Why bonds are better collateral than bitcoin and ether for crypto lending

Crypto market is missing credit

The financial system is built on credit, which serves as its bedrock. Without credit, the entire system would crumble. However, despite its critical importance to the economy, credit is not available in the crypto markets due to the absence of verifiable identity, which makes it impossible to assess the creditworthiness of potential borrowers.  In a functioning economy, total issued credit is 20 to 25 times larger than cash. To unlock the full potential of the crypto market, the industry must address the credit availability issue and develop a reliable way to assess creditworthiness. Only then can the crypto industry achieve its full potential and grow to its fullest extent.

Credit expansion opportunity

Traditional institutional assets, also known as Real World Assets (RWAs), are tangible assets such as bonds, stocks, commodities, and commercial paper that are owned and/or managed by institutions like banks, pension funds, and insurance companies. There is an opportunity for these institutional assets to be leveraged to enter the crypto market as economic trust, potentially leading to the transfer of trillions of dollars in assets from Wall Street to crypto markets. 

Technological advances, such as blockchain, have been key drivers of growth in the crypto industry. However, financial engineering enabling the transfer of trust for on-chain credit is expected to be an even more significant factor in the expansion of the crypto markets. Normally, any type of credit expansion can affect an economy by increasing productive capacity or boosting demand. Credit expansions amplify the business cycle, leading to higher economic activity. Crypto credit is no exception, which could involve creating new financial products that enable institutions to leverage their existing assets to access new pools of liquidity in the crypto markets. As more institutional investors enter the crypto space, we can expect to see greater innovation in financial solutions that drive growth and provide new opportunities for investors. With the rise of the crypto markets, more lines of credit can be deployed, potentially leading to an influx of trillions of dollars in new capital, but also bring new challenges and risks that need to be addressed. 

OpenEXA is creating new financial products and tools that allow institutions to leverage their existing assets in the crypto market as trust while enabling low-cost, low-risk, 24/7 trading. The potential transfer of trust leading to the injection of trillions of dollars in credit could fuel the growth of the crypto market and make it mainstream.

 Borrowing economic trust as collateral

Given the current identity problem in the crypto markets, traditional forms of credit are unavailable for now. As a result, collateralized lending is emerging as the only viable solution. Fortunately, there is a vast array of traditional assets, such as bonds or stocks (RWAs), that can be used as collateral for crypto loans. 

The supply of U.S. dollars is limited, with M1 and M2 money supply currently totaling $20 trillion. However, there is a potential for up to $700 trillion of RWAs to be borrowed as trust (collateral) to generate credit. Credit has a significant impact on the markets, which in turn affects the entire economy. This is where real world assets can play a key role in facilitating credit to grow the crypto market.

 The case for stable credit

Credit is the foundation upon which finance is built. It is the largest, most critical, and volatile part of the economy. The biggest expansion in the crypto markets will come from borrowing trust (RWA) that creates stable credit, not just technological advances. 

That's why it's so important to find a way to bring stable credit to the crypto markets. OpenEXA borrows economic trust from the real world and transforms it into decentralized trust on the blockchains in order to issue stable credit on the chain. OpenEXA's stable credit token (OXA) backed by institutional assets (AUT’s) can unlock the flow of stable credit to the crypto markets.

Risk of using volatile assets as collateral

When a volatile asset is used as collateral, there is a significant risk of sudden liquidation. Such liquidations tend to happen during periods of market turbulence, which can cause chain congestion and drive-up transaction fees as many people rush to exit their positions and too many liquidations occur at once for the network to handle efficiently. As a result, using volatile assets as collateral can be risky, potentially leading to significant losses for lenders and borrowers alike.

When collateral becomes volatile, it can disrupt the delicate balance between financial leverage and market stability. In order to restore stability, the system must be deleveraged, which can be difficult in modern finance where leverage is often used as a tool to maximize returns. Using volatile assets as collateral can be highly capital inefficient, making them a poor choice for many lenders. Put simply, if you want to prevent the loan from being liquidated even in the event of a 75% drawdown of the collateral, you will need a 4-to-1 (or 400%) over- collateralization ratio. However, if you want the loan to remain safe from liquidation in the face of a 90% drawdown, you will need to increase the overcollateralization ratio to 10-to-1 (or 1000%). 

Therefore, it's crucial to ensure that collateral is of sufficient quality and stability to prevent such scenarios. While modern finance often relies on leverage to maximize returns, it's important to balance the benefits of leverage with the potential risks associated with volatile collateral. By doing so, we can help promote a stable and sustainable financial system for all.

If you want to prevent the loan from being liquidated even in the event of a 75% drawdown of the collateral, you will need a 4-to-1 (or 400%) over- collateralization ratio. However, if you want the loan to remain safe from liquidation in the face of a 90% drawdown, you will need to increase the overcollateralization ratio to 10-to-1 (or 1000%). 

Use of AUT and OXA backed by bonds as collateral and the benefits

To achieve a very low probability of liquidation, a crypto-collateralized loan needs to maintain an extremely high ratio of over-collateralization. Put simply, if you want to prevent the loan from being liquidated even in the event of a 75% drawdown of the collateral, you will need a 4-to-1 (or 400%) over- collateralization ratio. However, if you want the loan to remain safe from liquidation in the face of a 90% drawdown, you will need to increase the overcollateralization ratio to 10-to-1 (or 1000%). 

Using volatile assets as collateral can be highly capital inefficient, making them a poor choice for many lenders. For this reason, OpenEXA will use non-volatile assets such as AA/AAA bonds as collateral. These bonds will be an excellent option for collateral because they tend to be more stable and predictable in value with plenty in supply. This can help reduce the risk of sudden liquidation and market volatility. We have data going back to 1842, and bonds have held their ground well.