DeFi Explained: Crypto Lending
The world of decentralized finance, as innovative as it is, has brought on a number of new words and concepts. Having to navigate through such unfamiliar and often incomprehensible ideas can be confusing, which is why we are here to do the heavy lifting for you. This week’s edition of DeFi Explained will cover the concept of crypto lending, an alternate investment form where fiat money or cryptocurrencies are lent to borrowers in exchange for crypto assets kept as collateral. How does this work? Why is it important? What are the benefits and risks associated with crypto lending? These are all questions that will be answered in this article.
What is Crypto Lending?
Cryptocurrency lending is one of the most emerging trends in the decentralized finance space, with the market reaching $8 billion in total lifetime loan originations in 2019. The market size has only increased since then, an indicator that the crypto lending marketplace is here to stay. But what exactly is crypto lending and why is it growing so fast?
In essence, crypto lending is a form of decentralized finance where cryptocurrencies or fiat money is lent by investors to borrowers in exchange for crypto assets, which are kept as collateral. This is similar in concept to how banks give out loans to interested parties short on cash, earning interest in the process. But with crypto lending, anyone with crypto assets can be an investor and earn interest payments in exchange for providing the loan without the need for an intermediary like a bank
How Crypto Lending Works
The lending process will vary depending on the platform where it is being carried out, but the general flow of procedure is as follows.
There are two main parties involved in the crypto lending process, the lender or investor, and the borrower. The lender or investor is the one receiving interest payments from the borrower. The borrower secures the investor’s investments by depositing his crypto assets as collateral, which will serve as compensation if things go awry.
Both the lender and borrower follow different steps on their chosen lending platform. Generally, the lender will first choose the interest rate their payments will be based on. Then, the lender will provide the borrower with the crypto assets they have requested in exchange for bonds proving that crypto has been lent. The lender will then start receiving more bonds as interest. If a lender at any time decides they want their investment back, then all the bonds they have received are sent back in return for crypto.
The borrower follows a different procedure. The borrower first registers on their desired lending platform and specifies the sum of money they are looking to borrow. Based on this amount, the collateral crypto required is calculated, which the borrower must deposit on the platform. Once this has been done, the borrower can take out a loan.
Fixed Interest vs Variable Interest
Depending on the lending platform, the interest rate set can be either fixed or variable. Centralized lending platforms, where a Know Your Customer approach is implemented, operate similarly to traditional fintech companies. These platforms have a custodial system in place to protect your assets and tend to offer fixed interest rates that are determined by the company. Examples of centralized crypto lending platforms are BlockFI, Hodlnaut, and Celsius Network.
On the other hand, decentralized crypto lending is different. Instead of lending and borrowing is managed by a trusted body, decentralized lending platforms are governed by a set of protocols that in turn rely on smart contracts to oversee the distribution of crypto loans and payments. These platforms often offer variable interests which change depending on market demand and supply. One advantage to variable interests is that they are often lower than those offered by centralized lending platforms. They are also more transparent, as all transactions are recorded on public blockchains. Examples of such platforms are Maker and Compound.
Benefits of Crypto Lending
What makes crypto lending so attractive is the added features it has compared to traditional loans. These benefits are what sets crypto lending apart from any other investment form.
With crypto lending, you don’t have to worry about passing the standard background checks that come with traditional lending. This includes having an active bank account, possessing a good credit score, earning a sizeable income. Crypto lending platforms are only concerned with the amount of collateral that you can provide, and little else. This makes it very accessible.
Low Interest Rates
Unlike personal loans or credit cards, the interest rates available on crypto lending platforms are quite inexpensive. You can generally get a crypto loan on an interest rate that is less than 10 percent.
The process of receiving loan funds is very fast as compared to traditional bank loans with crypto lending. Most crypto lending protocols such as Aave and Compound have automated markets for loans which means a lender can supply assets or a borrower can borrow assets within minutes. This makes it very attractive for both those who want to earn quickly on their assets and those who need cash fast.
Value-Based Loan Amounts
With crypto lending, the loan amount that can be borrowed is based on the value of the asset. This percentage differs from platform to platform, with loans granted as high as 90% of the value of your collateral cryptocurrency. Platforms also allow you to choose which form you want to receive your loan funds in. This can be in either certain digital currencies or U.S dollars.
Risks Associated with Crypto Lending
Although crypto lending is an overall very attractive innovation, there are some risks associated with it. These risks should be considered by both those looking to serve as an investor and those interested in borrowing.
One major risk that arises when dealing with anything in the cryptocurrency world is that of volatility. As there is no central authoritative governing body overseeing the value of most coins, they can be subject to rapid increase or decrease in value. Margin calls are a consequence of this volatility and affect borrowers the most. Margin calls arise when the value of your collateral drops below a certain point. This may result in the lender requiring the borrower to increase the amount of collateral they have provided by depositing more crypto. At times, the lender or even crypto lending platform itself may sell some of the borrower’s assets to cut the loan-to-value ratio.
Lack of Insurance
Unlike bank accounts, crypto lending platforms do not insure their funds. So if you are lending your digital assets and the exchange fails for any reason or even if the protocol ends up failing, you could lose everything.
Be Aware of Locked Collateral
If a borrower is using cryptocurrency to secure a loan, then they cannot access their holding for any other trades or transactions until the loan is paid in full. This can be disadvantageous both in emergencies where a user may want to liquidate their holdings, or if the price of a currency suddenly drops. This limitation of many crypto lending platforms is something that both prospective borrowers and lenders should be aware of.
In conclusion, crypto lending is a novel concept, essentially traditional lending optimized for decentralized finance. Crypto lending is inexpensive, fast, and accessible, making it a great option for those with a decent amount of crypto holdings looking for a way to earn passive income from their crypto assets. However, whether you are a lender or a borrower make sure you understand the associated risks before making the leap.