Using Bitcoin as Collateral

I always recommend investing in Bitcoin because, over time, it will normally generate a healthy capital gain. The problem is that if you ever need that money, or part of it, for any reason, you will probably think about selling those bitcoins.

But that involves several things:

The first is that you have given up an asset that will very likely be worth more in the future.

The second is that you will normally have to deal with the Spanish Tax Agency.

That is why I find another option increasingly interesting: using Bitcoin as collateral. In other words, using it as security to get a loan without having to sell it.

This way, once Bitcoin is worth more, your debt measured in bitcoins will be smaller, so you will come out ahead.

And there is more. If Bitcoin rises in value, you may NEVER need to repay the debt while the Bitcoin remains pledged as collateral.

Surprising, right?

The idea is neither new nor exclusive to cryptocurrencies. In fact, It can be done with other assets such as investment funds, shares or real estate. You own something valuable; the lender knows that this security—known as collateral—exists and therefore agrees to lend you part of its value.

Imagine that you have 100,000 euros in an investment fund and you need 20,000 euros. Instead of selling shares for those 20,000 euros, you can use the fund as collateral for the loan, get the money and keep the investment.

With Bitcoin we can do something similar.

The main advantage: you don't have to sell Bitcoin

Let's say years ago you had 20,000 euros and bought Bitcoin. That investment is now worth €100,000. If you sell it all, you have an €80,000 capital gain on which you will have to pay tax.

However, if you keep those bitcoins and merely use them as collateral for someone to lend you €20,000, you are not selling them. What you receive is a loan and, provided the product is genuinely structured that way and does not involve selling or exchanging your Bitcoin, you are not realising that capital gain at that point, so you do not have to pay anything to the Spanish Tax Agency.

This is precisely the appeal of the system: you get euros to spend on what you need, but you still have your bitcoins.

Of course, as you can imagine, the lender is not lending you money because they trust you, but because they hold your Bitcoin as collateral.

And that's the most complex part.

Bitcoin volatility doesn't help here

Although volatility can make an investment profitable, it does not help when using it as collateral.

Pledging an investment fund also involves risk—an index can fall by 40% in a major crisis—but Bitcoin has historically suffered larger drops of more than 70%, often in relatively short periods.

And this matters a lot when the asset is the collateral for a loan.

Let's look at it with the same example above, because it's easier to understand with numbers.

You have 100,000 euros in Bitcoin and you borrow 20,000 euros.

That means your debt equals 20% of the value of the collateral you deposit. You will constantly see a name for this ratio when researching this type of loan: LTV, which stands for Loan To Value.

It is important to understand what it represents:

How much you owe compared with the value of the Bitcoin you have provided as collateral.

In the example you owe 20,000 euros and you have 100,000 euros backing them, so you have plenty of room.

But now imagine that Bitcoin is starting to fall.

Your bitcoins are no longer worth 100,000 euros, but 80,000. Then 60,000. And, in theory, maybe 40,000 (this probably never happens).

The loan, however, remains roughly the same, i.e. there is less collateral backing the same debt.

And the company—when borrowing fiat money—or the DeFi protocol that lent you the money will not wait until your Bitcoin is worth less than what you owe.

What if Bitcoin drops too much?

Every loan sets a threshold beyond which the company or protocol considers the collateral insufficient.

Depending on the product, you may be asked to add more Bitcoin, provide another asset or repay part of the loan. In other cases, the process may be automatic and, once a certain threshold is reached, the platform sells your Bitcoin to recover the money it lent you.

The latter is what is known as liquidation , and this is how DeFi protocols such as Aave. That is precisely what we want to avoid.

We set up the entire arrangement to obtain money without selling our Bitcoin. If we miscalculate the risk, we end up selling it anyway—not when we choose, but after a major fall, which is far worse because it is sold for less than it was worth when you took out the loan.

Moreover, that sale may trigger the very taxable capital gain we intended to defer.

That is why the key factor when using Bitcoin as collateral is not simply obtaining the loan, but how much we borrow.

The less you borrow, the more soundly you will sleep

Let's go back to the example of 100,000 euros of Bitcoin and suppose that the loan establishes that you will be liquidated when the debt reaches 70% of the value of the collateral.

If you borrowed only €20,000, Bitcoin would have to fall to about €28,600 to reach that level. In other words, it could lose more than 70% of its value before reaching the limit.

In other words, you have plenty of room because such a fall is unlikely.

Consider another case. With the same €100,000 in Bitcoin pledged as collateral, imagine that you borrow €50,000.

In that case, you would reach the limit when your Bitcoin fell to about €71,400. That is a drop of nearly 30%, and a 30% fall in Bitcoin is nothing extraordinary.

At that point, the platform would liquidate your position and you would be left with much less than you had initially.

That is why using an index fund and using Bitcoin as collateral are different: the level of risk changes dramatically because of the asset’s volatility.

So, if you ever use Bitcoin as collateral, I recommend keeping the debt very small relative to the total value of your Bitcoin. Alternatively, keep capital available to add collateral or repay some of the debt if necessary.

There is another problem: you have to hand over your Bitcoin

And here's another risk that's not the same as a traditional fund.

To use Bitcoin as collateral, you must deposit it wherever the chosen company or protocol requires. You therefore need to understand exactly who has custody of that Bitcoin, what they can do with it and what would happen if the company or protocol ran into trouble.

This is no minor detail. It matters far more than choosing between a lender charging 3% and one charging 6% interest. Saving three percentage points is irrelevant if custody becomes the real problem.

Conclusion: should you use Bitcoin as collateral?

My advice is if you're not 100% convinced, don't.

That said, if you have accumulated Bitcoin for years, have a large capital gain and want liquidity without disposing of an asset you intend to hold for the long term, it may be reasonable.

You will still need to keep an eye on its volatility.

Furthermore, if Bitcoin continues to mature, its market capitalisation and liquidity grow, and institutional money keeps flowing in, it is reasonable to expect its price movements to become less extreme over time. In fact, this is already happening.

Using Bitcoin as collateral therefore makes sense if three conditions are met:

1. You have a big enough position in Bitcoin.
2. You need a relatively small amount of it.
3. Related to both points above, the loan leaves me ample room before any possible liquidation.

If I need 50,000 euros and I only have 100,000 in Bitcoin, I'd probably look for another solution.

If I have 500,000 and I need the same 50,000, it's different.

In the end, like any investment, this formula isn't good or bad by itself, but depends on how you use it and how aware you are of the risk you're taking.