Bitcoin-Backed Loans: DLC vs Custodial Lending Risks

The crypto lending market hit $53 billion in Q2 2025, up 27% from the previous quarter. But beneath that growth lies a fundamental question every Bitcoin holder should understand before using their coins as collateral: who actually controls your Bitcoin during the loan?

The answer matters more than most borrowers realize. The 2022 collapses of BlockFi, Celsius, and Voyager wiped out billions in customer funds, not because Bitcoin failed, but because custodial platforms did. Those failures have accelerated a shift toward non-custodial alternatives, particularly Discreet Log Contracts (DLCs), that let borrowers access liquidity without surrendering their keys to a third party.

How Custodial Bitcoin Lending Works (and Fails)

Traditional custodial lending is straightforward: you send your Bitcoin to a platform, they hold it as collateral, and you receive a loan in dollars or stablecoins. Platforms like Ledn, Unchained Capital, and Nexo operate this way.

The appeal is obvious. These platforms handle everything, integrate easily with fiat banking, and require no technical knowledge. Ledn processed over $1 billion in loans in early 2025, demonstrating real demand.

But custodial lending carries serious risks that aren't always visible until it's too late.

Rehypothecation is the practice of reusing customer collateral for the platform's own purposes, lending it out again or using it as collateral for their own borrowing. When markets turn, this creates cascading failures. Ledn has explicitly avoided rehypothecation, but many platforms haven't made the same commitment.

Counterparty risk means you're trusting the platform to remain solvent, honest, and competent. Celsius looked fine until it wasn't. BlockFi's exposure to FTX took it down despite its own risk management.

Regulatory risk adds another layer. Platforms can freeze withdrawals due to regulatory pressure, leaving borrowers unable to access their collateral even if they want to repay.

To be fair, custodial platforms have improved their practices since 2022. Many now offer proof of reserves and clearer terms. For users who prioritize convenience and aren't comfortable with more technical solutions, custodial lending from reputable platforms remains an option. Just go in with eyes open about what you're trusting.

DLCs: A Non-Custodial Alternative

Discreet Log Contracts, enabled by Bitcoin's Taproot upgrade in 2021, offer a fundamentally different approach to bitcoin collateral management.

Instead of sending your Bitcoin to a company, DLCs lock it in a 2-of-2 multisig address controlled jointly by you and the lender. Neither party can move the funds unilaterally. The contract's outcome (repayment, liquidation, or default) is determined by price data from oracles, which automatically enable the appropriate settlement.

Here's what that means practically:

• Your Bitcoin never sits on a company's balance sheet
• No single party can rehypothecate or misappropriate your collateral
• Loan terms execute automatically based on predetermined conditions
• Everything happens on Bitcoin's base layer, not a proprietary database

Lygos is one platform building on this model, offering Bitcoin-backed loans from $25,000 to $100 million for institutions and high-net-worth individuals. Borrowers receive USDC or USDT while their BTC collateral remains in native Bitcoin scripts rather than a custodian's wallet. After acquiring Atomic Finance in 2025, Lygos has positioned itself for sophisticated borrowers who want verifiable, on-chain loan terms without the opacity of pooled lending.

Other players in this space include Lava, which has developed its own DLC protocol, and Firefish, which uses multisig structures for peer-to-peer loans starting around 6% annually.

The Tradeoffs of Non-Custodial Lending

DLCs aren't a magic solution. They eliminate some risks while introducing others.

Oracle dependency is the most significant. DLC contracts rely on external price feeds to trigger liquidations and settlements. If an oracle fails, is manipulated, or simply goes offline, the contract may not execute correctly. Platforms like Lygos use established oracle providers like Magnolia Financial to mitigate this, but the risk exists.

Complexity is real. Understanding multisig addresses, contract mechanics, and settlement processes requires more from borrowers than simply clicking "deposit" on a custodial platform. This isn't a criticism of the technology; it's an acknowledgment that self-sovereignty comes with responsibility.

Bitcoin script limitations constrain what DLCs can do natively. Some platforms work around this by settling in stablecoins on other networks (like Ethereum), which introduces bridge and smart contract risks that partially offset the benefits of keeping collateral on Bitcoin.

Liquidity and terms may be less flexible than custodial alternatives. Current DLC platforms typically offer 60-75% loan-to-value ratios with rates under 15%, competitive but not always the cheapest option available.

Why Institutions Are Paying Attention

The institutional shift toward non-custodial bitcoin loans isn't just about ideology. It's about risk management.

After 2022, institutional treasurers and family offices became acutely aware of counterparty risk. The question "what happens if this platform fails" now gets asked before signing agreements, not after.

DLC-based lending provides verifiable answers. The collateral's location is on-chain and auditable. The loan terms are encoded in the contract itself. There's no need to trust financial statements or proof-of-reserve attestations from third parties.

For entities managing significant Bitcoin positions, this transparency has value beyond the technical elegance. It simplifies due diligence, reduces insurance requirements, and avoids the regulatory complications of having assets held by a potentially precarious intermediary.

Making a Decision

The choice between custodial and non-custodial bitcoin lending depends on your situation.

If you're borrowing $10,000 against a small Bitcoin position and prioritize simplicity, a reputable custodial platform with clear terms and no rehypothecation might serve you well. The risks are real but manageable if you understand them.

If you're an institution, high-net-worth individual, or simply someone who takes self-custody seriously, DLC-based lending aligns with why you hold Bitcoin in the first place. Platforms like Lygos exist specifically for borrowers who want meaningful credit facilities without sacrificing cryptographic control over their collateral.

Either way, the days of blindly trusting custodial platforms should be behind us. The 2022 failures weren't anomalies; they revealed structural vulnerabilities in how centralized lending operates. Whether you choose DLCs or stick with custodial options, go in understanding exactly what you're trusting and what could go wrong.

The Bitcoin lending market is maturing. For borrowers willing to do the work, there are now real alternatives to handing your keys to someone else and hoping for the best.