The seemingly innocent act of earning interest on bitcoin actually supports short sellers.
Why Do Institutions Give Out Interest-Like Payments For Your Bitcoin Deposits?
The only reason is that they’re making even more money by lending out your bitcoin to other people. But to whom and for what purpose?
Why Would Someone Want To Borrow Bitcoin?
Could they be depositing that bitcoin into another institution which pays even higher interest? That seems unlikely. Most firms reduce the amount you earn as your balance grows. Even if there were a gigachad club which pays higher interest rates than they offer to plebs, why would someone want to pay money to temporarily hold bitcoin?
Could they be using that bitcoin as collateral for a low interest rate loan on fiat? That also seems unlikely as they would need to pay interest on both loans, which would be higher than a pure fiat loan, plus they’d be exposing themselves to margin calls if the price of bitcoin were to dip.
What other possible uses for borrowed bitcoin are there? I think it’s to use in a leveraged trade.
You could use bitcoin as collateral for leveraged long positions, but you could also use fiat so it is unlikely that people are borrowing bitcoin for long or leveraged long positions.
You can also sell short the bitcoin you’ve borrowed, either leveraged or not. This is probably one reason to borrow your bitcoin.
There are also derivatives, some of which require possession of bitcoin. The most common derivatives are options and futures.
A Quick Walkthrough On Derivatives
Options come in two flavors: puts and calls. Either one can be bought or sold.
Put buyers obtain the right to make the put seller buy bitcoin from them at a specified price (called the strike price) on a specified day (called the expiration day). If the spot price of bitcoin on expiration is above the strike price, they are not obligated to sell the bitcoin — it doesn’t make economic sense to sell bitcoin at a lower price than what the open market is willing to pay. The put seller is obligated if the buyer wants to “exercise” the option.
To be a put seller, you’d only need to show enough cash to fulfill your possible part of the contract. No need to borrow bitcoin for this.
To be a put buyer, you wouldn’t need to hold any bitcoin because you’re buying the right to make someone buy bitcoin from you. If the contract had value on the expiration date, you could resell it to someone else who is holding bitcoin.
Call buyers obtain the right to make the call seller sell bitcoin to them at the strike price on the expiration day. If the spot price of bitcoin on expiration is below the strike price, they are not obligated to buy the bitcoin — you wouldn’t buy bitcoin at the strike price if you can buy it for less elsewhere. As with puts, the seller of the call is obligated if the buyer wants to “exercise” the option.
To be a call buyer you wouldn’t need to hold any bitcoin because you’re buying the right to make someone sell bitcoin to you. You wouldn’t even need the cash to buy all of the bitcoin in the contract because you could resell the option for a profit if the contract has any value at expiration.
However call sellers are a different story. To sell a call you’d need to prove you have enough bitcoin to fulfill your possible side of the contract. Often this means you need to deposit all of the bitcoin for the calls you intend to sell. But selling a call is essentially a bearish position. You’re betting that bitcoin will not exceed the strike price you’ve chosen to sell. Call sellers might be the people who are borrowing the bitcoin you’ve deposited.
Futures are obligations to buy and sell bitcoin at the strike price on the expiration date. One person buys the contract, which obliges them to buy a certain amount of bitcoin for the strike price on the execution date. One person sells the contract, which obliges them to sell a certain amount of bitcoin for the strike price on the execution date.
Futures buyers are similar to call buyers, except they will need to prove they have the cash to fulfill their side of the contract.
Futures sellers are similar to call sellers. They are another candidate for who might be borrowing your bitcoin.
Who Are The Bitcoin Borrowers?
So the list of candidates of who might be interested in borrowing your bitcoin are:
- Call sellers — People who see a limited upside to bitcoin by a specified date.
- Futures sellers — People who believe the price of bitcoin will be below a chosen level on a specified date.
- Short sellers — People who believe the price of bitcoin will go lower in the near future.
And what is interesting is they must be making more money with it than you are earning in interest, otherwise they wouldn’t be doing it.
Is Short Selling Necessarily Bad?
When a diamond-handed hodler deposits some of their stack to receive a fraction of a percent per month, they provide supply to the short sellers, which increases the selling volume. This artificially dilutes the buy pressure that naturally occurs as the user base grows and the existing Bitcoiners continue to DCA. If the only selling were to be organic conversions by bitcoin holders to pay expenses, the spot price of bitcoin would probably be far less volatile.
While volatility isn’t bad, sharp moves to the downside can have the effect of scaring off new users until the volatility has diminished.
Who Cares About The Spot Price Of Bitcoin?
Many of us are in this for the revolution, for the separation of money from the state. But that perspective comes only after you’ve learned a bit about bitcoin.
What will attract the next 100 million bitcoin maximalists? The blast above 60,000 turned many heads in late 2020, including those of the financial news networks, the big banks and their wealthiest customers. NgU (“Number go Up”) technology is what will convince the curious precoiners to peer down the rabbit hole. Once you learn enough about bitcoin, no one becomes less bullish.
What Would Happen If Plebs Stopped Aiding The Short Sellers?
If everyone withdrew their precious sats from firms which lend to short sellers, the rates for these loans would have to rise. However, the rates would rise both for the short sellers and for those who continue helping the short sellers.
From the plebs’ position, we have a Prisoner’s Dilemma. For those unfamiliar with the prisoner’s dilemma, imagine you have two participants. If both cooperate, both benefit. If one cooperates and the other betrays, the betrayer is rewarded. In this situation, the plebs are the participants. Cooperating with one another involves withdrawing your satoshis, while betraying involves depositing your sats for others to borrow.
If no one withdraws or, worse, if deposits continue to grow, the liquid supply of bitcoin will remain high enough for shorting to be easy and any spot market effect will continue. I cannot quantify what that effect is, but necessarily it is greater than the value plebs are receiving in interest payments, otherwise the big institutions could not afford to make those payments.
If only some plebs withdraw, those who continue to collaborate will be rewarded with higher interest rates. Unfortunately the good plebs who do withdraw their sats will still be subject to the effect that short selling has on the spot market.
If every sat is withdrawn, the short sellers’ supply of bitcoin is reduced, perhaps to the point that leveraged shorting of bitcoin becomes too costly or too risky to warrant the effort. You cannot short sell something if no one will lend it to you. In this scenario, the plebs win. NgU technology will do its thing and the news networks, baffled by the meteoric rise in fiat terms, will market bitcoin to the masses. Companies and governments will adopt bitcoin as a payment method and later as a unit of account.
The growth of the bitcoin user base and widespread adoption will happen even if we continue to aid the short sellers, but without that artificial selling pressure, we could get there much sooner.
This is a guest post by Raymond Walsh. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.