The State of Bitcoin As Collateral
The State of Bitcoin As Collateral
The State of Bitcoin As Collateral
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Banking on Bitcoin: BTC as Collateral
Banking on bitcoin
The case for bitcoin as collateral
The value of the global market for collateral is estimated to be close to $20 trillion in assets.
Government bonds and cash-based securities alike are currently the most important parts of a well-
functioning collateral market. However, in that, there is a growing weakness as rehypothecation
creates a systemic risk in the financial system as a whole. The increasing reuse of collateral makes
these assets far from risk-free and shows the potential instability of the financial markets and that it
is more fragile than many would like to admit.
Bitcoin could become an important part of the solution and challenge the dominating collateral
assets in the future.
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Banking on Bitcoin: BTC as Collateral
There are several reasons for bitcoin collateral's declining dominance in the futures market.
Stablecoin and USD collateralized futures are more favorable for long exposure. They are also less
complicated when trading altcoins than the BTC collateralized futures.
However, there are also clear advantages of using BTC as collateral in the derivatives market. BTC
collateralized futures are powerful hedging instruments and come without any counterparty risk. This
is different from stablecoin collateralized futures, which are exposed to risks affiliated with
centralized stablecoin issuers. We therefore expect BTC collateralized derivatives to maintain a
significant share in the future.
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Banking on Bitcoin: BTC as Collateral
As shown in the chart above, the open interest of the BTC futures market increased fivefold in 2020
and pushed all the way to $14 billion in January. After the March crash of 2020, an interesting trend
shift has been seen. Stablecoins and USD collateralized futures have started capturing larger parts of
the derivatives market, shifting dominance from BTC collateralized futures. As seen in the chart
below, BTC collateralized futures now only account for 57% of the open interest in the futures market,
compared to 86% on Jan 1st, 2020.
Figure 4: Bitcoin Used as Collateral in the Futures Market (Various Leverage Assumptions)
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Banking on Bitcoin: BTC as Collateral
About 95% of all the open interest in the bitcoin options market is
collateralized by bitcoin
Above, we discussed the futures side of the derivatives market, but there's also a thriving options
market using BTC as collateral. The open interest in the options market is approaching the size of the
entire bitcoin futures market's open interest.
In contrast to the futures market, bitcoin is by Figure 5: BTC Options Market - Open Interest
far the dominating means of collateral in the
options market, accounting for about 95% of
all contracts. Due to the lack of transparency
on how open interest is estimated in the
options market, we have excluded options
from our estimates of the total amount of BTC
used as collateral in the crypto market.
However, we assume that the collateral size
compared to the open interest is much smaller
than in the futures market, as traders get
exposure to large contracts just by purchasing
cheap options products. Hence, we assume a
much smaller collateral base than for futures,
Source: NYDIG, Skew, Bybt, CoinGecko
despite the similar size in open interest.
The lending market for bitcoin is young but rapidly growing. The first companies in this sector
launched their offerings only four to five years ago. This has now become a billion-dollar industry and
an essential part of the overall bitcoin market.
However, this is not surprising when we see how massive the lending activity in traditional markets is.
Collateralized loans are seen everywhere, from mortgages and cash loans to the enormous repo
market with overnight lending.
There are numerous reasons for using bitcoin as collateral for loans. The most common are leveraging
up on existing crypto positions, arbitrage plays, market-making and covering operation costs without
selling any holdings.
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Banking on Bitcoin: BTC as Collateral
Source: Credmark
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Banking on Bitcoin: BTC as Collateral
The company processed almost $20 Figure 8: Genesis - Active Loans Outstanding
billion on loans in 2020 to institutions
only, showing tremendous demand for
traditional actors entering crypto
lending. In Q4, the company pointed to
the inflow of institutional lenders as well.
Ultra-high-net-worth individuals,
corporations, traditional hedge funds,
and family offices wanted to enter the
market for the first time and were looking
to generate excess yield on idle cash.
There is clearly a significant demand for
liquidity in the crypto market.
Source: Genesis
Source: Genesis
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Banking on Bitcoin: BTC as Collateral
As seen above, 53.9% of all active loans from Genesis are in BTC. A substantial increase from the third
quarter, when only 40.8% of loans outstanding were in BTC. However, Genesis points toward the price
appreciation of bitcoin and hence its impact on its share of outstanding loans as the main reason.
However, the most exciting development of 2020 was the steady increase in ETH loans outstanding.
After ending Q1 at 5.5%, the share of ETH loans outstanding grew 177% over the next three quarters,
ending the year at 15.5%. Of course, some of this growth is attributable to ETH's price inflation. Still,
a significant part of these newly issued loans was tied to in-kind placements in Grayscale's Ethereum
Trust, according to Genesis.
BlockFi's internal numbers, shared with Arcane Research, shows that the company is a clear
competitor to Genesis on the institutional side. In 2020, BlockFi processed $18.6 billion in loans to its
institutions and private clients. The company had $4.4 billion in outstanding institutional loans by the
end of 2020, and according to David Olsson, VP, Head of Institutional Distribution at BlockFi, they
expect the growth to continue in 2021:
These clients are not just based in the U.S. but spread across the world. As seen in the chart below,
60% of BlockFi’s institutional clients are based in the U.S, 25% in the Asia-Pacific and the last 15% are
based in Europa.
Figure 10: BlockFi Institutional Clients
Source: BlockFi
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Banking on Bitcoin: BTC as Collateral
BlockFi has a valued offering among retail investors, where individuals can earn interest on deposited
cryptocurrencies, with 6%-8% interest rates. Customers can also borrow USD or stablecoins against
BTC, ETH or LTH and exchange between these assets and stablecoins when needed.
As seen in the chart below, BlockFi's internal numbers, shared with Arcane Research, shows that the
growth for BTC-collateralized loans has been remarkable over the past years, both in USD and BTC
terms.
Source: BlockFi
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Banking on Bitcoin: BTC as Collateral
A notable difference from other companies is the possibility of borrowing over 40 different fiat
currencies. The company is an E.U. licensed & regulated financial institution and $100 million worth
of custodial assets are insured via Lloyd's of London. Nexo has its own token, NEXO, which is backed
by the underlying assets of Nexo's loan portfolio. The current market cap of NEXO is $450 million, and
30% of Nexo's profit is shared with holders of the token in the form of dividends. The company has
processed over $8.2 billion on loans since its inception.
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Banking on Bitcoin: BTC as Collateral
This retail-focused company now has approximately $300 million in AuM. The two primary use cases
they see for BTC-collateralized loans are people wanting to cover everyday expenses through quick
loan products and leverage up their BTC positions with cash loans. When speaking to Michael Stroev,
COO and Head of Product at Nebeus, he said the following about the growth in 2020:
The demand for our bitcoin backed loans, OTC desk, and multisignature
custody has accelerated so far in 2021, and we expect to see demand
increase throughout the year due to the immense interest in bitcoin from
corporations and traditional wealth managers. A healthy bitcoin
economy to us means an increasing number of clients taking control of
private keys with our multisignature vaults and an increasing number of
long-term holders that are ready to improve their life with a loan from
their bitcoin."
The lending space is clearly full of companies that are revolutionizing how we think about lending.
Over time, this competition will see the rates fall, getting more aligned with lending rates in
traditional financial markets. The numbers show that retail customers are not alone in embracing
crypto-collateralized loans, but Genesis' $19 billion in processed loans in 2020 shows that the
institutions are here as well.
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Banking on Bitcoin: BTC as Collateral
Source: DeBank
BTC at work on Ethereum grew by 3,170% from June 2020 until today, as users wanted to utilize their
bitcoin as collateral in the vast field of DeFi platforms.
