Bitcoin is for savings and payments, but can also be used for collateral and lending.

Using your bitcoin as collateral and lending your bitcoin for yield are two different ways of using your bitcoin. These options operate as different models and come with unique sets of risks and rewards. Before engaging in either, it’s important to understand the differences.

Let’s compare.

Bitcoin-backed loans: Accessing liquidity with collateral

A bitcoin-backed loan involves posting bitcoin as collateral and receiving a cash loan in return. The bitcoin collateral acts as a secure guarantee for the lender, giving them assurances for their investment since they can liquidate the collateral in the event the borrower defaults. For the duration of the loan, the bitcoin is held by the lender or their capital provider, without being lent-out, shorted, or transferred to any other third parties (aka “rehypothecation”).

Here’s the basics of how it works:

1. Post collateral: You post bitcoin collateral to the lender.
2. Receive cash: You receive a cash loan, to be repaid at a specified time with interest.
3. Collateral custody: Your bitcoin is held securely by the lender, or transferred to their capital provider to pledge as collateral to receive funds for the loan, and never rehypothecated to other third parties.
4. Deploy the cash: You use the cash as you see fit, such as for generating a return.
5. Repay loan: At your loan’s maturity date (or earlier), you repay the loan amount with interest.
6. Collateral return: Upon repayment, your bitcoin collateral is returned to you.

In this system the lender's potential profit is capped at the agreed-upon APR. This is attractive to the lender, because the rate of return exceeds what they could earn elsewhere in the market, and their investment is secured by high-quality collateral.

As the borrower, you gain access to immediate cash without selling your bitcoin, thus retaining ownership for potential price appreciation. If you use the borrowed cash to generate a return exceeding the loan's interest cost, you stand to benefit financially.

Lending bitcoin for yield: Earning interest through lending

Lending bitcoin for yield involves depositing bitcoin on a platform that reuses it by lending to third parties (a practice often referred to as “rehypothecation” in the bitcoin space). These third parties then use the bitcoin to generate yield, such as through short selling or margin trading:

• Short selling: Short selling (aka “shorting”) involves borrowing bitcoin and selling it in the market with the expectation of buying it back in the future at a lower price to profit from the price decrease.
• Margin trading: Margin trading involves borrowing bitcoin to execute trades with greater leverage than your own holdings, seeking to amplify potential profits on price fluctuations while simultaneously increasing the risk of significant losses.

Here’s the basics of how lending bitcoin for yield works:

1. Deposit bitcoin: You deposit your bitcoin on a yield platform.
2. Rehypothecation: The platform lends your bitcoin to third parties, who engage in activities like short selling or margin trading to generate yield.
3. Fee payment: The third parties pay fees to the platform at regular intervals for the use of the bitcoin.
4. Yield distribution: The platform distributes a portion of these fees to you as yield, proportional to your amount of bitcoin deposited and at a rate that can fluctuate based on market demand and platform policies.
5. Withdrawal process: When you request to withdraw your bitcoin, the platform typically fulfills it from a pool of bitcoin they hold that hasn’t been lent out. If withdrawal demand exceeds their readily available (non-rehypothecated) bitcoin, the platform will need to source additional bitcoin, potentially by recalling the lent-out bitcoin from the third parties.

In this system, your potential profit is capped at the yield rate, which can fluctuate with market conditions. This can be appealing as it requires no activity beyond depositing your bitcoin to earn yield, often without long-term commitment.

The platform's primary role is risk management. They’re financially incentivized to lend as much bitcoin to third parties as possible who can earn the highest returns and pay the most fees, however, higher returns carry increased risk of third-party insolvency due to risky ventures. By depositing your bitcoin, you take on these additional layers of risk, which are difficult to assess and monitor, due to the opaqueness of the third parties’ activities and their leveraged exposure to unpredictable market conditions.

This structure introduces the critical risk that your bitcoin may not be available for withdrawal when requested, as the entire model depends on third parties returning the bitcoin they themselves may have re-lent or deployed, leaving the platform unable to fulfill redemptions.

