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Using Bitcoin as loan collateral gains traction

Read time 6min 10sec

Players in the crypto market believe using Bitcoin as collateral to secure loans will disrupt the traditional banking system.

This, as several start-up lenders begin using crypto-currencies as collateral for personal loans.

Yesterday, the value of Bitcoin soared 5% to over $10 300 – a five-month high – after US Federal Reserve chairman Jerome Powell said the central bank was exploring a digital currency. At the time of publishing, Bitcoin was trading at $10 200.

According to Richard De Sousa, CEO of local crypto-currency exchange AltCoinTrader, MakerDAO and BlockFI are probably the best-known for crypto-collateralised loans.

He says decentralised finance (DeFi) has come of age, as anybody who wants to obtain a collateralised loan can do so without the red tape of banks.

“If a person owns Bitcoin or Ethereum and decides they would like to obtain finance for a real estate project or to start a business, they can now do so by putting their crypto up as collateral,” says De Sousa.

“Most people fear the crypto price will rise and do not want to sell their Bitcoins but would preferably loan against them, and this allows the person to pay back any loans and interest over time and then still get back their crypto.”

De Sousa notes the process is quite simple and usually done with minimal effort. “You would send your Bitcoins or Ethereum to one of these companies, and they will either deposit the loaned US dollars directly into your bank account or issue a stablecoin,” he explains.

Stablecoins are tokens designed to hold a specific value and are usually pegged one to one to a fiat currency like the US dollar or physical assets like gold.

De Sousa says stablecoins are essential to the DeFi ecosystem and will allow users to purchase additional crypto, or can be sold for fiat in another country.

“One significant advantage of a crypto-backed collateralised loan is if you borrow R120 000, and you put up one Bitcoin as collateral valued at R158 000, today’s price, and the Bitcoin price moves to R200 000 by the time your loan is paid back, you get your one Bitcoin back valued at the new Bitcoin price,” he notes.

Calculated risk

According to De Sousa, it has been reported via the Ethereum blockchain that large amounts of Ethereum have been locked in the collateralised debt positions.

“MakerDAO owns most of these Ethereum addresses. This is evidence of a growing market as banks and financial institutions are becoming more restrictive and exceptionally invasive.

“Decentralised finance loans can be obtained without the red tape of banks. Collateralised loans can be acquired without the painful KYC [know your customer] process and endless intrusive paperwork of traditional centralised financial institutions.”

He points out DeFi solutions like MakerDAO or BlockFi do not require credit checks or bank-level KYC procedures, meaning a broader reach to unbanked people that do not have access to conventional finance.

“The crypto community is seeing many new disruptive businesses providing features that traditional financial institutions offer. The only difference is that crypto companies are making these features easier and more appealing to their customers in ways that conventional institutions can’t,” De Sousa says.

Eugéne Etsebeth, COO of local crypto exchange iCE3X, says: “One company I am following closely is Celsius and they provide users with a wallet which allows them to earn a return on their coins and borrow US dollars against their crypto.”

Etsebeth explains that crypto earners can use a wallet to earn interest by placing their Bitcoin into a pool of collateral. He adds crypto borrowers can use a wallet to place their Bitcoin (in return for a fiat cash loan) into a pool of collateral.

According to Etsebeth, crypto hedgers can also use a wallet to borrow Bitcoin from the pool of collateral in order to hedge or short the Bitcoin markets, then the crypto hedgers pay interest.

“There is an increase in uptake in this model because the returns are mostly better than traditional collateral markets. Added to that, security and insurance on collateral pools have improved, along with a democratised and easy user experience.

“At ICE3 exchange, we are seeing a surge in activity of customers trading and getting funds into their own wallets, likely for access to collateral borrowing,” says Etsebeth.

“Disruption often occurs when customers are frustrated at bad service, slow performance and high fees. The Bitcoin collateral model is already disrupting parts of the traditional model. Banks – like Rabobank recently – are introducing negative interest rates, which means a user may pay interest to the bank. Crypto-currency collateral allows earnings of up to 12% annual percentage yield. You do the math.”

Valuable asset

Farzam Ehsani, co-founder of local crypto exchange VALR, says: “To understand the process of using Bitcoin as collateral to secure loans, we need to step back to understand two different forms of loans – secured and unsecured loans.”

He notes unsecured loans are loans granted without any collateral to back them up, while secured loans use some sort of collateral that the lender can take possession of if the borrower defaults.

“Collateral can be any sort of asset the lender deems to have value, such as a house, a building, shares, bonds, gold, cars, machinery, etc. Using Bitcoin as collateral to secure loans is just another form of a secured loan where the lender sees value in taking possession of Bitcoin in case the borrower defaults.”

However, Ehsani says since Bitcoin is still volatile, lenders that accept Bitcoin as security will often stipulate a large “haircut” on the value of the Bitcoin – “if one Bitcoin is put up as collateral and is worth R163 000 today, the lender may only lend R80 000 against this in case the value of the collateral decreases”.

He points out there is definitely an uptake in this model and is something VALR is considering.

“More and more people view Bitcoin as a more long-term store of value than traditional money and don't want to sell their Bitcoin for fiat currency. They, therefore, prefer to hold Bitcoin and then borrow fiat currency with the view that the value of their Bitcoin will go up over time. However, we are not seeing very long-dated loans in the market yet. This will emerge as the market matures.”

Ehsani believes that even though banks are still cautious about Bitcoin and its uses, it is only a matter of time before they embrace this new asset class and start building new products (like Bitcoin-collateralised loans) to offer to customers.

“So is this disrupting banking? I’d say it’s a component of the future of banking. Banks that disregard Bitcoin and other crypto-currencies do so at their own peril.”

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