As we see from the chart to the right, the most Figure 14: BTC on Ethereum - Token Distribution
influential bitcoin-backed ERC-20 token is
Wrapped BTC (WBTC). It currently contributes to
72% of the total amount of BTC placed on
Ethereum. Tokens on WBTC are issued through
BitGo, which mints and redeems tokens as a
centralized third party. Once the WBTC tokens
are minted, the tokens can interact freely with
DeFi platforms, and BitGo cannot intervene in
these transactions. The centralized custody
solution is also utilized by Huobi BTC (HBTC),
currently the second-largest bitcoin-backed ERC-
20 token. Source: DeFi Pulse
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Banking on Bitcoin: BTC as Collateral
A plausible scenario as the market matures further should be reduced funding rates for BTC
collateralized perpetuals in addition to a lower premium rate on the BTC collateralized futures.
However, the counterparty risk affiliated with stablecoins could also maintain the status quo in terms
of the basis and funding rates of the derivative instruments.
In essence, it's hard to conclude on the further developments of the derivatives market. While BTC's
role as the leading collateral instrument is about to fall below 50% if the trend persists, regulatory
uncertainty looms in the stablecoin space, suggesting that bitcoin collateralized derivatives
instruments will continue to serve an important role onwards.
Source: Credmark, Assumptions by Arcane Research *Assuming that 50% of all collateral in the lending market is BTC
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Banking on Bitcoin: BTC as Collateral
High quality collateral often comes with a price premium. This occurs as the underlying properties of
the asset leads investor demand for said asset to increase. The same observation is true for bitcoin.
The lending market is currently in a phase of great adoption, onboarding new customers while
improving their services and offering high yields on deposits. The high interest rates will likely lead to
a further growth in users of the lending markets, and can have knock-on effects on the price of bitcoin
as more people demand bitcoin in order to deposit their bitcoin on lending platforms to earn a yield.
Furthermore, as the acceptance of bitcoin as collateral increases, the opportunity cost of holding
bitcoin will drop and its value increase. Holding bitcoin will give you increased financial freedom, a
freedom investors are willing to put a higher price tag on.
All these effects will likely lead to more growth in the BTC backed Ethereum protocols, as more users
seek to utilize their bitcoin as collateral in the decentralized markets.
15
Where Crypto Enters the
World of Finance
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in crypto.
As innovative products like lending platforms, Bitcoin-backed leverage and derivatives trading continue to drive
the evolution of the crypto industry, having access to secure, reliable and regulated spot exchanges has become
more important than ever. This is where Bitstamp comes in to strengthen the bridge between crypto and finance.
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to crypto
Banking on Bitcoin: BTC as Collateral
17
Banking on Bitcoin: BTC as Collateral
Contents
Report Summary: Banking on bitcoin ................................................................................................. 3
1 What is Collateral? .................................................................................................................... 19
1.1 Bitcoin’s unique properties ................................................................................................ 19
1.2 What is collateral? .............................................................................................................20
2 The Derivatives Market .............................................................................................................26
2.1 Futures market.................................................................................................................. 27
2.2 Options ............................................................................................................................. 35
3 The Lending Market ................................................................................................................. 37
3.1 Why bitcoin is used as collateral for loans ......................................................................... 39
3.2 The lending market in 2021 ............................................................................................... 41
3.3 Sizing the lending market .................................................................................................50
4 Decentralized Finance .............................................................................................................. 52
4.1 Defi-platforms..................................................................................................................... 53
4.2 Bitcoin as collateral in DeFi .................................................................................................54
4.3 Wrapped Bitcoin – Where is this used? ................................................................................56
5 The future of bitcoin collateral .................................................................................................. 57
5.1 Short-term development .................................................................................................. 57
5.2 The potential long-term development ............................................................................. 60
6 Appendix: Details on collateral assets .......................................................................................62
6.2 What’s the alternative collateral? ..................................................................................... 64
6.3 Comparison of collateral ................................................................................................... 67
6.4 Why bitcoin and not other cryptocurrencies? ................................................................... 68
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Banking on Bitcoin: BTC as Collateral
1 What is Collateral?
In this section, we will dive into the concept of collateral. What it is, which types of collateral are used
today, and what defines good collateral. But first, we want to introduce the reader to some of bitcoin's
unique properties, to keep in mind while reading the rest of this section.
No counterparty risk
Bitcoin is not backed by anything, and the value is inherent in the asset itself, as every individual can
store their bitcoin in their own wallets. The network is decentralized and secured by thousands of
computers worldwide. There is no third party who can seize the user's bitcoin or censor their
transactions. This makes bitcoin free of counterparty risk and leaves the individual in full control.
A global market
Bitcoin is borderless. Without centralized authority, the concept of borders is also removed, making
bitcoin global and available for everyone. The world has never seen a type of money that enables
instant transfer of value worldwide without relying on trusted intermediaries, such as banks or
governments.
24/7/365
The bitcoin market never closes, which means that the asset is available 24/7, 365 days per year. This
is without a doubt unique, as most financial markets are closed during weekends, limiting the hours
when assets are available for buying and selling, but also transferring. This makes bitcoin arguably the
most liquid asset in existence, as it's always available.
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Banking on Bitcoin: BTC as Collateral
The concept
Put simply, collateral is defined as the asset a The kind of assets that are used as collateral
lender requires as security for a loan. vary, but the next section will look at the most
Protection for the lender and secures their common ones.
values in case of default or trouble with
interest payments. If the borrower breaches
the agreed terms, the lender can seize the What kind of assets are used
collateral and sell it to secure its value. as collateral today?
Collateral is a useful tool to minimize risk and The most common type of collateral in
traditional financial markets are, without a
has grown to become a significant part of
doubt, government bonds and U.S.
today's financial world. There are a range of
Treasuries. There is a massive market for
collateral assets being used today, and some
overnight loans, the repo market. This enables
of the most common assets are bonds and
cash-based products alike, equities, real short-term borrowing of cash in exchange for
estate, and gold. The type of collateral is often government securities, often bonds. ICMA
related to the kind of loan in question. estimates that the global repo market may be
over EUR 15 trillion in outstanding size, with a
Naturally, mortgages are secured by houses
and car loans by cars, but there are a range of turnover of about EUR 3 trillion per day. They
other loans secured by other assets. also estimate that over 80% of EU-originated
repo collateral is in the form of government
bonds. Looking at the U.S. market, Treasury
Perhaps the most common type of
securities may account for about two-thirds of
collateralized loans are cash loans, both
the repo market.
personal and institutional. The need for
liquidity for personal use and business
So what are government bonds or Treasury
purposes has become an essential part of the
securities, you may ask? This is, put simply,
world economy. A commonly used term is
debt issued by the government and is defined
"Loan to Value" or LTV. This is the value that
as one of the safest assets to hold since it's
the borrower needs to post as collateral in
backed by the government. These are initially
relation to the loan value. For example, if a
issued to support government spending but
lender sets an LTV ratio of 0.5 and the
are also available in the secondary market.
borrower wants a loan of $100,000, the
collateral value needs to be 100% more than
Another type of collateral that perhaps feels
the loan value, which is $200,000.
more familiar for most readers is real estate.
𝐿𝑜𝑎𝑛 100,000 When borrowers apply for a mortgage, the real
𝐿𝑇𝑉 = = = 0.5 estate itself is used as collateral for security for
𝐶𝑜𝑙𝑙𝑎𝑡𝑒𝑟𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 200,000
the lender. Real estate is also categorized as a
very attractive and safe form of collateral, as it
historically has been holding its value well.
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Banking on Bitcoin: BTC as Collateral
This is another huge market, and the total discussed further in the next section, the
mortgage debt outstanding in the U.S. challenge of transferability takes us to a new
amounted to approximately 16 trillion U.S. and emerging asset that can be used as
dollars in 2019, according to Statista. collateral: bitcoin.
