Bitcoin has dominated the news in 2017 with its remarkable gains, and despite widespread skepticism within the financial establishment, the cryptocurrency has continued to progress towards its integration into more traditional transactions. After seeing more and more retailers accepting bitcoin, supporters of virtual currency are now turning to a key traditional banking function: lending using bitcoin as collateral.
Big banks have yet to take the lead in offering bitcoin loans as a growth engine, but smaller niche institutions have emerged to explore the forefront of crypto-finance. There are two reasons that bitcoin loans are set to become the next big thing with digital currency investors, and even if you don’t plan to invest in bitcoin, you need to be careful. building the financial infrastructure to support crypto lending. .
1. Bitcoin owners need a tax-efficient exit strategy
The main reason that bitcoin-based lending is such a potential growth industry is that there is a growing body of wealth that bitcoin owners want to mine without incurring huge negative tax consequences. Under current tax law, whether you are selling bitcoin for a conventional currency or spending it on goods and services, the IRS taxes you on any gain between what you paid for that bitcoin and its value in US dollars when you sold it. The resulting capital gain is taxed either at ordinary tax rates for bitcoin held for one year or less, or at long-term capital gains rates if you have owned the cryptocurrency for more than one year. year.
However, a loan is not a taxable event. If you put bitcoin as collateral for a dollar loan, you can spend the money immediately without having to pay taxes on the appreciation of your bitcoin holdings. You are obligated to repay the loan in dollars, but you can sell bitcoin later when the loan matures and defer taxes until that later sale. Alternatively, you can probably extend the loan if your lender agrees – as long as the value of the bitcoin collateral remains sufficient to secure the loan. The desire to avoid taxes will drive the demand for bitcoin loans.
2. Bitcoin lenders can now hedge their risk
The potential problem with bitcoin loans has been on the lending side. Until recently, any institution that wanted to make bitcoin loans had no reasonable way to protect against a catastrophic drop in the value of its collateral. For example, a bank can lend someone $ 10,000, taking a single bitcoin as collateral. When the value of that bitcoin is between $ 15,000 and $ 20,000, that leaves a lot of room for prices to drop, but the bank could still face a potential loss if bitcoin drops below $ 10,000 and that the borrower has no other financial assets on which to collect.
This changed when the CBOE started trading bitcoin futures earlier this month. Now, a financial institution can use futures-based risk management techniques to hedge potential exposure to a bitcoin price collapse. The biggest Bitcoin CME Futures will be even more useful for large lenders in hedging strategies. As long as there are enthusiastic bitcoin investors willing to take the other side of financial institutions hedging transactions, lenders will be able to protect themselves.
Is there a systemic risk ahead?
As long as bitcoin loans have provisions for lending institutions to protect themselves from a volatile bitcoin market, the resulting risk should be manageable. The danger is that if the competition for bitcoin loans becomes fierce, lenders could relax their standards in order to gain more business. Without adequate protection, rapid and dramatic changes in bitcoin prices could make lenders vulnerable to more losses than they can afford.
Before large banking institutions are likely to get involved in bitcoin lending, you can expect them to develop their hedging strategies more precisely. For now, however, the smaller players involved in such transactions are likely to make mistakes that the market can learn from in the years to come, regardless of what happens to bitcoin prices in the interim. .