Can debt ever be “good?” Your views on this question say a lot about not just your relationship to money, but your outlook on the world. Controversial though this subject may be, Bitcoin’s potential as a debt instrument has become a hot topic. This article discusses one way in which Bitcoin may become important in borrowing and lending.
Good Debt vs. Bad Debt
Bitcoin enthusiasts often react to the idea of debt with revulsion. After all, excessive mortgage debt triggered the 2008 financial crisis. Governments that papered over the crisis with more debt created even bigger problems that will eventually re-emerge. The well-known headline encoded into the Genesis Block by Satoshi Nakamoto speaks volumes: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Few forces strip people of their freedom and dignity like debt gone wrong: pawn shops; payday loans; usurious credit card interest; loan sharks; austerity measures; the endless cycle of borrowing just to tread water. The close connection between debt and slavery was documented at great length in the book Debt: The First 5,000 Years.
Given the strong negative emotions debt conjures, it’s easy to forget that debt is just a technology. And like any technology it can help or harm. The outcome largely depends on the skill and wisdom of the user.
Conventional wisdom says that good debt is money borrowed to pay for things that increase in value. For example, The Motley Fool puts it this way:
“Good debt” is typically defined as debt used to finance something that will increase in value in the future. Mortgage debt is a classic example: You get a mortgage to buy a house today, and in 30 years, when you’ve paid off that mortgage, the house could be worth two or three times its purchase price. Other examples of good debt include student loans (because getting a degree vastly improves your future earnings) and business loans (because putting money into your business allows you to expand and increase future profits).
The problem is that predicting the future value of anything, especially over long periods of time, is difficult even for experts. As the 2008 financial crisis proved, the house you buy with borrowed money may be worth a lot less than what you paid for it by the time you sell. Each new class of graduating college seniors gets a harsh dose of reality when some members discover that no employer wants to pay a premium for the degree that was earned with large sums of borrowed money. And about one third of all new businesses fail within two years in the United States, and so on.
In other words, the conventional wisdom is worse than useless as a tool to distinguish good debt from bad.
The missing ingredient from the conventional view of debt is the type of collateral being used. Collateral is property pledged by a borrower to a lender in the event of default. Because collateral protects the lender from total loss, loans using collateral are said to be “secured.”
Collateral can take many forms. Tangible collateral includes vehicles, land, and houses. Less tangible collateral might include a business or part of one.
Unsecured loans offer the lender little to nothing in the event of default. For example, a credit card company can try to collect on a default, but if the borrower has no money the lender gets nothing. The same applies to a payday lender. A loan shark threatening physical violence as a penalty for default is in the same boat. Breaking kneecaps or credit scores does little to restore the lender’s balance sheet. The high interest rates charged by lenders in uncollateralized loans offer protection from total loss should the borrower default.
The risk to a lender in a collateralized loan is captured in the loan-to-value ratio (LTV). It is defined as:
LTV = loan value/collateral value
All other things being equal, the risk to a lender rises and falls with the LTV ratio. For example, a ฿1 mortgage on a ฿10 house yields an LTV ratio of 0.1. If the borrower defaults, the lender stands to reap a ninefold return. Conversely, a loan of ฿4 for a car valued at ฿1 represents an LTV ratio of 4. The lender risks a 75% loss in the event of default. The LTV of an unsecured loan approaches infinity because the value of the collateral is at or near zero.
Although loan value is easy to quantify, collateral value can be more difficult. The costs of repossessing and liquidating property give the lender a strong incentive to demand an interest rate premium from the borrower. And the condition of physical property can significantly affect its resale value.
There’s another problem as well: divisibility. In the event of a single missed payment, the borrower stands to lose the entire unit of property. In taking out a mortgage or car loan, the borrower assumes the risk of losing all of the collateral if they hit a rough patch.
Accounting for borrower risks, we can arrive at a clearer picture of bad debt. Bad debt is any arrangement in which the borrower stands to lose physical, mental, or financial viability. A loan backed by an essential, illiquid, indivisible asset can cause a catastrophic loss for the borrower.
The difficulty of valuing and dividing collateral can lead to bad debt, even if the money was used to buy something that increases in value.
Bitcoin as Collateral
Three properties make bitcoin unique as a form of collateral:
- Fungibility. The value of a digital coin is based solely on its face value. Borrower and lender each value the collateral equally, reducing the costs of the loan.
- Divisibility. A digital coin can be split into units of smaller value without loss. This contrasts with indivisible collateral such as cars, paintings, and houses.
- Transferability. A coin can be sent from any user to any other without restriction and at low cost. The Bitcoin network’s censorship-resistance and nearly perfect uptime make this possible.
These three properties allow for efficient partial liquidation events (aka “shaving”). Partial liquidation occurs when part of a loan’s collateral is sold and the proceeds given to the lender. Conditions under which such an event might occur include failure to make a scheduled payment, and increase in LTV ratio due to exchange rate decline.
Partial liquidation can reduce risk for both borrower and lender. The lender knows that a payment will be received even when the borrower can’t or won’t pay. And the borrower knows that even in the event of a temporary financial setback, only that portion of the collateral needed to make payment will be lost. Repeated often enough, partial liquidation could even start to resemble a series of controlled cash-out events.
Bitcoin is interesting as a form of collateral for another reason — it scales better than anything that has come before it. Exactly the same systems can be used whether the loan amount is $100 or $1M.
Why would anyone in their right mind want to secure a loan with bitcoin? Here are some reasons:
- Borrowing against your bitcoin doesn’t trigger a capital gains tax event. In other words, you can “cash out” without paying taxes — legally. Depending on the purpose of the loan, you may even be able to deduct the interest from your taxable income.
- Your ability to sell bitcoin may be limited by your exchange’s withdrawal polices. A loan backed by your bitcoin, in contrast, can potentially far exceed this limit.
- If you repay the loan, you keep your bitcoin, no matter how much it may have increased (or decreased) in value in the meantime.
- Because your collateral is divisible, you can miss payments and only lose that portion needed to pay the lender. Contrast this with securing a loan with a car or house, in which case a single missed payment leads to total loss of collateral.
The wealthy have used liquid, fungible assets such as stocks and bonds to secure low-interest loans for a long time. The practice is so common that it has been dubbed “rich man’s subprime”. These loans come with few restrictions other than the proceeds can’t be used by the borrower to buy investment securities. Noting “significant risks,” FINRA even posted an advisory about securities-based loans in 2015.
Two companies are currently working toward making bitcoin-collateralized loans a reality. Unchained Capital offers bitcoin-secured loans of “up to $1,000,000 without a credit check,” a service launched in late 2017. Interest rates range from 10-14% for a 3-24 month term and an LTV of 50%. SALT Lending has been working toward a launch in late 2017. Of the two, more technical information is available for SALT Lending. Additional efforts around lending an bitcoin are also underway.
The SALT White Paper details the company’s approach to bitcoin-collateralized loans. A user interested in spending local currency can take out a loan denominated in that currency, but using bitcoin as collateral. Monthly payments are made from borrower to lender in local currency. At the end of the loan’s term, the borrower recovers the collateral.
Collateral used in a SALT loan is secured by a 2-of-3 multisignature script. The three parties are borrower, lender, and the SALT oracle. The oracle is responsible for initiating partial liquidations, which one of the two other parties must sign. This arrangement reduces, but doesn’t eliminate the risk that compromise of the oracle will lead to lost collateral.
Bitcoin offers unprecedented features for use as collateral in secured loans. Whether you like the idea of borrowing against bitcoin holdings or hate it, bitcoin-backed loans appear poised to play a major role in the digital economy.