Other related business collaterals are As already mentioned at the beginning of this
inventory or plant and equipment, where report, bitcoin has several unique properties
lenders secure their values through company that make it optimal as collateral. It is the first
assets. hard asset without any credit or counterparty
risk. It is available in a global and liquid market
Using securities as collateral is also a common at all hours of the day. It's even easily
practice to access more liquidity. While this is transferable at a minimal cost.
often used to reinvest in the market and
increase one's exposure, it can also be used to This sounds like the perfect collateral asset,
access more cash for other purposes. but let's dive into a more detailed analysis of
what defines good collateral. Not even bitcoin
Gold has a long history as a reserve asset, and is perfect. Yet.
while the gold standard is not used by any
governments today, it has been a common The examples above show us that it is possible
system historically. Gold's role as money and to categorize collateral assets. On one side, we
collateral faded over time, but after the have bonds, securities, equities, and cash.
financial crisis of the late 2000s, it came back These assets have several issues, with
on the radar. In 2011, the European counterparty risk being the most problematic.
Parliament's Committee on Economic and
Monetary Affairs agreed to allow central A typical activity in financial markets is the
counterparties to accept gold as collateral. reuse and rehypothecation of collateral. The
Subsequently, gold has been reclassified to a IMF estimated in 2018 that the same collateral
Tier 1 asset under Basel III and increasingly was reused 2.2 times. Meaning that, on
accepted as collateral over the past ten years. average, collateral received in one transaction
is reused for more than two new transactions.
Even as gold has emerged as a global safe- Institutions typically receive collateral in the
haven asset and become a trillion-dollar repo market or derivatives transactions. If this
market, gold's collateral market is just a is eligible for reuse, they may post this as new
fraction of the likes of governments' bonds, collateral or use it in short sales. According to
equities, and real estate. Greg Muecke of the IMF, collateral reuse has become a
Tradewinds Markets highlights the lack of significant financial market activity and is a
digital ownership records as the main reason. common practice.
This makes it challenging to separate the value
of gold from its physical location. The logistical The reuse rate has increased again over the
challenges of transferring physical gold make past few years after a substantial setback after
it less attractive. Muecke furthermore the financial crisis in 2008, as a result of
explains: counterparty risk aversion. This leaves some
regulators and supervisors concerned. For
"Seven hundred years later, lenders still face example, the former Vice-President of the
the same issue they faced in 14th century ECB, Vítor Constâncio, has stressed that:
England: physically moving metal around the
globe is time-consuming and costly." "activities of rehypothecation and reuse of
securities amplified the creation of chains of
While gold satisfies many of the desired inside liquidity and higher leverage"
attributes for good collateral, which will be
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Banking on Bitcoin: BTC as Collateral
The Financial Stability Board (FSAB) has also experiment with quantitative easing like we've
analyzed this more broadly and found that never seen before and the constant cuts in
appropriate monitoring of collateral reuse at interest rates, puts fiat currencies under
the global level will be an important step extraordinary pressure and risk of devaluation.
forward, but that no immediate regulatory The money supply increase, yield curve
actions are needed. suppression, and debt monetization have
historically shown to create a bad environment
The IMF further highlights that collateral reuse for the pricing of bonds and cash instruments.
significantly increases asset price volatility
since more collateral becomes available in the On the other side, we find real, hard assets.
financial market. This allows participants to Real estate, gold, and more recently, bitcoin,
build up leverage beyond what is feasible in a fulfill these requirements. There is no
situation where no reuse of collateral is counterparty risk in these assets, as the value
possible. Another issue is the risk of losing is inherent in the asset itself.
purchasing power. The current monetary
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Banking on Bitcoin: BTC as Collateral
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Banking on Bitcoin: BTC as Collateral
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Banking on Bitcoin: BTC as Collateral
Derivatives Market
Arguably, the first significant collateral use case for bitcoin came with the introduction and growth of
the derivatives market in crypto. BTC collateralized derivatives have played an important role in BTC's
price discovery, but they are currently losing market share to USD and stablecoin collateralized
products.
Lending Market
The growth in the crypto lending market has been extraordinary over the past year, and 2020 has seen
billions of dollars from institutions being deployed in the lending market. The institution-focused and
market-leading company Genesis saw a YoY growth of 245% in their outstanding loans. Our
estimation shows that over 400,000 BTC could already be used as collateral in the lending market
today.
Decentralized Finance
The growth of DeFi in 2020 has incentivized bitcoin holders to tokenize their bitcoin on Ethereum to
use their bitcoin as collateral in the wide array of services offered from the various DeFi platforms. By
February 23rd, a total of 169,991 BTC has been tokenized on the Ethereum blockchain.
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Banking on Bitcoin: BTC as Collateral
As bitcoin started to gain traction, demand for Bitcoin became a convenient collateral in the
arenas to hedge and increase exposure arose. derivative market for several reasons. First of
Exchange infrastructure inspired by the all, the regulatory framework applied to the
framework of the traditional finance scene was derivatives market is strict. This made it
built, of course, with some disruptive difficult, if not impossible, for new exchanges
innovations given the crypto sector's to offer derivative products using fiat
experimental nature. currencies as collateral for trades. Secondly,
the stablecoin market was relatively nascent
Initially, the derivative exchanges in crypto all and small by the time the first major derivative
utilized bitcoin as collateral for trades. Bitcoin exchanges were built and started to gain
was mainly used as collateral out of sheer traction. Third, bitcoin is superb collateral for
convenience. the exchanges. But why?
1. Bitcoin's fast, reliable, and global transaction infrastructure enables derivatives exchanges to
expand globally at a rapid pace, as customers in every corner of the world are eligible and able to
send collateral and start trading in mere minutes.
2. Bitcoin collateralized exchanges are the clearinghouse. The exchange itself acts as the
clearinghouse and seize collateral when the counterparty defaults. The exchanges themselves
decide the optimal maintenance margin threshold and automate the liquidation process while
also building insurance funds to cope with extreme market movements.
3. By using bitcoin (or other crypto assets), the exchanges can offer trading products with far higher
leverage than those of the regulated markets. While the higher tiers of leverage are extreme, and
expected returns are more analogous with those of casinos, data from BitMEX clearly show that
users are not shy to commit to trades with the highest tiers of leverage available.
4. Traders who don't want to have stablecoin exposure or sit with dollars have an option to put their
bitcoin at work in leveraged trades.
5. The inverse nature of the bitcoin collateralized derivatives is ideal for shorting.
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Banking on Bitcoin: BTC as Collateral
In its essence, bitcoin collateralized futures rather than the exchange itself. In a case of a
exchanges work the following way: massive, rapid price move, large numbers of
A trader post bitcoin as collateral and commits bankruptcies may occur. Resulting in a BTC
to a trade. If the counterparty defaults, the deficit in the market. I.e., the funds are
exchange act as a clearing house, seizing the insufficient to cover the profits of the
position using auto-liquidation engines, profitable traders. In this case, the deficit is
stepping in to forcefully sell the trade in the proportionally distributed between the traders
market (if more collateral is not posted). who made a profit that day. Meaning the
Therefore, traders can decide to transfer traders get paid, but not the full amount. This
additional collateral to the exchange and avoid process is called socialized losses. To prevent
liquidation. socialized losses, the derivatives exchanges
have insurance funds. The insurance funds act
In other words, given Bitcoin's 24/7 up-time, as the last line of defense to prevent auto
traders can post more collateral at any time, if deleveraging. During normal volatility, the
needed. Thus, traders can manage their insurance fund is built up steadily by
margin balance in case the trade is about to liquidating trades on the maintenance margin
become liquidated. (0.5% of the margin).
Bitcoin-collateralized futures are inverse, The open interest in the BTC collateralized
meaning that the price is quoted in one futures market has trended upwards (when
currency, usually the dollar, and margined and denominated in USD) ever since inception.
settled in the base currency, bitcoin. Meaning Currently, around $6.7 billion worth of open
that the traded contract is priced in USD but interest is tied up in BTC collateralized futures
settled in BTC with the underlying contract trades. In BTC terms, the open interest has
being worth $1/BTCUSD, while the PnL
fallen. It peaked at around 350,000 BTC on Feb
calculations are priced in BTC.
25th, 2020, and has since fallen to 182,606 BTC,
Trading on the futures exchanges is peer to while stablecoin and USD margined futures
peer. The counterparty is another trader, has taken large market shares.
