Junk Bond Indigestion in the Bitcoin Economy

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Recent defaults by high profile debtors in the Bitcoin economy serve as a stark reminder that promises of exceptionally high yields on Bitcoin-denominated debt do not represent the “going rate” or remotely plausible yield expectations for debt or other Bitcoin investments; they represent nothing more than the risk premium for low-quality debt.

Many participants in the Bitcoin financial markets have become accustomed to seeing interest rates on Bitcoin-denominated debt of 15%, 18%, or even 24% or more — and some have mistakenly come to believe that such yields are the norm or the “expected” yield for lending in the Bitcoin economy. To the extent that market participants view debt as a “safer” option than other Bitcoin-denominated asset classes, or as offering “guaranteed” returns, many have even come to view these kinds of yields as representing a lower bound on reasonable expectations for what they envision as riskier asset classes such as equities.

This could not be further from the truth.

The reality is that these exceptionally high yields correspond to debt which in the fiat world is referred to as “junk”. Such junk debt carries a high yield due to the risk premium, or the additional return demanded by creditors to compensate them for the high risk that the debtor will default. The predominance of junk bonds and other junk debt in the Bitcoin world does not reflect realistic rates for normal loans to creditworthy individuals, it reflects the high degree of credit risk which creditors shoulder when making loans — which are often either unsecured or secured only in name — to individuals or businesses who are often anonymous and generally entirely unaccountable as a result. These entities are not offering exceptionally high yields out of the kindness of their hearts, or because they’re helping to spread the wealth. Nor are they offering such yields in response to a widespread expectation of rampant inflation in the Bitcoin economy and a rapid erosion of Bitcoin buying power. On the contrary, junk bond issuers are compelled to offer exceptionally high yields in order to attract capital in the first place.

For comparison, margin lending rates for Bitcoin on leading exchanges are often in the vicinity of 2% per year and rarely climb into double digits, even during times of especially high demand for margin loans. Likewise for the more reputable borrowers on platforms such as BTCJam.com: established borrowers often pay low single digits, and borrowers offering anything in double digits may be viewed with suspicion and treated with a high degree of caution.

Again, this difference between low lending rates on high volume exchanges and niche lending platforms, on the one hand, and junk debt in the Bitcoin space, on the other, is attributable to little more than the market’s expectation of a premium for risky loans.

The second half of 2013 has served as a stark reminder of this risk, as a series of prominent debtors, many pseudonymous, each defaulted on the contractual obligations of their high yield debt — either missing interest payments, declining to offer face value repayment on demand in accordance with the terms of their contracts, or both. The fact that they have defaulted does not necessarily indicate anything at all about these debtors’ general trustworthiness, their intentions, or anything else about them as individuals. They might be very fine, upstanding individuals, for all anybody knows. But the fact is, they defaulted, and in retrospect the markets turned out to be right to require a high risk premium as compensation for the significant probability of default. If anything, interest rates should have been higher for such loans.

(In a very different case, a pseudonymous individual formerly offering guaranteed annual returns of over 20% in exchange for Bitcoin deposits recently claimed to have been the victim of “hacking” that resulted in the loss of several thousand BTC belonging to creditors. When challenged to provide proof of a transaction accounting for the loss of over 4000 BTC, he pointed to a transaction for exactly 4000 BTC that had occurred a full two weeks before he had mentioned the idea of a “hack” at all, a period of time during which he also repeated assertions about never keeping large amounts of Bitcoin on a server anyway, specifically due to the security risk. As of this writing, the individual’s creditors still don’t know when or whether they’ll receive their capital back, nearly three weeks after the claimed “hack” caused their money to disappear.)

The bottom line is that a steady diet of junk debt has left many market participants with a skewed sense of what is reasonable in terms of yield for Bitcoin-denominated investments in general and debt in particular.

If the market works rationally, one might hope the end result of the junk bond indigestion which is now working its way through the system will be a resetting of general yield expectations downward for high-quality debt — as well as for other asset classes — and perhaps a resetting of yield expectations upward for unsecured loans to entities who insist on remaining anonymous and unaccountable. With luck, maybe it will also result in heightened skepticism toward guaranteed high yield deposit schemes and the risk of eventual loss to invisible “hackers” or other nefarious forces.

All material on this site is carefully reviewed, but its accuracy cannot be guaranteed; please do your own checking and verifying. This specific article was last reviewed or updated by Dr Greg Mulhauser on .

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