Example: Bitcoin as collateral

Say one Bitcoin is worth $100,000. A borrower asks you for a $1 million loan and offers 10 Bitcoin as collateral, which is worth exactly $1 million today. Collateral is what you keep if the borrower doesn’t pay you back. If the borrower offered $1 million in cash, you’d probably be happy. But Bitcoin isn’t cash.

The risk is that Bitcoin’s price falls before the loan is repaid. It has lost more than half its value in each of its big downturns since 2011, and in several of them it fell by more than 80%. If it fell 80% during your loan, the 10 Bitcoin would be worth only $200,000, against $1 million owed. So you might still make the loan, but ask for more collateral: $5 million worth, or 50 Bitcoin, which would still cover the loan after an 80% fall. Counting each dollar of Bitcoin as only 20 cents like this is called a haircut, in this case an 80% haircut.

The haircut is a preventive control. You can add a detective one too: check Bitcoin’s price every day, and if the collateral’s value drops below an agreed level, ask the borrower to add more. This request is called a margin call. None of this means “don’t lend against Bitcoin”. It means pricing the risk so the reward is worth it, and spotting trouble early if things move against you.