May 16th, 2024

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Bitcoin-backed Loans & Custody Models Explained

I remember it like it was yesterday. The little bit of bitcoin I had mined with so much effort was now worth 3X what it had cost me to mine it. I was elated– I wanted more. More Bitcoin, more miners, more freedom. However, it was my only saleable asset at the time. I was torn - my only way to grow the business was to sell the new crown jewel of my portfolio. I had no choice. I felt like I wanted to vomit, but I still did it. It felt wrong, and I never wanted to sell bitcoin ever again.

In my desperate search for someone that would give me a loan with bitcoin as collateral, I realized that no one understood bitcoin as well as we did. 

No one saw it as the world’s greatest loan collateral asset, like we did. 

After being laughed out of a few rooms, Adam and I decided to solve our own problem and start Ledn, so that others could access financing without selling their bitcoin too. 

Fast forward 6 years and here we are again. Many people that bought bitcoin at $20K have seen their investment 3X. They want to turn that newfound digital wealth into a real world experience, but they don’t want to sell it. Every time this happens we get a flurry of referrals and questions, and I see many threads on X and Reddit pop up asking for reputable places to use your bitcoin as collateral. After receiving many messages and seeing many posts, I’ve decided to create an unbiased guide of the bitcoin-backed lending ecosystem, from the vantage point of someone who’s been doing this for over half a decade now.

RELATED CONTENT:  The Ultimate Guide to Crypto Lending

Before we get into a breakdown of the competitive landscape and offerings today, let’s review some background context on loans and a brief history of Bitcoin-backed loans.

On Loans & Balance

Most financial transactions reach “finality” in an instant. Paying for coffee, groceries, buying or selling bitcoin, all can be completed in a heartbeat, and each party gets what they want right away after the exchange. 

Example: Miguel is happy to pay $10 for a sandwich because it would cost him more time or money to make it himself, and the Sandwich shop is happy to sell it at $10 (and pay an extra $1 to the credit card processing companies) because they can make the sandwich for $6. 

There’s a harmonious balance in the transaction above, and everybody wins. If all parties to the transaction don’t feel like they are being fairly compensated, the balance breaks. In other words, the sandwich shop doesn’t scale– or goes out of business.

A “loan” is also a type of financial transaction. There is a “seller” or supplier of capital, the lender– and there is a “buyer” or consumer of capital, the borrower. But it has one additional consideration, which is that a loan does not reach finality right away. It’s a long-term commitment that can go on for years. Because of this, it is even more important, and more challenging, to strike the right balance between the parties.

In the case of Bitcoin-backed loans, the lenders are those investors or institutions that provide the U.S. dollar liquidity in exchange for an interest rate, and borrowers are those bitcoiners who post their bitcoin as collateral to obtain the capital they desire, without having to sell their bitcoin.

My Precious

As you’ve heard me say before, unsecured credit doesn’t exist, and over 80% of all debt in the U.S. is collateralized by assets. So, let’s frame this conversation around balance in the context of collateralized lending. 

Lending is older than coined money. Even back then, seed loans were collateralized with gold and other assets. In fact, the first set of laws in human history, the Hammurabi code, set maximum interest rates that could be charged for certain loans. In the modern age, a lender of capital needs to be comfortable with the levels of security or protection that he or she is getting from the borrower, as well as the interest rate that he or she is receiving in exchange for lending the capital. Similarly, the borrower must feel that he or she is getting sufficient value from the capital obtained to warrant the risk transferring custody or control over his or her collateral, plus paying an interest rate. 

The important thing to keep in mind here is that: For both the lender and the borrower, the capital at stake is “the most important asset in the world”. 

In other words, dollar lenders are often indifferent to the type of collateral that a borrower posts, as long as their precious dollars are protected. And borrowers don’t care much about where the capital or dollars come from, as long as they feel their precious collateral assets are safe and can be recovered.

As you can already see, reaching this balance is an art as much as it is a science.

In the bitcoin-backed lending industry, there have been several attempts to reach this delicate balance between lenders and borrowers. Some have scaled better than others, and some have failed to do so. At the end of this essay, you should have a better understanding of the industry dynamics and constraints that have led to those outcomes.

Finding Balance

Building a bitcoin lending product has been an incredible experience. When you start, it looks a bit like this:

Lender: “I’m willing to lend you U.S. dollars. I’d like to hold 4:1 collateral to the loan amount, and full control and custody of the Bitcoin. I also need the ability to liquidate instantly when certain prices are triggered. The rate at which I could lend you money is 20% APR.”

