In the aftermath of the 2022 crash due to the collapse of DeFi, it became obvious to everyone that when you earn interest on bitcoin, it turns out that your bitcoin in the exchange isn’t really there.
The insane yield being offered by the crypto ecosystem was not sustainable. It was always obvious to many (but not all) bitcoiners from the beginning, but at least now pretty much everyone is on board. You can’t just get 20% APY without taking on some kind of risk.
Post collapse, Celsius, Voyager, and other “bitcoin yield” services halted bitcoin withdrawals while filing for bankruptcy because they simply didn’t have the bitcoin to pay users back. People put their bitcoin on these platforms to generate interest on bitcoin deposited, then the company mismanaged those deposits, and now the bitcoin is simply gone. It’s not there anymore.
Things are still going to court, so it’s unclear how these specific situations are going to unfold, but the lessons learned are already clear. Everyone wants your bitcoin, but if they lose it playing yield chasing games, you bear the brunt of the consequences. It’s your job to learn how to keep your bitcoin safe and secure in self custody.
Interest, Yield, Risk, And Money
8% Yield Is Not A Bank Account
To be honest, the whole “yield” situation wasn’t clear to me back in 2019 and 2020. I was just excited about earning anything over 0.25% return on my idle cash in a traditional bank account. I didn’t even realize the simple fact that if you’re getting more than a few percent return on your money that there’s something going on behind the scenes.
At one point, I had a significant amount of bitcoin and stablecoin dollars (GUSD) in a bitcoin lender lender (BlockFi), and assumed it was pretty much safe like a bank account. As it turns out, it wasn’t.
I knew that it didn’t have FDIC insurance like banks in the US did, but I just couldn’t imagine a scenario where I couldn’t get my money out. These were responsible guys with a legit business! They have investors I know the names of! They have a Twitter account and are bullish on bitcoin! Sure, looking back, those seem like dumb thoughts, but I’m just being honest here because there are obviously lots of other people who were in the same boat. I don’t think there’s anything wrong with admitting previous mistakes.
What I didn’t realize at the time, but soon began to understand, is that the only reason they can offer something like 8% is because they are generating more than 8% by some other method. Once you factor in operating costs, you have to then ask, how the hell are these guys generating a consistent 10-12% or more interest on their money? The answer is that they are investing your money into… well, nobody knows. You can’t verify what they’re investing in, so you are basically just trusting the brand and hoping they are being responsible behind the scenes.
Picking Up Pennies In Front Of A Steamroller
As this realization dawned on me, I began to think, “Why would I risk 100% of my bitcoin for a measly 8% return (sometimes even less!)?”. Eventually, I decided to forego the interest. I took all of my bitcoin off of these platforms an no longer consider it an option. I keep all my bitcoin safe in cold storage.
Fast forward two years, and several major crypto lenders (Celcius, Voyager, BlockFi) have frozen depositors’ assets and are going through bankruptcy proceedings.
With regards to the bankrupt lenders, some people may get a portion of their assets back at some point in the future, but many will likely get nothing. It’s all up in the air. If you were counting on earning interest on a chunk of your bitcoin as a source of consistent income, you could be royally fucked right now.
Not only would your income stream be gone, but your principal would be locked or nuked. Gonzo.
Depositing your money into these lending platforms, regardless of “brand trust”, or status as a publicly traded company does not mean that your bitcoin is safe. There are no bailouts in bitcoin!
20% Yield Is Not “Basically Risk Free”
WHERE DOES THE YIELD COME FROM has become a bit of a meme in the bitcoin space, as bitcoiners try to explain to DeFi users that you can’t just get free money for doing nothing. The amount of money you receive in yield has to be from some kind of economic activity, somewhere in the system.
If someone is offering you 20% yield on your investment, they have to be generating more than 20% returns on whatever it is they’re doing in order to pay you your yield and earn a profit for themselves.
Another basic principle to keep in mind is that the higher the yield, the riskier the economic activity. That’s why you earn less than 1% on a USD savings account, and you’ll maybe around a 3% dividend if you hold a blue chip stock. Once you start getting higher than that, you’re venturing into ultra-risky investments like junk bonds, which are hovering around 5-6% in 2022.
