The Investor’s Guide to Bitcoin and Crypto Loans
Bitcoin and cryptocurrency loan products may come in different structures and use diverse models to generate profit for the issuing entity
Artwork by Crystal Le
The rapid adoption of bitcoin and cryptocurrencies as an asset class unlocks several opportunities for investors. One such opportunity involves using these digital assets as collateral for loans directly tied to their underlying value.
Bitcoin and crypto loans give investors access to cash to meet their immediate needs, all while retaining any potential upside on the cryptocurrencies they hold. However, these loans are not risk-free, as evidenced by the billions of dollars lost by crypto investors in 2022 while lending assets to crypto loan platforms.
This article demystifies the concept of bitcoin and crypto loans. Readers will learn the benefits and risks of crypto loans, the options available, and answers to frequently asked questions about crypto loans. We first address some common reasons investors may consider getting a crypto loan.
Why get a crypto loan
A cryptocurrency-backed loan is desirable for several reasons. The most obvious is that it gives investors access to cash without liquidating their cryptocurrency portfolio. Individuals may borrow against their crypto to finance major expenses such as paying off mortgages or buying a car.
Others may get a cryptocurrency loan to leverage their position and acquire more crypto assets. In a typical example, an investor may use 20% of their crypto portfolio to borrow US dollars and spend the borrowed amount on buying more cryptocurrency.
The ideal scenario is that the move pays off, upon which the investor can spend realized gains on repaying the initial loan and retaining the rest as profits. However, they may also incur losses if the value of the collateral asset(s) drops substantially during the loan duration.
A crypto loan allows investors to tap into a credit line without spending capital. It becomes unsurprising then that several centralized and decentralized products with crypto loan offerings have attracted a significant user base for these loans.
Types of crypto loans
Cryptocurrency loan products may come in different structures and use diverse models to generate profit for the issuing entity. They may be classified into two broad categories: centralized and decentralized crypto loans.
- Centralized finance (CeFi) loans: CeFi loans, as the name suggests, are offered by centralized entities. A significant characteristic is that investors relinquish their collateral ownership by depositing supported assets on the platform. In exchange, they receive a credit line and can borrow money against their capital.
- A major downside of using a CeFi loan platform is that customers have little visibility into how the lender uses the deposited assets. Users must trust that the platform implements the best security and risk management standards to ensure they can withdraw their capital when they want.
- Decentralized finance (DeFi) loans: DeFi loans fundamentally differ from CeFi loans because no third party manages deposited collateral. Instead, the funds are stored in autonomous smart contracts designed to manage operations such as pooling user assets, yield generation and liquidation.
- DeFi loans are desirable due to their transparency and because the underlying protocols are computer codes that cannot be easily manipulated when built correctly. Loans are also largely overcollateralized, ensuring that there is minimal risk of default. The protocol automatically liquidates users’ positions when they fall below the defined threshold.
- However, DeFi loan platforms present unique risks. Users must understand and assess these risks before using a bitcoin or crypto loan platform.
Crypto loan risks
The risks associated with crypto loans are diverse. For instance, prospective users may consider the fundamental value of the collateral asset, how the company generates the interest that it pays customers, collateral requirements,and technology risks.
- Token risk: The primary risk of taking out a crypto loan is the volatility of most digital assets. The risk becomes more profound if the underlying token has no fundamental value and continues in a downtrend for a relatively long time. An investor using such tokens may face liquidation if negative developments, such as a security exploit or network downtime, lead to a rapid decline in the value of the collateral asset. Bitcoin (BTC) is considered the most secure token, with ether (ETH) being the next best collateral asset. The risk curve becomes significantly greater, with other crypto assets having greater downside potential in the event of a market sell-off.
- Counterparty risk: Many crypto loan platforms, especially centralized services, take on significant counterparty risk to generate yield for customers. These companies typically loan customers’ assets to hedge funds, quants and high-volume traders, institutional investors, and in some cases, other everyday investors searching for a crypto-backed credit line.
- However, the records show that this counterparty exposure risks user funds. The recent collapse of lending platforms such as BlockFi, Celsius, and Genesis reveals that these platforms may rehypothecate user funds. Rehypothecation is where the entity facilitating the loans uses posted collateral for their needs. Additionally, the entire lending system is mostly connected together as the firm may loan assets to its investors or other entities without the requisite collateral.
- Finding a platform with the least counterparty risk must be a top priority for anyone who wants to take out a loan against crypto. Ideally, platforms that do not offer interest-generating products pose minimal risk. Bitcoin-only lenders that adopt multi-signature or cold storage solutions are also relatively safer as they imbibe the ethos of security and self-custody. Borrowers enjoy more peace of mind knowing funds cannot be rehypothecated by the lender and are not stored by the lender on a third-party exchange where it is still susceptible to such rehypothecation, despite the lender’s claims. Lenders offering low interest rates are more than likely rehypothecating customer funds, so be careful not to choose a loan provider as it’s cheaper.