Borrower: “I’d like to borrow dollars and keep full custody and control of my bitcoin. I’m willing to post 1:1 collateral to the loan amount,  and I need at least one week to come up with extra bitcoin collateral, as I have it in cold storage. The highest interest rate I am willing to pay is 5% APR.” 

Today, the bitcoin-backed lending model that is globally available to consumers at scale, is one where borrowers overcollateralize their loans with bitcoin at 2:1, transferring custody of the collateral to the lender– which is a centralized entity in most cases, and paying an average of 14-20% APR at current rates. Once the loan is repaid, the collateral is returned to the client. Margin calls and liquidations occur at specific price triggers, typically there are no time windows to meet collateral calls. There’s been several subtle iterations of this model, each with corresponding tradeoffs. More on this next:

Walk a mile in my shoes

I am a bitcoiner. Custody and control of private keys is and always has been a very important consideration for our team and I when designing our products. I’ll be the first to admit that collaborative custody, also known as multi-signature custody, is an awesome solution that Bitcoin enables. But, after years of building lending products on Bitcoin, I’ll also be the first to tell you that it’s a challenge to use collaborative custody for loan collateral. The reasons come back to the above– balance between the lender and the borrower. 

Collaborative custody in the context of loan collateral is great from the viewpoint of the bitcoiner who is borrowing, but let’s try to reverse the roles: If we asked you– a bitcoiner, to give up full control of your bitcoin, and take dollar collateral in a bank account that you can see the balance of, but that needs 2 out of 3 approvers to take possession of the dollars, once the loan approaches a liquidation scenario– and, by the way, that dollar transfer may require potential arbitration to be completed, would you accept? Most Bitcoiners wouldn’t - that’s where the balance breaks. Many fail to appreciate that for the other end of the trade, the dollars are what’s most important.

Whose Bitcoin is it Anyway?

Another challenge that collaborative custody presents is the idea of control. If Bitcoin is sitting in an address that requires 2 out of 3 independent signatures to transact, and it can be done through any combination of the 3 signatures, which of the 3 independent signing parties controls the bitcoin? Who “owns” the bitcoin? If no one signer can control it, is it really his or hers? If no one has control over it, how can it be on anyone’s balance sheet as an asset?

Across the world there are standards for custodians to follow in order to be deemed “Qualified Custodians”. These standards are usually developed as combination of policies and procedures that enforce a basic set of standards and security for institutions and consumers. How could a custodial setup with 3 independent signers, where one or more of them are not qualified custodians, be be considered “qualified custody”? 

Banks and financial entities have access to the cheapest cost of capital in the world. But they also have to abide by the tightest and strictest regulations. This makes it nearly impossible for them to work with collaborative custody in its current form. Which, in turn means, that banks can’t fund multi-signature custody loans easily– or at all. How you see this expressed in the market is by multi-sig loans not being widely available to consumers at scale, and where available through Peer to Peer offerings, they are limited to very small amounts. It’s usually not for a lack of borrowers– they’re there. But who doesn’t show up to the party is the capital providers, who don’t feel they are being compensated adequately enough to show up in size.

Now lets cover the competitive landscape of bitcoin-backed loan offerings in the market today:

Everything for Everyone

Like in any market, customers have different preferences. Companies compete to cater to different segments of the market, based on what they believe will help fulfill the company’s mission. 

At Ledn, our mission is to build the most transparent and honest lending solution that can make working capital accessible to bitcoiners worldwide, and to treat them equally! 

We’ve made strategic decisions that ensure our clients have the most choices and best experience when it comes to loans. 

With regards to custody of collateral, clients can choose to have their loan collateral remain in custody, through our Custodied Loans, or allow the collateral to be rehypothecated and verified through periodic proof of reserves. In both cases, clients must transfer control of the bitcoin collateral to Ledn. To offer transparency, Ledn was the first lender to ever undergo a Proof of Reserves attestation with a Certified Public Accountant back in 2021, and we complete Proof of Reserves reports every 6 months, where our clients can verify that their assets are accounted for accurately. We also produce our Open Book Reports every month, which breaks down how assets are being utilized to power the services that we offer. As a regulated entity, Ledn must also obtain personal information to comply with our anti-money laundering and KYC programs, which enables us to interact with large financial institutions and obtain the most competitive funding rates for our loans.

