If you are a Bitcoin investor with a low cost basis and liquidity needs, you might want to consider taking out a Bitcoin-backed loan. These loans use your Bitcoin as collateral so that you can get quick access to cash without the need for a credit check or middle man. This can be advantageous for those that do not have a strong credit score or ability to get a fiat loan from a bank.
In addition to the ease and speed of which Bitcoin holders can get access to liquidity, there are the key benefits of avoiding a taxable event and not losing exposure to your crypto during a bull market phase. This is a tactic that has been used by the wealthy for a long time, but might be a new concept for those that recently became wealthy through crypto investments. Let’s look at a quick example to show the potential benefit.
Let’s say John is a crypto investor that needs $100,000 for a home remodel, medical expenses, business expansion, tax payment, etc. and has all of his liquid assets in cryptocurrencies. After all, most crypto investors want to hold as little fiat cash as possible for month to month spending.
Option #1: John sells $100,000 worth of crypto that has a cost basis of $10,000, generating a taxable gain of $90,000. Federal and state taxes might be around 25%, meaning he will owe the IRS $22,500. In the year after he sells his crypto, it continues in the overall upward trajectory and gains another 50% (the average annual Bitcoin return is well above 50%, depending on what time frame you use). So in addition to losing the $22,500 in taxes, John also had the opportunity cost of $50,000 that his crypto would have gained in the year. His total cost of selling the $100,000 of crypto for liquidity needs is $72,500 in a single year.
Option #2: John takes out a loan against his Bitcoin for $100,000. It needs to be over-collateralized, so he must put up roughly $200,000 worth of Bitcoin to access the $100,000 in stablecoins that he sells and transfers to his bank for cash. The interest rate on this loan is 15% and he has to pay a 1% loan origination charge. After one year, he owes $116,000 to get his Bitcoin back. The total cost of the loan is $16,000. But during that time his crypto went up in price by 50%, so he has an unrealized gain of $50,000. In this simplified example, his true net cost of the loan was actually negative $34,000. In other words, he gains $50,000 by keeping his crypto exposure, which completely offset the $16,000 cost and translated into a gain of $34,000 for the year.
So using option #1 above, which most investors chose, John lost $72,500. Using option #2, John gained $34,000. The difference between the two options is a staggering $106,500 in a single year. If you need $100,000, would you rather pay $72,500 to access it or gain $34,000 in the same time period?
It is also worth pointing out that in the environment of rapid depreciation of the dollar, borrowers will be able to pay back the loan with less valuable dollars in the future while maintaining full upside to their appreciating cryptocurrencies. With each passing year, it should become increasingly easy to pay back the dollar-denominated loan as the value of the dollar declines.
Risks of Bitcoin-Backed Loans and Mitigation Methods
Of course, the conditions could vary in any given year and there are other risks to consider, so let’s dive in a little deeper.
The most obvious risk to using a Bitcoin-backed loan is that you give up custody of twice as much Bitcoin as you received in funds from the loan. A loan-to-value (LTV) ratio of 50% is commonplace. There are clear cautionary tales around giving up custody to your crypto including Celsius, BlockFi, FTX, BitConnect and others. “Not your keys, not your crypto” is certainly an important concept for crypto investors to grasp.
For this reason, we caution against against using lenders that take full custody of your crypto and especially entities that will then start investing with your crypto in hopes of generating a return. This practice is called rehypothecation and is used regularly in traditional finance. It can help to reduce borrowing costs, increase efficiency and improve price discovery. But anyone that has been following the crypto markets in recent years understands all too well what can go wrong with rehypothecation. For this reason, we recommend extreme caution when borrowing from lenders that will take full custody of your crypto and then place risky bets with it in order to try to make additional gains.
But did you know that there are other options that do not involve giving up full custody or rehypothecation?
Allowing the borrower to retain full custody of their crypto would not make sense for a lender as they would face defaults with little recourse. Allowing the lender to have full control is all wrought with risk as discussed above. But multi-signature wallets provide a solution that ensures that neither the borrower nor the lender have full custody of the crypto.
A 2-of-3 multi-signature wallet is used with a trusted third party holding the third key. In order to have access to the crypto used as collateral, 2 of 3 keys need to be used. So neither the borrower, lender, nor third party can access the crypto without cooperation from one of the other parties. The third party will only sign a transaction to move the collateral under the strict rules of the contract, either signing with the lender in the case of default or signing with the borrower in case of loan repayment/return of collateral.
