Coinbase’s Bitcoin Loan Offering: Risks, Legal Insights, and Lessons for Borrowers

R Tamara de Silva

Earlier today, Coinbase launched a new program allowing U.S. users to take out loans against their Bitcoin (BTC) holdings. This marks a notable development in the integration of traditional finance with digital assets. However, it also invites scrutiny due to challenges faced by similar programs in the past. This post examines the mechanisms Coinbase employs to address double-spending risks, the potential pitfalls of its BTC loans offering, and lessons from previous fintech attempts.

Introduction to BTC-Backed Loans

Coinbase’s BTC-backed loan program bridges cryptocurrency investments and traditional lending. By allowing users to leverage their Bitcoin holdings as collateral, Coinbase seeks to offer a bridge between digital asset investments and liquidity needs. While Coinbase’s announcement was roundly heralded- understanding the mechanisms and risks associated with these loans is important for borrowers and financial professionals alike.

Double-Spending Risks and Coinbase’s Approach

One of the key challenges in offering BTC-backed loans is mitigating the risk of double-spending. Double spending occurs when the same BTC is used simultaneously in multiple transactions. Coinbase implements mechanisms to address this.

Borrowers must transfer their BTC to Coinbase’s custody, where it is securely held as collateral. This ensures the BTC cannot be spent or used elsewhere while the loan is active. By leveraging Bitcoin’s public ledger, Coinbase can verify the authenticity and uniqueness of the pledged BTC. This process ensures that it hasn’t been double-pledged.

If the program integrates decentralized finance (DeFi) principles, smart contracts may play a role in locking collateral. These contracts execute predefined conditions automatically, preventing unauthorized use of the collateral.

Lessons from Past Failures in BTC Lending

Several fintech firms have introduced BTC-backed loans in the past. The results were mixed. The failures of past ventures provides a context for understanding the risks Coinbase, and more importantly, its customers face.

In the past, some firms allowed borrowers to pledge insufficient collateral. This left them exposed when BTC’s price dropped. For example, in the case of Celsius Network, market volatility overwhelmed its risk management systems, leading to liquidity issues and eventual bankruptcy.

The speed and efficiency of liquidating collateral are crucial in volatile markets. BlockFi, for instance, faced difficulties during market downturns. Forced to sell collateral rapidly to cover loan defaults, it exacerbated losses.

Firms like QuadrigaCX experienced security breaches and mismanagement of customer assets. These events eroded trust in their platforms.

Risks Unique to Coinbase’s Program

While Coinbase appears to have learned from past mistakes, risks remain in BTC-backed lending programs.

Bitcoin’s price can experience sharp declines. This can leave borrowers under-collateralized and require Coinbase to liquidate assets quickly. Coinbase states that it loans will be overcollateralized. However, that is contingent on a snapshot in time of the price of BTC. This price can change and the loan’s level of collateralization can change just as quickly.

Despite even robust systems, which Coinbase undoubtedly would have, the risk of hacks or insider threats to the BTC held in custody cannot be eliminated.

Also automated liquidation mechanisms must perform flawlessly under high-stress market conditions to avoid cascading failures. Previous failures in operational efficiency during volatile periods have resulted in significant losses.[i] Not to mention, failures and glitches in the platforms themselves.[ii]

Coinbase’s ability to maintain high-performance systems during periods of extreme market activity will be important to the program’s long-term success. Borrowers who experience forced liquidations during market downturns may challenge the terms or execution of the loan agreements.

If a large number of borrowers default simultaneously, or if BTC liquidity dries up during a sell-off, Coinbase may face a liquidity crunch.

Automated liquidation mechanisms, while essential for mitigating risk, often spark controversy due to perceived transparency issues. Borrowers may feel uninformed about when and why liquidation is triggered, especially if thresholds are not clearly communicated - or if rapid market fluctuations create confusion about the timing and fairness of liquidations. Borrowers may feel they are treated unfairly if their BTC is sold at a significant loss during volatile markets only to see the price recover with their BTC holdings gone. Similar practices by other firms have led to widespread dissatisfaction and even legal challenges.

