This is an opinion editorial by Leon Wankum, one of the first financial economics students to write a thesis on Bitcoin in 2015.
Today, the most common form of collateral used by a borrower to secure the repayment of a loan to a lender is real estate. This practice is common among mortgages, personal loans, and business loans. Banks lend to people and institutions that own real estate. Other common forms of collateral include corporate inventory, cash, stocks, and bonds. I will show why bitcoin has the potential to become the preferred collateral in the future.
There is an emergence of a variety of lending products around bitcoin. Bitcoin as a free bearer instrument serves as a primary collateral. Due to its deterministic supply schedule, which is limited, there is an incentive to hold bitcoin. This created a demand for bitcoin users to lend their holdings and receive returns or cash in return. Borrowing against your bitcoin makes economic sense for two reasons. Firstly there is a capital gains tax if you sell and secondly, from a “spend perspective” we are encouraged to spend fiatnot bitcoin, as long as the value of bitcoin increases faster than fiat interest rates.
However, bitcoin should only be used to borrow against it, not to earn yield. Earning a 6% return while being able to lose everything is not worth it. And for lending purposes, you can use non-custodial solutions like Hodl Hodl that are available. Multi-signature wallets (a type of wallet that requires more than one signer to move funds) allows lenders and borrowers to share access to funds.
You can still have a crypto relationship with your bitcoin as a borrower. Let’s say you borrow against your bitcoin using a multisig address. In that case, you can always access this address not only through the platforms interface but also using any blockchain explorer. With that, you can always double check that your warranty is stored in the same place and also check your escrow account in real time. This prevents the risk of rehypothecation, a practice whereby banks and brokers use the assets deposited as collateral by their clients for their own purposes.
As explained by Nick Neuman, the fact that bitcoin transactions and addresses are publicly verifiable eliminates a huge amount of risk from the financial system. It allows proof of reserves, where a financial institution must provide their bitcoin address or transaction history to show their reserves. Transparency requires more ethical behavior on the part of financial service providers.
Storing bitcoins is pretty straightforward, there is no daily maintenance. Bitcoin just needs to be kept safe from cyber attacks. A financial services provider can set up their cold wallet (a device that stores cryptocurrency offline) and protect their bitcoins from the threat of theft. Bitcoins can also be stored in a multi-signature wallet. This allows both lenders and borrowers to manage funds together and protects borrowers from the risk of lender bankruptcy. In this case, the borrower would lose their coins.
With bitcoin, the retention of collateral decreases. Banks usually have a large number of appraisers and auditors who continuously evaluate the collateral deposited. Property valuation takes a long time. There are standards by which properties are valued. But these are constantly changing and the properties need to be assessed individually based on location and conditions. Bitcoin, on the other hand, has a real-time market price that is accessible to everyone.
Social issues are also associated with the use of real estate as a preferred form of collateral. It has created an exclusive financial system in which it has become increasingly difficult to build credit as real estate has become expensive and less accessible.
House prices have increased almost 70 times since 1971, which corresponds to the “Nixon shock” of August 15, 1971, when President Nixon announced that the United States would end the convertibility of the US dollar into gold. This decision ushered in a new era in which central banks began operating a system based on fiat money with variable exchange rates and no currency standards (history.stato.gov). Since then, inflation rates have steadily risen. Many have turned to real estate to secure their wealth. As a result, the price of real estate has been moved away from its fair value based on its usefulness: it is an income-generating activity and can be used for production purposes. It now mainly serves as a store of value for institutions and those who are trying to beat monetary inflation. Conversely, bitcoin is easy to access, purchase, store, use and maintain. You can buy bitcoins for as little as one dollar. Bitcoin allows for much easier access to credit.
The use of bitcoin as collateral allows in particular easy access to credit systems for developing countries. In places with little access to credit markets like Indonesia, bitcoin will be adopted as a savings instrument and possibly to be used for credit.
Furthermore, bitcoin allows a lot more private financial system. A lender could use a cryptographic key to authenticate a borrower without requiring the borrower to disclose sensitive private information which could then be disclosed over the Internet in the event of a data breach.
Finally, just like selling a stock, a bitcoin sale can be executed quickly if a borrower defaults. Unlike the stock market, bitcoin markets operate 24 hours a day, 365 days a year. A sale can therefore be made at any time if necessary. Real estate, on the other hand, usually has to go through an auction procedure if the borrower defaults. This is another reason why bitcoin is predestined to be used as collateral. Due to the volatile price of bitcoin, most lenders require bitcoin-backed loans to be overly secured. However, this is more of a feature than a bug as it requires more financial discipline on the part of the borrower which usually leads to greater efficiency and higher productivity. Regardless, as volatility decreases with greater adoption, this practice will change in the future as well.
Overall, bitcoin’s excellent properties make it the ideal collateral type for both borrowers and lenders. Bitcoin lending services will reduce the incentive for anyone to sell, which will obviously have a positive impact on the price – see: Allen Farrington and Sacha Meyers, “Bitcoin Is Venice”, page 161.
The improvement of ownership systems in the West over the past centuries has enabled economic actors to discover and realize the potential of their economic activity and generate additional productivity. Fiat money has distorted this system. Bitcoin will restore it and expand it around the world. As a digital property, bitcoin will create a financial system where owning property and using it for credit will be much more accessible than it is today. This allows for greater productivity and efficiency in the global economy.
This is a guest post by Leon Wankum. The views expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.