Exploring Bitcoin's Potential as Pristine Collateral for Lending

Welcome to the 24th edition of The Bitcoin Newsletter,

I’ve just returned from the Baltic Honeybadger Conference in Riga, marking my fourth time attending since 2019—and this year, I had the privilege of speaking there for the first time.

My presentation focused on the evolving role of bitcoin as collateral in real estate development financing. While bitcoin is often recognized for its primary functions as money (a medium of exchange, store of value, and unit of account), its potential as collateral is particularly compelling. Thanks to its deflationary design, bitcoin is anticipated to increase in purchasing power over time. This makes it an attractive asset for taking on fiat-denominated debt, which tends to lose value over time due to monetary devaluation. In this 24th edition of my newsletter, I will delve deeper into bitcoin's potential as a pristine asset for lending.

Best regards,

Leon

DEEP DIVE

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Exploring Bitcoin's Potential as Pristine Collateral for Lending

Bitcoin’s excellent properties as a store of value also have a positive impact on its use as collateral. Both functions, store of value and collateral, are closely linked. While real estate, the most commonly used asset in the global financial system, offers the advantage of generating cash flow for interest repayment, something bitcoin does not, this is not a decisive factor for an asset’s effectiveness as collateral. Instead, an asset’s ability to retain value over time is what matters for securing loans. Bitcoin exemplifies this through its disinflationary issuance schedule and inherent scarcity, coupled with outstanding monetary characteristics that drive sustained demand. These factors collectively position it as pristine collateral for lending.

The infrastructure surrounding access to financial services related to bitcoin and its use as collateral is still in its infancy, but the possibilities are extremely promising. Bitcoin has the potential to become the collateral of choice in the future. As a bearer instrument, bitcoin serves as pristine collateral for lending. Whoever controls the private keys associated with a bitcoin address controls the bitcoin balance on that address. Due to its deterministic supply schedule, which is hard-capped, there is an incentive to hold bitcoin. This has created demand for bitcoin users to lend their holdings and receive fiat currency in return, as more people seek to hold larger quantities of bitcoin for a long time or without the intention to sell.

Borrowing against bitcoin makes economic sense for two reasons:

1. In most jurisdictions, there is a capital gains tax if bitcoin is sold, so avoiding a sale is beneficial.
2. From a spending perspective, one is encouraged to spend fiat, not bitcoin, as long as the value of bitcoin is increasing faster than the interest rates charged by fiat credit institutions.

However, bitcoin should only be used to borrow against it, not to earn yield. Earning a 6 percent yield, as was common in the 2020–2022 period with cryptocurrency lending platforms like BlockFi and Celsius, while being able to lose it all is not worth it.

For lending purposes, non-custodial solutions are emerging. Multisignature wallets (a type of wallet that requires more than one signer to move funds) allows for lenders and borrowers to share access to funds. This makes it possible to maintain a cryptographic relationship with Bitcoin as a borrower.

Publicly verifiable Bitcoin transactions and addresses significantly reduce risk in the financial system. They enable "proof of reserves," where financial institutions must disclose their Bitcoin addresses or transaction history to prove their holdings. This transparency helps reduce the risk of rehypothecation, where banks and brokers use client assets as collateral for their own purposes, a risky practice that can lead to speculation and potential losses.

The transparency requires a higher standard of ethical behavior from financial services providers and reduces the likelihood of Ponzi schemes. (Nonetheless, it is important to recognize that the risk of a Ponzi scheme can never be completely eliminated due to the possibility of malicious actions by individuals.) The fact that bitcoin is programmable enables the creation of programmable lending products and ownership mechanisms. Among other benefits, this feature solves the problem of trusted third parties by building non-custodial lending mechanisms and storage systems**.** Providing an added layer of security and trust.

Using bitcoin as collateral offers lenders benefits like low storage and maintenance costs, with real-time market pricing accessible 24/7. Unlike traditional assets, bitcoin doesn’t require daily upkeep—just secure protection. If a borrower defaults, bitcoin can be quickly sold due to its high liquidity and around-the-clock markets.

