Welcome to Episode 115 of Special Situation Investing.
Bitcoin’s unique attributes offer never-before-seen possibilities in the lending market and, assuming that bitcoin itself is ultimately successful, it’s worthwhile for investors to explore and understand these possibilities.
The fact that bitcoin is a highly liquid, 24/7 global market built on instantly verifiable and securable cryptography which can be embedded into smart contracts, results in never-before-seen possibilities for both lenders and borrowers. For the sake of clarity, it’s probably best to break each of these subtopics down individually before combining them together again to analyze their impact on institutions and individuals. To further simplify the discussion, most of the examples presented will be from the borrower’s perspective.
BTC market is highly liquid and open 24/7
To begin, bitcoin trades twenty four hours a day, seven days a week, and doesn’t close for holidays. In addition to being a 24/7 global market, bitcoin is highly liquid with an average daily trading volume that, expressed in dollars, often exceeds the volume of the largest companies in the S&P 500.
For both borrowers and lenders,, bitcoin’s sizeable liquidity and 24/7 availability represent obvious advantages. Lenders can ensure that loans are properly collateralized at any point in time and borrowers can access capital through borrowing at any point and with relatively short notice.
It can be difficult to appreciate the difference between a 24/7 global payment network and the money in your bank account until you’ve experienced and interacted with both markets. In my own experience, I’ve seen it take from Thursday of one week until Tuesday of the next week just to transfer money between two banks even though I have existing accounts with both institutions. Stock trades take at least three days to settle in a brokerage account and a wire transfer for the sale of a house or other large transfer of money can take an equally lengthy amount of time.
Contrast this with bitcoin transactions that move across boarders in an instant. You can send bitcoin over the lightning network from the US to Afghanistan in seconds with no multi-day settlement time or KYC (know your customer) roadblocks along the way.
BTC market is global
The global nature of bitcoin is another attribute that will effect lending markets going forward. Like its 24/7 liquidity, its global scope is an attribute easy to overlook if you’ve never reflected on or interacted with it.
Consider the advantage of a global asset from the perspective of a company doing business in multiple different countries that is looking to borrow in just one place. Let’s use the example of a mining company that’s based in the US but which does most of its business in other countries. If the miner wants to borrow in dollars via a secured loan, they could, obviously, use some of their foreign infrastructure or currency as security against the loan but the lender might be concerned that the collateral is at risk. If the mine is located in a politically unstable region, the lender might worry, with good reason, about the collateral being nationalized or devalued.
Should the borrower use bitcoin as collateral rather than foreign infrastructure or currency, then the lender would no longer be concerned about stranded or impaired assets. A bitcoin held by a mine operator in a politically unstable or war torn region is just as good as a bitcoin held in custody at the Bank of New York Mellon but clearly physical infrastructure and currency is valued differently from one political jurisdiction to the next.
BTC is easily audited
The amount of, authenticity of, and ownership of bitcoin is instantly auditable.
Like its other attributes, this is no insignificant feature. Consider the perspective of an individual looking to borrow against a valuable asset that they already possess. The most common form of secured loan for individuals would be a home equity line of credit (HELOC). Securing a HELOC, however, will require at least a month in most cases. The lender must verify the property’s title as well as any leans against it and, depending on the loan-to-value ratio, will sometimes require an inspection of the property itself. As anyone who has purchased a home knows, the process is the opposite of instant global settlement.
Contrasting a HELOC with bitcoin, we see that a bitcoin loan can be secured much more quickly and in some cases within a single day. Given that the market for bitcoin secured loans is still in its infancy, it’s easy to imagine the process being even more streamlined as time goes on. The speed at which a bitcoin-backed loan can be secured, compared to that of a HELOC, is driven by fundamental differences in the assets themselves. Verification of home ownership, equity in the home, and the home’s condition simply take more time to establish in the real world than does the locking up of a bitcoin in a mutltisig escrow account. One takes days weeks or even months and the other only minutes.
Other assets that might be used as loan collateral share real estates limitations. Art, collectibles, precious metals and even vehicles are equally challenging and time consuming for lenders to value and, even if valued appropriately, can be impaired by the borrower before the lender takes possession of the asset, should that unfortunate step be required.
Pristine collateral
In the aftermath of the 2008 financial crisis, banks across the US found themselves in possession of droves of newly foreclosed homes. Real estate prices had fallen precipitously which was bad enough for their balance sheets but the situation was made worse in cases where the previous owners had nearly destroyed the asset that the bank now owned. Appliances, fixtures, and sometimes wiring itself had been removed by disgruntled former home owners and the banks were left with even less collateral value than they’d previously imagined.
With bitcoin as collateral, the collateral itself can not be impaired by a disgruntled borrower which in effect raises the value of that collateral in the eyes of the lender. Taking the comparison a step further, repossessing property is often a drawn out process that can involve the legal system or law enforcement to resolve, whereas bitcoin secured in a multisig address can immediately be transferred to the lender if and when that step is required. Each of these individually discussed attributes can be tied together and seen even more clearly by walking through the mechanics of a “flash loan.”
