchanges is that you are not allowed to move your coins as you wish, either through conscious censorship or technical failure.

Whatever your decision, we advocate spreading risk across multiple wallets. Perhaps keep a small percentage of your bitcoin online for spending or trading purposes and keep the rest offline either through a wallet application or through a hardware wallet. Remember that with bitcoin, compromise of the network itself is highly unlikely, but this does not preclude individual accounts from being hacked, one-by-one. You should plan to follow all the same security measures that you would with your bank account. Additionally, some exchanges allow for “whitelisting” or only enabling withdrawal to certain approved addresses. If you have a large amount of bitcoin or other cryptocurrency, you may want to consider multi-signature solutions like Casa that require the use of several private keys (typically controlled by different users) to authorize payment. At the very least, you many want to consider sharing the details of your account(s) with a trusted relative or lawyer.


¹Purpose Bitcoin ETF

²Currently, open interest in bitcoin futures is roughly $11 billion: https://www.coindesk.com/open-interest-in-bitcoin-futures-drops

³https://www.nytimes.com/2021/01/13/business/tens-of-billions-worth-of-bitcoin-have-been-locked-by-people-who-forgot-their-key.html

Contact Us

Looking for guidance managing your wealth? Balentine is committed to providing the education and advice our clients need to realize their goals.