The obscure way Bitcoin could get used in the financial system

You take the mass adoption you're offered, not what you want

Given the actions taken by the Fed, ECB, BOJ and BOE in the past decade, I’m of the opinion that it’s unlikely any western country is going to limit its central bank’s printing by adopting a Bitcoin standard. However, that doesn’t mean Bitcoin has no place in the established order. If Bitcoin is integrated into the system, here’s how I think it could happen.

This article builds on my previous piece, How the Eurodollar system works.

Collateral shortage

There is a shortage of high quality collateral (a valuable asset securing a loan) in the Eurodollar system. There are only so many Treasury notes, bills and bonds to go around, and demand is high. One solution is to use lower quality collateral, for example Italian BTPs (the Italian equivalent of a Treasury). Sure the BTPs are volatile and rather risky, but at least there’s a lot of them God bless those profligate Italians! Another solution is to use the same collateral for multiple loans, a bit of financial wizardry referred to as rehypothecation. Here’s how it works.

Headquartered Overseas so we Don’t Pay Taxes Corporation pledges $100 million of Treasuries to We Launder Money for Billionaires Bank as collateral for a loan. We Launder Money for Billionaires then takes the Treasuries and pledges them as collateral for a loan from It’s Only Fraud if You Get Caught Money Lender. And so on and so forth, the same collateral getting used again and again. This is rehypothecation and it’s a hell of a drug.

I’ve heard people say that it’s not uncommon for Treasuries to get rehypothecated up to several dozen times. The result is a long string of loans that are secured by a small pool of assets. At that point it can become difficult to disentangle ownership. If a Treasury has been rehypothecated 30 times, who actually owns it? How do the loans get unwound if a money lender goes bankrupt?

Here’s where Bitcoin might find a use case. I could see Bitcoin getting used as collateral in the Eurodollar system, owing to several unique advantages inherit to the world’s most popular cryptocurrency.

Why it makes sense to use BTC as collateral

1 - Bitcoin doesn’t take sides

US Treasuries are decidedly not a neutral asset. They’re controlled by the American government and as Russia learned the hard way, Treasuries can be confiscated on a whim. Furthermore, when push comes to shove the US Treasury and Federal Reserve will manage Treasuries in whatever way serves the domestic interests of the United States, not the world at large.

Bitcoin is a neutral asset, unaffiliated with any country. So long as no powerful nation or corporation co-opts the network*, Bitcoin will remain an uncontrolled asset that cannot be stolen. People and institutions the world over can safely hold Bitcoin.

*At one point a majority of Bitcoin mining was in China and there was the perpetual fear that the CCP might attack the network. However, mining has since diversified abroad.

2 - Deflationary monetary policy

Bitcoin’s inflation rate gets cut in half every four years. Assuming that demand remains constant or increases (a big assumption), an ongoing reduction in new supply should keep the price steady or rising over time. Price appreciation is important because if an asset is used as collateral it should have a flat/increasing valuation. When the value of collateral falls it can force deflation as loans get unwound.

A visual representation of how Bitcoin’s inflation rate falls over time

3 - Ownership is recorded on the blockchain

I mentioned that as collateral gets rehypothecated it can become difficult to determine ownership. If a single T-bill has been pledged in 30 different loans, who has the rightful claim on it? Bitcoin solves this. With a transparent blockchain everyone can see exactly how the collateral has been transferred between parties. Bitcoin in the Eurodollar system would be infinitely more transparent than how banks do business now.

4 - Demand is high

There is clear demand for more collateral in the financial system. Banks and money lenders aren’t rehypothecating Treasuries 20 or 30 times just for the sheer hell of it, they’re doing it because collateral supply is low while demand remains high. High demand means that institutions are always looking for alternatives, such as Mortgage Backed Securities (MBS) or Italian BTPs.

Once Bitcoin is big enough it’s possible that Eurodollar money lenders might start experimenting with BTC backed loans, just as lenders adopted MBSs in the past. However, before Bitcoin get picked up a few things must happen.

What’s holding Bitcoin back?

