Borrowing Against Bitcoin: Do You Still Own Your BTC?

Article by: Andjela Radmilac

Compiled by Saoirse, Foresight News

Bitcoin holders who need cash don’t have to sell their BTC; they can choose to collateralize their Bitcoin to secure a loan, maintaining exposure to Bitcoin’s price while using its value as loan collateral.

However, the issue is that many lending services are deployed on other blockchain networks. Numerous blockchain lending applications operate on Ethereum, which independently tracks on-chain asset ownership. Yet, users’ Bitcoin records are on the Bitcoin mainnet, and Ethereum-based applications cannot directly access Bitcoin network assets as collateral.

One solution: Users entrust their Bitcoin to a custodial institution in exchange for an on-chain token that lending platforms can recognize. The original Bitcoin is held by the custodian, while the newly issued token represents that Bitcoin asset on another blockchain.

This model indeed allows borrowers to obtain loans without selling their Bitcoin, but it shifts the holder’s dependencies. Borrowers now rely on the custodian to securely hold their Bitcoin, adhere to redemption rules, maintain the token’s pegged value, and ensure the lending protocol operates smoothly.

Coinbase, Circle, and WBTC all offer this type of service and compete with one another. On September 4, Circle released its cirBTC product documentation, officially entering a market already dominated by cbBTC and the established WBTC. The underlying logic of all three products is identical: bitcoins are entrusted to a custodian, in exchange for issuing transferable "wrapped tokens."

The key focus of competition among platforms is the real-world usability of the tokens and the reliability of the entire mechanism when users want to redeem native Bitcoin.

The mechanism of custodial wrapped Bitcoin tokens can be likened to a negotiable warehouse receipt: the goods are stored in the warehouse, but the receipt can be transferred. The custodian holds the underlying Bitcoin, while the tokens can circulate among users; the product’s terms define who is authorized to redeem the tokens for actual Bitcoin.

The process for depositing Bitcoin is as follows: after the deposit is confirmed, an equivalent amount of corresponding tokens is minted on another chain—a process known as minting. Redemption is the reverse: tokens in circulation are burned, and the service provider releases the native Bitcoin according to the procedure. BitGo has described the deposit-redemption mechanism for WBTC: approved partner merchants facilitate the exchange through custodians and charge a fee.

Retail investors can also directly purchase already issued wrapped tokens on the secondary market. Transactions involve only the transfer of token ownership, without requiring additional Bitcoin to enter the custody pool. The underlying assets remain the original batch of Bitcoin and their corresponding tokens; wrapping does not create new tokens on the Bitcoin mainnet.

Each wrapped token is theoretically equivalent to one Bitcoin, so wrapped tokens do not help holders avoid the risk of Bitcoin price declines. Even if your tradable assets become tokens on another blockchain, their price movements and gains or losses remain fully tied to Bitcoin.

The redemption mechanism keeps the token's price close to that of Bitcoin. If the market price of the wrapped token falls below the value of its underlying asset, qualified traders can buy the token, redeem it for native Bitcoin, and profit from the arbitrage spread after deducting costs. This buying pressure narrows the discount. However, redemption restrictions and processing delays can weaken this arbitrage mechanism. Knowing that underlying Bitcoin exists does not mean you can successfully redeem and obtain it.

Once tokens are deposited into the lending platform, users can initiate a loan. Smart contracts are self-executing programs on the blockchain that accept wrapped Bitcoin as collateral, allowing users to borrow USD-pegged stablecoins. While incurring debt, users retain exposure to Bitcoin’s price fluctuations.

Borrowers must provide collateral worth more than the loan amount, as the price of Bitcoin may decline during the loan period. If the price drops significantly and the collateral safety buffer is exhausted, the platform will liquidate the collateral to cover the debt.

Ultimately, this leads to the very situation users intended to avoid: losing part of their Bitcoin position without actively selling.

During the liquidation process, other market participants may repay part of the debt on behalf of the borrower to acquire the collateral, and the platform sets incentives to attract liquidators to participate.

The wrapped token itself does not generate interest. To earn returns, holders must perform additional actions, such as re-lending the token. All returns stem from these subsequent actions and introduce additional risks beyond simply holding the token.

