What is crypto lending?
The concept of cryptocurrency lending involves taking crypto from one user and providing it to another for a fee. Crypto lending involves depositing cryptocurrency that is lent to borrowers in exchange for regular interest payments. Crypto lending platforms can be classified into two types: decentralized crypto lenders and centralized crypto lenders. The exact method of managing loans varies from platform to platform. The core principles of crypto lending remain the same regardless of whether they are offered on centralized or decentralized platforms.
You don't just have to be a borrower, either. Locking your crypto in a pool that manages your funds can passively earn you income and interest. The risk of losing your funds depends on the reliability of the smart contract you use. This could be because the borrower put up collateral, or a CeFi (centralized finance) platform like Binance manages the loan.
How does crypto lending or crypto loan work?
There are three parties involved in crypto lending: the lender, the borrower, and a DeFi (Decentralized Finance) platform or crypto exchange. Before borrowing any crypto, the loan taker usually has to put up some collateral. Flash loans can also be used without collateral (Learn more about it below). On the other hand, you might have a smart contract minting stablecoins or a platform lending out funds from other users. Crypto lenders add their crypto to a pool, which manages the whole process for them and forwards the interest to them.
Decentralized Finance (DeFi) Lending:
Decentralized finance (DeFi) lending is a platform that is not centrally governed but instead provides borrowing and lending services using smart contracts. Loans through DeFi are instant, and users can deposit collateral and access funds instantly through decentralized apps (dApps).
Using a digital wallet, users can deposit crypto and start earning interest immediately. Interest is compounded minute-by-minute. The majority of DeFi lending platforms require overcollateralization of loans, requiring 110% (or more) of the loan amount to be deposited. DeFi and centralized platforms differ in that collateral deposited on them earns interest even if it is attached to loans.
Crypto Lending: An Overview
1. The crypto lending platforms enable investors to borrow against deposited crypto assets and lend out crypto assets to earn interest. Since 2020, lending platforms have grown to billions in total value.
2. There are two components to crypto lending: interest-bearing deposits and loans. Like a bank account, deposit accounts work similarly. Depending on the platform and the cryptocurrency, users can earn interest, up to 8% APY on their deposited cryptocurrency. Platforms can lend out deposited funds or invest them in other ways.
3. Typically, crypto loans are collateralized lending products that require the users to deposit a minimum of 100% (and up to 150%, depending on the lender) in crypto collateral to borrow cryptocurrency or cash.
4. In the same way as traditional loans, the interest rates vary by platform, and payments are required on a monthly basis. With cryptocurrency loans, the loan terms can be as short as seven days and up to 180 days, and the interest is charged hourly, just like Binance does.
5. Some lenders offer indefinite credit lines instead, such as Nexo, which offers 0% interest rates.
Various Types of Crypto Loans
Several types of cryptocurrency loans are available:
1. Collateralized loans
A collateralized loan requires the deposit of cryptocurrency as collateral and is the most popular type of loan. Overcollateralization is required on most platforms, meaning that borrowers can access only a certain percentage of their deposited collateral (typically less than 90%). Generally, the lower the loan-to-value (LTV), the lower the interest rate and the lower the margin call risk.
2. Crypto line of credit
Rather than providing a traditional loan with a predetermined term length, some platforms offer a cryptocurrency line of credit. In this type of collateralized loan, users are able to borrow up to a certain percentage of their collateral, but no repayment terms are set, and users only pay interest when they withdraw funds.
3. Uncollateralized loans
Uncollateralized loans are less popular, but they work in the same way as personal loans. Borrowers must complete a loan application, pass identity verification, and complete a creditworthiness review in order to qualify. Since there is no collateral to liquidate in the event of a default, these loans have a higher risk of loss for lenders.
4. Flash loans
These loans are usually available on crypto exchanges and are instant loans that can be borrowed and repaid at the same time. Loans like this are extremely risky and are typically used to take advantage of market arbitrage opportunities, such as buying cryptocurrency for a lower price in one market and instantly selling it in another for a higher price.