So when a DeFi protocol offers you 20% yield on your money staked on their protocol, you have to ask, “Where does the yield come from?”, because it’s certainly not “risk free” yield.
The reality of the situation is that many of these DeFi AND CeFi programs to generate yield are dependent on new entrants to the system in order to fund the yield obligations of current participants, essentially making them DePi’s (Decentralized Ponzis) (Also, yes, I just coined that term).
High Yield Means High Risk, And You Can’t Escape That
What DeFi users fail to recognize is that even if the technology works, the economic system does not. Yield on money is something that arbitraged out and flattened across similar risk activities over time. There simply cannot be a “pocket” of 20% yields that doesn’t get exploited until the yield becomes in line with other risk-similar activities.
In other words, if the yield is truly is worth 20% returns, means it’s a high risk investment, and there will be a large amount of failures, with a good chance that you’ll lose all of your investment. If the yield is from standard reliable business activity, then you will not be able to get such a high yield. That’s just how economics works.
Participants in DeFi might be able to sustain their risky investment activities for a short period, but what are they doing to earn so much return on investment? Many times, they are trading other DeFi tokens and staking in other DeFi protocols, making it DeFi on DeFi on DeFi. Turtles all the way down.
Once cracks in the system started to show, people withdraw their money, and and everything collapses. Ponzis only work on the way up.
But Bitcoin Isn’t A Productive Asset!
A common criticism of bitcoin is that it “isn’t a productive asset”, which makes it not worth holding as an investment. This is often lobbed at bitcoiners from the DeFi camp, claiming that their tokens offer yield for stakers, which supposedly means they are productive assets by contrast.
My response is, “Great!”. Bitcoin shouldn’t be productive. It’s money. It’s neutral. It’s inert. Money isn’t supposed to generate yield because it doesn’t do anything. PEOPLE do things that create value, and value-add is how you earn interest on money invested. If you want to get interest on your bitcoin, invest in a bitcoin business.
Where does the yield come from in bitcoin? It comes from economic activity from productive humans.
Token “Productive” Yields Come From Trading Other Tokens
Furthermore, it’s wrong to assume that just because a token offers yield, that it is actually “productive”. Investing money in a company means you get a return on your investment because the company is engaged in value-add activity in the real world.
You can look into what a business does, and make a clear decision on whether or not your investment is worth the risk. DeFi, on the other hand, doesn’t offer this type of transparency.
A token may offer a high interest return, but you don’t know what any of the economic actors on the other side of the transaction are doing. Hypothetically, they could be using your tokens to start a business or do something else “legit”, but the vast majority of the time they are just trading shitcoins with leverage, and there’s no way for you to know.
Not Your Keys, Not Your Coins
One of the most famous memes in bitcoin is Not Your Keys, Not Your Coins, and for good reason. If you don’t hold the keys to your bitcoin, then someone else does, and that presents a risk to your bitcoin. Someone who holds the keys to your bitcoin can restrict the movement of your bitcoin whether you like it or not, and in order to earn yield on your bitcoin, you gotta hand over the keys.
What Is Custodian Risk?
Custodian risk is the risk of losing your bitcoin due to issues with the entity that’s holding your bitcoin. In most cases, this would be the lender or exchange where your bitcoin is held. Three great examples from 2022 alone are Voyager, Celsius, BlockFi, and Hodlnaut. All of these lenders were attracting depositors with high interest rates, then lending out customer deposits on the back end.
When those loans went bad, as customers tried to withdraw their money, the money simply wasn’t there. The most enraging example of this was Celsius, who denied being insolvent right up until they activated “HODL Mode” for users, deceiving them into thinking this was for their own protection.
Some people had tens of bitcoin deposited in these exchanges with the intent of earning interest on their deposits. I’ve read some stories of people quitting their jobs and planning on living off the interest. Now that the custodian is bankrupt, they have no cash flow and their savings are gone too.
Custodian risk is not limited to lending out deposits. As was the case of Mt. Gox and many other bitcoin exchanges since then, an exchange can be hacked.
If an attacker gets takes bitcoin from your account due to an exchange being insecure, the bitcoin is gone. If you use a well capitalized and financially capable exchange, in some cases they may make users whole, but in many other cases, it simply means your money is gone, or it may be tied up in class action lawsuits for many years to come.