Other lenders have prioritized collaborative custody for loans, with different resulting tradeoffs. An example of this would be Unchained Capital, which offers bitcoin-backed loans for U.S. Companies in select states only, requiring more collateral than the industry average, and charging a slightly higher interest rate than similar loans These loans are only available to an exclusive segment of American bitcoiners, but it allows bitcoiners to maintain one shard of the multisig address where the collateral sits. This shard or partial signature allows them to visualize the collateral on-chain, but does not give them control over the Bitcoin. Clients must also provide personal information to comply with regulations.

An alternative approach has been to prioritize collaborative custody and privacy, but limiting size and volumes. An example of this would be HodlHodl Lend, a peer-to-peer platform that matches lenders of U.S. dollar stablecoins and borrowers willing to post bitcoin as collateral. Both borrowers and lenders can access the platform without having to share any personal information, or KYC. Loans have a maximum amount of $25,000 each. These loans are widely available and accessible to clients worldwide and allow for collaborative custody, but funding is extremely limited. Large financial institutions and large pools of capital are heavily regulated and have strict anti money laundering programs that would make it impossible for them to participate in transactions without KYC. Similarly, collaborative custody is not compatible with most banks or large regulated institutions as we covered above. 

The HodlHodl team recently launched another initiative called Debifi, with the goal of allowing entities to fund borrower loans directly, presumably to solve the USD funding limitation. The solution is not operational yet at the time of writing, but we will update the blog with more details once it’s out. 

Yet another approach has been to raise funding by doing an Initial Coin Offering (ICO), which means launching a native platform token, and to increase loan accessibility by supporting a large number of crypto collateral assets (in addition to bitcoin). An example of this approach would be Nexo.

Launching a platform token introduces significant regulatory risk to any operator– as an example, Nexo had to settle with U.S. regulators by paying a $45 million fine and agreeing to exit the U.S. market.  Additionally, Nexo supports 37 collateral assets, including Terra (Luna2), dogecoin, and even its own NEXO token. Support for more esoteric and illiquid collateral assets allows companies to cater to more clients, but it also increases the complexity and risk of any lending operation. Loan risk management engines rely on deep liquidity on collateral assets to close out loans during times of stress - and finding liquidity for illiquid assets can be difficult even during normal market conditions - hence why these assets are referred to as “illiquid”. 

The below chart captures the sections we’ve covered above:

As you can see, there are different options in the market that cater to different client preferences and risk appetite. Hopefully this article can help you determine which, if any, is the right one for you. 

And remember, regardless of which platform you decide to use, if you choose to use your bitcoin as collateral– don’t trust, verify! Take it upon yourself to diligence your platform(s) of choice. If you’re looking for some guidance, we’ve also put together a list of questions that you should ask your service provider here. 

Hodl!

Notice for Canadian Residents: As of August 3, 2023, any Canadian BTC or USDC Savings Account is transitioned into a new non-interest earning BTC or USDC Transaction Account for the purposes of allowing Canadian clients to manage their Ledn loans.

Notice for U.S. Residents: As of August 3, 2023, any U.S. BTC or USDC Savings Account is transitioned into a new non-interest earning BTC or USDC Transaction Account. On that date, the account balance in any U.S. Legacy Savings Accounts will remain in such accounts and continue to be non-interest earning. 

This article is intended for general information, educational and discussion purposes only, it is not an offer, inducement or solicitation of any kind, and is not to be relied upon as constituting legal, financial, investment, tax or other professional advice. This article is not directed to, and the information contained herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution, publication, availability or use would be contrary to law or regulation or prohibited by any reason whatsoever or that would subject Ledn and/or its affiliates to any registration or licensing requirement. This article is expressly not for distribution or dissemination in, and no Ledn product or service is being marketed or offered to residents of, the European Union, the United Kingdom, the United States of America or any jurisdiction in Canada, and such product or service may only be marketed or offered in such jurisdictions pursuant to applicable laws or reliance on regulatory exemptions. A professional advisor should be consulted regarding your specific situation. Digital assets are highly volatile and risky, are not legal tender, and are not backed by the government. The information contained in this publication has been obtained from sources that we believe to be reliable, however we do not represent or warrant that such information is accurate or complete. Past performance and forecasts are not a reliable indicator of future performance. Any opinions or estimates expressed herein are subject to change without notice. This article may contain views or opinions of the author that do not necessarily reflect the opinions, standards or policies of Ledn. We expressly disclaim all liability and all warranties of accuracy, completeness, merchantability or fitness for a particular purpose with respect to this article/communication. Read our Disclaimers at https://ledn.io/legal/disclaimers