Bitcoin works exceptionally well as collateral; far better than anything else I can think of. And I have a feeling that's about to matter.

The fact is that collateral has been tremendously abused in the financial systems of the West. Most people ignore this, of course, including professionals who should know better. They've been relying upon the Fed Put, which is the implied guarantee that the Fed will never allow the S&P to drop very far… that if it starts to collapse, they'll flood the markets with liquidity, push their associates to buy, or will simply buy shares themselves in "market operations."

With ever-rising prices, questions about collateral rarely come into play. As a result, some really bizarre games are being played with it.

The Present State of Collateral

Only those who work in the guts of the financial system have a real handle on the state of collateral, but it is clearly a train wreck. I say that for several reasons, but none more telling than a very strange thing called re-hypothecation.

Re-hypothecation is one of those things that, upon first hearing of it, you think, "that can't be true." Stated very simply, re-hypothecation works like this:

I use several US Treasury bonds as collateral for a loan from my stockbroker.

Then, my stockbroker takes a loan from Bank A, pledging my bonds as their collateral.

Then, my stockbroker takes a loan from Bank B, again pledging my bonds as their collateral.

Believe it or not, this is fully legal, and it's done all the time. In the US this is capped at 140% of the original collateral. In England there is no limit.

Can you see why there is a fundamental problem with collateral these days?

It Doesn't Matter Until It Matters

As crazy as this situation may be, so long as prices never go down, the game can continue; no consequences will arise.

Except that every once in a while – even with a supposedly omnipotent Fed – things do go wrong. This is what happened with Lehman Brothers in 2008. And covering all that insufficient collateral cost US taxpayers some $700 billion. At one point the Treasury Secretary rushed to an emergency meeting at the White House and told the president that if the "troubled asset relief" plan wasn't provided, the entire financial system would collapse. (Or so it was reported.)

Things are not essentially better now than they were then, and if prices fall significantly there simply isn't enough good collateral in the system to cover the debts of banks and shadow banks.

This stands to become a life-threatening issue to hedge funds, which tend to be highly leveraged.

Why Bitcoin Is Better

With Bitcoin, collateral is certain. First of all, it can't be diluted by the creation of new dollars, Euros and Yen. Only 21 million bitcoins will ever exist, and almost 90% of those are already in circulation.

More than that, Bitcoin can be used with multiple signatures (a simple process called multi-sig) so it can't be spent more than once without the permission and knowledge of the original parties.

On top of that, securing collateral with Bitcoin is easy, provided you have just one competent IT person on staff. More than that, it's fast: You don't need to wait for escrow agents, lawyers and God knows who else to sign off on it. The tech guy either has the keys or he doesn't. That's it.

Bitcoin may be the most perfect and reliable collateral the world has ever known. And whenever it is that things get serious, informed players will demand it. Given the legality and prevalence of re-hypothecation and other money games, this may be the only way to be sure.

Bitcoin's Built-In Leverage

The saving virtue of this from the hedge fund side is that Bitcoin has been escalating in value from the beginning, and will likely continue to do so for a long time. What that means for the financial player is a scenario like this:

My hedge fund borrows $50 million from a big bank, pledging 240 bitcoins as collateral. This is protected with a multi-sig system, so neither of us can cheat on it. So long as two plus two equals four, that bitcoin is secure.

The dollar price of bitcoin, however, triples over the next year or two. Now, I can triple my loan to $150 million. Either that or reclaim 160 bitcoins

So, my hedge fund got the loan it wanted because it had provably good collateral, then tripled the loan on that same collateral. For a lot of funds – especially once the regime of the never-falling price cracks – this can make the difference between survival and failure.

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Paul Rosenberg

freemansperspective.com