- Technical Risk: Crypto lending introduces technical risks, which are mostly not present in traditional banking. The most basic form of risk is the irreversibility of blockchain transactions. In a classic example, the developers of Solana-based DeFi protocol OptiFi mistakenly locked $661k worth of assets while trying to destroy a smart contract.
- Other technology risk includes private key theft, smart contract exploits and price oracle manipulation. These outcomes are more closely associated with DeFi loan platforms. Nonetheless, centralized lenders are not immune as they actively participate in DeFi to generate revenue.
- Margin Call: Investors risk losing their collateral if they fail to manage their position actively, and it falls below an acceptable loan-to-value (LTV) ratio. Consider an example where an investor deposits $1,000 worth of BTC to borrow $500 at an 80% LTV. This means the user would receive a margin call if their collateral balance drops to around 80% of the borrowed amount. In our example, the user’s collateral will be sold to cover the loan if the collateral’s value drops to $600.
- Most platforms have clearly stated LTV ratios and would issue a margin call for the user to deposit more assets if their position is at risk of liquidation. The volatile nature of the crypto market means users must respond swiftly to margin calls or lose their collateral. Investors may prioritize using crypto loan platforms that send automated price alerts if the LTV ratio is in danger of being breached. Being financially prepared and able to deposit collateral at any time day or night is also essential.
- Repayment failure risk: Fixed crypto loans include a predetermined repayment schedule for borrowers. Failure to keep up with payments may result in additional charges or collateral liquidation.
- Flexible loans allow users to repay their loans at any time. Still, users may struggle to repay loans if they incur substantial losses on their investments or face financial challenges in real life. Such outcomes may lead to permanent losses that could be avoided by not having exposure to crypto loans.
Pros vs. cons
Taking out a loan against crypto collateral presents numerous benefits to investors. At the same time, it may present unique disadvantages that investors must understand before going down that path.
- Instant Liquidity: Investors can meet their immediate cash or liquidity demands without losing any potential upside on their crypto investment. This option comes in handy, especially during emergencies or funding large purchases.
- Leveraged investment: They can also boost their exposure to a certain asset(s) and thus maximize profits on their portfolio. For example, an investor may spend the borrowed amount to buy more cryptocurrency expecting the market to gain substantially. A positive outcome means more profits, as they can sell a portion of their portfolio to repay the loan.
- Tax benefits: Investors avoid tax headaches when they choose to borrow against crypto rather than sell it to book profits or losses. In most jurisdictions, such borrows are not considered taxable events, thus allowing investors the option to hold on to their crypto assets for as long as they want.
- Absence of self-custody: Most centralized loan platforms require users to relinquish their assets’ custody. This approach means greater counterparty risks and even the possibility of losing funds permanently if the platform mismanages user funds or files for bankruptcy.
- Amplified losses: The volatile nature of the crypto market means users face substantial losses if the decision to purchase more assets using crypto collateral backfires. They could lose most of their collateral and completely miss out on any return on investment.
- Regulatory constraints: This disadvantage primarily applies to crypto loans through DeFi protocols. Since such platforms are typically run by decentralized autonomous organizations (DAOs), investors cannot initiate legal proceedings if they lose deposited assets. Similar limitations also face crypto loans initiated with offshore companies operated by obscure entities.
Bitcoin-backed loans allow users to tap into bitcoin’s collateral value to borrow fiat or stablecoins. This is one of the safest ways for users to obtain a crypto loan since BTC can be less volatile than other crypto assets and offers access to the highest LTV threshold (second only to stablecoins). Many CeFi and DeFi platforms support bitcoin-backed loans. They also tend to implement custody and security practices that align with the ethos of Bitcoin holders. The most Bitcoin-native options are loan products built on layer-2 bitcoin networks such as Liquid or Stacks. Such applications inherently rely on the Bitcoin network for security and offer a degree of self-custodial access to Bitcoiners.
Bitcoin-backed loans Examples
- Verify 21 – Verify 21 is a Bitcoin-only centralized lending platform where Bitcoiners can borrow against their BTC without worrying about the risk of rehypothecation. Verify 21 has no tokenomics feature, which often leads to increased volatility in the value of customer assets and creates new risk vectors for the platform.
- Verify 21 uses the popular institutional-grade cold storage solution BitGo. Users give up self-custody to access Verify 21’s credit line but can rely on an on-chain proof of reserves scheme to confirm that assets are held 1:1 by the custodian.
- Sovryn – Sovryn is a decentralized lending and borrowing protocol built on the Rootstock (RSK) bitcoin sidechain. The platform allows users to access bitcoin-backed loans by converting their BTC to RBTC (a pegged version of bitcoin on RSK).