Figure 16: BTC Futures Market - Open Interest
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Banking on Bitcoin: BTC as Collateral
The bitcoin collateralized futures market is The perp was an innovative derivative
currently a space affiliated with fierce instrument. It shared most of the traits of
competition and many influential exchanges traditional futures contracts while
holding significant market share. The BTC differentiating itself from futures contracts by
collateralized futures market saw booming not having an expiry date. By using funding
interest following the 2017 bull market, as rates, the perps maintain a close peg to the
traders sought to leverage their bitcoin to spot markets. This funding rate is the
hedge and speculate amid the bear quintessential ingredient enabling the perps to
market. The market was then heavily trade without any expiry date.
dominated by BitMEX.
This quickly became a very popular derivative
The main reason behind BitMEX's dominance instrument in crypto, namely due to the
can be traced back to May 2016, when BitMEX convenience of not having to roll over any
launched the perpetual inverse swap contract positions. According to a paper issued by Carol
(perp). Alexander of University of Sussex Business
School, the trading volume of BitMEX's perps
surpassed those of the entire spot market in
2018, as illustrated in the chart below.
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Banking on Bitcoin: BTC as Collateral
The BitMEX dominance persisted for a while, On January 1st, 2020, BitMEX alone
but as exchanges saw the success of BitMEX's contributed to 58% of the open interest in the
perpetual, they launched similar derivative BTC collateralized futures market. By January
instruments. Over time, this made the 17th, 2021, BitMEX's dominance in the BTC
derivative scene more diverse, and throughout collateralized futures market had declined to
2020 BitMEX lost its role as the market-leading 15% of the total open interest for reasons we
BTC collateralized derivative platform, as will discuss later in this report.
visible in the chart below.
Now, OKEx is the leading entity in the market, 14% of the total open interest. Yet, Binance's
accounting for 25% of the total open interest. most popular derivative instrument, their
Interestingly, most of the open interest on linear perpetual swap, is collateralized in
OKEx is found in the futures contracts, Tether. There are advantages of stablecoin-
whereas the perpetual contract has not really collateralized derivatives, and we will uncover
garnered the attention on OKEx as it has on them later in the discussion.
other exchanges.
FTX offers a vast amount of derivative
Bybit has the largest BTC collateralized instruments and is arguably the most
perpetual contract but does not offer any innovative force in the derivative market. They
futures. Bybit holds 15% of the total open allow traders to post bitcoin as collateral for
interest in the market. their trades. However they use a cross-
collateralization model that leads the
Huobi and Deribit offer both perps and futures collateral to be converted to USD if the margin
on bitcoin and respectively contributes to 16% becomes insufficient. We, therefore, exclude
and 13% of the open interest in the BTC them from the market composition. All the
collateralized futures market. while, we both acknowledge their services,
their usage of bitcoin collateral, and also their
Binance is also a significant player in the BTC enormous growth over the last year.
collateralized futures market, contributing to
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Banking on Bitcoin: BTC as Collateral
The derivative market is relatively opaque. The reported weighted effective average
What we do know is the size of the open leverage ratio trended between a whooping
interest in the market. On February 3rd, 2021, 15x-40x for the entire duration. However, a
the BTC collateralized futures market had a large bulk of the contracts traded on the
total of $6.7 billion worth of open interest or platform were structured between 1-10x
about 182 000 BTC. The open interest is not leverage. Given the maturing market and the
representative of the actual BTC held as lack of recent data, we will base our market
collateral given that the futures markets are sizing on a more conservative leverage ratio,
high leveraged. In order to estimate the size of and acknowledge that we might overstate the
the BTC collateral held by exchanges, we size of the collateral held on the derivative
would either need to receive information from exchanges.
the derivative exchanges themselves on their
AUM or the average leverage ratio of their Below we've made a chart illustrating the
positions in the market. amount of BTC held as collateral on the
derivative exchanges under various leverage
Most exchanges were reluctant to disclose this assumptions.
information, so we're currently unable to
conduct any precise information on the total Given an assumed average leverage ratio
collateral held on these exchanges. However, across the BTC collateralized futures market of
back in 2019, in a fresh breath of transparency, 5x (blue line), we find that around 36 500 BTC
BitMEX published a blog on their leverage is currently used as collateral on the
statistics from May 2018 to April 2019, exchanges. Under higher leverage ratios, such
disclosing the average leverage ratio of trades as 10x (red line), the amount of BTC held as
on the platform while also revealing the collateral shrinks to 18 300 BTC. While an
distribution of contracts held under various average leverage ratio of 3x (teal line) gives a
degrees of leverage. collateral size of 60 869 BTC.
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Banking on Bitcoin: BTC as Collateral
Collateral discussion
Stablecoin and USD collateralized futures have taken large market shares from BTC
collateralized futures, and BTC collateralized futures now only account for 57% of the open
interest in the futures market, compared to 86% on January 1st, 2020.
As the derivative market in crypto has Several forces have driven these
matured, more kinds of collateral have been developments. The catalyst has been BitMEX's
introduced. With the launch of CME's BTC fall from grace, with the main drivers being the
futures in December 2017, accredited investors "Bloody Thursday" March 12th crash and the
could partake in leveraged bitcoin positions October 1st CFTC charges on BitMEX.
posting USD as margin (also settled in USD).
Meanwhile, exchanges have also begun
offering stablecoin-margined derivatives. The March 12th crash impacted the leveraged
long positions, as it led to a cascading of
The trend throughout 2020 has been that liquidations dragging bitcoin down from
more traders have moved over to stablecoin $8 000 to $3 800 in the course of 24 hour. The
and USD margined futures contracts, with crash ended as BitMEX went down for
bitcoin collateral losing major market shares maintenance. Following this crash, the bitter
the last year. consequences of over-leveraged trades
became clear, and the derivative market's
This is illustrated in the chart below, showing open interest took a hard hit. In addition to
that the total open interest of USD or that, BitMEX's reputation was also impacted
stablecoin collateralized futures (teal) and by examining the open interest in the
approaches the open interest of BTC market as a whole, it becomes clear that many
collateralized futures. BTC collateralized traders moved from BitMEX's perpetual to
futures now only account for 57% of the other markets. Many of which use stablecoin
market. as margin.
Figure 20: BTC Futures Market: Share of Open Interest by Contract Margin
31
Banking on Bitcoin: BTC as Collateral
On October 1st, BitMEX took another heavy hit as the CFTC charged the exchange for illegally
operating a cryptocurrency derivatives platform and anti-money laundering violations. This led to a
large outflow from BitMEX over to other competitors – at large to Binance. In addition, it led more
exchanges implementing stricter KYC-procedures to avoid the same faith that struck BitMEX. The
chart below illustrates the impact of these two events and how USD and stablecoin margined futures
now contribute to a significant amount of the open interest in the futures market of $13 billion.
The reasoning behind the movement of funds As the value of the collateral declines, the risk
from BitMEX to stablecoin margined of liquidation increases, meaning leveraged
derivatives products could be coincidental, but long trades on the inverse perpetuals are even
there are several arguments as to why more dangerous when collateralized in bitcoin
stablecoin-margined futures might be a better than with stablecoins. The convexity of BTC
instrument than bitcoin-margined futures for margined contracts is unfavorable for longs.
leveraged crypto exposure.
