I got a call from one of my clients this week, and he asked me to explain to him how the loans on Crypto.com work. He thought that he was able to access $4,000.00 by locking up $2,000.00 worth of bitcoin. In reality, it works the other way around. He is able to access $2,000.00 by locking up $4,000.00 worth of bitcoin. This is known as over-collateralization.
He was curious as to why it works this way, and whether or not this is a benefit for him for the debt to function like this. There are pros and cons depending on what actually ends up happening in the market. Let’s dig in.
Useful Reading
One of my previous newsletters on Using Debt and Leverage to Your Advantage covered the structure of debt within the crypto world. I cover key terms such as Loan to Value Ratio and Lending Rates.
Over-Collateraliztion of Loans
Crypto literacy is financial literacy. The more you know about how cryptocurrencies work, the better off you will be managing your own finances, regardless of whether or not cryptocurrencies are a part of your portfolio. There are concepts that you are exposed to within the world of cryptocurrency that prompt you to think differently about the financial services that you receive from the traditional financial (TradFi) system.
One of the things that forced me to think differently about credit, and loans, is over-collateralized debt. This is the opposite of how debt works within our current financial system and is worth understanding in depth. Let me lay out a scenario, then we can discuss the pros and cons of an over-collateralized debt agreement vs an under-collateralized debt agreement.
Debt Scenario
I want access to $5,000.00
I lock up $10,000.00 worth of Bitcoin and instantly get myself a loan for $5,000.00
I am free to do whatever I like with the $5,000
I pay interest on the $5,000.00 and the interest is typically added to the principle on a daily basis
Rules of the Debt
The borrower is allowed to take out at most 50% of the value of the collateral as debt
If the value of the borrower’s debt reaches 85% of the value of the collateral…
a. My collateral is liquidated by the lender (company or smart contract)
b. I do not need to pay back my debt
There are really just those two rules. Things get a bit more complicated depending on what you actually do with the money that you borrowed.
For example, if you decided to buy a cryptocurrency with the money that you borrowed two things can happen. The cryptocurrency can either go up in price or down in price.
If it goes up, then congratulations, you’ve made money from borrowed money
If it goes down in price then you start to find yourself in a sticky situation.
You still owe the money as a part of your debt agreement, but now you’re holding assets that you are unable to sell for the owed amount. The worst-case scenario is if the value of your collateral decreases to the point of liquidation, and the value of your cryptocurrency never increases to reimburse you for your lost collateral. I’ve had this happen to me and it’s not a fun situation to find yourself in.
Over vs Under Collateralized Debt
The world largely operates on an under-collateralized debt system. The majority of loans are not secured with assets of value totalling the amount of debt borrowed. Credit card debt, mortgages, and lines of credit are largely secured with your credit score. That being said, you can definitely use assets such as land, property, and even jewelry to secure higher and higher amounts of debt from financial institutions. Within the world of cryptocurrency, it is impractical to manage debt this way due to the irreversibility of cryptocurrency transactions.
Under-Collateralized Debt
Pros
With debt that is under-collateralized, you are essentially borrowing money that you think you will have the means to pay back in the future. The benefit of using under-collateralized debt is that you can live outside your current means. You can even use this debt strategically to enhance your quality of life or invest in a project that gives you cash flow to service the loan itself.
This is the ideal way to use under-collateralized debt and is actually the concept that underpins the entire fiat monetary system. Create (mint/print) new money today, to fund expansion, so that we have a more prosperous future. This is a scenario where capital is correctly and aptly deployed in the marketplace.
Cons
Misallocation is catastrophic for the borrower and can be problematic for the lender. If the borrower of money does not allocate capital correctly and ends up defaulting on their loan, multiple consequences ensue. The borrowers’ credit rating goes down, and can even go to 0 in the event that the borrower needs to declare bankruptcy. The lender also takes a loss on the debt agreement, as the debt was under-collateralized. Even if the bank would like to regain the entire value of the loan, the borrower does not have enough assets to pay back the amount they borrowed.
Our financial institutions have enough insurance, and safeguards in place to stomach a default every once in a while. However, if enough borrowers default on their loan at the same time, we end up with a situation like 2008. In this scenario, it is not just the borrower and the lender that end up losing money, the entire financial institution may need a bailout.
The only institution with the ability to come up with the amount of money needed to bail out banks is the central bank. In the event that they print money to bail out the banks, everyone using the currency suffers from a reduction in the price of the currency.
The practice of loaning out more money than what you have on hand has a name in the banking world; fractional reserve banking. We’ve been practicing FRB for centuries now. It has been around pretty much as long as banking itself. The issue with FRB is when the amount of reserves the banks are required to have on hand drops too low. As of 2020, American banks have a 0% reserve requirement.
This effectively means that they can create loans at will, without needing to have cash in their reserves. I hope this goes without saying, but I think this is the way that we get into runaway debt problems on a national scale.
Over-Collateralized Debt
Pros
Over-collateralized debt is much safer overall than under-collateralized debt. This is because there is always enough collateral securing the debt in the event that the borrower is unable to pay the debt back. Neither the borrow nor lending is at risk of not being able to pay back the debt.
If you need access to money, but do not want to incur capital gains tax from selling your assets, then over-collateralized debt is very helpful. Obtaining debt through over-collateralization allows you to obtain cash, keep your assets, and not pay capital gains. In other words, you can eat your cake and have it too.
I’m pretty sure this is not the case with the traditional financial system, but within the world of crypto, you can instantly get a loan at the click of a button. No questions asked, no paperwork, no credit check. This is because the immediate risk of taking on debt is zero.
Cons
The most apparent con to over-collateralized debt is that the borrower only (typically) receives 50% of the value of their collateral in cash. That means that you have to lock up twice as much money as you intend to take on as debt. An over-collateralized loan may not be the best and most efficient use of capital for the borrower. The borrower may just be better off selling their assets at once, or over time and using the money directly.
The alternative is paying interest on the debt and not having access to the underlying collateral. Additionally, as long as there is outstanding debt, the collateral is not able to be touched by the borrower. The borrower should be sure that they’re not going to need the collateral for any other reasons for the entire duration they intend on having the loan.
My Personal Debt Situation
IMAGES AND CONTENT REDACTED — [ May 1st 2022 ]
If you have any questions or need clarification on how any of this stuff works, don’t hesitate to comment below or respond to this email with your questions.
Regards,
Keegan
Resources:
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