- Users deposit RBTC to borrow the protocol’s stablecoin ZUSD which they can convert to fiat to meet their liquidity needs. Since non-custodial protocols handle the loan origination and repayment process, there are no KYC requirements, and borrowers enjoy self-custodial access with Sovryn.
- Hodl Hodl – Hodl Hodl is a peer-to-peer lending protocol built on the layer-2 bitcoin solution Liquid Network. Users can borrow against BTC on the platform by selecting from a list of open offers set up by lenders or setting up new borrow requests with their desired parameters.
- Hodl Hodl enables full self-custodial access by locking deposited collateral in a multisig contract. The borrower can access their BTC deposit by fulfilling the loan terms, while the multi-sig contract will easily transfer the collateral to the lender if the borrower fails to reach the payment terms. Hodl Hodl users can take out loans using the most popular stablecoins, although borrowers must make repayments in the collateral asset.
Our in-depth guide on the best bitcoin loans provides information on bitcoin-only lending platforms and how investors can choose from the options available. Readers considering taking a bitcoin loan often find the information contained helpful.
Cryptocurrency-backed loans are hugely popular and involve investors borrowing cash/stablecoins using cryptocurrencies (other than BTC) as collateral. The popularity of crypto-backed loans does not detract from their high-risk nature. Aside from the inherent increased volatility of altcoins, users incur technical and counterparty risks by taking crypto-backed loans.
- Aave – Aave is the largest decentralized lending protocol in terms of locked value and represents a popular choice within the DeFi ecosystem. Aave is deployed across 11 different networks and offers the same service of letting users borrow against their crypto or earn a yield on deposited assets. The platform supports a wide range of assets and includes its AAVE native token, giving access to rewards earned by the Aave protocol.
- Nexo – Nexo is a centralized lending platform that has been live since 2018. As one of the few survivors of the recent crypto winter, Nexo has cemented its position as one of the leading players by strictly authorizing only overcollateralized loan facilities for retail and institutional clients.
- Nexo lists several assets and features a native NEXO token which gives users access to lower interest rates on borrowings and a higher yield on deposited assets. Borrowers can repay their loans anytime if they maintain a healthy LTV on their collateral assets.
- Compound Finance – Compound Finance is the second-largest DeFi lending protocol for accessing crypto-backed loans. Compound is Ethereum-native, supports a wide range of assets, and features the native COMP token for governance and distribution of protocol rewards.
- Like most DeFi protocols, Compound has had its fair share of security snafus, including a $102 million mistake in 2021. Technology-based risk is one of the many reasons investors must do due diligence before obtaining a crypto loan.
Can I get a crypto loan without collateral?
No. Most cryptocurrency lending platforms require users to over-collateralize loan positions. This safeguard ensures the platform can easily liquidate user assets in the case of a default. Although newer protocols offer under-collateralized loans, such products are relatively nascent and pose greater risks.
How much can I borrow in crypto?
The amount you can borrow in crypto typically depends on the type of collateral asset and the LTV thresholds defined by the loan platform. In most cases, users can borrow up to 90% of stablecoins and up to 50% on BTC and ETH deposits. Users are usually recommended to take only a loan offer representing a smaller portion of their borrowable amount to avoid early liquidation.
Are crypto loans legal?
There are no publicly-known laws that prohibit investors from accessing crypto-backed loans. Instead, most top-tier crypto lenders actively acquire various regulatory licenses to legalize their operations. Meanwhile, DeFi protocols still operate independently as regulators grapple with the right approach to manage the emerging technology.
How are crypto loans taxed?
Tax laws on crypto loans may differ based on jurisdictions. It is best to consult with a licensed tax advisor for guidance. That said, the law in most regions, including the United States, is that borrowing against crypto is not taxable. Investors only pay taxes when selling cryptocurrencies.
Are crypto loans safe?
Crypto loans are as safe as the lending platform can secure user assets, and the user can maintain a healthy LTV threshold. Users must do their research to find the most reputable platforms and ensure a healthy LTV ratio throughout their loan duration. In most cases, borrowing only up to 20% of deposited collateral and using relatively hard collateral such as bitcoin (BTC) provides a cushion even against severe market declines.
Getting the most out of bitcoin and crypto loans
The opportunity to take out loans against bitcoin or any other cryptocurrency makes digital assets more appealing. In most cases, users can obtain a loan within minutes – a level of collateral liquidity not accessible with other asset classes.
Meanwhile, bitcoin-only loans offer greater security because of the asset’s highly-liquid profile and decentralized network structure. Investors must carefully weigh the risks of crypto-native loans and prioritize the most secure options for their long-term investment portfolio.
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