Inside the Bitcoin Lending Landscape
Bitcoiners have dreamed of lending and earning interest on their coins for over a decade. With companies like BlockFi offering juicy 6% interest rate, has this dream finally come true? Or is it just a minefield, where you are only a stone’s throw away from disaster? We’ll peel through some of the layers of this onion to try and better understand the current Bitcoin lending landscape, so you can make a more informed decision before parting with your hard-earned sats in the hopes of collecting more sats.
First, let’s go over some basic principles. All parties involved in a business transaction should have a common and equal understanding of what should happen and the risks involved. The loan is like any other business agreement. If you lend me your bitcoin, you should expect me to tell you exactly what I’m going to do with your money, what the risks are, and what if I don’t pay you back. It takes time to work through the details, but that’s where the devil lies. Details matter.
Imagine asking you to lend me 10 bitcoins. I should be able to tell you not only that I plan to use your money to buy a house, but I will also tell you exactly which house I will be buying. That way, if I fail to repay the loan, you can place a lien (a legal claim) on the title of the property that was purchased with your money. This type of arrangement is generally referred to as a mortgage or mortgage. The title to the property is called collateral.
As a lender, you are worried about the 10 bitcoins you loaned me. You want to be absolutely certain that you can get as much of your 10 bitcoins back as possible if I stop paying off the loan. Because your 10 bitcoins are “in” the property, you worry about the value of the property – the value of the collateral. You will want to make sure that I have insured the property and that I am maintaining it. What if house prices drop 50% and the property is worth only 5 BTC? If I defaulted on the loan and you tried to sell the property, you would now lose at least 5 BTC. So, if the market price of the property goes down, you might demand that I “publish” or provide more collateral, such as the title of my car or boat.
Here’s an interesting wrinkle: many governments now officially consider bitcoin as a property in the same way that they view real estate as property. The best proof of this is that you would expect to report capital gains or losses on Bitcoin transactions for US tax purposes, just as you would for real estate. Some governments go further and want you to pay tax on the market value of your bitcoin holdings, just like you would real estate. These tax treatments strongly affirm and reinforce the idea that bitcoin, presumably a given set of UTXOs, is property.
Because bitcoin is a property, it can be used as collateral. This means that you can borrow (or “mortgage”) your bitcoin fairly quickly and at negligible cost, whereas it can take several weeks and quite a bit of money to be able to borrow against real estate. You can probably see how the pieces of this puzzle are starting to fit together now.
Now let’s take it up a notch and think about a way to make some really good profits without getting our hands dirty doing real jobs like plumbing or carpentry. Imagine working as a trader in a bank or an investment firm. Our job is to make money consistently and without the risk of loss due to price fluctuations. Generally speaking, this type of “risk-free” trading is called arbitrage. Let’s take a look at an arbitrage strategy, which is the cash and carry trade. This is also sometimes referred to as basic trading.
Imagine you could buy a barrel of crude oil today from your neighbor Carl for $ 50 cash (that’s the spot price). When you log into your brokerage account, you notice that you can sell that barrel of oil for $ 60 in a month. It costs $ 5 to store the barrel for a month. Your profit would be $ 5, which is a 9% return in just four weeks, and there isn’t much risk involved. You can do the same trade using bitcoin instead of crude oil, and your storage costs will be much cheaper. As of this writing, the bitcoin futures contract for a month from now CME Group is trading at around $ 58,950 while the spot price is around $ 57,170. If you buy bitcoin now and immediately enter into a contract to sell it in a month’s time, you will make a profit of $ 1,780, or 3%. Do it every month every month and $ 10,000 turns into $ 14,000 over the course of a year. The more money you can invest in trading, the more money you can make.
What’s the catch? You will need a lot of money to get started. Where are you going to get all this money? You have to convince someone to give it to you. Maybe you can start a business and issue some equity, debt, or a ridiculous token. And if you have to pay people for the use of that money (debt issuers do, stock and token issuers don’t), make sure you pay less interest than what you’ll earn. on the transaction.
There are endless variations in this trade, as the only thing that is really needed for the opportunity to arise is for a derivative to be priced differently from the spot price. For example, the Grayscale Bitcoin Trust issues shares, and that share price has been a bit higher than the bitcoin spot price. But if the stock price trades more closely at the spot price, or if it falls below the spot price, then the profits of that particular carry trade will be reduced or disappear altogether.
The disappearance of this porterage operation does not imply that a particular professional business enterprise which was making money through this trade is in a situation of financial distress. You should expect that a professional company will be able to start another carry trade, like the CME futures contract. It should not be the case that a professional trading company fails due to the unavailability of any of these trades for a long time. But you never know.
You have probably already realized that you can do this trade yourself, but it will take a little effort. It makes sense that a professional company like BlockFi would design the trade, froth the top a bit, and then send you the leftovers.
So, back to the original question: has the dream of bitcoin lending come true?
What most people today believe as “lending” bitcoin to earn interest is not actually a loan. To use BlockFi as an example: legally, you give up your property, and BlockFi has no obligation to return it. The executives of this company have not posted their personal homes, cars or boats (since their last fundraising success, these are now probably yachts and private jets) with you as collateral. In fact, you probably don’t even know who the directors of this company are.
What’s particularly confusing is that many of these platform operators use the word “loan” quite liberally in their marketing materials and on their websites. They might even promote that they are regulated. But that only means they or they are authorized to offer loans to the public. That does not mean you lend to the company, even if it could be sneakily implied.
The bottom line is this: Today’s popular “loan” platforms are not what you might think they are. There is a strong asymmetry of information and power in these relationships, and the game is against you. You strike a handshake deal with anons who run a pseudo-hedge fund, throwing some of your savings to them and hoping for the best. So far, things seem to be going well. But past performance is no guarantee of future results. BTC-e and Mt. Gox kept their promises, until they didn’t. Bear Sterns, Long Term Capital Management, and countless others have kept their promises until they don’t.
There are good reasons why banks are so strict about lending: They don’t want to lose money. With Bitcoin, you are your own bank. You should be equally strict in assessing creditworthiness and have your bitcoin borrowers post collateral (even if it is an additional Bitcoin collateral), and make sure you have a binding contract. before granting a loan to a private person or a company.
This is a guest post from Justin Smith. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.