Loans backed by bitcoins allow borrowers to obtain funds while keeping ownership of their bitcoins by using their holdings as security.
Loans backed by bitcoin are a creative way to combine traditional lending with the cryptocurrency sector. These loans provide a special way for holders of Bitcoin to access liquidity by allowing them to use their digital assets without having to sell them. The procedure has been simplified by the growth of cryptocurrency lending platforms, improving the accessibility of these loans.
What is cryptocurrency lending?
With its innovative new approaches to borrowing and investing with cryptocurrencies, cryptocurrency lending is completely changing the way people engage with digital assets. Lenders, who take advantage of market volatility to earn higher interest rates than traditional savings accounts, are the backbone of this system. They deposit their cryptocurrency holdings into lending platforms.
Conversely, borrowers are able to obtain funds without having to sell their cryptocurrency holdings. Borrowers can obtain loans in stablecoins or fiat currencies by offering collateral, which is typically in the form of other cryptocurrencies. This allows them to access liquidity without giving up ownership of their assets.
A significant driver of this innovation is the rise of decentralized finance (DeFi) platforms, which use smart contracts to automate the lending process, eliminating the need for intermediaries and enhancing transparency and security. Showcasing the potential of DeFi to transform financial services, platforms like Aave, Compound and MakerDAO have become prominent players in this space.
In DeFi, lending Bitcoin usually involves using Wrapped Bitcoin (WBTC), which is compatible with smart contract networks such as Ethereum, Arbitrum, Polygon, or Solana, enabling users to participate in decentralized lending.
Understanding Bitcoin-backed loans
Bitcoin-backed loans operate on principles of collateral management and stand as a secure gateway for users to leverage the collateral value of Bitcoin and access fiat or stablecoins. This financial avenue is revered for its safety, with Bitcoin’s comparative stability against other crypto assets and its ability to unlock the highest loan-to-value (LTV) threshold second only to stablecoins.
The LTV ratio measures the loan amount relative to the appraised value of the asset being purchased. It’s a key indicator for lenders to assess risk, with lower LTV ratios typically indicating lower risk.
A plethora of platforms in both the CeFi and DeFi realms support Bitcoin-backed loans. These platforms often adhere to custody and security standards that resonate with the ethos of Bitcoin holders, prioritizing robust security measures.
Among the myriad options available, some Bitcoin-native solutions manifest through loan products built atop layer-2 Bitcoin networks like Stacks. These products inherently rely on the security of the Bitcoin network while providing a degree of self-custodial access to Bitcoiners.
How to get a Bitcoin-backed loan
Before securing such a loan, borrowers must understand the collateral management process, loan eligibility criteria, potential loan default consequences and available refinancing options.
Step 1: Borrower applies for a loan
Borrowers begin by applying for a loan through a platform specializing in Bitcoin-backed lending. During the loan application process, they provide details about the collateral, which is typically Bitcoin, and specify the desired loan amount.
Step 2: Borrower deposits Bitcoin into a lending platform’s crypto wallet
Upon approval, the borrower deposits the specified amount of Bitcoin into a crypto wallet provided by the lending platform. This Bitcoin is held in escrow for the loan term, serving as security.
Step 3: Lending platform determines the LTV ratio
The platform then assesses the asset valuation of the Bitcoin collateral and determines the LTV ratio, which sets the maximum loan amount relative to the collateral’s value. For example, if a borrower deposits $10,000 worth of Bitcoin and the LTV ratio is 50%, they can borrow up to $5,000.
Step 4: Loan disbursement process begins upon approval
Once the loan is approved, the loan disbursement process begins, with the borrower receiving the approved amount in their desired currency or stablecoin. Meanwhile, the Bitcoin collateral remains securely held in the platform’s wallet. The borrower makes regular interest payments throughout the loan term, typically monthly. The interest rate depends on several factors, including the loan amount, the borrower’s creditworthiness, and market conditions
Benefits of Bitcoin-backed loans
It’s critical to balance the advantages and disadvantages before thinking about loans secured by bitcoin. The preservation of Bitcoin assets is a major benefit. To get cash, users do not need to sell their Bitcoins. This satisfies their present cash demands while preserving ownership of their digital goods and maybe profiting from price increases in the future. Additionally, compared to traditional loans, crypto loans frequently have faster approval processes and quicker access to funds, which can be very helpful in emergency situations where instant liquidity is needed to meet obligations or take advantage of possibilities.
Another benefit is the global accessibility and flexibility of Bitcoin loans, which are available worldwide irrespective of geographical location or credit history. Users enjoy the freedom to select loan amounts, purposes and repayment options, enabling them to access liquidity based on their individual financial needs and circumstances.
Moreover, lending Bitcoin on cryptocurrency platforms can yield users attractive interest rates, often surpassing those of traditional savings accounts. Also, borrowing against Bitcoin holdings can offer tax advantages by circumventing capital gains taxes incurred from selling Bitcoin, optimizing users’ financial approaches while reducing tax liabilities.
Risks associated with Bitcoin loans
First, the inherent volatility of the market and Bitcoin’s price swings can be dramatic, and that creates risk for Bitcoin-backed loans, potentially leading to the liquidation of collateralized Bitcoin if its value drops below a predefined threshold. Price fluctuations in Bitcoin can significantly impact loan repayment obligations, necessitating borrowers to develop careful risk management strategies.
Second, Bitcoin loan interest rates are subject to market fluctuations, exposing borrowers to increased borrowing costs if interest rates rise during the loan term. The variability in interest rates can affect the overall affordability of the loan and impact borrowers’ financial stability over time.
The evolving regulatory landscape introduces ambiguity around Bitcoin loans, creating uncertainty in legal, accessibility and service conditions. As regulations change, the availability and terms of Bitcoin loans can be affected. Borrowers must stay informed about these developments and adapt their strategies to navigate potential impacts effectively.
Cryptocurrencies are not insured by traditional institutions, potentially leading to loss of collateral in case of hacks or lender insolvency. Furthermore, entrusting Bitcoin holdings to lending platforms exposes borrowers to risks such as fraud, insolvency and security breaches. It’s crucial to select reputable platforms with robust security measures and transparent policies to mitigate platform-related risks effectively. Conducting thorough due diligence and research can help borrowers identify trustworthy platforms and minimize the likelihood of adverse outcomes.
If the value of cryptocurrencies drops below a certain threshold, lenders might demand more collateral or the sale of assets. Margin calls can happen quickly, necessitating quick action from borrowers to keep their loan-to-value ratios intact. This could result in the sale of assets or the need for more collateral. Last but not least, the inability to trade or transact cryptocurrency assets while carrying outstanding loan balances may present difficulties during price declines, limiting borrowers’ ability to effectively access or utilise collateralized assets and adapt to shifting market conditions or financial needs.