Captain’s note
- Some custodians use deposited crypto as collateral for their own purposes, a practice the SEC says is sometimes called rehypothecation.
- The SEC notes that some custodians commingle crypto assets instead of holding each customer’s assets separately.
- On Coinbase’s loans, bitcoin is converted to cbBTC and held as collateral in a Morpho smart contract, according to Coinbase.
A bitcoin-backed loan asks you to give up control of your bitcoin for as long as you owe money. Custody is the word for who has that control. It decides whether your coins come back when you repay, and whether they could be lent to someone else in the meantime. It is the least discussed part of crypto lending and, judging by 2022, the most important.
Custody in one paragraph
Bitcoin is controlled by private keys. The SEC’s bulletin on crypto custody explains that a wallet does not hold the coins themselves but the private keys that authorize transactions, and that losing a private key means losing access to the crypto. In self-custody you hold the keys and carry sole responsibility for them. With third-party custody, a company such as an exchange or a dedicated custodian holds them for you. A collateralized loan always moves your bitcoin to someone else’s control, because the lender needs to be able to sell it.
Rehypothecation
The SEC suggests asking any third-party custodian how it uses your crypto, and explains that some custodians use deposited crypto assets as collateral for their own purposes, such as lending. That practice is sometimes called rehypothecation. For a borrower it means your collateral may not be sitting still: it may be pledged or lent onward, so getting it back depends on someone else repaying the custodian.
The 2022 cases show how that can end. The FTC says Celsius took title to customers’ deposits, used them to fund operations, pay other customers, borrow from other institutions and make high-risk investments, and routinely made unsecured loans. The SEC found that BlockFi used investors’ crypto to make investments, including loans to institutional investors, and made a false and misleading statement for more than two years about the level of risk in its loan portfolio and lending activity.
Commingling
The SEC also notes that, to reduce costs, some custodians commingle crypto assets instead of holding each customer’s assets separately. In a pooled wallet your claim is a line in the company’s records, not specific coins on the blockchain. If the records are wrong or the pool is short, everyone in it shares the problem.
Who owns the coins if the lender fails
This is where custody stops being technical. The SEC warns that investors who deposit funds or crypto with a crypto asset entity might cease to have legal ownership of those assets and might not be able to get them back when they want to. After Celsius filed for bankruptcy, the FTC settlement suspended a $4.7 billion judgment so that Celsius’s remaining assets could be returned to consumers through the bankruptcy proceedings. Customers became claimants, waiting on a court, rather than owners withdrawing their coins.
Familiar safety nets do not fill the gap. The SEC’s 2022 bulletin explains that bank deposits are insured by the FDIC and credit union deposits by the NCUA, and that brokerage accounts may be covered by SIPC if a broker fails, but SIPC does not protect for the loss of most crypto assets. A crypto lender’s failure usually leaves borrowers and depositors with a claim, not with a payout from an insurance fund.
Wrapped bitcoin and smart contracts
Onchain loans change the custody picture rather than removing it. On Coinbase, the bitcoin you pledge is converted 1:1 to Coinbase Wrapped BTC (cbBTC) and transferred to a Morpho smart contract. Two things follow:
- The collateral is held by a smart contract under the protocol’s published rules rather than in a company’s wallets, which addresses the classic rehypothecation risk on the collateral itself. Ask the platform directly if you want that confirmed for your loan.
- During the loan you hold a wrapped token, not native bitcoin, and Coinbase lists protocol-level security vulnerabilities and liquidity issues among the risks. After repayment Coinbase says the collateral is returned to your account automatically.
The comparison between the two models is in Centralized vs DeFi Crypto Lending: Who Holds the Collateral.
Questions to ask before your coins move
| Question | Why the SEC’s bulletin points to it |
|---|---|
| Who holds the keys to my collateral during the loan? | Whoever controls the keys controls the crypto |
| Will my collateral be lent, pledged or used in any way? | Rehypothecation means your coins may not be there |
| Is it held separately or pooled with others? | Commingling turns specific coins into a claim |
| What happens to it if you go bankrupt? | Depositors might cease to have legal ownership |
| How and when is it returned after repayment? | Withdrawal terms and fees decide your exit |
Tip: If the answers are only in a blog post or a support chat, ask where they appear in the loan agreement. The agreement is what counts in a dispute or a bankruptcy.
Custody is one item on a longer list; the rest is in How to Compare Crypto Lenders: A Checklist Built From Regulators’ Warnings.