Bitcoin as collateral for lending and borrowing

bitcoin collateral

Recently websites such as SALT lending began offering to lend US dollars to borrowers using Bitcoin as collateral.

They are also allowing borrowers to use other cryptocurrencies such as upcoming cryptocurrency Ethereum.

Before I go any further I want to state that I am a fan of Bitcoin. It is a great alternative to Federal Reserve notes. And it is a way to conduct transactions without anonymously without service fees. Bitcoin is built on blockchain technology. This technology offers many applications in development or yet to be discovered.

However, Bitcoin does come with its flaws. This idea of Bitcoin as collateral is the latest flaw that I have noticed.

Bitcoin is known for its extreme volatility. It has risen almost 300% since the beginning of the year, with dips totaling as much as 30% of its value in a matter of weeks along the way. So looking at that knowledge honestly, it is fair to say Bitcoin is still more of a speculator’s financial instrument than a currency used in transactions for goods and services. And when it is used for goods and services the merchant often converts the Bitcoin into Federal Reserve notes or some other government issued currency.

How this relates to Bitcoin collateral

Since Bitcoin is inherently volatile borrowers are likely to face margin calls at some point. A margin call is simply the percentage of collateral needed by the lender to keep the loan open. So if SALT lends a borrower $500 for $1000 worth of Bitcoin collateral. And the terms state that a margin call will take place at a certain percentage of the principal’s value in relation to the value of the collateral drop.

SALT’s website states in its FAQ:

Do I still own my asset [Bitcoin…etc]?

Yes. You still own your asset and can sell it at anytime. If you choose to sell, any outstanding unpaid loan principal, interest and fees will be deducted from the value of your asset and repaid to the lender before sale proceeds become available to you.

So Bitcoin as collateral adds an element of volatility that did not previously exist to the market. If there are a large pool of margin calls in could send the price of Bitcoin plummeting overnight. The bid market could dry up quickly.

The problem of levering Bitcoin until the investor is bone dry

The second problem that exists is that there is nothing stopping an investor from taking his original pool of bitcoin. Then taking out a loan using that Bitcoin as collateral and then using those Federal Reserve notes to go purchase more Bitcoin. An investor has the ability to do this until he is levered to within an inch of his life. This could cause a huge bubble on the way up as well as a huge crash on the way down.

There is no rational solution to this other than the market itself. An investor or borrower should be aware of the risks before they involve themselves in this risky investment.

Simply buying and holding Bitcoin is much safer than using Bitcoin collateral.