Absolute dollar return
Linear contracts Secondly, stablecoin margined perpetuals are
Firstly, the stablecoin-margined contracts are used more for absolute dollar return, than they
linear, meaning that exposure is constant, are for hedging market exposure, meaning
whereas the bitcoin-margined contracts are they are more frequently used by speculators
inverse. In a case where the trader enters a and arbitrageurs.
long position on an inverse contract and the
bitcoin price declines, the underlying collateral
for the trade will depreciate alongside the long
Less complex
position itself. Thirdly, stablecoin-collateralized derivatives
on altcoins are less complex than bitcoin-
collateralized derivatives. Bitcoin
32
Banking on Bitcoin: BTC as Collateral
collateralized derivatives on altcoin pairs are collateralized trades are more straight-
often solved by constructing quanto forward.
derivatives. They are collateralized and settled
in BTC, but the underlying pair does not These nuances could explain the 2020 trend of
involve BTC. Meaning, that if a trader longs an the market moving towards linear futures,
ETHUSD quanto derivative, and ETHUSD goes highlighting that there clearly are some
up, while BTCUSD goes down, the trader disadvantages to using bitcoin as collateral on
realizes a BTC gain, but BTCUSD dropped, and derivatives. This has prompted both BitMEX
in the end, her USD gain is much lower. and Deribit to seek to add new margin assets
Quanto contracts are thus more complex as to their exchanges in 2021.
they involve more variables, while stablecoin-
33
Banking on Bitcoin: BTC as Collateral
Yet, while stablecoins have some advantages compared to BTC as derivative collateral assets, the
picture is not all black and white.
34
Banking on Bitcoin: BTC as Collateral
2.2 Options
Here we've mainly focused on the futures side of the derivative market, but there also is a thriving
option market using BTC as collateral. The open interest in the options market is approaching the
size of the open interest of the entire futures market in bitcoin and has surpassed the open
interest of the bitcoin collateralized futures market.
On March 1st, 2020, the total open interest in the BTC options market sat at $760m. Now a year later
the total open interest sits at $6.3 billion after peaking at $9.8 billion by the end of January. That's a
growth of 1,186% in one year, marking 2020 the breakthrough year for bitcoin options!
35
Banking on Bitcoin: BTC as Collateral
While Deribit has a fiercely strong grasp of the BTC options market as of now, the exchange remains
bullish on the further growth potential for the platform and industry in general.
36
Banking on Bitcoin: BTC as Collateral
The lending market for bitcoin is young but Credmark, the industry-leading credit data
rapidly growing. The very first companies in firm, has been collecting data from all crypto
this sector launched their offerings only four to lending firms since 2018 and has invaluable
five years ago. This has now become a billion- insights into the untransparent world of crypto
dollar industry and an important part of the lending data. When talking to the CTO and Co-
overall bitcoin market. founder of CredMark, Neil Zumwalde, he
explains that collecting lending data from all
However, this is not surprising, when we see the companies has been as challenging as it
how massive the lending activity in traditional looks from the outside:
markets is. As discussed in section 1,
collateralized loans are seen everywhere, from "We have literally
mortgages and cash loans to the gigantic repo been running around
market with overnight lending. NYC for several years
to gather all this
One of the first companies that introduced data. It's not been
bitcoin-collateralized loans was Salt Lending. easy"
It was launched in 2016 by a group of bitcoin Neil Zumwalde,
enthusiasts and introduced asset backed CTO & Co-Founder, Credmark
lending to the cryptocurrency market and later
grew to become a 40+ employee company
offering both institutional-grade crypto
custody and blockchain monitoring products.
37
Banking on Bitcoin: BTC as Collateral
The table below shows the estimated size of between 0.5 -1. A LTV ratio of 0.5 means that
the crypto lending market and the growth over the borrower needs to deposit twice as much
the past years. As seen, the growth of 2020 has as the loan value, meaning that a loan of
been extraordinary. $100,000 would require that the borrower
deposits $200,000 as collateral.
The observant reader can see that the dollar This may seem like an unnecessary high buffer,
amount of all outstanding loans is much as the lender is secured against any loss as long
smaller than the amount of active collateral. as the value of the collateral doesn't drop more
This takes us back to the Loan to Value (LTV) than 50% before some of it is sold to cover
ratio that was discussed in section 1. Lending losses. However, as we saw in March last year,
companies are not interested in losing any a 50% can happen within a few days, and
money on their business and hence ask lending companies do not want to take any
borrowers to lock up more than they're unnecessary risk.
borrowing. This LTV ratio varies from the type
of borrower that is taking the loan, but is often
38
Banking on Bitcoin: BTC as Collateral
There are numerous reasons for using bitcoin as collateral for loans. The most common are for
leveraging up on existing crypto positions, arbitrage plays, market-making and covering
operation cost without selling any holdings.
There are several reasons for why crypto level. Referring back to the March crash of
lending has grown over the years. First of all, 2020 once again, we recall how the price
the world of digital assets enables a fast, easy, crashed brutally. Many have later blamed
and uncomplicated loan process, which is some of this on massive liquidation cascades
much more appealing than going through a from BitMEX and other derivatives platforms.
bank and mountains of paperwork. These A dangerous situation when the liquidity in the
collateralized loans are also available for crypto market was drying up due to the fear
anyone that can fulfill the collateral that was spreading across all financial markets
requirements. No credit checks or evaluations due to the Covid-19 outbreak.
from your bank, making lending available for a
broad range of people. These are also available Many retail traders experienced life-changing
worldwide, and you don't need a personal losses during the March crash. However,
relationship with your local bank to get a loan. institutional players in the lending market did
A new, digital and borderless lending market is not see the same liquidation problem,
emerging. according to Neil Zumwalde from CredMark:
So what are the most common use cases for "Only 10% of institutional borrowers saw
these bitcoin-collateralized loans? Are their positions getting liquidated, much
borrowers just taking out loans to get better lower than what was seen in other sections
cash flow in their everyday life? Not exactly. of the market"
There are many reasons why someone would
want to borrow against their crypto holdings: The structure of collateral in the lending
market differs from that seen in the derivatives
market. Borrowers are not always
Leverage up: buy more crypto automatically liquidated and often get up to
This is most likely the most common reason 72 hours to deposit additional collateral to save
and a clever way professionals increase their their positions. Lending companies do not
exposure in a cryptocurrency. By locking up have an interest in their customers getting
BTC or other cryptocurrencies, borrowers get liquidated, as their business is to provide loans.
a cash loan that is used instantly to buy more In the derivatives market, many platforms
cryptocurrency. Why don't these people just even have liquidation fees, locking in profits on
go to derivatives exchanges and increase their traders' losses.
exposure like other traders?
This shows the fundamental difference
There is one big difference: automated between leverage in the lending market and
liquidations. Leveraged trading through the derivatives market, and explains why this
lending gives a totally different liquidation is growing in popularity.
process. Many derivatives exchanges have
automated liquidation bots that sell your
positions when the price drops below a given
39
Banking on Bitcoin: BTC as Collateral
40
Banking on Bitcoin: BTC as Collateral
There is a sea of companies in this section of Several companies we have talked to are
the crypto industry. Some are heavily-focused highlighting the increase in the bitcoin price as
on institutional customers, others solely a clear driver of new loans over the past year
targeting retail and the consumer market. and at the beginning of 2021, as mentioned by
Nevertheless, the lending market is currently Phil Geiger, Director of Product Marketing at
in a state of rapid growth. It's been a great year Unchained Capital:
for most companies, driven by the increased
demand for bitcoin and the price rise of late.
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Banking on Bitcoin: BTC as Collateral
Genesis
One of the most prominent players in the Genesis started in 2013 when the company
lending market is Genesis. The company just launched the first U.S OTC bitcoin trading
published its Q4 2020 report and had an desk. Today, the company facilitates billions of
absolute banger of a year. The last quarter of dollars monthly in trades, loans, and
the year was described as "tremendous transactions. Genesis Products and Services
growth", and the company's active loans are only available to qualified Accredited
surged to $3,8 billion. This is a roughly 80% Investors and Institutional Investors. Their
growth from Q3. As seen below, the dollar one-stop-shop for institutional digital asset
amount of outstanding loans started growing needs has given Genesis a market-leading
exponentially during 2020 with a YoY growth position.
of 245%.
