Why all the attention about collateralization?
This is something that is vital to discuss for a simple reason: the world is craving high quality collateral. When we look at the global economic and financial system, we see a major shortage in this area.
It is a situation that is stifling growth and hindering progress. As with many things, cryptocurrency offers the potential to change things completely. Perhaps, for the first time, the private sector can develop high quality collateral.
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Why Collateral Is Needed
For economies to expand at a powerful rate, debt is required. Some believe this not to be the case. However, absent debt, new ideas do not get funded. We also see wide spread progress impossible. This would ultimately stifle innovation.
When a company wants to build a new factory it takes out a loan. This allows for the building of the plant, an asset the company obviously believes will generate wealth above and beyond what was put in. For this reason, collateral is required. If the company does not have that, it will have to seek lending from some of the more risky areas. For this reason, the cost of doing business increases.
Real estate is probably the most common example of collateral. One purchases a home and that is the collateral against the loan. Default will lead to the home being foreclosed upon. The challenge here is real estate is non-liquid.
Of course, if we look at the construction of the house, that was done using loans. The developer will often finance the land and the individual units are build with construction loans. Ultimately, when the unit is sold, that loan is paid off.
As we can imagine, progress would be a lot slower if the developer had to pay for all aspects out of pocket. How many have tens of millions of dollars to complete this?
Internationally, things get even messier. There are an assortment of risks doing business with different countries, using currencies outside one's own. For this reason, investors and lenders seek to minimize the risk as much as possible.
Here is where collateral enters the picture.
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Pristine Collateral
The higher the quality the collateral, often the less that is required. When an entity comes to the table with pristine collateral, it will get whatever it wants.
What qualifies as pristine collateral these days? There is only one thing: United States Treasuries.
Why is this so? Because it has all the qualities required.
US Treasuries are low-risk since the government never defaulted on them. This is vital For almost 90 years, payments were made. That cannot be said about other countries.
They are also liquid. The US bond market is one of the most active markets in the world. Treasuries can be sold during trading hours, usually with little problem.
Finally, they are fully transparent. We know when the bond was issued, what the rate of interest is, and how much the asset is worth. Since markets are liquid, anyone can look up the pricing to see what the tradeable value is.
Nothing else in the world meets all these expectations. To contrast, the EU, with their negative interest rate bonds, are having a tough time selling them. EU banks are being forced to take them since the New York based banks are not touching them.
Sadly, the private sector offers up nothing.
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Mortgage Backed Securities
Banks and the financial industry are continually trying to create high quality collateral. Thus far, it was a complete failure.
Remember the Great Financial Crisis and how that kicked off? Many believe it was the subprime market that was the culprit. The challenge with this view is that was not a large enough market to nuke the global economy. What was big enough, though, was the lack of quality collateral globally.
Hundreds of trillions of dollars in loans are made within the financial system. These are do, often, on a nightly basis. The overnight market is enormous. Here, financial institutions collateralize assets for short-term lending. It gets even crazier when you investigate the shadow banking system.
One of the beliefs was that securitizing mortgages and packaging them up made sense. These were thought to be high quality since, after all, people always paid their mortgages. These assets were then taken and collateralized throughout the world. There were assets created upon these assets. All was good as long as the underlying remained strong.
Of course, as we know, confidence quickly waned. When some started to go back, it was realized this was not high quality. In fact, a lot of it was crap. Thus we had a good ole fashioned bank run. The difference was, instead of depositors running to the bank to get their money, banks were running to have others made due on the collateral.
Unfortunately, this is where the entire thing collapsed.
While banks (and everyone else) obviously overleveraged, the fact that collateral went bad made things exponentially worse. This is a situation that persists to this day.
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Cryptocurrency Is The Answer
Blockchain was designed as a trust mechanism. It is also fully transparent. This present a major opportunity for cryptocurrency to step up and create some high quality collateral.
Bitcoin is a prime example of what is possible. If we look at the attributes of that, we can see how this can evolve into a massive form of collateralization.
We know exactly how much Bitcoin is available. In fact, due to lost keys, it is likely there is less Bitcoin that can be accessed as compared to what is on the blockchain. Nevertheless, we know the number of units and what wallets they are in.
At the same time, Bitcoin has a massive market. It is rather liquid with billions of dollars traded. The market is open 24/7 which means that reaction times can be instant. No waiting for market hours to transact.
Of course, Bitcoin is not the only asset that is eligible for this. We can see that anything tied to blockchain could have similar potential. The idea of "code is law" is very powerful. It has the potential to create assets either at the blockchain level or within a smart contract whereby trust can be established without a third party. This removes a layer of risk often associated with the traditional financial market.
The fact the private sector is able unable to step up and offer a solution in this area is very telling. Cryptocurrency has the potential to fill the void. Since we all become banks, it is an opportunity that will be present for everyone. The ability to collateralize assets means that the industry will expand more rapidly than most believe. We could see an evolution of many orders of magnitude in only a few years.
When people ask what problem does cryptocurrency solve, this is one of them. It has the ability to develop asset that are trusted since they are tied to decentralized, permissionless systems that are outside the control of any one individual (or entity).
Ultimately, the process of collateralization puts value to work. Instead of being locked up, it can be used to generate even more economic progress. As cryptocurrency builds value, it can unleash what is created for even greater wealth generation.
This is going to be a major part of the cryptocurrency story. And it is one the world needs.
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