Bitcoin collateralised lending: what are the potential risks and how they are managed?

Although Bitcoin and other cryptocurrencies have become increasingly accepted by investors and institutions, crypto remains an emerging asset class with a particular set of risks.

Setting aside one’s tolerance for huge price fluctuations, the fragmented crypto ecosystem, with its hundreds of exchanges and wildly variable prices, is still too chaotic for many investors.

In addition, increasing anti-money laundering and KYC (Know Your Customer) regulations present yet another challenge for professional investors looking to move large amounts of fiat into the space.

It’s clear that investing in cryptocurrency directly has its challenges. Investors are therefore turning towards other ways to profit or even reap a stable income in the cryptocurrency environment. And one approach that is gaining favour is crypto collateralised lending via a private credit fund.

What is crypto collateralised lending?

Crypto collateralised lending works like bonds and other traditional yield-generating debt instruments where investors earn interest from borrowers.

In this case, we’re talking about lending fiat money to crypto ecosystem players while holding their tokens (such as the Bitcoin they own) as collateral. This is in contrast to traditional financial instruments, where assets like property, gold, or business inventory are held as collateral.

As you can see, crypto collateralised lending allows investors to reap potentially higher yields than that offered by other debt instruments despite high interest on fiat loans.

This is because borrowers such as Bitcoin miners and arbitrage traders are in fairly unique situations and are motivated to pay higher interest rates than conventional fiat borrowers. See our previous article for a more detailed explanation.

What are the potential returns for investors/lenders of crypto collateralised loans?

Crypto collateralised loans are designed for cryptocurrency players underserved by the existing banking ecosystem. They may have very large and valuable Bitcoin holdings, but traditional financial institutions are typically unwilling to hold these as collateral, and banking regulations make it extremely expensive for them to do so.

Crypto collateralised lending is one of the very limited ways that borrowers can get the fiat liquidity they need. Given the highly profitable nature of what they do, they are incentivised to pay higher interest rates compared to traditional loans.

For investors, this translates to attractive potential returns of (for example) 8% to 18% per annum.

What are the potential risks & how are they managed?

Investors looking for yield are generally concerned with the risk of default and loss, which is the probability of the borrower not being able to repay the loan.

In the case of crypto collateralised lending, the risk of default and loss is dependent on the level of collateralisation, as in the event of default, the lender has the right to terminate the loan and sell the bitcoin (collateral) to recover back the loan amount.

In a 2021 report by Arcane Research, Bitcoin was lauded as “the perfect collateral asset”. According to Arcane, Bitcoin has a few key features that make it particularly suitable:

● No counterparty or credit risk

● Available for trading around the globe and around the clock

● Can be transferred instantly with full finality

What these mean is that bitcoin as a collateral is much higher on the liquidity curve in comparison to traditional collateral asset classes such as real estate or goods, where the debt recovery process can be costly and lengthy.

Risks can also be further managed by having an experienced fund manager actively managing this. For example, the Fintonia Secured Yield Fund is an over-collateralised private credit loan fund — what this means is that the amount of Bitcoin held as collateral is worth more than the loan disbursement and more than sufficient to cover any potential loss from default.

In addition, Fintonia Group utilises margin calls to manage the volatility of Bitcoin. Whenever the price of Bitcoin falls below a safe level, the borrower must top up their collateral within hours, or the collateral may be liquidated automatically.

Ultimately, we believe that crypto collateralised lending is a very compelling market opportunity for professional investors looking for impressive yields while avoiding direct exposure to cryptocurrency risks.

Regardless of where you stand on crypto collateralised lending, it’s important for all professional investors to work with institutions that have the experience and comply with the highest industry standards.

With cumulative decades of experience in financial services and tech, digital assets specialist Fintonia Group has what it takes to help investors navigate crypto’s turbulent waters.

As a MAS-regulated fund manager, Fintonia Group manages institutional-grade funds, including the Fintonia Secured Yield Fund, with the best possible security and risk management measures, allowing investors to find stability and yield within the fast-growing, volatile cryptocurrency ecosystem.