The 5 principles of bitcoin lending
Bitcoin lending is very similar to general investing. Nevertheless, funding bitcoin loans has some characteristics, that other asset classes don’t share exactly this way. This guide highlights the 5 most important principles you should consider when lending bitcoins.
1. Diversification → Distribute your investments
Diversification is a very old and often cited principle of investing. We could go into the mathematical details here which show the effects of diversification very precisely. But we rather want to give you a hands-on approach that you can apply as a lender on Bitbond without the need to study statistics beforehand.
Diversification in finance simply means that you place many smaller bets instead of a few big bets. This strategy should yield a decent average return that lets you sleep at night quietly at the same time. If you place only one bigger bet, the potential return might be large, but the same applies for the potential loss. Bitcoin lending on Bitbond should yield a return of approximately 10% p.a. in a diversified portfolio of bitcoin loans. So how do you diversify?
Amount per loan
The minimum amount that you can invest per loan is pretty small at currently 0.01 BTC. We kept this minimum amount so small on purpose. That way you can build a portfolio of 100 loans with an investment of just 1 bitcoin. We recommend not to invest much more than the minimum amount into one loan.
Generally we advise to stick to the following 2 rules of thumb:
1) Only fund 20% or less of the requested loan amount. So if it’s a very small loan of just 0.1 BTC, don’t put more than 0.02 BTC into this loan.
2) Let one single loan comprise only 5% or less of your portfolio. So if you plan to lend a total of 2 bitcoins for instance, then you shouldn’t put more than 0.1 BTC into one loan (since 2 x 5% = 0.1). You can check your total investment in your investment overview – it’s the bold figure in the ‘Total outstanding principal’ column.
Diversification has more than just the investment amount dimension. It is also good to diversify other aspects of your loan portfolio. One cool thing about global bitcoin peer-to-peer lending is that there are loan listings from many different countries.
Despite the fact that economic cycles tend to follow a global trend, the economic environment varies from country to country. While one region might be in recession, another part of the world might still experience a dynamic economic activity. When times get tough, defaults on debt also tend to increase. Therefore it makes sense to have a geographically diverse loan portfolio.
Bitcoin lending is still quite young so not all countries might be equally represented in our listings. But the opportunities are growing daily. We recommend to build a portfolio whereone country makes up 30% or less of the entire portfolio in value terms. Ideally it should be less.
Loans on Bitbond have terms between 6 weeks and 5 years. Generally loans with a longer duration have a higher default probability. A longer time horizon brings more uncertainty. Therefore a longer duration is always reflected in a higher interest rate compared to a shorter duration.
Holding different loan investments with different terms makes mainly sense for one reason. Your capital tie-up is not concentrated over one specific term. When you have a basis of longer dating loans and another portion of shorter dating ones you can act more flexibly. If you don’t need immediate liquidity you can re-invest cash flows quickly. Otherwise you can keep the liquidity and have it ready for consumption.
On the other hand, if you only hold short-term loans you have to put more effort into actively managing your portfolio. This can certainly be fun, but you need to have the spare time to do it.
Each rating category represents a different default risk. Higher interest rates reflect the increased risk of lower ratings. Therefore the average returns from different rating categories should be roughly in the same range.
But to make the most of our risk based pricing method (a blog post about this will come soon), diversify between rating categories. Ideally you have only about 20% of your loan investments in each rating category A to E.
If you want to concentrate your portfolio a little more towards one or the other end we still recommend at least keep the concentration below 40% in one rating category. This should also be based on value instead of number of loans.
2. Loan terms → Go for larger loan amounts
If borrowers default on their loan one of two things happen. Either the lender receives the identity details of the borrower and can take legal action on his or her own. Or we from Bitbond sell the claim from this loan to a debt collection agency.
The latter case is typically better for lenders. The recovery amount will on average be higher when a professional agency collects the debt instead of individuals. But selling the claim is only feasible, if the value is above a certain threshold. Otherwise the costs of collection are larger than the claim.
Therefore loans that are very small are more difficult to collect. But keep in mind that “very small” isn’t the same amount all around the world. Purchasing power varies across countries. A loan of 0.8 BTC might be quite normal in Chile but pretty small in Switzerland.
To have an approximate indication we recommend to invest in loans that are 1.0 BTC or more in the developed world and 0.5 BTC or more in emerging markets. You can see the origin of the borrower easily from the country flag on the listing.
And keep in mind that the diversification principle states that it is good to invest rather smaller amounts per loan. Only because you invest into a loan that has a larger loan amount does not mean that the amount you contribute to this loan needs to be bigger.
3. Loan purpose → Check the description for plausibility
From the project description you can see what the borrower needs the bitcoins for. Before you place a bid check what it says in the text. Each borrower can write up to 1,000 characters. While the description doesn’t have to be long, it should make sense to you.
Note that many borrowers on Bitbond are not native English speakers. So grammar and spelling might not always be perfect. But what counts is the purpose why they actually borrow. If there are just a couple of words that don’t really tell you what the borrower intends to do with the bitcoins, be cautious.
4. Affordability → Lend only what you can afford to lose
Bitcoin lending is still a new and in some respects even experimental endeavor. We strongly believe in the benefits that it brings. But many things are still in development. As an asset class bitcoin lending should deliver effective returns of about 10% p.a. (if you follow these bitcoin lending principles).
But as with all new things it is possible that things might go wrong and not all borrowers repay as they are supposed to. Therefore we recommend only to lend bitcoins you can afford to lose. By the time you will also get a better feeling how to invest and what is your preferred strategy.
5. Loan portfolio → Learn from past investments
Check the results of your previous bitcoin lending investments on a regular basis. A check every two months would be a good minimum frequency. Try to find patterns in the performance of loans and then apply them to your future investments. We all can only learn from data what works and what doesn’t.
When you’re just starting out check out our statistics page. You can download the entire history of loans that were originated through Bitbond. This is a good way to learn and to build your own lending hypothesis.