People exposed to the Mt. Gox hack still haven’t gotten their coins back 10 years later, and will only get a fraction of what they owned in 2013.
What Is Rehypothecation?
Rehypothecation is when you lend your bitcoin to an exchange for yield, and then they lend that bitcoin to someone else. Again, we return to the question of “Where does the yield come from?”. In many cases, it’s because whoever you lent your bitcoin to is lending it out to someone else.
You might get 5% returns, but your exchange is getting some amount higher than that from their lending activities. When they lend out your bitcoin, now they are giving up the keys to the bitcoin to someone else, and you have no insight into who they are lending to.
What this means is that an exchange engaging in this type of lending usually doesn’t actually have enough bitcoin to fulfill all customer withdrawals simultaneously. They are operating with fractional reserves, relying on the fact that most people won’t all withdraw their bitcoin all at once… until there’s a bitcoin bank run, and then there’s a problem.
One sign that an exchange doesn’t have enough bitcoin to pay their users is when they start having long withdrawal times and have unexpected delays or unforeseen requirements for you to get your coins.
The risk of rehypothecation is present with ANY exchange, not just lenders. Again, not your keys, not your coins. If you have bitcoin on an exchange, it’s a bitcoin receipt, not real bitcoin.
Borrowing Fiat Against Your Bitcoin Fixes This (Kind Of)
While bitcoin isn’t isn’t “productive” (because it’s money), you still have options available to you to turn that money into a productive asset, without selling your bitcoin. The easiest and most straightforward option is to lend out your bitcoin for dollars, then put those dollars to work. It’s a bit of a roundabout way of earning yield on your bitcoin, but it it solves this specific problem of not wanting to sell your bitcoin, but also not wanting to let money just sit around doing nothing.
With dollars, you can then put that money into a business, an investment, or other traditional way of earning yield.
For example, you could get a fiat cash loan by putting up bitcoin for collateral, then invest it into real estate. You can then use the cash flow from a rental or refinance the house to pay off the loan. I looked into this and the loan terms don’t make this an actually profitable deal, but this is the general idea (The loan is for 1-3 years but there’s no way you could pay off the loan that fast without some kind of other source of money or getting lucky with market conditions)
Of course, there are a few clear risks to consider. The first is that it costs money to get a loan, so your yield on dollars has to be greater than the cost of the loan. The second is that bitcoin’s price can be volatile, and loan terms universally require that you maintain a specific loan-to-value ratio otherwise your bitcoin gets liquidated.
1. Cost of The Loan VS Yield Earned
When you take out a fiat loan against your bitcoin, there are some costs associated. The first would be the origination fee, which is the one-time cost of creating the loan. This will be likely be a percentage of the value of the loan, something like 1%.
Then, there will also be the interest rate you pay on the loan. Interest rates vary across lenders, especially in the nascent bitcoin lending industry. Interest rate terns will also vary based on the terms of the loan, meaning the amount borrowed and the length of time borrowed. At the time of writing this, rates are currently somewhere between 8% and 15%.
What this means is that if you are borrowing at a rate of 10%, you have to earn something above 10% interest on your dollars in order to make your money back AND earn a profit. Also, don’t forget about taxes.
So it’s not like you can just borrow some money against your bitcoin and put it in an index fund to arbitrage some returns on your bitcoin. You really need a specific plan of how you are going to earn some return on the money you borrow.
2. Loan-To-Value Requirements
The other thing you have to keep in mind is that for a bitcoin loan, they are typically “marked to market” in real time, and there’s a specific LTV requirement. This means that you are required to have a certain amount of value represented by your bitcoin collateral against the fiat loan. This is typically 40% or 50% depending on who you borrow from.
When bitcoin experiences high volatility to the downside, this can be an issue.
For example, if you borrowed $10,000 against 1 BTC (currently valued at $20,000), that’s a 50% LTV. Your loan is worth $10k and the bitcoin is worth $20k. The loan is worth 50% of the value of your collateral.
