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Big risks loom large for those lending against bitcoin

Using cryptocurrencies to back loans is fraught with danger

bitcoin roulette

This won’t end well (via Shutterstock).

A story by Brady Dale on CoinDesk published Friday covers some recent attempts by companies to lend against cryptocurrency holdings. The most recent example is a small outfit called Dominion Capital, which is now hoping to succeed where others have not. As described by Dale:

“Essentially, the service would allow individuals and projects to borrow against either their own crypto assets (or those invested by supporters) rather than converting them directly to cash.”

Loans would be at about 50 percent of the collateral. So if someone comes in with 100 bitcoin, they would only be able to borrow about half its value. At current prices, the total loan amount would be about $442,000.

There are lots of reasons to borrow against an asset. Tax treatments of loans—depending on how they’re structured—can be an effective way to enjoy some of the benefits of a sale (like use fiat money to buy mining equipment, for instance) without forking over some of those gains to Uncle Sam.

It’s nothing new. Equity swaps have been around for years and they do basically the same thing but against stocks or an equity index. A borrower gets cash against his or her stocks, paying back interest for the term of the loan and gaining from any potential subsequent rise in those stocks.

However, cryptocurrency is a different animal. While stocks crashed during the financial crisis, bitcoin has suffered multiple crashes in the past several months.

The volatility on bitcoin is astoundingly larger than that of, say, the S&P 500. The 30-day standard deviation on an annualized basis for the S&P 500 has been just shy of 20 percent. For bitcoin, it’s five times that, according to Bitmex. In recent days, volatility has been as much as 192 percent.

As noted by Dale about Dominion’s proposed product, “There will be terms in place—similar to margin calls—in case the value of the collateral asset drops dramatically.”

Since December, bitcoin prices have fallen more than 50 percent. There have been multiple days where double-digit percentage drops have taken place.

Dominion has spent $1 million building their product and they’re trying to raise another $5 million to get it off the ground. They’re ideal is to have $100 million in credit available to borrowers.

However, with bitcoin’s volatility being what it is, that money can get lost very fast if a lender misjudges risk.

And we know what can result when that happens.

Lawrence Lewitinn, CFA is editor in chief of Modern Consensus. Disclosure: Lewitinn owns no cryptocurrencies in his portfolio.