SPEECH TITLE: Bitcoin lending and yield
SPEAKER: Adam Back
CONFERENCE: Plan B Forum 2022

Introduction

I’m going to talk about bitcoin lending and yields and understanding the risks that are related to that and why they arise (sort of the natural interest rate for bitcoin).

Bitcoin asset as collateral

People talk about bitcoin as an interesting collateral because it’s bearer. So, if you provide it as collateral, it’s kind of hard asset, right? Other kinds of assets are not quite as guaranteed, so you’re relying on a custodian or relying on the borrower to not pledge the same asset multiple times. But because bitcoin is like a gold bar, if you give the gold bar to the bank, they know they have it. There’s no possibility for you to borrow against it multiple times. So, in mortgage lending, it’s a kind of scam where people try to take out multiple mortgages in parallel and complete on the same day, and then the lenders do a check to see if there’s another mortgage and there isn’t. But tomorrow, there are three mortgages on the same property, right? You know, that kind of thing is not going to be possible with bitcoin because you can’t duplicate it and the transactions are non-double spendable. So, only one lender would receive the bitcoin collateral and therefore release the loan. So, it has that kind of bearer advantage even though it’s electronic. But people who are going to lend against bitcoin are going to want the bitcoin as collateral because that’s their safety. They don’t want you to promise to give them the bitcoin because they’re worried that you might change your mind or that you might lose the keys. Now, you have a different problem as the borrower. You give somebody else your bitcoin that they could lose the keys, or more likely, and quite common in the fine print of the collateralized lending, is that the lender is allowed to lend the bitcoin to somebody else. So, you think, well, I gave them the bitcoin as guaranteed that I’m going to repay the loan, and they charge me a certain interest rate, but actually, they’re trying to get an even higher interest rate by lending your bitcoin to somebody else, sometimes without security. So, what you think of as a low-risk proposition, that they’re going to cold store it, turns into a high-risk proposition because, as we’re going to talk about, the main way to create yield on bitcoin, which has a low natural interest rate, is to lend it unsecured to other people, like hedge funds, such as Three Arrows Capital, who famously failed.

Rehypothecation

I was talking about re-lending, that’s called rehypothecation and is very common in the financial industry. People think that they have stocks in a brokerage account, but if they read the fine print, the brokerage is allowed to lend the stocks that you think you own, and in the worst case, the broker could come unstuck. They could have lent out, they could lose control of their risk and end up not being able to give back all the stock because they lent it to somebody else who lost money and defaulted. And they ended up holding a loss that they realized, and then they don’t have enough money to basically re-buy the assets that they’ve lost by over-rehypothecating. Of course, it’s attractive for the financial players because they can make more money, and they can lend the same asset multiple times or do fractional lending, but it does sort of magnify risk, increases overall leverage, and a default risk in a financial system. But it’s being replicated in a bitcoin space by some of the players, some of those things have come to reality in the last three months or so that DeFi-related lenders that were taking collateral under-secured have actually failed. That’s partly made more likely by the rehypothecation.

There are some lenders that don’t do rehypertification and take steps to prove to the borrower that the coins are not being lent out again. The way they can do that is typically with some kind of multi-sig. As the borrower of US Dollar stablecoins or something, you’re gonna put the bitcoin collateral into a multi-sig. There’s a few companies doing this: Unchained and Hodl Hodl. As a borrower, you put the bitcoins into a 2 of 3 multi-sig. You have one of the signatures, and the platform has one, and the lender has one. Sometimes the lender is the platform itself, sometimes it’s a peer-to-peer lending. So, Hodl Hodl, the lender is another user who’s lending the stablecoins. I think, in Unchained’s case, the third signature is a law firm as a kind of independent party, and they’re lending their own capital or capital from another bank or something like that. But at least you can see that in the Hodl Hodl case that the coins are not going to move unless both of the other parties collaborate it’ll collude against you. So there is a rationale for in a Hodl Hodl case for the platform to take the collateral, which is, if the borrower gets liquidated, there’s a loan-to-value ratio, and if the price falls too much, they could need to give the bitcoin or part of the bitcoin to the borrower to repay the dollars that you’ve borrowed. In that case, sometimes the borrower gets annoyed and won’t release the keys, and so in that case, the Hodl Hodl and the lender will sign to take the collateral. It’s manually managed, there’s 24 hours, and it’s relatively flexible because the borrower can change the loan-to-value ratio in a number of ways.