The key differences

While both bitcoin-backed loans and lending bitcoin for yield offer a way to earn a return on your bitcoin while typically avoiding a taxable event, they differ in several important ways:

	Bitcoin-backed loan	Lending bitcoin for yield
Purpose	Secure a cash loan using bitcoin as collateral	Earn yield by lending bitcoin to third parties
Rehypothecation	No	Yes
Bitcoin custody	The bitcoin is held by the lender or their capital provider	Bitcoin is transferred to third parties, who may transfer to other third parties, etc…
Return rate	The lender's return is capped at the interest you pay. Your use of loaned cash is at your discretion.	Your return is capped at the yield rate. The platform’s use of your bitcoin is at their discretion.
Operation	You are responsible for deploying cash proceeds and managing the associated risks.	The platform is responsible for deploying the bitcoin and managing the associated risks.
Return of bitcoin	Return of your bitcoin happens upon full repayment of your loan, with the lender sending to your wallet.	Return of your bitcoin is subject to the platform’s liquidity, policies, and the third parties’ practices.

Risk scenarios:

For both bitcoin-backed loans and lending bitcoin for yield, different scenarios can put your bitcoin at risk, for different reasons:

1. Falling bitcoin price:

• Bitcoin-backed loans: A declining bitcoin price reduces your collateral’s value, pushing up your Loan-to-Value (LTV) ratio. If the LTV exceeds a set threshold, it can trigger a margin call or automatic liquidation, meaning sharp drops can force sales of your bitcoin at disadvantageous times. To mitigate this, borrowers often over-collateralize.
• Lending bitcoin for yield: If your bitcoin is lent to short sellers, a falling price strengthens their position. But if it’s lent to leveraged long traders, a price drop increases their risk of losses, possibly affecting their ability to repay your bitcoin.

2. Rising bitcoin price:

• Bitcoin-backed loans: A rising bitcoin price increases your collateral's value, reducing the LTV and lowering risk for both borrower and lender.
• Lending Bitcoin for yield: If your bitcoin is used by a short seller, a rising price pressures their position and can lead to insolvency if they cannot repurchase at the higher price. Conversely, long positions may benefit from a rising price, reducing counterparty risk.

3. Liquidity crunch or mass withdrawals

• Bitcoin-backed loans: A surge in borrowers withdrawing collateral should not cause issues, as the bitcoin is held in a secure wallet. Once a loan is repaid, collateral is returned, typically within 1-3 business days.
• Lending bitcoin for yield: Sudden withdrawal demands can strain the platform’s liquidity, potentially leading to collapse. For bitcoin that has been rehypothecated or locked in other trades, it may be difficult or impossible to fulfill all withdrawal requests, which can trigger a bank-run dynamic, risking platform insolvency.

4. Custody issues:

• Bitcoin-backed loans: Custody risk is limited to the lender or their capital provider—who must be trusted to securely hold and return your bitcoin. While having a different risk profile than self-custody, this risk can be reduced by selecting a reputable lender, especially those offering proof of reserves to show the collateral isn’t rehypothecated.
• Lending bitcoin for yield: Custody risk is spread across multiple layers, which is difficult to assess and monitor. Your bitcoin passes through the platform, the borrower, and possibly additional third parties via rehypothecation. Each layer introduces uncertainty, with custody practices that are often opaque or unverifiable.

Summary

To summarize, both bitcoin-backed loans and lending bitcoin for yield expose your bitcoin to risk, but in different ways.

• Bitcoin-backed loans carry risk with the lender’s custodial practices and are primarily sensitive to price declines that can impact LTV ratios, potentially triggering margin calls or liquidations at inopportune times.
• Lending bitcoin for yield carries custodial, operational, and market risks across an often opaque network of counterparties, amplifying the impact of price volatility in both directions, borrower solvency, and platform-level liquidity crises, including the potential risk of withdrawal freezes or bank-run scenarios.