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One thing is for sure: the cryptocurrency landscape is changing; regulatory frameworks continue to evolve, as do new products. How can advisors help their clients navigate the options within the space?

In today’s issue, Meredith Yarbrough , managing partner at La Hoja Capital Partners, explores bitcoin’s role as collateral in lending and the potential benefits it can bring.

In Ask an Expert, Eric Tomaszewski from Verde Capital Management looks at bitcoin-backed mortgages, whether they exist, how they work, and the risks involved.

- Sarah Morton

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Bitcoin as Collateral: Good for Borrowers, Good for Lenders, Good for Investors

Finance, an ancient discipline shaped by various moral philosophies, has seen borrowing and lending practices evolve over centuries. Early Islamic, Judaic and Hindu traditions prioritized mutual benefit and asset stewardship, focusing on equitable risk-sharing rather than interest payments. In this context, thoughtful and pioneering credit managers are emerging to integrate bitcoin, a distinctive digital asset, into a novel opportunity to reshape financial relationships. When added to the collateral package in structured lending, bitcoin's inherent properties create potential benefits for borrowers, lenders and investors. By aligning the interests of all parties with a long-term perspective on asset value, bitcoin collateralization can foster a more sustainable and mutually beneficial approach to private credit.

Bitcoin as Collateral

We see innovative asset managers like Battery Finance Inc. use bitcoin in a hybrid collateral model where loans are underwritten based on the value of the real estate asset and a portion of bitcoin to be purchased with loan proceeds, thus creating two collateralized assets to secure the loan.

Bitcoin’s unique characteristics strengthen the loan structure, as it functions as both a growth asset and an inflation-sensitive asset. Its increasing adoption and market demand stem from its innovative blockchain technology and decentralized nature, positioning it as a store of value against inflation and geopolitical turmoil. Unlike precious metals, bitcoin's supply is truly finite, capped at 21 million coins, with mining projected to conclude around 2140. This scarcity contributes to its value proposition, reinforcing its role as a growth asset while enhancing its sensitivity to inflation dynamics.

Benefit to Lenders and Investors

The foremost responsibility of the credit manager is ensuring the return of principal and interest. Managers must balance yield targets with credit risk, often introducing incremental risk as the need for incremental yield fluctuates with interest rate changes and inflation outcomes.

Furthermore, in an environment of rapid and profound technological change, many sectors are under pressure to adapt their business models amidst uncertain transformations. Sustained periods of relatively high inflation intensify the challenges for these enterprises. For credit managers, any substantial change in operational strategies represents a substantial change in credit risk. By adding bitcoin to the collateral structure, a manager may reduce credit risk while maintaining yield targets.

Furthermore, bitcoin's substantial growth potential augments overall portfolio returns. By incorporating bitcoin collateral, portfolios benefit from enhanced diversification, as bitcoin's performance remains uncorrelated with traditional credit portfolio characteristics, such as interest rates and inflation dynamics. With this tool at their disposal, managers can prioritize high-quality borrowers and resilient structures, sidestepping the common dilemma of introducing incremental credit risk to achieve incremental yield.

Benefit to Borrowers

Integrating bitcoin into the collateral structure offers significant advantages for borrowers by fostering a shared long-term perspective on its value. This alignment ensures that lenders are incentivized to act in the best interest of the partnership.

Borrowers benefit from the professional management of the bitcoin asset by the credit manager, who monitors price thresholds and manages profit events. This active management helps optimize the asset's value, providing borrowers with an added layer of expertise and oversight. Additionally, the accrual of bitcoin equity offers borrowers greater flexibility, allowing for pre-payment and early exit options from the loan.

Furthermore, incorporating bitcoin into the collateral package can provide borrowers with access to more favorable loan terms. The enhanced collateral security may lead to lower interest rates and better borrowing conditions, reflecting the reduced risk profile of the loan. Bitcoin’s emergence in collateral structures has the potential to revolutionize the lending landscape. Its ability to mitigate credit risk amid escalating uncertainties highlights its transformative power.

Ultimately, the successful implementation of this strategy hinges on the competence and agility of the credit management team.

- Meredith Yarbrough, managing partner, La Hoja Capital Partners

Ask an Expert

Q: Can I utilize bitcoin as collateral to purchase a home?

Yes, there are ways to use bitcoin for this purpose, but it's complicated and dependent on several factors. However, how the bitcoin is custodied or wrapped can narrow the options.

It's more important to ask yourself how bitcoin fits into your goals and expectations for you and your family. From there, it's about assessing the risks, which are volatility with your collateral, potential liquidation risks, regulatory risks and custodial risks.

Q: Can you dive further into the risks?

Regulatory Environment : The legal/regulatory landscape for using bitcoin as collateral for mortgages is still evolving. Staying informed is key.

Volatility and Risk Management : Bitcoin's price volatility presents a significant risk. That is an understatement as BTC just traded 20% lower in less than 24 hours. Price moves are important as lenders typically require a lower loan-to-value (LTV) ratio to mitigate this risk, meaning borrowers may need to provide substantial collateral.

Interest Rates and Fees : Interest rates and fees for bitcoin-backed mortgages may differ from traditional mortgages and have, in most cases, been several percentage points. Borrowers need to compare the costs and benefits of these innovative products.

Security/Custody : Ensuring the security of the collateral is also a key element. Lenders often use third-party or multi-sig wallets to safeguard the bitcoin collateral.

- Eric Tomaszewski, Financial Advisor, Verde Capital Management

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