Zac Prince, Founder and CEO of BlockFi, recently joined the Bitcoin Fundamentals
podcast to talk with host Preston Pysh and Mark Yusko of Morgan Creek Capital Management about the fundamentals of Bitcoin lending, why it’s important, and BlockFi’s vital role in the market. Here are some of the key issues they covered.
A Game-Changing Innovation
Credit-lending allows consumers to access otherwise unobtainable capital in order to pay off debt, make large purchases, or invest in the economy. In recent years, the credit-lending market has become a ripe environment for fintech companies. After banks pulled out of lending markets following the financial crises, consumers and institutions weren’t able to access debit and credit as they once could. Firms like SoFi and LendingClub filled the void left by banks, and the online lending industry as a whole has been able to capitalize. Fintech is now responsible for 38% of the personal loan market in the US.
In some ways, fintech is simply a new wrapper on the traditional financial system, with a focus on online platforms, intuitive UI, and ease of access. Bitcoin, however, represents more dramatic innovation.
“Bitcoin isn’t necessarily a brand new asset, but it’s built on top of a brand new network that enables you to access assets around the world with no intermediary, 24/7, and it’s completely global by design,” said Zac Prince.
This “brand new network” relies on Bitcoin for capital. From the user’s perspective, obtaining a Bitcoin-backed loan feels like interacting with any other financial services company, except it’s in the crypto space. Clients go through know your customer (KYC) procedures, create an account, transfer their Bitcoin to a generated wallet address, and then access their loan in their account.
As Mark Yusko put it, BlockFi is “a financial services company utilizing the wave of technology around blockchain and Bitcoin and crypto to provide essential services as we transition from the analog to the electronic and, ultimately, to the digital financial ecosystem that’s ahead.”
More Than Bitcoin
Although Bitcoin dominates the crypto lending market, consumers can put up capital using other cryptocurrencies, including Ethereum and Litecoin. At BlockFi, clients can receive their loan in different stablecoins, which are one-to-one interchangeable with dollars, or even PAX Gold. Clients can continue to earn crypto interest on their stablecoins once they receive them at up to 8.6% APY.
How Does Bitcoin Lending Actually Work?
If a client secures a Bitcoin-backed loan with BlockFi, their Bitcoin collateral is commingled with BlockFi’s other assets. In order to pay our clients crypto interest on a monthly basis and to meet withdrawal requests on a timely basis, we engage in a number of activities, including (1) keeping a material amount of digital assets available for withdrawal with third parties such as Gemini, BitGo, and Coinbase; (2) purchasing, as principal, SEC-regulated equities and predominately CFTC-regulated futures and (3) applying risk management to the lending activities in the institutional market. The credit risks to these institutions are mitigated by credit due diligence and/or collateral (such as cash, crypto, or other assets).
BlockFi has two different kinds of clients accessing loans. We have retail clients, e.g. any non-business entity, and we have institutional clients. Retail clients borrow directly through our mobile or web app, receiving funds that are secured by the value of their cryptocurrency holdings on BlockFi’s platform. Institutional borrowers, on the other hand, have the option to secure over-collateralized, one-to-one collateralized, or under-collateralized loans.
Institutional clients looking to secure an over-collateralized loan from BlockFi’s platform need to post collateral that is above the amount they are borrowing. For instance, if a client is seeking a loan for a single Bitcoin, they might need to deposit 1.5 or two Bitcoins’ worth of value. Over-collateralization contributes to the overall protection of BlockFi’s clients’ assets.
Let’s say an institutional client takes out a Bitcoin loan. Soon after, the price of Bitcoin begins to drop. The borrower receives a margin call, and the Bitcoin provided by BlockFi clients is still safe. If the price continues to drop to the point of parity with the original over-collateralized amount and the client hasn’t stepped back into the market to replenish their escrow, the collateral might then be liquidated to keep the Bitcoin protected.
“This is so different from how anything works in traditional finance because [in traditional finance] you might have to wait two days for a stock certificate to clear,” explained Zac Prince. “That’s a huge risk. Even if you are over-collateralized, that’s a risk if you can’t step into the market and settle immediately.”
By contrast, in the crypto space, trades occur 365 days a year and 24 hours a day on a global scale. That makes it possible to step in if the price drops dramatically and to sell immediately.
Bitcoin-backed loans can be advantageous for investors who currently hold Bitcoin and are bullish on the future trajectory of the price, but need immediate liquidity for an unexpected expense or investment opportunity. Bitcoin-backed loans offer the ability to continue holding Bitcoin while achieving liquidity without the tax burden of selling Bitcoin.
“If your cost basis on Bitcoin is really low, and potentially half of the position or more than half of the position is a gain, paying 25 to 50 percent in taxes on a large part of your Bitcoin holding is a very expensive way to finance something,” Prince explained. “When you get a loan, you’re not selling your Bitcoin and you benefit from any price appreciation that may occur.”
Borrowing Bitcoin is only available to institutional investors. These investors are primarily market-making firms, trading firms, hedge funds, and other institutions active in the cryptocurrency market. One purpose of these loans is that traditional financial institutions might not be actively helping them participate in the cryptocurrency market.
What’s the Use Case?
Market-making is one of the most fundamental use cases for Bitcoin lending. This process involves a client buying Bitcoin for one price and selling it for a higher price. Market makers perform these trades throughout the day, provide the market with liquidity, and get paid by capturing the spreads in their trades. This strategy occurs in traditional markets as well, but since the crypto market is still nascent, the level of sophistication required to capture the spreads is dramatically lower than what’s typically needed in traditional markets.
Bitcoin lending, and companies like BlockFi, offer institutional investors the ability to buy and sell crypto at a larger scale.
Managing the Risks
In terms of clients’ assets, BlockFi has a perfect performance record with no losses through our lending activities. This record was maintained through the market capitulation coming off of the $20K Bitcoin high in October of 2018 and even through the coronavirus pandemic.
“The day after Bitcoin went down by 50 percent, we were operating across our entire platform completely normally,” said Prince. “We were still over-collateralized and still processing loans for our retail and institutional clients.”
The issue isn’t simply if our risk management system works--it does. The real goal for BlockFi is to continue to provide a positive experience for our clients in the face of market volatility. We’re capable of using our own equity capital to hedge extreme volatility even during turbulent fluctuations.
Under-collateralized loans only represent a small percentage of overall funds, and we offer them as a valuable service to institutional clients that are able to pass an extensive underwriting process. We understand the importance of ensuring our under-collateralized funds are vetted to the highest level. Additionally, a client's right to receive digital assets in their BlockFi Interest Account, along with any other unsecured or unsubordinated debt, are ranked higher than BlockFi equity and BlockFi employee capital.
The Future Looks Bright
Bitcoin lending isn’t the only exciting aspect of BlockFi’s offerings. In the second quarter of 2021, we’re planning to debut the Bitcoin Rewards Credit Card. As the world’s first-ever Bitcoin rewards credit card, it’s a huge leap forward in providing greater legitimacy to the crypto market and excitement in both crypto and traditional climates.
“People think of us today as a crypto lender or maybe a crypto-financial services company,” said Prince. “Five or 10 years from now, it’s just going to be financial services. We’re going to be doing all of the things that traditional fintech companies do, we’re just going to be doing them better, faster, and cheaper for consumers than they’re able to.”
You can listen to the full podcast episode HERE