When applying for a loan, you’ll come across a term: collateral. It’s an asset that the lender accepts as security for the loan. If you default on the loan, the lender can seize the collateral and sell it to repay the debt. The financial institution needs a guarantee that the loan they’ve given the buyer isn’t a lost fund. Collateral typically takes the form of real estate. Since the collateral offers assurance that you’ll pay back the money, the loan secured by collateral has lower interest rates. You, for your part, have a compelling reason to pay the loan on time, as you stand to lose the asset you’ve pledged as collateral.
Besides real estate, other common types of collateral include vehicles, gold, cash, stocks, and bonds. Soon enough, Bitcoin (BTC) will be used on a large scale as collateral for lending. At present, very few companies accept BTC as collateral for a loan. Bitcoin can be used to take out a stablecoin loan and serves as a means of insurance for the lender. You must pledge a certain amount of your digital asset to access a percentage of the value of that asset in stablecoins. You can access liquidity without selling your holdings, which can be tax advantageous.
There are two types of crypto loans, namely centralized finance (CeFi) and decentralized finance (DeFi). The former is a custodial crypto loan where the lender has full control over the Bitcoin during the repayment term, while the latter relies on smart contracts to ensure the borrower meets the loan requirements. Once you receive the money, you can do whatever you like with it. Carefully consider the loan-to-value ratio. Be sure you know what you’re doing and time the market perfectly.
Is Bitcoin the Perfect Collateral Asset? Let’s Find Out
Bitcoin is an asset, not a currency, as many mistakenly believe. Investors are savvy and know that having BTC in their wallets is a true advantage, deserving consideration. Its monetary supply is fixed, and Bitcoin is non-inflationary. The BTC price changes on a grander scale than local currencies, so you should reach out to a financial advisor before making any significant decisions. There’s a big difference between Bitcoin and stocks and bonds from an economic standpoint. Now coming back to the topic at hand, it makes sense that BTC should be used as security. Even if some banks have started to offer traditional loans using Bitcoin as collateral, it’s not the norm in the market.
The Case for Bitcoin as Collateral
As Bitcoin gains more relevance in mainstream finance, it becomes paramount that it’s examined as to how it would fit into our current systems and institutions. For starters, BTC is unlike any other asset class. More specifically, it’s available for trading 24 hours a day, seven days a week, all over the world. The digital money can be transferred on the spot, at no cost, at any time. Every user is identified through multiple combinations of numerical keys. Since there’s no name attached to any user, the transactions are private. Bitcoin is without counterparty risk. There’s no likelihood of one of the parties involved in the transaction defaulting on its contractual obligation.
One of the biggest sources of counterparty risk in the modern financial system is the rehypothecation of collateral. Collateral used in one transaction is deployed for one or two new transactions. Simply put, the lender borrows money from another financial institution using the asset you originally submitted as collateral. If you borrow against your BTC, you can access the wallet address via the online platform’s interface or a blockchain explorer. You can verify if the collateral is stored in the same place and monitor your escrow account in true time. The transactions are searchable in the database to anyone who can access it.
As mentioned earlier, some institutions have entered the lending market. It’s estimated that roughly 400,000 BTC are already used as collateral in the market. Reasons for using Bitcoin as collateral for loans include but aren’t limited to taking advantage of the current positions, arbitrage plays, market-making, and covering operation costs without selling any holdings. BTC storage is straightforward, and there’s no daily maintenance. It just needs to be kept safe from cyberattacks. The most common type of crypto scam is phishing emails, where malicious actors send emails requesting login credentials to the account.
Leverage Up: Buy More Bitcoin
By securing Bitcoin and other cryptocurrencies, you can get a cash loan that you can use right away. From a spending perspective, you’re encouraged to spend fiat money. Your attempt to exchange it for goods and services will no doubt be successful. Equally, you can use the loan to buy more cryptocurrency. Leveraged trading through lending implies a completely different liquidation process. You’re not automatically liquidated. As a matter of fact, you have a few days to deposit more collateral to save your positions. It’s not in the best interest of lending companies for customers to get liquidated. In the derivatives market, it’s a completely different story.
There are substantial opportunities for the leveraged trading of digital assets. Both parties in the equation are secured by the blockchain protocol, so they find inherent value in leveraged trading and secured lending. Although there’s potential for high earnings, there’s no guarantee. As a result, leveraged trading is suitable only for experienced traders. If you’d like to go ahead with your plan, examine your financial situation, determine how much you’re willing to risk, and carry out a detailed analysis of the cryptocurrencies you’re looking to trade. A combination of BTC and stablecoins will reduce your portfolio’s sensitivity to market fluctuations.
To sum up, BTC might be used as collateral for lending in the near future. The Bitcoin blockchain is the most secure one, mining is becoming more decentralized, and traditional market players provide liquidity. The collateral itself can be used for further investment. Stablecoins can be used for collateralized loans, but they come with counterparty risk. The consequences for the borrower can be disastrous.
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