Flash loans
Flash loans are smart contracts typically executed on the Ethereum network that allow users to borrow and return money within minutes of initiating a transaction. These contracts are only possible when using assets that trade around the clock, settle anywhere in the world and where custody and authenticity can be verified in seconds. To better understand these unique financial contracts, let’s first break them down into their component parts.
According to Investopedia, a smart contract is “a self-executing program that automates the actions required in an agreement or contract. Once completed, the transactions are trackable and irreversible.” Smart contracts have multiple potential use cases, but the most widely used today are smart contracts for flash loans used in arbitrage.
Buying something cheap in one market and selling it for profit in another to capture the spread is a market niche that arbitrageurs have exploited for as long as markets have existed. But digital assets and smart contracts have added new capabilities to this well-established practice in the form of flash loan smart contracts.
Assume that an arbitrageur wants to exploit the price difference of bitcoin selling in two different markets. Using a smart contract he can borrow bitcoin from a lender, sell it in an expensive market, repurchase it in a cheaper market, and return the loaned coins with interest all while keeping the spread for himself and all within a single Ethereum block cycle. The interaction between borrower and lender lasts from seconds to at most minutes rather than a standard loan cycle which can, as we have noted already, be much much longer in traditional lending markets.
On the surface, the entire proposition seems risky in the extreme, and to be sure there are some risks associated with flash loans and smart contracts that are beyond the scope of this write-up, but there is one interesting safety feature built into the smart contract itself.
The safety feature built into the contract stems from logic of the smart contract in that the contract must succeed completely or fail completely but cannot partially execute. Because repayment of the loan is the final step in the contract then a loan that cannot be repaid will cause the whole contract to fail before it executes. In other words, if the loan can’t be repaid then the smart contract won’t execute and the loan never happened in the first place. If, on the other hand, the contract is executed then the loan, arbitrage, and repayment are all transacted and recorded into the blockchain in a single step.
Benefits to institutions
The benefits of digital assets like bitcoin to lenders and borrowers are too numerous to cover in such a short discussion. Bitcoin’s global, 24/7 liquid market and auditability allow for countless advantages over traditional lending products. Loans can be secured in minutes rather than months and come with more secure collateral than traditional forms such as real estate, infrastructure and other valuables.
It’s easy to imagine a world where bitcoin ETFs generate a yield for their clients through some form of lending. Lending of this kind would be cost prohibitive for gold, silver, or other commodity ETFs to implement. Flash loans, like the ones described above would be impossible to execute with physical commodities and therefore offer unique yield generation potential for digital property that were never previously available.
Furthermore, loans against digital property like bitcoin can be automated to a much greater extent than can loans against real estate and other assets. Historically, increases in automation are associated with decreased overhead and increased profitability for the institutions that implement them. Time will tell if the same economic tailwind of increased efficiency will have a similar effect on businesses in the wake of bitcoin-backed loans.
Benefits to individuals
Bitcoin lending will have no less of an impact on individuals as it will on institutions.
Consider that an individual of limited financial means currently has little to offer as security for a loan. In other words what little they have is not a worldwide, highly divisible, and fungible asset. Additionally, those who do have property or other valuables to offer might still be impacted by the country in which they reside, because again capital domiciled in politically unstable regions of the world is often viewed as stranded by would-be lenders.
If, however, an individual holds a global asset that is fungible, then that person’s collateral is as good as an asset held by the wealthiest person in the world. The amount held may differ but the quality of the asset and the process and parameters established to lend against it are the same. This simple fact is highly empowering and transformational for what might otherwise be marginalized groups.
Put simply, securing a loan using the home of the world’s richest person as collateral is an entirely different proposition from securing a loan against the home of a poor person in the one of the world’s most unstable countries. The two propositions differ in kind as well as degree. Securing a loan using bitcoin as collateral, however, is different between the world’s richest person and the poorest in degree only and not in kind because the asset itself is fungible.
Conclusion
It has been said that “we shape our tools and thereafter our tools shape us.” Less than two decades ago we created the decentralized block chain and trustless proof which is manifested most successfully today in bitcoin. Now, just as the old adage suggests, the tool we created seems to be shaping us by modifying how individuals and institutions interact, how loan contracts are structured, and how quickly contracts can be executed. It remains to be seen how successful the project will ultimately be, but it would behoove us as investors to continue to imagine what the future holds and to position ourselves as advantageously as possible for where the world is going.
One quick disclaimer before we wrap up. I haven't engaged in any bitcoin lending or borrowing personally. For now, I’m content to learn about the market and observe how it develops but I’ll be excited to share my experience if and when I do participate.
With that public service announcement out of the way I’d like to thank you again for listening. If you’d like to support the show you can always send us a boost on the Fountain podcasting app or drop us a note on our Substack page. We love hearing from all of you and we look forward to bringing you another episode again next week.
Bitcoin Lending