Bitcoin also provides an accessible way to obtain and build credit. It can be purchased for as little as one dollar, making it more inclusive than traditional assets like real estate or gold. This is especially valuable in developing regions, where limited physical infrastructure restricts access to the traditional financial system. With just a phone or internet connection, anyone can buy bitcoin and use it as collateral, even for loans from banks in different countries. Bitcoin possession can be easily proven through a digital signature that verifies a user’s control over the specified bitcoin.

In addition, 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 over the internet in the event of a data breach.

Integrating Bitcoin into traditional finance is challenging due to its high volatility, which can be intimidating for those not accustomed to it and believe it to be a sign of risk. However, while this volatility can be tough for individual market participants, it benefits the economy by fostering resilience, encouraging risk management, and promoting long-term stability. Most lenders require Bitcoin-backed loans to be overcollateralized due to this volatility, which enforces financial discipline among borrowers and enhances efficiency.

Overcollateralization acts as a safeguard against market fluctuations, providing security for lenders and encouraging disciplined asset management for borrowers. As bitcoin matures and potentially becomes less volatile, the need for overcollateralization may change, but it remains crucial in today's market environment.

Bitcoin’s exceptional monetary properties position it as the ideal collateral for both borrowers and lenders. As bitcoin lending services expand, the incentive to sell diminishes, which could positively influence its price. In the Bitcoin space, owning bitcoin has become synonymous with creditworthiness, making it the preferred collateral for Bitcoin-native financial services. As the asset class matures and integrates into traditional finance—through ETFs, for example—this mindset will likely spread throughout the global financial ecosystem. With a growing market cap, Bitcoin-native financial services will gain prominence and may even merge with traditional banks. Over time, these factors will enhance the acceptance of bitcoin as collateral, leading to deep and liquid bitcoin backed credit markets.

Bitcoin’s potential as collateral holds significant promise in credit-intensive industries like aviation, real estate, semiconductor manufacturing, space exploration, and energy production. As a valuable long-term collateral option, bitcoin offers businesses a strategic advantage when integrated into project financing from the start. This not only enhances creditworthiness but also provides a hedge against inflationary pressures of the existing fiat system. With its accessibility and ease of use, bitcoin is likely to become increasingly favored over traditional physical assets.

By incorporating bitcoin into their financing strategies, companies can bolster their resilience and protect against inflation. At this year's Baltic Honeybadger Conference in Riga, I discussed how the real estate sector, in particular, can benefit from this approach. WATCH

I look forward to addressing this topic in detail in the future and putting it into action.

WORTH TO KNOW

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**Podcast and publications

Riga Bitcoin Baltic Honeybadger 2024: Bitcoin’s Role as Collateral in Real Estate Development** I thoroughly enjoyed discussing Bitcoin’s potential for real estate development financing at the Baltic Honeybadger Conference 2024 in Riga.  I’ve uploaded the slides to X, and you can watch the full presentation in the recorded live stream. WATCH | SLIDESBitcoin Magazine: Bitcoin’s role as collateral in real estate development financingIn my latest article on Bitcoin Magazine, I look at the benefits of using bitcoin as collateral in real estate development financing. READ

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ResourcesPhil Dushey - What Types Of Assets Might You Use For A Collateral-Based Loan? READ

Max Keidun - Bitcoin Can Be Super Collateral If Lenders Understand Its Value READStephen Hall - 4 Things to Know About Financial Inclusion Around the World Right Now READGeorge Gilder - Knowledge and Power: The Information Theory of Capitalism and How it is Revolutionizing our World

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Photo Credit: Marinus van Reymerswale - The Banker and His Wife

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Disclaimer: the content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Make sure you do your own research before making any investment and be aware of your own risk tolerance. If you like to build on my thoughts, feel free, but please cite me as the source. 2024 - Leon A. Wankum. 

Editing and content creation by Clemens Haidinger.

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