Bitcoin (BTC 5.58%) is one of the most flexible types of asset you can own. Upon first glance, it is not immediately obvious why this is the case. To the uninitiated, Bitcoin just looks like digits on a screen. However, in recent years, an enormous amount of infrastructure has been built up around Bitcoin to allow it to be useful in a variety of new ways. One of those ways is as collateral to take on debt.
Bitcoin can be used as collateral to take on debt
How Bitcoin works as collateral
Bitcoin can function as collateral on cryptocurrency exchanges and decentralized finance (DeFi) applications. In either case a user can take out a loan against their Bitcoin. These loans use overcollateralization, meaning that the borrower must supply Bitcoin that's worth more than the amount they borrow. If someone puts up $10,000 worth of Bitcoin, then a typical application will allow them to borrow at least $5,000 worth of stablecoins such as USDT (USDT -0.02%). The debt typically accrues daily and may be paid back at any time without penalty. The Bitcoin is locked up until you repay the principal amount back, at which point you can withdraw it.
Overcollateralized debt agreements do not come without risk. If the value of Bitcoin drops too low, then the lending platform will issue a margin call. This is a notification telling the borrower that the value of their collateral is too low and is at risk of being liquidated. There are two thresholds here: the margin call level and the liquidation level. Each platform defines these thresholds for itself, but they are usually defined as 80% and 85% of the value of the collateral, respectively.
So if a borrower uses $10,000 worth of Bitcoin to borrow $5,000 worth of stablecoins, and the value of the Bitcoin drops to $6,000, the borrower is given a margin call. If the collateral drops to $5,750, the platform liquidates some or all of the Bitcoin to pay down the debt. In the worst-case scenario, a borrower will lose all their Bitcoin from a liquidation. However, they would get to keep the original stablecoins that they borrowed in the first place.
Given the risk of being liquidated, and the volatility of Bitcoin, it is crucial that I carefully manage my loan-to-value ratio -- the ratio between the amount that I am borrowing and the amount of collateral I've provided. Since Bitcoin can and has dropped 35% in a short time before, it is ideal if I keep my loan-to-value ratio below 50%.
How I use Bitcoin as collateral
There are three reasons I might consider collateralizing my Bitcoin. The first is to pay less tax. I prefer to not sell my Bitcoin. As soon as I do, I would generate a taxable event that would end up increasing my tax bill at the end of the year. So if I need access to money, the more tax-advantageous way of doing things is to borrow against my Bitcoin.
I could also use Bitcoin to take out a loan for paying an expense. If I need money, then collateralizing provides me with an appealing alternative. The USDT can be turned into U.S. or Canadian dollars with the help of an exchange, and I can then use that money to pay the expense.
I can also take out a loan to generate a return. Instead of spending the USDT stablecoin, I can deposit it into a yield farm on a DeFi platform. At this point, I've turned my debt into a passive income stream. As long as the return on the yield farm is higher than the interest I'm paying on the loan, this is a profitable arrangement.
Bitcoin is flexible
Some people tell me that Bitcoin is useless other than for buying low and selling high. But Bitcoin can be collateralized to take on debt for a variety of reasons. To me, this proves that Bitcoin has a role in the future of our financial systems. Bitcoin is a sophisticated bearer instrument like gold, not just an obscure digital money. I see financial institutions latching on to use cases like this to build and expand on their service offerings. Such a flexible asset has its place in the world economy.
