This is an opinion piece 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 repayment of a loan to a lender is real estate. This practice is common for mortgages, personal loans and business loans. Banks lend to people and institutions that own real estate. Other common forms of collateral include company stock, cash, stocks and bonds. I will demonstrate why bitcoin has the potential to become the collateral of choice in the future.
There is an emergence of a variety of loan products around bitcoin. Bitcoin as a carrierless instrument serves as the primary collateral. Due to its deterministic supply schedule, which is capped, there is an incentive to keep bitcoin. This has created a demand for bitcoin users to lend their holdings and receive a return or money in return. Lending against your bitcoin makes economic sense for two reasons. First, there is a capital gains tax if you sell and second, from a spending perspective, we are encouraged to move into fiat, not bitcoin, as long as the value of bitcoin increases faster than currency rates.
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However, bitcoin should only be used to borrow against it, not to earn returns. Earning a 6% return while potentially losing everything is not worth it. And for loan 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 signatory to move funds) allow lenders and borrowers to share access to funds.
You can also have a crypto relationship with your bitcoin as a loan. Suppose you borrow against your bitcoin using a multisig address. In this case, you can also access this address not only through the platforms interface, but also with any blockchain explorer. With this, you can always check that your collateral is stored in one place and also monitor your escrow account in real time. This avoids the risk of rehypothecation, a practice whereby banks and brokers use assets deposited as collateral by their clients for their own purposes.
As Nick Neuman explained, having bitcoin transactions and publicly verifiable addresses takes a huge amount of risk out of the financial system. It helps to prove reserves, where a financial institution must provide its bitcoin address or transaction history to see its reserves. Transparency requires more ethical behavior from financial service providers.
Bitcoin storage is quite simple, there is no daily maintenance. Bitcoin alone needs to be protected from cyberattacks. A financial service provider can set up their own cold wallet (a device that stores cryptocurrency offline) and protect their bitcoin from the threat of theft. Bitcoin can also be stored in a multisignature wallet. This allows lenders and borrowers to manage funds together and protects borrowers from the risk of lenders failing. In this case, the borrower will lose his coins.
With bitcoin, the maintenance of collateral decreases. Banks usually have a large number of appraisers and auditors who continuously evaluate the posted collateral. Appraising a property is particularly time-consuming. There are standards by which real estate is valued. But these are constantly changing and properties must be evaluated individually according to their location and condition. Bitcoin, on the other hand, has a real-time market price available to everyone.
Social issues are also associated with the use of real estate as the preferred form of collateral. It created an exclusive financial system in which it became increasingly difficult to build credit as real estate became expensive and less accessible.
House prices have increased nearly 70 times since 1971, corresponding 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 . The move ushered in a new era in which central banks began operating a system based on fiat currency with floating exchange rates and no monetary standard (history.state.gov). Since then, inflation rates have increased steadily. Many have turned to real estate to secure their wealth. As a result, the price of real estate has been removed from its fair value based on its utility – it is an asset that generates income and can be used for manufacturing purposes. It now serves primarily as a store of value for institutions and those trying to combat monetary inflation. In contrast, bitcoin is easy to access, buy, store, use and maintain. You can buy bitcoins for as little as one dollar. Bitcoin allows much easier access to credit.
The use of bitcoin as collateral significantly allows easy access to credit systems for developing countries. In places where access to credit markets is limited, such as Indonesia, bitcoin will be adopted as a savings tool and eventually be used for credit.
Additionally, bitcoin allows for a much more private financial system. A lender could use a cryptographic key to authenticate a borrower without requiring the borrower to reveal sensitive private information that could be leaked on the Internet in the event of a data breach.
Finally, like a stock sale, a bitcoin sale can be completed quickly if a loan 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. The real estate, on the other hand, usually must go through an auction process if the loan defaults. This is another reason why bitcoin is predestined to be used as collateral. Due to the volatility of bitcoin’s price, most lenders require bitcoin-backed loans to be over-collateralized. However, this is more of a feature than a bug, as it requires more financial discipline from the borrower which generally leads to greater efficiency and higher productivity. However, as volatility decreases with increased adoption, this practice will also change in the future.
In general, the excellent properties of bitcoin make it the ideal type of collateral for loans and advances. Bitcoin lending services will reduce the incentive to sell, which of course will have a positive impact on the price – see: Allen Farrington and Sacha Meyers, “Bitcoin Is Venice”, page 161.
The improvement of property systems in the West in the past centuries has allowed economic actors to discover and realize the potential of their economic activity and to generate increased productivity. Fiat money has distorted this system. Bitcoin will restore it and expand it worldwide. As a digital property, bitcoin will create a financial system where owning property and using it for credit will be much more accessible than today. This increases the productivity and efficiency of the global economy.
This is a guest post by Leon Wankum. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.