Bitcoin, superior collateral?

With a global market size estimated at $20t, collateral assets are a fundamental building block of financial markets as they affect economic growth and financial stability alike. Collateral is defined as the asset a lender requires as security for a loan. Currently, this market is highly dominated by government bonds and cash-based securities. However, the increasing reuse of this collateral makes these assets less attractive to risk-averse market participants and exposes the fragility of financial markets. Bitcoin with its unique features might disrupt lending of modern banking systems and is set to compete with the currently dominating collateral assets.

With Bitcoin and the rise of digital assets, a new player is joining the field of collateral assets bringing some disruptive properties that are enabled by its underlying blockchain technology. The utilization of Bitcoin as collateral is currently, especially present in derivative markets or lending solutions. As it continues to span into new applications and use-cases, the market awareness of Bitcoin and its unique features is rising alongside. In the recent months, we saw Genesis, the world's largest institutional-focused digital asset lender, having $14.6b total active loans (as of March 31, 2022) and $44.3b loan originations in Q1, MacroStrategy taking out a $205m BTC collateralized loan via Silvergate Bank to leverage their BTC exposure, and in a Wall Street first, the largest U.S. crypto exchange Coinbase collateralizing its BTC for a cash loan (no amount disclosed) with Goldman Sachs, the bank’s first bitcoin-backed loan. In addition, inflows into wrapped BTC (wBTC) to enable DeFi exposure are historically strong and are likely to accelerate from here. With Bitcoin having a deterministic supply schedule that is hard-capped and a sound monetary policy, major adoption catalysts like these represent yet another push towards Bitcoin being perceived as a form of pristine collateral by markets.

Bitcoin vs. traditional collateral assets

To date, government bonds and U.S. treasuries dominate the collateral asset market, as they are perceived as safe and liquid yet bear the risk of rehypothecation, a form of re-using previously pledged collateral for new loans, and thus systemic risk. Bitcoin despite being a very young asset offers an alternative as Bitcoin's feature set is unlike those of any other asset class. As we outline below, Bitcoin's unique properties make it a pristine collateral asset that is unmatched due to the following feature set:

• No counterparty risk: Bitcoin value is intrinsic as is it not backed by anything. No middleman is needed for custody as every individual can store their BTC in their own wallets having full control of their assets. No third party can seize their BTC or censor transactions. The network is decentralized and permissionless.
• Global market: Bitcoin is borderless. Without centralized authority, the concept of borders is also removed, making Bitcoin global and available for everyone. The world has never seen a type of money that enables instant transfer of value worldwide without relying on trusted intermediaries, such as banks or governments.
• Availability: The market never closes resulting in no limiting hours. Bitcoin runs 24/7/365 making it the most available liquid asset.
• Transferability: Any amount of BTC can be stored in a wallet and be transferred at a low cost globally.

Table 1 puts Bitcoin and its unique properties into the context of government bonds and U.S. treasuries and other possible collateral assets such as gold and real estate. The desired properties that make good collateral are derived from the framework used by the European Central Bank (ECB).

The comparison clearly indicates that Bitcoin’s feature set makes it a highly competitive pristine collateral challenging the current markets. With recent events, especially assets without counterparty risk might see increased adoption as aggressive monetary and fiscal expansion is getting more present. Moreover, when it comes to lending, due to Bitcoin’s ease of transfer, and ease of verification, individuals can get approved for a loan exceptionally fast without complex credit checks or collateral appraisals. As Bitcoin is easy to value, it reduces the risk to the loan issuer and thus enables tighter net interest spreads. For instance, gold loan rates range between 9%-24%, whereas Bitcoin’s lending rates range between 4%-8.95% depending on the loan term and Loan-To-Value (LTV). The LTV determines the amount of crypto collateral needed as it is calculated by loan amount divided by collateral market value. According to Matthew Ballensweig, managing director and co-head of trading and lending at cryptocurrency-exchange Genesis, a common loan-to-value ratio lies between 40% and 60%. On the downside, Bitcoin comes with rather high volatility and limited liquidity compared to more traditional asset classes that will likely be resolved as Bitcoin matures. Additionally, there are no unsecured financial Bitcoin lending products as they require over-collateralization, which is not an optimal credit mechanism from a lender’s perspective. For an in-depth analysis, we recommend Arcane’s comprehensive report on “The State of Bitcoin as Collateral” and Fulgur Venture’s “Bitcoin’s killer app is its use as collateral”.

Bitcoin vs. other crypto collateral and stablecoins When it comes to the cryptocurrency landscape, Bitcoin as pristine collateral stands out compared to other digital asset alternatives because of the following features related to its first mover advantage and network effects:

• Security: offers the highest security among all blockchain ecosystems, with Bitcoin recently hitting a new hashrate ATH, therefore rendering attacks very expensive.
• Infrastructure: most prominent and decentralized infrastructure with institutions building financial products and tools on top of it to facilitate BTC trading.
• Liquidity: with the dominant infrastructure and market exposure, Bitcoin offers the highest liquidity and therefore the lowest spreads as well as highest volume.
• Stablecoins: with increasing Stablecoin products and confidence in utilizing them, Bitcoin is facing a competitor that is showing a strong adoption trend, especially within derivative markets. However, stablecoins often come with counterparty risk of centralized entities or depeg risk for (semi-)decentralized stablecoins whereas Bitcoin features no counterparty or credit risk.

