Crypto-backed loans: how they work

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How to obtain liquidity from a crypto-asset portfolio without selling it: LTV, margin calls, liquidation and the central role of custody

A crypto-backed loan allows you to obtain liquidity by using crypto-assets as collateral, without selling them. The holdings remain exposed to the market but are locked until the debt is repaid. The mechanism rests on four elements: the value of the collateral, the Loan-to-Value ratio, the contractual thresholds and the entity that holds the assets in custody.

Crypto-backed loans: liquidity without giving up exposure

The mechanism is straightforward. Holders of crypto-assets, usually Bitcoin, pledge them as collateral for the loan; the lender provides liquidity in euros and obtains coverage for its credit. The borrower does not sell the assets and therefore retains exposure to the market performance of the underlying. The loan can meet a temporary liquidity need, but whether it is worthwhile depends on the cost of financing and on the performance of the asset’s value, which may also decline.

This is, however, a market that is still less mature than traditional lending, and interest rates may be higher. By way of example, initial collateral equal to 200% of the loan, corresponding to an LTV of 50%, may be associated with a gross annual rate of 12%; with collateral at 500%, i.e. an LTV of 20%, the indicative rate may fall to 6%. These are illustrative assumptions, not terms applied or offered by CheckSig.

Crypto-backed loans: the role of LTV, thresholds and liquidation

LTV measures the ratio between the value of the loan and the value of the collateral. If you receive €50,000 in liquidity and lock up Bitcoin worth €100,000, the LTV is 50%: the collateral is worth 200% of the debt. If the value of the collateral falls by 20%, to €80,000, the debt remains €50,000, but the LTV rises to 62.5%. It is this change that the contractual thresholds are designed to manage.

The contract sets out from the start the thresholds governing the relationship between the parties:

• Collateralisation threshold: the loan is activated only once the value of the collateral reaches the agreed level, for example 200% of the principal disbursed.
• Alert threshold: if the value of the collateral falls below a predetermined level, for example 145% of the debt, the borrower receives a margin call and may add collateral or repay part of the loan.
• Liquidation threshold: if the value falls further, for example to 120% of the debt, the collateral is liquidated in accordance with the terms of the contract.

Crypto-backed loans: why it matters who holds the collateral

Bitcoin is often used as collateral for this type of transaction: it trades 24/7 on global markets that are generally highly liquid, so under normal market conditions it can be liquidated quickly; during periods of high volatility, however, liquidity and execution prices may deteriorate significantly. The critical point is therefore not the ability to sell the collateral, but the margin separating its value from that of the debt. This is why the soundness of the loan depends, among other things, on a prudent initial LTV, clearly defined intervention thresholds and the custodian’s ability to monitor and enforce them promptly.

It is therefore essential that this role be entrusted to an authorised crypto-asset service provider, able to demonstrate that client assets exist, are attributable to clients and are not reused for activities outside the scope of the contract. This requires asset segregation, full reserve availability, independent controls and adequate technical custody standards, from key management to infrastructure security.

Hence the industry’s push towards models based on transparent custody and clearly separated roles. This is not a theoretical scenario: CheckSig provides custody for crypto-assets pledged as collateral for crypto-backed loans, monitoring the value of the collateral and executing the instructions set out in the contract.