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 stocks, cash, stocks, and bonds. I will show why bitcoin has the potential to become the collateral of choice in the future.
There is an emergence of a variety of lending 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 hold bitcoin. This has created a demand for bitcoin users to lend their holdings and receive a return or money in return. Borrowing against your bitcoin makes economic sense for two reasons. First, there is a capital gains tax if you sell and second, from an expense 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 it all isn’t worth it. And for lending purposes, you can use noncustodial solutions like Hodl Hodl which are available. Multi-signature wallets (a type of wallet that requires more than one signer to move funds) allow lenders and borrowers to share access to funds.
You can still have a crypto relationship with your bitcoin as a borrower. Suppose you borrow against your bitcoin using a multisig address. In this case, you can still access this address not only through the platforms interface, but also using any blockchain explorer. With this you can always check that your warranty is stored in the same place and even monitor your escrow account in real time. This avoids the risk of rehypothecation, a practice by which banks and brokers use the assets deposited as collateral by their customers for their own purposes.
As Nick Neuman explains, the fact that bitcoin transactions and addresses are publicly verifiable removes a lot of risk from the financial system. It helps to prove reserves, where a financial institution must provide their bitcoin address or transaction history in order to show their reserves. Transparency requires more ethical behavior from financial service providers.
Bitcoin storage is quite simple, there is no daily maintenance. Bitcoin just 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 lender bankruptcy. In this case, the borrower would lose his coins.
With bitcoin, the maintenance of the collateral decreases. Banks usually have a large number of appraisers and auditors who continuously assess the collateral posted. The valuation of a property is particularly time-consuming. There are standards by which real estate is valued. But these are constantly changing and properties must be assessed individually based on 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. He 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 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 American dollar into gold. This decision ushered in a new era in which central banks began to operate a system based on fiat money with floating exchange rates and no monetary standard (history.state.gov). Since then, inflation rates have risen steadily. Many have turned to real estate to secure their wealth. As a result, the price of real estate has been driven away from its fair value based on its usefulness – it is an income generating asset and can be used for manufacturing purposes. It now primarily serves as a store of value for institutions and those trying to combat monetary inflation. In contrast, bitcoin is easy to access, purchase, store, use, and maintain. You can buy bitcoins for as little as a dollar. Bitcoin allows much easier access to credit.
The use of bitcoin as collateral notably 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 possibly be used for credit.
In addition, bitcoin allows a lot 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 then be leaked onto the Internet in the event of a data breach.
Finally, just like a stock sale, a bitcoin sale can be completed 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 process if the borrower defaults. This is another reason why bitcoin is predestined to be used as collateral. Due to bitcoin’s price volatility, 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 more efficiency and higher productivity. Either way, as volatility decreases with increased adoption, this practice will also change in the future.
Overall, bitcoin’s excellent properties make it the ideal type of collateral for borrowers and lenders. Bitcoin lending services will reduce the incentive to sell, which will of course 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 over the past centuries has enabled 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 it is 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.