Source: Genesis
In Q4, the company pointed to the inflow of institutional lenders. Ultra-high-net-worth individuals,
corporations, traditional hedge funds, and family offices wanted to enter the market for the first time
and were looking to generate excess yield on idle cash. There is still a significant need for liquidity in
the crypto market, which results in favorable yields for participants who lend cash or stablecoins to
companies like Genesis. The counterparties to these institutional lenders are borrowers at Genesis,
who bring the liquidity out in the crypto market to profit on spreads and mispricing. Genesis
emphasizes that the recent bull run has shown that there still is a lack of cash to sophisticated trading
firms to fully collapse the structural basis that continues to persist between the futures and the spot
markets. Even with the possibility to earn double-digit yields on these spreads, Genesis highlights
that: "The funding curves continue to widen out given how much long exposure is being taken via
levered products relative to fully-funded spot buying".
42
Banking on Bitcoin: BTC as Collateral
Source: Genesis
Although the demand for cash is clearly As seen above, 53.9% of all active loans from
present, only 23.2% of Genesis' loans Genesis are in BTC. A substantial increase from
outstanding in the fourth quarter were USD the third quarter, when only 40.8% of loans
and equivalents. The chart below shows the outstanding were in BTC. However, Genesis
2020 loan portfolio composition for Genesis. points toward the price appreciation of bitcoin
and its impact on outstanding loans as the
main reason.
43
Banking on Bitcoin: BTC as Collateral
However, the most interesting development Arcane Research recently highlighted the
of 2020 was the steady increase in ETH loans decline in the premium of the Grayscale
outstanding. After ending Q1 at 5.5%, the Ethereum Trust. It's not hard to see why some
share of ETH loans outstanding grew 177% of investors have been placing ETH in Grayscale's
the next three quarters, ending the year at Trust this year, as the chart below shows how
15.5%. Some of this growth is, of course, the premium has been extremely high. The
attributable to ETH's price inflation but a sharp decline in the premium could suggest
significant part of these newly issued loans was that at least some determined sellers have
tied to in-kind placements in Grayscale's wanted to cash out on the shares received
Ethereum Trust, according to Genesis. after the lock-up period.
Source: NYDIG
*ETHE and ETHE NAV adjusted for 9-1 stock split pre Dec 17th
44
Banking on Bitcoin: BTC as Collateral
BlockFi
Another market-leading lending company that Moreover, BlockFi now has more than $10
most readers probably are familiar with is billion in asset on its platform with over
BlockFi. The company launched in 2017 and 125,000 funded accounts.
has become one of the industry's biggest
names, cleverly combining a traditional Over $500 million in BTC deposits
finance approach with the new possibilities of
crypto finance. from retail borrowers
As seen in the chart below, BlockFi internal
The U.S.-based and fully regulated company numbers, shared with Arcane Research, shows
doesn't have a utility token like many of its that the growth for BTC-collateralized loans
retail-focused competitors, but is backed by have been remarkable since launch, both in
some of the biggest names in the crypto USD and BTC terms.
industry. Their latest Series C funding round
was led by Morgan Creek and raised $50 The chart shows the total collateral from retail
million, taking the total equity funding to $100 customers at BlockFi. As BlockFi offers up to
million. 50% in Loan-to-Value (LTV) for retail
customers, that indicates outstanding
BlockFi has a valued offering among retail USD/stablecoins loans of more than $250
investors, where individuals can earn interest million by the end of 2020. This number does
on deposited cryptocurrencies, with 6%-8% not include loans that have ETH or LTC as
interest rates. Customers can also borrow USD collateral, so the total USD value of BlockFi’s
or stablecoins against BTC, ETH, or LTH and outstanding retail loans is most likely well
exchange between these assets and above $250 million.
stablecoins when needed.
Source: BlockFi
45
Banking on Bitcoin: BTC as Collateral
More than $4 billion in outstanding These clients are not just based in the U.S, but
spread across the world, as seen in the chart
institutional loans
below.
The company also has several offerings for
Figure 29: BlockFi Institutional Clients
institutions. Clients can borrow BTC, ETH, and
LTC for hedging, market-making, shorting or
other working capital needs, but also borrow
USD or stablecoins for dollar financing. BlockFi
also has an OTC desk and performs derivatives
transactions.
46
Banking on Bitcoin: BTC as Collateral
47
Banking on Bitcoin: BTC as Collateral
Different from the likes of Genesis and BlockFi, This retail-focused company now has
many of the retail-focused lending companies approximately $300 million in assets under
let customers earn yields on a much broader management, and the two primary use cases
group of cryptocurrencies. Celsius let they see for BTC-collateralized loans are
customers borrow by using more than 25 people wanting to cover every day expenses
different cryptocurrencies as collateral. through quick loan product and to leverage up
their BTC positions with cash loans. When
Nexo shares profits with token speaking to Michael Stroev, COO and Head of
Product at Nebeus, he said the following about
holders the growth in 2020:
Nexo has built a solid client base and has
surpassed 1 million users, and offers services to “The main trend is people realizing that
both retail and institutional customers through companies, like Nebeus, offer services that
instant crypto-backed loans with their fully- allow people to use their digital assets to get
automated platform. cash and earn a profit, all without selling
their digital assets. Moving their assets to
As many of its competitors, it offers both the Nebeus makes a lot more sense than
possibility to earn interest on cryptocurrency keeping them sitting in exchange platforms
deposits and to borrow with cryptocurrency as that don't provide any benefits.”
collateral. Nexo has more than $4 million in
assets under management, has processed over
$5 billion and accepts 16 cryptocurrencies.
- Michael Stroev, COO and
A notable difference from other companies is Head of Product at Nebeus
the possibility of borrowing over 40 different
fiat currencies. The company is a EU licensed &
regulated financial institution and has a $100
48
Banking on Bitcoin: BTC as Collateral
The demand for our bitcoin backed loans, OTC desk, and
multisignature custody has accelerated so far in 2021, and we expect
to see demand increase throughout the year due to the immense
interest in bitcoin from corporations and traditional wealth
managers. A healthy bitcoin economy to us means an increasing
number of clients taking control of private keys with our
multisignature vaults and an increasing number of long-term holders
that are ready to improve their life with a loan from their bitcoin.”
The lending space is clearly full of companies that are revolutionizing how we think about lending.
Over time, this competition will see the rates fall, getting more aligned with lending rates in
traditional financial markets. The numbers show that not only retail customers are embracing crypto-
collateralized loans, but Genesis $19 billion in processed loans in 2020 shows that the institutions are
here as well.
Another interesting development in 2020 was the rise of the DeFi lending market, where retail
customers deposited billions of dollars into both audited and unaudited smart contracts. The year saw
the rise of names like MakerDAO, Aave and Compound, and last year ended with roughly $3.5 billion
in outstanding loans from these three platforms, with almost $9 billion deposited as collateral. By
comparison, Genesis had $3,8 billion in active outstanding loans by the end of 2020, which shows that
the lending market in DeFi is significant and will challenge many CeFi companies over the next years.
While the DeFi space is mostly based on Ethereum, some have found clever ways to use bitcoin as
collateral in DeFi as well, which will be explained in more detail in the next section.
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Banking on Bitcoin: BTC as Collateral
Source: Credmark
Information regarding the distribution of the various assets used as collateral on the different
lending platforms is not disclosed. We’ve heard assumptions of 70-80% of the active collateral being
structured in the lending market, but have also found reporting that suggests the share of bitcoin
used as collateral is lower than that.
50
Banking on Bitcoin: BTC as Collateral
Recently, Genesis published their Q4 report highlighting that 53.9% of the loans outstanding were
BTC loans. This suggests that at least 53.9% of the loans from Genesis are not backed by BTC
collateral. Given that Genesis serves institutional investors and market makers, it’s natural that the
demand for bitcoin loans is higher than on other platforms, so we’ve established 50% as a satisfying
assumption of the size of bitcoin’s share as collateral in the lending market.
This gives us the approximate size of 420,000 BTC used as collateral in various loans in the lending
markets with a growth of 213,000 BTC from Q4 2019 to Q4 2020. We stress that this assumption is
not necessarily correct, but as long as the lending participants are careful with disclosing any
information regarding their AuM, it serves as a proxy to estimate the current size of BTC collateral in
lending.
