Bitcoin (BTC -1.66%) is one of the most flexible types of assets you can own. At first glance, it is not immediately obvious why this is the case. To the uninitiated, Bitcoin looks like numbers on a screen. However, in recent years, an enormous amount of infrastructure has been built around Bitcoin to enable it to be useful in various new ways. One of these ways is to provide collateral to get into 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, which means the borrower must provide Bitcoin that is worth more than the amount they are borrowing. If someone puts up $10,000 worth of Bitcoin, a typical application will allow them to borrow at least $5,000 worth of stablecoins such as USDT (USDT -0.23%). Debt typically accumulates daily and can be repaid at any time without penalty. Bitcoin is locked until you repay the principal amount, in which case you can withdraw it.
Oversecured debt agreements are not without risk. If the value of Bitcoin falls too low, the lending platform will issue a margin call. This is a notification informing the borrower that the value of his collateral is too low and risks being liquidated. There are two thresholds here: the margin call level and the liquidation level. Each platform sets these thresholds for itself, but they are usually set as 80% and 85% of the collateral value, respectively.
So if a borrower uses $10,000 of Bitcoin to borrow $5,000 of stablecoins, and the value of Bitcoin drops to $6,000, the borrower receives a margin call. If the collateral falls to $5,750, the platform liquidates some or all of the Bitcoin to pay off the debt. In the worst case scenario, a borrower will lose all their Bitcoins following a liquidation. However, they could keep the original stablecoins 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 I borrow and the amount of collateral I have provided. Since Bitcoin can and has dropped 35% in the short time before, it’s 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 not to sell my Bitcoin. As soon as I do that, I would generate a taxable event that would eventually increase my tax bill at the end of the year. So if I need access to cash, the most tax-efficient way to do things is to borrow against my Bitcoin.
I could also use Bitcoin to take out a loan to pay an expense. If I need money, the guarantee provides me with an attractive alternative. USDT can be converted into US or Canadian dollars using an exchange, and I can then use that money to pay for expenses.
I can also take out a loan to generate a return. Instead of spending the USDT stablecoin, I can deposit it in a yield farm on a DeFi Platform. At this point I have turned my debt into a passive income stream. As long as the return on the yield farm is greater than the interest I’m paying on the loan, it’s a profitable arrangement.
Bitcoin is flexible
Some people tell me that Bitcoin is useless except for buying low and selling high. But Bitcoin can be guaranteed to go into debt for various reasons. To me, this proves that Bitcoin has a role to play in the future of our financial systems. Bitcoin is a sophisticated bearer instrument like gold, not just an obscure digital currency. I see financial institutions clinging to cases like this to grow and expand their service offerings. Such a flexible asset has its place in the global economy.