Using this multi-signature method, no single party has control of the crypto used as collateral. The lender can’t access it or place risky bets with it, the borrower can’t take back the capital until the loan is repaid and the third party can’t legally access the crypto without one of the other two parties signing a transaction. The is similar to using an escrow service, but even better because the funds are not trusted to any single party. This means that a company like Celsius, FTX or others can’t lose your crypto, vastly improving the model for crypto-backed lending.
Top 4 Bitcoin-Backed Lending Platforms
The two main companies that take this multi-signature approach to crypto-backed loans are Unchained Capital and Hodl Hodl. I do not have affiliate relationships with either company. I am just sharing the results of my research.
Unchained Capital
Unchained Capital’s main business is helping crypto investors set up multi-signature wallets to increase the security of their Bitcoin holdings. Unchained provides the wallet software, onboarding help and holds one of the three keys. The customer holds the other two in separate geographic locations, vastly improving their crypto security. They also help with inheritance planning so your Bitcoin passes to loved ones in the manner that you would like.
The Bitcoin-backed lending part of their business uses the 2 of 3 multi-signature wallet method with a trusted third party. That third party key agent is Kingdom Trust and they are tasked with upholding the terms of the contract and signing a transaction if Unchained is unavailable or loan terms are breached.
Let’t use their website calculator to see what a $100,000 Bitcoin-backed loan would look like. Investors can borrow up to $250,000 and choose a loan term of 6 months or 12 months. Interest-only payments are made monthly until the end of the loan term, when the full balance is due.
Unchained Capital loans are not available in all states. One aspect of using Unchained Capital that some Bitcoin purists do not like is the KYC (know your customer) requirement. If this is something you would like to avoid, there is another non-custodial Bitcoin-backed lending option to consider below.
Hodl Hodl
Hodl Hodl is mainly a peer-to-peer Bitcoin trading platform that allows investors to buy and sell crypto outside of exchanges and without KYC. But Hodl Hodl also facilitates peer-to-peer non-custodial Bitcoin-backed loans globally. They have been in business for over 7 years with over 50,000 deals closed.
As with Unchained Capital, Hodl Hodl uses multi-signature contract escrow wallets.
Step 1 Contract Creation: Lend at Hodl Hodl generates a unique multisig escrow address.
Step 2 BTC Deposit and Loan Payment: The Borrower deposits Bitcoin collateral in escrow directly from his wallet. The Lender transfers the loan amount to the Borrower according to the contract.
Step 3 Repayment and Contract Closing: The Borrower returns the loan amount plus the interest to the Lender’s wallet. When the loan is repaid, the Lender releases Bitcoin back to Borrower’s wallet.
Hodl Hodl never takes control of your crypto. They don’t require KYC or credit checks, cutting out the middleman. They only hold one out of the three keys to the multisig escrow, which ensures safety for both borrowers and lenders. Hodl Hodl only intervenes in case of a dispute that can’t be resolved between the two parties of the contract. After all of the required information has been received and analyzed, the support manager will make a decision and decide whether to allow a refund of Bitcoin back to the seller, or to allow the buyer to release the Bitcoin to his own wallet address. During the dispute process, the bitcoins remain locked in escrow.
There is currently one offer to lend up to $100,000 in USDC for 12 months at an APR of 19.75%. But you can post your own offer at the terms of your choice on the platform and wait for someone to accept it. Most of these offers to borrow are done at rates closer to 10%.
For full details on how the Hodl Hodl lending platform works, you can click here.
THORChain Lending
THORChain lending offers an interesting option for crypto-backed loans that might appeal to some investors. They offer innovative benefits including borrowing with no interest, no loan expiration time period and no liquidation risk. But note that THORChain lending does have custodial risk, as you have to give up full custody of your crypto and it can rehypothecated.
THORChain is an L1 blockchain that has been around for nearly 5 years, but the lending feature was added in 2023. It is a decentralized liquidity network with an interoperable blockchain that allows cross-chain token swaps in a non-custodial manner. There are multiple DeFi platforms built on THORChain that offer Savers Vaults that pay interest on crypto deposited. They have been very innovative in the space, being the first to offer protection against impermanent loss for liquidity providers.
The network was hacked twice in 2021 for around $10 million, but no users lost funds. Hackers of Atomic Wallet supposedly used THORChain to conceal their crypto heist, which looks bad on the surface but others have pointed out that it proved the project is solid and able to function smoothly with ample liquidity.