The risks associated with crypto lending
Due to the volatile crypto market, cryptocurrency lending is inherently risky for both borrowers and lenders. Crypto enthusiasts have been left unenthusiastic following the recent Celsius debacle, where billions in deposits have been frozen overnight.
The following are a few risks associated with crypto lending:
Margin calls
In cases where users pledge collateral and borrow against it, a drop in the collateral's value can trigger a margin call. Crypto loans suffer from this when the LTV falls below the agreed-upon rate. In such situations, borrowers either need to deposit additional collateral to get the LTV back down or risk liquidation.
Illiquidity
As soon as crypto assets are deposited onto crypto lending platforms, they become illiquid and cannot be accessed easily. Despite the fact that some crypto lending platforms allow lenders to withdraw deposited funds fairly quickly, others may require long waiting periods.
Unregulated
The crypto lending platforms are unregulated and don't offer the same level of protection as banks. As an example, U.S. bank deposits have Federal Deposit Insurance Corporation (FDIC) coverage up to $250,000 per depositor, so if a bank becomes insolvent, user funds will be protected. However, cryptocurrency lending platforms that experience solvency issues do not provide protections for their users, and funds may be lost.
Interest rates are high
In spite of some crypto loans offering low interest rates, the majority of crypto loans charge over 5% APR. The highest crypto loan charge (or more) is 13% APR.
Crypto Loans: How to Get One
Crypto loans can be obtained through centralized lending platforms (such as BlockFi) or through decentralized lending platforms (such as Aave). In the next step, users will choose the type of loan they wish to borrow and how much they wish to borrow. There will be a variation in the amount available depending on the collateral and amount deposited.
Users will be required to deposit collateral into the platform's digital wallet before they can borrow funds, and they will receive them instantly credited in their account or digital wallet.
Mostly loans get approved instantly, and the terms of the loan are locked in through smart contracts.
Crypto Loans: How to Get One
Crypto loans can be obtained through centralized lending platforms (such as BlockFi) or through decentralized lending platforms (such as Aave). In the next step, users will choose the type of loan they wish to borrow and how much they wish to borrow. There will be a variation in the amount available depending on the collateral and amount deposited.
Users will be required to deposit collateral into the platform's digital wallet before they can borrow funds, and they will receive them instantly credited in their account or digital wallet.
Mostly loans get approved instantly, and the terms of the loan are locked in through smart contracts.
Lending crypto: How to do it
The process of becoming a crypto lender consists of signing up for a lending platform, selecting a cryptocurrency to deposit, and sending funds to the platform. A centralized crypto lending platform may pay interest in kind or with tokens generated by the platform. Unlike a centralized exchange, a decentralized exchange pays interest in kind, but it may also pay bonuses.
How safe is crypto lending?
Cryptocurrency lending has both advantages and disadvantages.
Advantages of Crypto Lending:
1. The majority of loans are collateralized, so even if they default, lenders can recoup their losses via liquidation.
2. They also offer higher interest rates than traditional bank accounts.
Disadvantages of Crypto Lending:
1. The lending platforms have the authority to lock users' funds in place, as Celsius does, and investors have no legal protection.
2. Borrowers may also be exposed to risks because collateral can go down in value and be liquidated, resulting in a lower return on investment.
3. Globally, lending platforms are being targeted by regulators, with regulations forming around deposit accounts and even BlockFi being fined $100 million for violating securities laws by the Securities and Exchange Commission (SEC).
Note: In general, crypto lending may be a safe option for scrutinous users, but borrowers and investors should be aware of the risks.
Is Lending Crypto a Good Investment?
The interest earned on deposits made to a lending platform can often be greater than that of traditional banks when users deposit crypto to the platform. Deposited funds are loaned to borrowers, who pay a portion of the interest, and can also be invested alternatively to increase their return. As a result, crypto lending can be a good source of income.
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