Risks Loom as Crypto Collateral Gains Ground in Traditional Lending

Crypto, in all of its forms, is poised to move more mainstream, blurring lines between traditional and decentralized finance.

The GENIUS Act is gaining its share of attention this week, moving toward establishing a federal stablecoin framework amid news that the Senate passed the bill on Tuesday (June 17), sending it to the House. In other recent announcements, we’re seeing the rise of bitcoin as a form of collateral in loans issued by big banks — used an inputs to determine applicants’ net worth and liquidity, and by extension, loan terms.

JPMorgan is a key example. The bank said that earlier this month that it would begin offering loans to clients, where bitcoin ETFs such as BlackRock’s iShares Bitcoin Trust would be used as collateral for both retail and institutional loans. Goldman Sachs had been accepting bitcoin as loan collateral as far back as 2022.

Elsewhere, MicroStrategy’s subsidiary MacroStrategy took out a $205 million term loan from Silvergate in 2022, in a loan that was collateralized by bitcoin ($820 million worth). The loan was eventually repaid (Silvergate wound down in 2023).

But delving into the regulatory filing, we get a glimpse of some of the risks that are inherent in bitcoin (or bitcoin funds) as collateral.

“If the price of bitcoin drops such that the LTV Ratio exceeds 50%, the Borrower is required to either deposit additional bitcoin in the Bitcoin Account or prepay a portion of the Loan such that the LTV Ratio is reduced to 25% or less,” the filing said.

The Negative Feedback Loops

We note that these are the general mechanisms of any loan — namely, that LTV swings require borrowers to put up additional collateral. There’s also the risk that a loan would be called, meaning it must be repaid in full immediately.

An April report from data center infrastructure and digital assets firm Galaxy estimated that the crypto lending market stood at $36.5 billion at the end of last year, including crypto collateralal debt. That’s down significantly from a peak of more than $64.4 billion in 2021, as several lenders had gone out of business.

But in the current environment, where the runway is being built via legislation and regulatory rollbacks to bring cryptos more fully into banking, the lending activity is poised to accelerate.

The Office of the Comptroller of the Currency issued a March letter that rescinded earlier guidelines on crypto and opened the door for banks and lenders to allow digital holdings to be part of secured lending activity.

The risks are inherent in the volatility of bitcoin and other cryptos, and even stablecoins have been marked by some swings where they depeg from the 1:1 relationship with the dollar. As the Federal Reserve noted in this paper published late last year, “the use of crypto assets as collateral creates negative feedback loops between vulnerabilities from valuation pressures and leverage … As the value of these investments approaches the value of the corresponding debt, creditors may liquidate crypto-asset collateral, amplifying the initial price decline.”

There are some technical considerations as well, the Fed wrote: “Congestion on blockchains can result in additional liquidations, since borrowers seeking to recollateralize their positions may be delayed.”