Even if a token is fully backed by Bitcoin, it is useless to borrowers if lending protocols do not accept it. Some token ecosystems have high adoption, yet ordinary users face significant difficulties redeeming native Bitcoin. Even when service providers claim the underlying assets are identical, the actual user experience can be vastly different.

WBTC leverages a merchant network to connect the minting and redemption processes, integrating with major exchanges and institutions. Most ordinary users acquire WBTC through exchanges. Supported lending protocols provide users with collateralized lending opportunities, while merchants handle the custody of Bitcoin within the reserve pool. This established ecosystem enables mature tokens to realize their value, making it difficult for new projects to replicate these conditions in a short time.

Coinbase has integrated the exchange feature into its exchange account. Eligible users, when withdrawing Bitcoin from their account, can select a supported network to receive cbBTC on-chain directly; when users send cbBTC back to Coinbase’s designated deposit address, native Bitcoin is credited to their account. The cbBTC exchange rules are subject to regional restrictions, but for eligible users, the entire process is nearly identical to a standard transfer.

Circle’s cirBTC is primarily designed for institutional clients, including traders and lending protocols, and is deeply integrated with Circle’s existing business and USDC. Circle states that the underlying Bitcoin is risk-isolated from the company’s own assets, with public reserve addresses, and it integrates with Chainlink oracles to enable on-chain software to access reserve-related data.

For borrowers, competition among products directly determines which platforms accept your Bitcoin as collateral and how easily you can exchange tokens back for BTC.

The business logic is clear: first make it easy for your existing customers to use the wrapped token, then convince external DeFi applications to adopt the asset. But the latter cannot be achieved solely through brand recognition and public reserve proofs.

Lending protocols must assess the lendable amount for each collateral asset. The protocol must ensure that, in the event of a borrower’s liquidation, the collateral can be smoothly sold. Liquidity represents the ability to quickly dispose of the collateral without crashing its market price. Even if a token reserve is abundant, it holds no practical value if there are few buyers on the target chain’s market.

This is why established, high-trading-volume wrapped tokens are more likely to be selected as collateral: more lending scenarios attract more holders and traders. New tokens face a catch-22: they must convince lending protocols to accept an asset with low user adoption, while also convincing users to hold a token supported by few protocols.

WBTC directly enables partner merchants to earn exchange fees. More broadly, convenient wrapped tokens can drive traffic to service providers, though actual profits depend on the business model. Unlike some USD-backed stablecoins that hold government bonds as underlying assets, the Bitcoin held in the custody pool does not automatically generate interest. The commercial value comes from various business activities generated by users subsequently using the tokens.

For regular users, verifying Bitcoin reserves is just the first step. Coinbase provides a cbBTC reserve data dashboard to help users compare the number of circulating tokens with the disclosed custodied Bitcoin.

Even if reserve assets are publicly disclosed, this does not address how assets will be handled in the event of a service provider’s bankruptcy or failure, nor does it guarantee that every token holder can redeem their tokens immediately. The product’s terms of service define who has the right to redeem, and the redemption service itself must be solvent. Knowing that Bitcoin exists does not mean you can recover your own coins.

When tokens are stored in a personal wallet, this is often overlooked: you control the private key for transferring the tokens, but the private key for the underlying native Bitcoin is held by the custodian. Even though the tokens are in your wallet, the underlying asset remains under the custody of a third-party institution.

Using tokens for lending and borrowing requires additional reliance on lending protocol software. The protocol must accurately execute business logic and obtain reliable price data to assess collateral value. Even if the issuer of the wrapped token holds 100% of its backing Bitcoin reserves, users may still suffer losses due to software vulnerabilities.

For holders who want to access cash without selling their Bitcoin, using wrapped tokens involves a trade-off. It enables Bitcoin to interact with DeFi applications that otherwise don’t support BTC, at the cost of fees and the need to trust multiple third-party institutions and smart contracts. Whether it’s worth using depends on the value provided by the application and the level of risk the user is willing to accept.

This also explains why multiple companies are competing to create wrapped tokens for the same Bitcoin asset. The core value of a wrapped token lies in granting users access to lending and other financial services.

The starting point for borrowing may be Bitcoin, but the most important thing in the end: whether the holder can get their Bitcoin back.