Trading and investment returns grab headlines in the financial world. But there is another area that is just as important, and often overlooked, collateral. Many financial crises have had their impetus in lax collateral practices. Too often, usually in times of economic exuberance, firms lower their standards on what is acceptable collateral.
Collateral is especially important to consider in the crypto space. Bitcoin has been compared to gold, called digital gold. But as we have seen recently, bitcoin is not a good source of capital, too volatile, not like gold.
Entering the new era of crypto based lending, we must figure out what makes for good collateral? There are four elements that support something as a good source of collateral: Liquidity — if things go bad, and the lender wants their money back fast, underlying collateral can be sold quickly. A low susceptibility to rising interest rates. In this regard, low-duration investments, like bonds with high coupons or short maturities, are often less sensitive to surprise interest rate moves. Some stability in price. Price volatility weakens the status of collateral. A decline in collateral value leads to a trading going "upside down". The asset is held in a bona-fide custody provider, bank or broker, an entity under regulation, full and transparent valuation and proof of ownership.
In crypto based trading, collateral quality is critical, as there are limited regulatory standards, meaning all responsibility lies with the collateral issuer. Decisions based on quality of asset, liquidity, and yield must be made. Bad decisions regarding what to accept as collateral can set the industry back a long way.
So, what are the appropriate assets to accept as collateral? Tokenized gold comes to mind, as it exhibits low price volatility and has an established market to sell into. But gold offers no yield, and yield, especially yield that can be counted on, is good for collateral to have.
Tokenized short-term government debt, maturity of ninety days or less, is a good source of collateral. It is one of the most liquid assets in financial markets. Its short maturity means its duration, sensitivity to interest rate movements is low. It is backed by the full faith and power of a government, so getting paid back has a decent probability. Reputable and regulated financial institutions custody short-term debt. Finally, conditions surrounding short-term government debt are easily monitored. There are usually warning signs that a government is nearing a point where they might have trouble making debt commitments. Paying attention to trade balances, money flows, government spending, and government debt can alert an investor to pending troubles. Problems for governments paying back rarely occur without some forewarning.
So, in the end, a good approach to collateral management is to accept short-term government bonds and monitor the economic situation carefully.
This blog is for educational and informational purposes only, covering general market trends, industry developments, and asset features. Nothing herein is investment advice, a solicitation, or a recommendation to buy or sell any assets. Etherfuse and its guests may hold stakes in some or all of the assets discussed.