1 - Inelastic supply

Although Bitcoin’s deflationary supply mechanism can be positive for pushing up prices, it can be a drawback in terms of supply. In a previous article I mentioned that the Treasury could buy back long term bonds and then issue short term bills. This won’t change the amount of debt in the system, but it will increase the supply of highly desirable T-Bills. Having an elastic supply of collateral gives monetary authorities some leeway to manage the system. They might mismanage it more than anything! But theoretically they could do something right one of these days.

As we all know, Bitcoin has an inelastic max supply of 21 million coins. Even if demand for Bitcoin as collateral is high, there isn’t a mechanism to create more BTC and distribute it as needed. Prices can go up but that only makes the existing collateral more precious, it doesn’t increase its overall supply. That’s why the market is likely to find a solution, in this case a “solution” being a way to expand Bitcoin’s reach despite the 21 million limit.

George Gammon @GeorgeGammon

@TheUnhedged In writing your piece I'd take into consideration the collateral multiplier. Currently, not only is money elastic, but so is collateral.

I mentioned to George Gammon that I would be writing this article and he suggested I consider the collateral multiplier, specifically rehypothecation which I’ve already touched upon. For me the key understanding is that when you have a base money with inelastic supply like gold or Bitcoin, someone will invariably find a way create more money from that base. For example…

• Rehypothecation... The same Bitcoin could get used for multiple loans. If 1 BTC is trading for $100,000, perhaps a single coin could back $1,000,000 worth of loans

• Fractional reserve banking*... Banks create money out of thin air, however, they must have some some reserves. If a bank uses a 10:1 leverage ratio, it could issue $1,000,000 worth of loans backed by 1 BTC

• Paper claims... A major institution/government can create paper claims on a hard asset. We did it with gold, and we’ll probably do it with Bitcoin. Many people are skeptical of crypto exchanges, since they’re perceived to deal in paper Bitcoin. QuadrigaCX is a great example. The owner of the exchange was a schmuck and ended up losing most of his customer’s money. Everyone on the exchange thought they were trading real coins backed by deposits, but the deposits were mostly gone. As soon as people tried to withdraw en-masse, QuadrigaCX immediately went bankrupt.
  
  Paper claims don’t necessarily have to be a scam. A major bank could hold BTC deposits and issue paper claims that are larger than the total amount of reserves.

*There is some discussion that even the fractional reserve banking model is outdated, and that banks can essentially create loans without any backing. Or as I understand it, banks may originate a loans then at quarter end they scramble to come up with the reserves they need to back those loans.

2 - Not enough trading volume

At present there’s not nearly enough trading volume on Bitcoin for it to be a good form of collateral in the massive Eurodollar system. Roughly $500 billion worth of Treasuries change hands every day. On the day that I wrote this article Bitcoin’s daily trading volume was $2.2 billion*. That’s 227 trading days for Bitcoin to equal one day’s liquidity in the Treasury market. Totally unworkable.

*You can’t trust trading volume based on the figures that you see on CoinMarketCap. A lot of that volume is wash trading. Use Messari.io for accurate trading volumes.

3 - Too volatile

As of 2022 Bitcoin is still too volatile to serve as collateral. For collateral to work it needs to have a relatively steady valuation that doesn’t fluctuate erratically. US Treasuries (at least traditionally) are safe and boring. While those might not be attributes you’d look for in a spouse, they work well in the financial system.

4 - Unclear regulation

Widespread use of Bitcoin as collateral is unlikely if financial regulations are unclear. There must be certainty in the regulations, so that banks and money lenders know the rules won’t change next week.

5 - Not large enough

The Bitcoin network doesn’t have a large enough market cap to be useful in the Eurodollar market on a mass scale. Just like trading volume, I don’t think there’s one magic number that will push BTC into relevancy. However, Bitcoin’s market cap definitely has to be bigger than it is now. Perhaps if BTC reached gold’s valuation that would be a good start.

Closing remarks

I think it’s far from a foregone conclusion that Bitcoin will ever reach mass adoption in the financial system. Government regulations, network security, price volatility, and a dozen other factors will help or hurt Bitcoin’s odds. However, there is certainly a chance… Our monetary system is unwell and innovation is needed. There is not enough collateral to fund robust economic growth, and Bitcoin could be one solution to help fill that void.

What’s your take on the subject? Do you think that the banking/Eurodollar system is ever going to use magical internet money?

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