Adoption in Bitcoin collateralized markets

The aforementioned properties of Bitcoin undeniably yield impressive adoption trends in a wide range of markets. Among these are not only derivative markets such as options and futures markets but also centralized and decentralized lending markets.

Derivatives Market The first significant collateral use case for Bitcoin was found in derivative markets in crypto as BTC collateralized derivatives played an important role in its price discovery. Bitcoin started to lose market share to stablecoin and fiat collateral in futures and options markets within the last couple of months as these are more favorable for long exposure and are less complicated for trading other cryptocurrencies. As of early 2021, BTC collateralized futures accounted for 57% of the open interest in the futures market, compared to 86% in early 2020. Illustration 1 depicts the impressive volume of futures markets with collateralized Bitcoin having a significant share of it. As Bitcoin collateral features no counterparty risk within an environment where some stablecoins tend to depeg, it is likely that BTC collateralized derivatives maintain a significant share of the market moving forward. In contrast to the futures markets, Bitcoin acts as dominating collateral in the options markets, accounting for ~95% of all contracts as of 2021.

Lending Markets The lending industry with Bitcoin collateralized loans is growing steadily as seen with institutional lending by Genesis, new lending products, and growth in centralized and decentralized lending applications. However, aside from all the benefits, these products leveraging crypto often bear some risks as well. Crypto lending platforms can be built on centralized or decentralized infrastructure depending on each platform’s specific approach to custody and interaction with regulatory protocols. Both centralized and decentralized platforms come with their own potential risks and benefits. Among the major risk vectors are volatility induced liquidation risk, taxation and regulatory risk, interest rate volatility as well as smart contract exploit risk in decentralized products.

Bitcoin in CeFi Centralized finance (CeFi) allows users to deposit Bitcoin as collateral or as a simple savings vehicle. Among these platforms seeing a huge influx in customers due to customer service needs and general familiarity compared to decentralized solutions are:

• BlockFi
• Nexo
• Gemini
• Crypto.com
• Celsius
• And most centralized exchanges

Decentralized crypto lending As Bitcoin does not support smart contracts, native BTC can’t be leveraged in DeFi. Hence, in order to realize decentralized lending, BTC has to be tokenized to enable utility such as collateralized loans using a smart contract protocol like Ethereum. As a result of various approaches to onboard Bitcoin on Ethereum or other smart contract platforms alongside different frameworks to ensure a Bitcoin peg, there is a varying degree of centralization among the tokenized Bitcoin products ranging from custodial to fully decentralized solutions, see Table 2.

With an on-chain representation of Bitcoin, users are then able to lock up their Bitcoin in smart contracts to tap into the permissionless nature of DeFi lending, paired with the non-custodial nature of many decentralized applications (dapps). Among these, prominent dapps enabling Bitcoin lending in DeFi are:

• Aave
• Compound
• Oasis
• Fulcrum
• Nuo Network

Due to Ethereum’s smart contract capabilities, its extensive developer community, and its network effects, Ethereum became the dominant blockchain for enhanced BTC utility in DeFi. To date, a total of 333’734 BTC or >1.75% of the circulating supply are tokenized on the Ethereum blockchain, see Illustration 2. Of that, an overwhelming 284,205 BTC are wrapped as wBTC, making wBTC the most dominant Bitcoin-backed ERC-20 token followed by Huobi’s hBTC.

With ~80k wBTC, about 30% of its supply is currently found in lending protocols such as Aave, Maker, and Compound. The other 70% is deployed in Curve pools, liquidity pools of decentralized exchanges, and derivative markets that are primarily structured linearly with stablecoin margined collateral.

Conclusion and Outlook

Bitcoin’s disruptive features make it a pristine collateral asset set to be a strong competitor of collateral prevailing government bonds and cash-based securities. Growth metrics are signaling adoption across the board. Once a pipe dream, financial giants and institutional money are getting comfortable with the idea of leveraging the benefits of Bitcoin and its underlying blockchain technology to explore bankable Bitcoin lending products with all the accompanying benefits such as attractive interest rates, ease of liquidation, or increase of asset productivity. On the flip side, these products face higher volatility, lower liquidity, might be prone to regulatory risk and come with over-collateralization, attributes that are linked to the maturity of Bitcoin as an emerging collateral asset class. Unlike any other asset class though, Bitcoin comes without both counterparty risk and credit risk, is globally available 24/7, offers low transaction costs and is the most portable asset to date. These unmatched and superior collateral properties make Bitcoin a pristine collateral asset that offers material advantage in an environment of ever tumbling yields. In Part II, we will highlight Bitcoin’s outstanding qualities as a reserve asset and outline how the untapped market size for collateralized Bitcoin and Bitcoin as a reserve asset might yield mesmerizing upside.