Collateral Management: Segregated vs. Pooled Systems

It is unclear whether Coinbase segregates collateral for each borrower or pools all collateral into a single account. The importance of this distinction for borrowers cannot be overstated.

If collateral is segregated, each borrower’s BTC is held separately. This ensures that one borrower’s default does not impact others, reducing systemic risks. Segregation also provides greater transparency, allowing borrowers to verify the status of their collateral and ensuring it is not used to cover other obligations.

In a pooled system, collateral from all borrowers is aggregated into a single account. While this approach may simplify operational processes for Coinbase, it introduces collective risk. For instance, losses from a single borrower’s default could theoretically impact the entire collateral pool, potentially leading to cascading issues. Additionally, if pooled collateral is combined with a sharp decline in BTC prices, the value of the pooled assets could drop significantly, putting all borrowers' collateral at greater risk.

The legal implications also differ. In cases of bankruptcy, segregated collateral is more likely to be returned directly to borrowers, as it can be clearly identified. Pooled collateral, however, may become part of Coinbase’s general assets, complicating recovery efforts.

Borrowers should inquire about Coinbase’s collateral management practices and consider the implications for their funds. Transparency on this issue is essential to understanding potential risks.

Guidelines for Borrowers

Retail borrowers considering BTC-backed loans should approach these products with caution, especially given Bitcoin’s market volatility. Before borrowing, it is essential to thoroughly understand the loan terms, including the collateralization ratio, liquidation triggers, and any potential fees associated with the loan. Borrowers should carefully consider whether the terms are sufficiently transparent to meaningfully assume risk.

It is also important to carefully review the loan agreement to understand specific liquidation mechanisms and collateralization ratios. Borrowers should ask: What happens if something goes wrong? Will they be able to call for assistance, or will they need to rely on submitting a ticket and waiting—possibly hours—for a response? Will the response come from a live representative (unlikely as platforms are make it almost impossible to reach a human being) or an AI chatbot with limited capabilities? How will this affect a customer during a crisis?

Additionally, borrowers should consider whether the loan agreement mandates arbitration in case of disputes. Understanding whether access to a court of law is foreclosed and the potential costs of arbitration are critical. Arbitration can often price people out of having their disputes settled.

Borrowers should assess their ability to repay the loan without relying solely on the stability of BTC’s value, as sudden price drops could result in forced liquidation of collateral.

Maintaining a buffer of extra BTC or other liquid assets to meet collateral requirements during volatile periods is prudent. By carefully evaluating these factors, retail borrowers can better manage risks and avoid unexpected losses.

Why Coinbase Stands Out

Coinbase’s reputation, regulatory adherence, and operational scale give it an advantage over smaller fintech firms. By requiring over-collateralization and maintaining transparent custody arrangements, Coinbase aims to mitigate some of the primary risks associated with BTC-backed loans. Additionally, the potential use of smart contracts adds an extra layer of security and automation. However, borrowers should remain mindful of the associated risks.

Closing Thoughts on BTC Lending

Coinbase’s BTC-backed loan offering represents a noteworthy advancement in the intersection of cryptocurrency and traditional finance. While the program incorporates measures to address significant risks, challenges such as price volatility, regulatory scrutiny, and operational resilience remain critical considerations for borrowers and market participants.

For legal professionals, financial market participants, and borrowers, understanding the intricacies of BTC-backed lending, including potential risks and compliance requirements, is essential. Thorough risk assessment and informed decision-making are key to navigating this rapidly evolving sector.

If you are exploring BTC-backed loans and would like guidance in evaluating agreements or trying to mitigate risks, our firm’s extensive experience in advising clients on fintech platforms and brokerages is here to assist.