The hidden risks of borrowing against your Bitcoin

When you borrow against your Bitcoin, the collateral doesn't just sit idle. With $56 billion in Bitcoin currently locked in lending markets, many borrowers are unaware of a practice called "onward lending," where their assets are passed to third parties to generate interest. This creates a risk: if those counterparties default, your collateral could disappear, leaving you as an unsecured creditor in bankruptcy. This was the painful lesson learned from the collapses of Celsius and BlockFi.

The process of a Bitcoin-backed loan involves several steps. A borrower posts their Bitcoin as collateral and receives dollars in return, but the question remains: where does the collateral actually go? Different lending models determine who holds it, who can use it, and how it is eventually returned.

The risk of onward lending highlights a critical flaw in some crypto lending practices. While temporary cash flow may be attractive, borrowers must weigh this against the potential loss of their Bitcoin forever. Understanding the mechanics behind these loans is crucial for anyone considering this financial strategy.