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Banking on Bitcoin: BTC as Collateral
4 Decentralized Finance
The growth of DeFi in 2020 has incentivized bitcoin holders to tokenize their bitcoin on Ethereum
to use their bitcoin as collateral in the wide array of services offered from the various DeFi
platforms. By February 23rd, a total of 169,991 BTC has been tokenized on the Ethereum
blockchain.
One of the megatrends of 2020 in crypto was In DeFi, anyone is free to participate, and the
the massive growth in decentralized finance. DeFi products and on-chain assets can easily
From January 2020 till Febrary 2021, interest in interact with each other. The decentralized
DeFi blossomed. aspects of the sector makes regulatory
enforcement far more difficult. This makes
This is highlighted by the monumental growth charges similar to those of BitMEX by the CFTC
in total value locked in DeFi, growing a less likely, meaning that DeFi platforms may
staggering 5213% in 14 months from $670m to prosper in a more stringent regulatory realm.
$35.6b. This could drive more adoption into platforms
providing solutions similar to those the
In DeFi, protocols for both lending and centralized vendors deliver today.
derivatives have grown in popularity, and all
the while it’s all built on – and primarily utilizes The openness in DeFi however, does not come
– Ethereum, bitcoin’s role in the ecosystem has without a cost. To some extent, the regulatory
also been significant. enforcement is motivated, by part, in
protecting users from scams, or loss of funds
Given we’ve already touched on the lending via overleveraged risk. Freedom comes at a
markets and derivatives markets, it might be cost, and users of DeFi platforms should be
seen as redundant to explore the role of bitcoin aware of the potential of flawed code or illicit
as collateral within DeFi. actors leading to a loss of capital. This
discussion will not be covered more densely in
However, we deem the openness and this report, but we urge users to do proper
composability associated with DeFi as research before moving their funds into DeFi
fundamentally important to address and thus platforms.
want to expand on bitcoin collateralization and
its role in this vibrant ecosystem.
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Banking on Bitcoin: BTC as Collateral
4.1 Defi-platforms
The most popular platforms on DeFi today are associated with the lending markets and
decentralized exchanges.
Within the lending markets, Compound, Essentially, the automated market maker
Maker, and Aave had a total borrowing volume allows you to trade trustlessly in DeFi, and also
of $7.8 billion on Feb 22nd, 2021, as seen in the employ capital and become the house by
chart below. On June 15 , the day before the
th providing liquidity to a liquidity pool. Those
launch of the Compound governance token who contribute with liquidity to the liquidity
COMP, the total borrowing volume in DeFi sat pools acts as market makers on the exchanges
at $159m, meaning that the borrowing and are rewarded with fees for providing
volumes in the three major platforms has risen liquidity.
by more than 4800% over the course of 8
months. In other words, this model enables users to put
their capital to work in a scene traditionally
Another popular sector in DeFi is the dominated by highly liquid entities in a more
decentralized exchanges, with Uniswap, traditional order book centric framework.
Curve, Bancor and Sushiswap being the These liquid entities are often the main
dominating platforms. The decentralized borrowers on the centralized lending markets.
exchanges use an automated market maker- By utilizing the automated market maker
model. model, decentralized exchanges have
democratized the process of rewarding those
who tighten the spreads in the market, and in
turn a new way to earn yield on collateral has
risen.
Source: DeBank
53
Banking on Bitcoin: BTC as Collateral
Source: DefiPulse
As seen in the chart below, a total of 169 991 BTC are currently at work in various ERC-20 protocols
operating in the DeFi ecosystem. BTC at work on Ethereum grew by 3000 percent from June 1 , 2020 st
to Feb 23rd, 2021 as users deposited their BTC onto the various bitcoin-backed ERC-20 tokens to utilize
their bitcoin as collateral in the vast field of DeFi platforms.
54
Banking on Bitcoin: BTC as Collateral
The chart below illustrates the market distribution of the various BTC backed ERC-20 tokens as of
January 27th. As we see from the chart, the most influential bitcoin-backed ERC-20 token is currently
Wrapped BTC (WBTC), which currently contributes to 72% of the total amount of BTC placed on
Ethereum, as 115 000 BTC has been moved to WBTC. Tokens on WBTC are issued through BitGo, who
mints and redeems tokens as a centralized third party. Once the WBTC tokens are minted the tokens
can interact freely with DeFi platforms and BitGo cannot intervene in these transactions. The
centralized custody solution is also utilized by Huobi BTC (HBTC), currently the second largest bitcoin-
backed ERC-20 token, having issued 22 000 HBTC.
Source: DefiPulse
Among the smaller contributors to the pool of bitcoin on Ethereum we find the other custody
solutions. renBTC uses the hybrid solution, SBTC the synthetic solution, while TBTC uses the
decentralized custody solution.
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Banking on Bitcoin: BTC as Collateral
56
Banking on Bitcoin: BTC as Collateral
We’ve now made some firm assumptions on the major use cases for bitcoin as collateral today. The
lending market is clearly in a booming trend, and so is the case for DeFi, where bitcoin serves a role
via specialized wrapped protocols. Bitcoin collateral within the derivative market has currently
experienced a hiatus as stablecoin and USD margined futures are experiencing growing traction. Will
this trend persist?
Source: Credmark, Assumptions by Arcane Research *Assuming that 50% of all collateral in the lending market is BTC
57
Banking on Bitcoin: BTC as Collateral
This will have implications on the exchange However, currently the lending space is
balances, as the exchange balance will likely dominated by crypto-lending specialized start
decline as a result of BTC moving to other ups. As more household names start offering
sectors. It should however be, noted that dollar these services the long term effects of
collateralized bitcoin loans are likely also to increased competition could be a further
increase, with BTC borrowers moving funds to reduction of the interest rates, as institutional
exchanges, which potentially could impact the investors grow comfortable with depositing
exchange balance in the other direction. Yet, their bitcoin to earn a yield, in turn leading to a
given the overcollateralization of the lending further increase of the supply of deposited BTC
platforms with LTV ratios of .5, the overall in the lending market.
effect should be fewer BTC available on
exchanges. There’s already evidence of more familiar
names from traditional finance starting to
2) Interest rates offer these services as Fidelity recently started
accepting BTC collateral for cash loans, albeit
As more BTC is collateralized in the lending
through a BlockFi partnership.
markets, the interest rates will likely decline.
The current interest rate level of 6-10% on
By offering these services Fidelity seeks to add
bitcoin deposits is a clear evidence of high
more value to their custody solution. Recently
demand for bitcoin loans. As more BTC is
both JP Morgan and Goldman Sachs have been
deposited on lending platforms, the supply
rumored to launch custody solutions and it’s
effects should lead to lower interest rates.
not unlikely that they too will offer cash loans
A second dynamic that might also impact for BTC collateral to attract more adoption to
their services.
interest rates is the profitability and growth in
the sector. The major lending platforms have,
as showed repeatedly in this report,
experienced huge growth the last year. This
will most likely tempt new entities to accept
bitcoin collateral for cash loans.
58
Banking on Bitcoin: BTC as Collateral
59
Banking on Bitcoin: BTC as Collateral
Source: Bitstamp
60
Banking on Bitcoin: BTC as Collateral
61
Banking on Bitcoin: BTC as Collateral
As already mentioned, government bonds and significant interest rate cuts. The spike in late
U.S. Securities are the leading forms of 2019 is what we’re going to look closer at now.
collateral in financial markets. The repo
market is gigantic, and these overnight cash When repo rates increase, it is expected that
loans from large financial institutions are banks or other financial institutions would
collateralized with bonds or other low-risk withdraw excess cash held at the Fed and lend
assets. it into the repo market to take advantage of
the high rates. This did not happen. So why
However, certain systemic issues are weren’t these institutions willing to do this and
necessary to consider. We saw clear evidence get paid exceptionally well compared to an
of how fragile the system can be in September average day?
