Crypto lending is one of the elements of yield farming (along with staking), where holders seek to earn a yield or interest from their holdings instead of merely ‘parking’ them. The barrier to entry with getting a conventional loan from most banks is high as clients need to go through rigmarole.
Since crypto lending is entirely decentralized, it saves time, costs, and processes as the system don’t rely on middlemen. Moreover, protocols have become trustless and will not go through any credit checks or personal history research.
Lending forms a big chunk of the billions traded within the decentralized finance or DeFi space. However, crypto lending is anything but unsecured, as traders need to understand its collateralization and how it works.
Fear not since this article will cover the somewhat confusing yet interesting world of crypto lending, including how it functions, its advantages, and disadvantages.
What is crypto lending?
Crypto lending involves the activity of crypto-backed loans acting as collateral for an exchange or platform providing credit to the borrowers. Anyone with cryptocurrencies can allocate these to lenders on particular services to earn interest (anywhere from a few percent to even 20% APY)
The debtors have to allocate collateral in the form of a cryptocurrency to receive the loan. Hence, there are fewer risks for creditors and services in the likely case of defaulting from the borrowers.
Borrowers receive attractive interest rates, typically lower than traditional finance firms. However, like any institution, other service fees do also apply. Lending platforms provide the credit on different term periods, generally ranging from a few days to 12 months.
Crypto-based loans are over-collateralized, meaning the borrower has to put up more crypto than the value of the money they would receive. For instance, if 1 BTC cost $10 000 and someone wanted to borrow this much in USD, they may need to lock 1.5 BTC.
Over-collateralization is one of the banes of lending in cryptocurrencies but has proven to be the only current method of dealing with volatility and defaulting uncertainties. We’ll explore this concept in the next section to understand more in-depth how crypto lending works.
Over-collateralization in crypto
Much of the crypto lending taking place is a borrower putting down cryptocurrency collateral in the form of BTC, ETH, etc., in exchange for USD or any other fiat currency. The primary reason for over-collateralizing is to safeguard the debtor’s assets when the value of the crypto collateral becomes unfavorable.
Lending platforms use what is known as the LTV or loan-to-value ratio, a percentage measurement of how much extra a borrower needs to secure in relation to the value of their loan.
The most common percentage is a 50% LTV (although other platforms go as high as 90%), meaning borrowers need to put up an extra half in crypto to receive their cash. If we go back to the previous example, a $10 000 loan (assuming 1 BTC costs the same) would mean the debtor needs to lay aside 1.5 BTC.
There are two primary reasons for over-collateralization. The first has to do with mitigating exchange rate risks during the term of credit. Let’s consider two scenarios. If Bitcoin’s price decreased at some stage of the loan, it would pose a risk to the lender since their stored collateral would be worth less than the $10 000.
The platform would liquidate your holdings for protective measures if the value shrunk below a certain threshold or price down limit. Essentially, the extra $5k acts as a buffer in case the price becomes too adverse for the lender.
In a second scenario, a rise in BTC would benefit the borrower because they may receive more BTC after paying back their loan. Lastly, the loan-to-value ratio safeguards the lender in case the borrower were to default.
The LTV is the downside of crypto loans since services have to manage the risks considering no credit and history checks are performed and because of price fluctuations.
Want to be ‘confused’ even more? A relatively new addition in crypto lending is flash loans, which are purely unsecured loans that need to be paid within seconds. A flash loan is not typical since the borrower cannot pay it back over several hours, days, weeks, or months.
Presently, the main use of such loans is for arbitrage opportunities which traders use to make a quick profit. Arbitrage in crypto is when you seek price discrepancies between two identical markets by quickly buying and selling them simultaneously.
Hence, flash loans are well suited for this purpose. Smart contracts facilitate flash loans where they stipulate rules for the debtor to pay back the loan before the deal ends. Otherwise, the funds are reversed back to the platform.
Flash loans seem to be the only credit in cryptocurrencies offered with zero collateral, although they are only practical for a skilled arbitrageur.
Any cryptocurrency enthusiast is familiar with ‘HODLing’ or ‘holding on for dear life’ to experience the maximum possible appreciation of the coin in question. While this strategy is the simplest and has paid dividends to millions, it’s a bit like leaving money in a bank account with low interest rates.
Yield farming allows holders to earn a yield from their idle holdings without selling them. Hence, you stand to gain from the natural price appreciation and also from interest. But what about the benefits for borrowers?
Technically, there are more risks with crypto lending from a borrowing perspective because of over-collateralization. So, the trade-off of having no credit checks comes with this limitation. Moreover, high volatility is well-documented in cryptocurrencies, which can be beneficial or another danger for borrowers and even lenders.
Many experts have expressed the sentiment of crypto lending being less advantageous for borrowers than creditors because of the said limitations. Nonetheless, crypto-backed loans are here to stay and hopefully can become better over time.
If you’re thinking of crypto lending either as a lender or a borrower, like any endeavor, you need to understand the risks involved and weigh up the pros and cons.