JPMorgan's move on crypto collateral is a watershed moment for banks

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Last week, reports emerged that JPMorgan is planning to allow clients to pledge bitcoin and ether tokens as collateral for loans by year-end.

On the one hand, this is a surprising step for a bank whose CEO has been publicly hostile toward the crypto industry. In the past, Jamie Dimon has called bitcoin, or BTC, a "hyped-up fraud," "Ponzi scheme," "pet rock" and "waste of time." He has not showered ether, or ETH, with the same scorn, acknowledging that "accessing certain blockchain things … might have some value." But there's a long stretch between the CEO's view of the assets and the bank's elevation of their legitimacy to the level of loan collateral.

On the other hand, the news didn't come out of the blue: It was flagged as an area of interest for the bank earlier this year, when sources reported that it was exploring crypto collateral and that it would activate the use of crypto spot ETFs as security for financing, suggesting that fears about the assets' volatility had been allayed.

What's more, the move makes sense.

When the Federal Reserve joined other financial regulators earlier this year in relaxing controls on bank crypto activity, it was only a matter of time before banks started rolling out crypto services.

Another piece fell into place with the issuance of supportive guidance from federal regulators on crypto custody services, as banks would need to hold the collateral. The path was further smoothed by the move from Fannie Mae and Freddie Mac to include crypto assets in wealth assessment. If BTC and ETH can be considered reserves when calculating mortgage risk, a natural extension is allowing them to act as reserves in other types of loans.

Regulatory support for the activity has been a key step, given banks' understandable reluctance to attract potentially punitive attention. But also relevant are increasing client demand and a deeper understanding of the favorable economics of crypto collateral.

Many of JPMorgan's clients are involved in the crypto market, as we saw earlier this year when the bank unveiled plans for direct links between customer accounts and Coinbase. Allowing crypto tokens to be used as collateral for loans or margin trading enables holders to leverage their crypto positions within the reassurance of a trusted brand, and means the bank can keep that value within its ecosystem.

Also, crypto collateral does not, contrary to common perception, need to be risky. The assets are more volatile than most stocks and bonds — but this can be compensated for in the loan-to-value ratio, with a significant haircut to cover the risk of a sharp price drop.

Another key feature is that crypto tokens are bearer assets. Pledging them against a loan usually involves placing them in bank custody, giving the lender the ability to seize and sell the assets with relative ease and speed in the case of default. Similarly, should the loan coverage be threatened by a crypto market plunge, the lender could have a covenant in place to allow for the swift sale of the assets to repay the loan and remove coverage risk.

Furthermore, unlike many other forms of collateral, crypto assets have a transparent 24/7 market price, enabling the lender to monitor collateral values in real time.

And the evolution of liquid crypto derivatives markets on regulated exchanges facilitates the hedging of crypto positions, adding an additional cushion to the volatility risk.

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So, not only is crypto collateral much less risky than other collateral assets such as real estate, yachts and certain illiquid shares or bonds, it's also a high growth business.

Loans on centralized crypto lending platforms do not usually generate public data, but some estimates put the amount outstanding at the end of Q2 at almost $18 billion, 15% higher than at the end of Q1. The amount outstanding on decentralized platforms is more transparent, and at the end of Q2 had reached over $26 billion, a quarterly growth of 42%. On-chain data suggests that, for decentralized platforms, Q3 saw further growth of over 35%.

For banks, the potential fees could deliver a higher margin than traditional collateral assets given the relative ease with which crypto assets lend themselves to smoother processes — no special clauses, unique valuations or credit assessments necessary.

And crypto-backed lending can end up delivering a self-reinforcing growth loop. Boosting crypto asset demand by enhancing their financial utility while removing an incentive for large holders to sell should, all else equal, lift prices. The resulting higher collateral values could result in larger loans, and higher fees.

However, growth in the use of crypto collateral could aggravate crypto market risk. Forced sales could lead to a drop in the asset price which in turn could trigger a cascade of collateral selling as loan integrity comes under threat. And we have to hope that guardrails fully prohibit the rehypothecation of pledged assets, as any lending out or repledging would snarl up collateral liquidity.

Nevertheless, the acceptance of crypto assets as collateral for bank lending is a big step forward for both crypto markets, which will benefit from enhanced institutional utility, and for banks, which can expand high-margin customer services while moving further into a new asset class.

Indeed, the positioning on the innovation curve is the most meaningful outcome of JPMorgan's move. Allowing new types of assets as collateral is a variation on an age-old business. Managing assets on-chain, however, requires a radical restructuring of business processes as well as a significant technology investment. It also nudges banks toward greater automation and the development of applications, perhaps even with some degree of decentralization, to facilitate a user-centric initiation of loans.

This is especially relevant for a bank such as JPMorgan that already has its own blockchain and already tokenizes money held in client deposits.

In sum, the acceptance of crypto assets as collateral by one of the world's largest banks is a boost to crypto asset utility. But an even deeper longer-term impact will come from banks adopting a new, more automated lending paradigm.