The Self Repaying Bitcoin loan

DeFi and Bitcoin Mining, together

In DeFi, borrowing Bitcoin can be cheap. There's a reason why you get a bargain too. There isn't much utility to borrowing Bitcoin for an everyday person, except for taking a short position or using it to neutralize risk in a structured transaction.

At the bluechip borrow/lend protocol Aave, there's a 5% utilization rate on the $1.22 billion of wrapped BTC deposits. The borrow rate is at 0.60% and has been stable for some time. Lots of capital sitting around for a very low price.

From DeFi BTC to BTC Mining:

This is not investment advice, but an interesting idea for long-term BTC holders. It's about taking cheap capital and creating utility from it. As with most return-oriented things, it does carry several risks.

The first risk is that you need to convert your Bitcoin to wrapped Bitcoin. When you do this, your Bitcoin is held at a central institution (resulting in third party hacking risk) and you're given the representative token (i.e. wrapped BTC) that can be used in platforms like Ethereum.

The second risk comes into play when you deposit your wrapped Bitcoin into a place like Aave. Now you're running protocol risk if it gets hacked.

The third risk arises when you borrow at a variable rate. If the borrow rate was to rise significantly, it could unravel the economic opportunity of the transaction. For story telling purposes, let's assume that the Bitcoin borrow rate on Aave stays flat for the next few years (it’s been the case for some time). With that rate, the cost of capital for this whole idea would be ~1.80% over three years.

The good thing about borrowing from DeFi is that there's no maturity date. It's a forever loan as long as the value of your collateral stays above the required amount. The neat thing about this idea is that you deposit wrapped BTC and then...borrow wrapped BTC. Thus, your loan and collateral are matched with no margin call risk.

The use of proceeds is the interesting part. When you convert your borrowed BTC into U.S. dollars, you're now officially short Bitcoin with those funds. Given the initial long Bitcoin position, you’ve created a neutral position (note: a successful outcome of this idea eliminates this neutralization). A gain on one side means losses on the other and vice versa. If you stopped here, this wouldn't be interesting. However, if you use (most of the) USD to buy Bitcoin mining equipment, then it changes the potential outcome of the story.

Picture of a data ceter running bitcoin “mining” equipment

The Repaying Device

First, the value of the Bitcoin mining equipment - when priced in USD - has a high correlation to Bitcoin price. Thus, you've now established a synthetic long Bitcoin position with some other variables to it. One additional consideration is that the value of the equipment may exhibit some price concavity depending on the number of machines in the network (also known as the Bitcoin network Hashrate). The other key and obvious thing about Bitcoin mining equipment is that it produces Bitcoin - this is why it's a repaying device.

Price of Bitcoin (yellow line) and two categories of ASICs (red and orange lines)

I mentioned using "most of the USD" earlier when buying equipment because part of it would be needed to pay for shipping and a hosting deposit for the machines. Unless you're a BTC miner, you probably won't be doing that yourself. There are a number of "mining as a service" providers where they'll source the machines for you and host them for a fee (which can be subtracted from the production as it happens). This idea works for a regular investor because of the availability of these new services. Building and maintaining your own data center is not an easy task.

At this point, you have two assets and one liability in this idea. A long Bitcoin position, a short Bitcoin position used to fund a purchase, and Bitcoin mining equipment which tracks the value of Bitcoin with some decay and produces Bitcoin.

The question becomes the following: how long would it take for the newly purchased machines to produce enough Bitcoins to payoff your borrowed BTC?

If you were able to produce enough Bitcoins net of operating expenses equal to your loan amount, you could repay your Bitcoin loan and it would have never affected your initial long Bitcoin position. Additionally, for 1.80% (remember the estimated cost of capital), you would then have Bitcoin mining equipment to continue mining. The cumulative value of the idea would depend on the lifecyle of the machines.

A machine's lifecycle will depend on proper care, the electricity and hosting cost, the network hashrate and Bitcoin price.

Downside scenarios

An extensive scenario analysis is not within the scope of this newsletter. However, it's worth noting two important downside situations. The first is the destruction of the equipment (e.g. theft, fire, defect without repair, etc). If this happens, there's no equipment to generate Bitcoins to pay off your loan. Proper safekeeping of the equipment is critical for this idea and any Bitcoin mining operation.

The second situation is a low enough Bitcoin price (and/or high enough network hashrate) relative to your electricity and hosting costs. Based on the electricity and hosting cost of the machines, at a certain Bitcoin price and/or network hashrate, all the mined Bitcoin has to be used for the operational costs - perhaps it's not even sufficient for that. At this point, the best decision would be to unplug the machines. Anyone interested in this idea would need to conduct analysis on the path of the network hashrate and Bitcoin price.

Note that an unplug situation does not necessarily mean a disaster because your loan is denominated in Bitcoin. Given that Bitcoin and ASICs are so tightly correlated, if what’s driving the unprofitable situation is Bitcoin pricing going down, then selling the ASICs - and rebuying a similar amount of borrowed Bitcoin - likely solves the problem. The question is whether you’ll be able to easily sell the equipment in an adverse market environment.

A Self Repaying Bitcoin Loan

Borrowing Bitcoin to purchase Bitcoin mining equipment (which produces Bitcoin) is akin to the "self repaying loan" meme that people love. The assets and liabilities are also all closely matched.

However, given the physical nature of equipment, it needs to be properly operated and cared for. The capacity and access of the borrower also affects the viability of the idea. Someone with (i) low electricity cost and (ii) low priced machines is greatly positioned to benefit the most with the least risks. You don't necessarily need to borrow the Bitcoin from DeFi either, but that source of capital carries the lowest interest rate.

This is not investment advice. All opinions are my own.