The hackers likely performed a cross-chain swap from ETH to BTC, which obscured the chain of custody. At any rate, there have been no hacks of the actual THORChain network or loss of user funds on the network reported in the past few years after the 2021 events. While THORChain is largely decentralized, they were criticized for pausing the network in order to protect capital during the hacks.
There is $250 million in total value locked (TVL) on THORChain DeFi platforms, which is up 33% in the past month. Volume has surpassed $500 million per day recently allowing users to trade between BTC, ETH, stables in an open-source and permissionless manner. No accounts or KYC are required.
Users can deposit crypto collateral and take out loans using THORSwap or ShapeShift. The founder of ShapeShift, Erik Voorhees, has been very supportive of THORSwap due to their ability to offer native (not wrapped) cross-chain swaps at the protocol level. THORChain is the only way at scale to go from BTC to ETH (or reverse) without using an intermediary.
“When I discovered THORChain and learned about it, it was the most exciting feeling I had gotten since learning about Bitcoin back in 2011.”
Lending allows users to deposit native collateral, and then create a debt at a collateralization ratio (CR). The debt is always denominated in USD (aka TOR), regardless of what L1 asset the user receives. Borrowing in THORChain involves using your deposited assets as collateral to take out a loan. The loan is denominated in USD (TOR) and can be received in various L1 assets. With a dynamic collateralization ratio, you can borrow flexibly without the worry of interest or liquidation. Repayment in THORChain is flexible, allowing you to repay at any time after your repayment lock has elapsed, and in any asset, which is then converted to TOR. The repayment amount is deducted from your debt balance, and proportional collateral is released back to you upon full repayment.
THORChain Risks
But note that you have to give up your collateral and there are risks to being able to get it back later. It is a complicated formula used for lending that I will not get into specifics. But my understanding is that the borrower’s ability to receive collateral back depends on the Rune price being solvent against loans, their stablecoin not losing peg, asset pools not becoming too shallow, avoidance of leveraged looping, and other risks detailed in the BlockScience THORChain Risk Report.
Nexo Lending
Some have also mentioned Nexo as an option for accessing liquidity, but their crypto-backed loans involve giving up custody without multi-sig protection. They offer low rates, no fees and no payment schedule. They utilize storage in Class III vaults through leading blockchain custodians and offer insurance. But your crypto is rehypothecated and invested in order to provide these benefits. The key part of nexo terms of service to know about:
“… you understand and agree that we can convert, pledge, re-pledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer, dispose of or use any amount of such Collateral, separately or together with other property, and for any period of time, and without retaining in our possession and/or control for delivery a like amount thereof or any other assets, at our sole and absolute discretion.”
To their credit, it is worth mentioning that they survived the crypto winter and collapse of most of their competitors. So whatever they do with the crypto collateral seems much less risky than what others were doing. Still, it is a risk to be aware of and consider when deciding which platform to use for your liquidity needs.
Bonus Pick: Ledn
They survived through the bankruptcies of competitors and took and slow and careful approach that paid off. Get the funds you need, keep the Bitcoin and Ethereum you love. Pay off your loans at any time without penalties. No monthly payments are required.
They have two options to either invest your collateral and provide a lower interest rate or custody your collateral with qualified custodians and banks (no rehypothecation). I did not include a full review, because I prefer the multi-signature wallet approach to holding collateral, as no single entity controls your crypto and it is less likely to be stolen or seized. But if you are comfortable with that approach, you can learn more here: https://ledn.io/borrowing
Bonus Pick: Fiat Loans
Some skeptics will point out that fiat borrowing is the better method versus risking your Bitcoin in any way. If a crypto investor needing liquidity is able to access the traditional banking system, this option should also be considered. Of course, this will require strong credit, KYC, and supporting corrupt legacy financial institutions.
The rates could end up being higher and in many cases the monthly payments will be larger, including both interest and principal. A personal loan is one option, but a better option may be a credit card with an introductory period of 0% APR. This period of owing no interest and only minimum payments can be up to 18 months (Wells Fargo Reflect Card). Whether using a personal loan or credit card with no interest, crypto investors could allow their crypto assets to continue to appreciate rather than selling, losing exposure and triggering a taxable event.
Disclaimer: I am not a financial advisor or tax expert. Please consult with professionals before putting your money at risk.
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