2019, when the US's repo market experienced
some historical spikes in overnight repo rates. We have already described the current reuse of
As explained in detail by the Financial Times, collateral in the repo market. The IMF has
the overnight repo rate spiked over 10%, a very estimated that the same collateral was reused
uncommon event. This led to the New York 2.2 times in 2018, often US Treasury securities.
Fed intervening in the repo market for the first These US Treasuries are supposedly risk-free,
time since the financial crisis by injecting cash but it's more complicated than that.
in an attempt to unblock the system.
As Caitlin Long highlights, these assets are not
What happened? risk-free because of the potential for the US
defaulting on its debt obligations but because
Someone needed cash badly and was willing to
of the collateral reuse. This is also called “re-
pay a high cost to obtain it. As seen in the chart
hypothecation.”
below, overnight repo rates have been close to
zero (0.1%) since March, when we experienced
Figure 39: U.S. Overnight Repo Rates*
Source: NewYorkFed *Treasury Repo Reference Rate: Broad General Collateral Rate (BGCR)
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Banking on Bitcoin: BTC as Collateral
The banks know this. There is no transparent “At the heart of the financial crisis, perhaps
overview of the financial system as a whole, the most critical element was the lack of
and we don’t know exactly how much of the visibility into the counterparty credit
US Treasuries collateral is double or triple exposure of one major financial institution to
counted. So while each institution can appear another. Probably the most glaring omission
solvent on paper, based on their positions in that needed to be addressed was that lack of
US Treasuries to fulfill capital and liquidity visibility, and here we are in 2016 and we still
requirements, the financial system as a whole don’t have it.”
is not solvent.
The IMF economist Dr. Manmohan Singh has
Caitlin Long uses an interesting analogy: published several pieces on the problem of re-
using collateral, the implications of collateral-
“It’s akin to musical chairs—no one knows chains. He has shown that the reuse rate has
how many players will be without a chair until climbed again over the past years. He has been
the music stops. Every player knows there recommending for years that regulators’
aren’t enough chairs. Everyone knows financial stability assessments of big banks be
someone will eventually lose.” adjusted to take into account “pledged
collateral, or the associated reuse of such
This gives us a better understanding of why the assets.”
repo market experiences these extreme
events. Banks are unwilling to take these bets, While government bonds and cash-based
which look like risk-free arbitrage when the securities alike are an integral part of a well-
repo rate spikes. This is not something functioning collateral market today, this
regulators speak about or admit, although illustrates the financial markets' potential
Long found this quote from the former CFTC instability.
Chairman Chris Giancarlo:
So, what’s the alternative collateral?
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Banking on Bitcoin: BTC as Collateral
The table below compares bitcoin, gold, and real estate and grades them based on the attributes of
good collateral, which was defined at the beginning of this report. Firstly, we’ll look at these assets'
liquidity and then discuss the safety attributes. Also, we’ll touch upon the storage capability of these
assets.
Table 2: Attributes of a Good Collateral
As seen from the table above, bitcoin’s unique properties make it optimal collateral. Although bitcoin
has a lower safety score than gold and real estate, this will improve as the asset matures. Bitcoin’s
high liquidity score is key in becoming a leading collateral asset, which is elaborated on in detail below.
This is mostly a summary of Fulgur Ventures’ estimates, with some adjustments.
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Banking on Bitcoin: BTC as Collateral
Liquidity Transferability
Bitcoin comes out on top in liquidity, with Another top score for bitcoin here, as it’s easy
nearly a full score, ending up with 9.2. Real and cheap to transfer, and the process is done
estate ended up with a low score of 2.8 in this in a few seconds. Responding to margin calls
section, while gold ended up slightly behind and topping up collateral is straightforward in
bitcoin with 6.8. bitcoin. On the other hand, we find gold: a
heavy asset that needs to be physically
transferred, a time-consuming and expensive
Market Liquidity experience. We have given gold a score of 4
As mentioned in section 1 of this report, a here. Real estate gets the lowest score
liquid market has a minimal spread between possible, as it’s more or less impossible to
the bid and the ask price, making large orders transfer.
possible without slippage and loss for the
seller. According to Fulgur, it is possible to sell
$1M bitcoin OTC with a spread between 0.1% Low deadweight cost
and 0.2%, which is pretty good. According to Both gold and bitcoin are fungible assets, and
BullionVault, the same seems to be true for we have followed Fulgur and given them both
gold, which has the same spread range. a score of 8. Real estate gets another low score
However, the spread is much higher in the (3), as it comes with an excess burden as
housing market, and Winkler et al. estimate collateral.
that the average spread for residential housing
is approximately 5%. Verifiability
Another home run for bitcoin, as the Bitcoin
Bitcoin is still a young asset, but we disagree network's decentralized manner lets anyone
with Fulgur and give bitcoin the same score as with a full node verify the asset. This is also
gold, 7, while real estate ends up with a 3 due much cheaper than verifying both real estate
to its much higher spread. and gold's authenticity. Real estate can have
hidden flaws, and gold can be fake. 2020 gave
Easy to value us a prime example of how this can end, as 83
Bitcoin is traded 24/7, all year around, so its tons of counterfeit gold was used as collateral
price is always updated. Hence, we deem for loans of almost $3 billion. One of China’s
bitcoin very easy to value and gives it a top largest gold jewelry manufacturers, Kingold
score of 10. On the other hand, gold is only Jewelry Inc, was behind the crime and had just
available for trading during the week and used gilded copper alloy. Many bitcoiners
hence challenging to value almost 30% of the joined the discussion when the story broke,
week (2 out of 7 days). Still, gold gets a 7 from and Tyler Winklevoss of Gemini noted:
us here, as the gold market price is highly
efficient during the week and not hard to “This is why bitcoin is gold 2.0. It’s
value. Real estate gets another low score here, mathematically impossible to counterfeit.”
ending up with another score of 3. There is
usually a limited number of buyers for a house,
and there is no effective price-setting
mechanism on top to get a valuation quickly.
This can take weeks.
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Banking on Bitcoin: BTC as Collateral
Source: Glassnode
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Banking on Bitcoin: BTC as Collateral
Anti-cyclicality
As discussed earlier in this report, investors 2020 when Covid-19 affected financial
want collateral assets that are non-correlated markets worldwide. Gold gets a higher score
to the financial markets. Bitcoin gets a score of than bitcoin and ends up with a 9, as it is less
7 here, as it historically has zero correlation affected by market turmoil and has been
with the stock market. You may ask why a non- uncorrelated with traditional markets
correlated asset only receives a score of 7? historically. Real estate gets a low score here
Bitcoin has shown to be highly correlated with (5), as recessions and negative economic shock
traditional markets when the fear is high and also have affected housing prices and demand
markets are plummeting. This was clear in historically.
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Banking on Bitcoin: BTC as Collateral
The network
Firstly, the bitcoin blockchain is the most secure of all blockchains today. No other cryptocurrency can
compete with the allocated resources worldwide to keep Bitcoin’s network safe. Bitcoin hashrate is
currently at 145.567 Ehash/s and shows the massive amount of computing power that is keeping the
network alive. Crypto51 highlights how much more it would cost to perform a 51% attack on bitcoin
than on other cryptocurrencies. As seen, bitcoin is much more expensive to attack, and the website is
intended to bring light to the risk of 51% attacks on smaller cryptocurrencies (although the numbers
are pretty outdated). Another example is this website, highlighting how many confirmations other
cryptos would need to be equivalent to six bitcoin transactions and hence be secure.
Liquidity
With the maturing infrastructure and market, larger players are entering. More traditional market
makers have entered bitcoin to provide liquidity, and bitcoin is the most traded cryptocurrency in the
space with the lowest spreads on exchanges and highest daily trading volumes.
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Banking on Bitcoin: BTC as Collateral
Disclaimer
• Banking on Bitcoin: BTC as Collateral (the “Report”) by Arcane Research is a report focusing on cryptocurrencies.
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