Bitcoin secured loans

They can partly or fully repay the loan in dollars, they can add more collateral at any time, and there is 24 hours notice once it gets within 90% of the liquidation level. I’d say it’s still fairly risky because bitcoin can move rapidly, what I’ve seen people do is take out a loan and then add extra collateral to just make it very low LTV and watch the price and try to keep it that way, you know, so if the price has moved a bit, they’ll add some more collateral or partly repay.

The platforms that are providing loans without collateral are typically doing unsecured re-lending, and it’s not always obvious who’s doing what. But there are a number of exchanges that earlier in the year, offered yield on bitcoin or other assets on the exchange. And the natural rate of interest on bitcoin is very low, so typically, they’re actually placing the money in somebody else in Celsius or Three Arrows Capital or in another fund that is placing it in one of those things. So, that’s basically what’s happening.

BTC loans and risks

Why do people want to borrow against bitcoin? A number of reasons. One is tax planning, to sort of defer a capital gain or to convert a capital gain from a short-term capital gain to a long-term capital gain. In some countries, there are different rates, or there is no long-term capital gain (like the long-term capital gain rate is zero percent), but the short-term capital gain rate is some higher percent. And so, if they need access to some money, they can borrow temporarily a low LTV to just get some cash for something they need to spend this year, and then next year, they’ll sell a small amount of bitcoin with low taxes and repay the loan. That’s one approach.

It seems like a lot of people are using it for leverage, which is high risk. They’ll borrow dollars against bitcoin and then turn around and buy more bitcoin with the dollars. Bitcoin’s already volatile, that adds to your risk. There’s a saying that if you are leveraged, it won’t turn a bad trade into a good trade, but it can turn a good trade into a bad trade. In other words, you can want to hold for the long term, but you’re forced to sell when you don’t want to. So, from that point of view, if bitcoin is volatile, maybe you’re better off without the leverage because you could end up with less bitcoin than if you’ve done nothing.

Another general problem with any kind of frequent trading is that sometimes people don’t account for taxes. They keep trading and they reinvest 100%, and then if their collection of bitcoin and other assets falls at the end of the tax year, they can end up with a tax liability, which is a very large proportion, or even over 100% in the worst case, of their remaining assets. And that obviously is very distressing for them. The point is, if you’re going to do that, you should set aside the estimated, so if you realize a gain, you should set aside the capital to pay tax. Otherwise, you’re taking an unsecured loan from the country you live-in’s tax department, and if they make a tax demand, that’s like a liquidation event if you don’t have the capital.

Another reason why leverage is high risk than people expect is effectively you’re using bitcoin as collateral to buy more bitcoin. If the price falls, you’re experiencing the fall more rapidly than you expect because the collateral falls in value, and the asset falls in value. If you model it out in a spreadsheet or something, you’ll see that this so-called quadratic effect, and it doesn’t take that big of a fall to create a liquidation risk. It’s pretty easy for that to get out of control.

2of3 secured collateral loans

The Hodl Hodl case is interesting. It’s fairly trustless and there’s not a great deal of documentation to take out the loan. Basically, you just sign up with an email, a password and it’s effectively non-KYC because it’s a loan secured by bitcoin between two users. Hodl Hodl is not really part of that and doesn’t need the usual loan documentation that you would need for a bank loan. Hodl Hodl’s only part in that is to access the arbitrator if there’s a liquidation that’s contested or something like that. The other advantage of the 2 of 3 is, if Hodl Hodl went out of business, the lender and a borrower could actually release the collateral at the maturity of the loan without involving the platform.

The thing to watch out for this is like cold storage during your own coins. If the lender and the borrower lose the passwords, there’s no recovery because really that 2 of 3 multi-sig you are effectively generating keys for it using the various passwords and Hodl Hodl is not a custodian, so they can’t help you recover it. If one of the parties lost the keys Hodl Hodl could possibly recover from it but if both of the parties lost the keys, you’ve now lost the bitcoin and maybe the stablecoin too (depending on how they’re stored). Typically, people are going to spend the stablecoins straight away or they wouldn’t have borrowed them.

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