In its short history, Bitcoin has generated a huge amount of commentary and has polarised views. Some see it as a game-changing, revolutionary form of currency. Others find it hard to see beyond its undoubted immediate problems, in particular its volatile value and its lack of regulation and transparency. Whatever your views, virtual currencies like Bitcoin are unlikely to go away: banks and financial institutions need to understand them, and take them seriously. As more individuals hold virtual currency and more businesses accept them as a form of payment, one question customers are more likely to ask financiers is, "Will you accept Bitcoin (or another virtual currency) as a form of collateral?"
What makes an asset good collateral?
A "good" security asset has a stable value which is easy to ascertain. It is also capable of being secured in a way that will:
- enable the lender to liquidate it easily; and
- be robust on insolvency and against other interests.
To what extent do these attributes apply to Bitcoin?
Does Bitcoin have a stable value?
Economists remain divided on whether Bitcoin satisfies the traditional functions of money: as a unit of account, a means of exchange and a store of value. To date it is arguably the last of these functions that Bitcoin has most clearly failed to satisfy. Bitcoin's peak unit value hit US$1,217 in November 2013. At the time of writing, the value of one Bitcoin is US$246. This volatility in itself makes Bitcoin an unattractive form of collateral at present.
Can you take effective security over Bitcoin?
As with any potential form of security, the first step is to understand the nature of the asset.
How does Bitcoin work?
Bitcoin is an electronically generated virtual "currency", which can be held and traded (for the most part) anonymously. The supply of Bitcoin is fixed by the application of a mathematical algorithm.
In simple terms, owning a Bitcoin means owning a pair of cryptographic keys, one "private" and the other "public". Visually, these take the form of a series of numbers and letters. Knowledge of the “private key” enables you to spend the Bitcoin. The Bitcoin infrastructure (known as the "block chain") uses the “public key” to verify that the “private key” is genuine.
So for an owner, knowing the "private key" and stopping others from knowing it is essential. Bitcoin users keep their private keys in "wallets", which can be held with a cloud-based provider, or stored offline (for example, on a USB stick).
So what type of asset is a Bitcoin?
It seems reasonably clear that Bitcoin is an intangible asset. Most intangible assets that lenders are used to dealing with, such as cash at bank, securities and contractual rights, are rights against another person (or "choses in action"). Bitcoin ownership itself does not create a right against another person. The value of Bitcoin ownership derives entirely from a third party's willingness to exchange it for cash or another asset. It is essentially an intangible commodity. Arguably, a volatile market value is an inevitable consequence: there is no ultimate recourse against a person with an ascertainable covenant strength.
However, if a wallet provider holds Bitcoin for an owner, the terms on which it does so may give the Bitcoin holder contractual and other rights against that wallet provider.
Possible security structures
If an owner uses a third party wallet provider, a lender should in principle be able to take a charge or assignment over the owner's rights against the wallet provider under that arrangement, as a lender would usually do when taking security over securities held by a custodian. Clearly, a lender would need to do significant diligence on the wallet provider. Many are based in offshore jurisdictions and may be uncooperative in dealings with traditional financial institutions.
A lender must also understand the nature of the owner's rights against the wallet provider. Who takes the risk of the wallet being hacked? Even apparent major players in the Bitcoin infrastructure have been found vulnerable: in February 2014, Mt. Gox (once the world's largest Bitcoin exchange) announced that around US$470 million worth of Bitcoin under its control had been "lost", and suggested that hackers might be responsible. Mt. Gox filed for bankruptcy protection in Tokyo shortly afterwards, and remains subject to insolvency proceedings.
What about security over the Bitcoin itself? A lender could potentially take a charge over a customer's Bitcoin and possession of an offline wallet with the private key. This may enable it to enforce the security on default by exchanging the Bitcoin for cash (to the extent it can find a willing buyer), or appointing a receiver to do so.
However, there are significant risks involved. The owner's delivery of the key to the lender does not stop the owner keeping a copy and using it. The lender would be relying on undertakings from the owner not to do so. This is a quite different level of control than a lender gets from blocking a bank account (for example).
In principle, a financier could instead provide finance against Bitcoin using a title transfer arrangement, rather than by way of a secured loan. The customer would transfer the Bitcoin outright to the financier’s Bitcoin address, and the financier would agree to transfer an equivalent number of Bitcoin back to the customer’s Bitcoin address at a later date. This has the advantage of generating a new private key on the original transfer, which only the financier would know. The financier would be likely to impose a significant "haircut" on the initial price to reflect Bitcoin's volatile value.
However, this is also unlikely to be an attractive option at present. In July 2014, the European Banking Authority recommended that national supervisory authorities discourage credit institutions, payment institutions and e-money institutions from buying, holding or selling virtual currencies until a comprehensive regulatory regime is developed.
The regulation of Bitcoin
Until now, the FCA has shown little interest in regulating virtual currencies. However, the tide may be turning. In a March 2015 report, the Government Office for Science recommended that regulators engage with the FinTech community to create a state-of-the-art regulatory reporting infrastructure to address new financial technology. Separately, in a paper published alongside the March 2015 Budget, the Treasury announced it would begin consulting early in the next Parliament on bringing Bitcoin exchanges within anti-money laundering regulations.
At present, there are undoubtedly significant practical and legal obstacles for financial institutions considering securing Bitcoin and other virtual currencies. However, the regulatory and technological landscape is shifting rapidly: that may not be the case for long.