However, if bitcoin drops down to $17,500, now the dollars you borrowed are valued at greater than 50%, and you need to “top up” your collateral with more bitcoin to get back down to 50%. If the price drops too fast and you can’t top up fast enough to meet the terms of the lender, your bitcoin could be liquidated to pay back the loan, meaning you can no longer get that bitcoin back, which was the whole point of taking out a loan in the first place. You become a forced seller.
With enough bitcoin, you can avoid this situation by over-collateralizing the loan by a significant amount, handing over 2x or even 3x the amount you need to secure the loan. However, this still presents a risk when bitcoin drops 80% in value or more, and you never really know when one of these catastrophic drops are going to hit. If you have the bitcoin in cold storage, then you’ve bought yourself more time to get your signing device and send over the bitcoin required, but if you simply don’t have any more bitcoin, you could be in trouble.
Honestly, I considered borrowing some money when bitcoin had dropped from $69k down to $50k because I thought, “No way it can drop further! We’re going to $100k in 2021”. Of course, that ended up not being true, and we dropped down below $20k. If I had been in the market at that price, it’s a possibility that my bitcoin would have been liquidated.
Where To Get A USD Loan By Backed By Bitcoin
There are a number of places you can get bitcoin-backed loans, but there are only three that I’d currently recommend based on my research and knowledge of the space.
I haven’t used any of these three myself, but I chose these based on their reputation, terms, and lending practices.
was a pioneer in the bitcoin-backed loan space and has long been a champion of bitcoin best practices. They offer a variety of high quality products that help people self-custody their bitcoin safely and smartly. They offer other financial bitcoin products like Bitcoin IRAs, as well as bitcoin custody tools like their multisig vault.
When you get a loan from Unchained, your bitcoin is held in a multisig quorum with Unchained, so you can ensure that your bitcoin is not being rehypothecated.
is also a great company that offers slightly better rates and lower minimum borrowing requirements. They offer international loans, and you can borrow in USD or USDC. They are the only lender that does “proof of reserves” every six months to prove that their books are in order and they own all the bitcoin they say they do.
is a decentralized version were you can borrow directly from other users based on terms that they set. HodlHodl is non-custodial, meaning that the HodlHodl platform doesn’t actually hold your funds at any time (they are locked in multisig escrow). This allows for global, P2P, trust-minimized, bitcoin-backed lending.
Getting a loan from HodlHodl is a slightly different process from using a traditional lender, but is still a great option, especially for global bitcoiners.
With all of these platforms, what sets them above many other lenders in the space is that they are bitcoin-only (no crypto) and that they are transparent. This is a huge contrast from many other lenders that may offer cheaper rates, but chase yield in risky DeFi lending schemes, block coinjoin transactions, discourage users from self-custody, use misleading advertising, and fractionally reserve their bitcoin holdings.
Of course, do your own research and use the company that works best for you, but these three are where I’d start your research.
Why I Used To Earn Interest My Bitcoin, But Now I Don’t
I’ll just let you know about my own personal mindset shift so you can get some perspective here. In years past, I did have some amount of bitcoin on BlockFi, and was earning something like 8% on the bitcoin I left on their exchange. It was actually part of my “financial plan” to always have this yield hitting my account every month, so I began to organize some of my finances around this concept.
Obviously, I didn’t understand what was actually happening at BlockFi at that time.
Many bitcoiners were warning users on Twitter and in podcasts about rehypothecation and fractional reserve policies used these companies, but I continued to ignore their advice for a while. Eventually I started to wonder, how much is 8% interest worth to me if I lose 100% of that bitcoin? When bitcoin goes parabolic, it can 10x over the course of a few months, so would I honestly miss a few percentage points gains? No.
So I took all my bitcoin off BlockFi, and it was the best decision I ever made. Now BlockFi is bankrupt, and I avoided the whole situation.
It was a great decision. I was able to sit back and just watch the fireworks because I knew that my bitcoin was safe in cold storage and only I controlled the private keys.
The culture of extreme ownership and personal responsibility within bitcoin is different from what many of us are used to, but when it comes to bitcoin, it pays in the long run to make the effort and learn how to safely and responsibly self-custody your bitcoin. When the price was crashing and people were panicking to get their coins off exchanges, I was able to sit back comfortably and watch events unfold.