Word Street Journal

The crypto lending space can be challenging due to the complex nature of these products and the numerous entities offering such services. This guide aims to simplify the lending or borrowing process to beginners.

There are numerous ways to make money in the digital asset industry, and crypto lending is one of them. This concept allows investors to earn passive income on their assets without losing or selling them. While the crypto lending sector is lucrative, it comes with risks, and participants need in-depth knowledge to navigate the space properly.

What is Crypto Lending?

Say an investor needs liquidity to invest in their business, diversify their investments into other asset classes, or make a big and urgent purchase but does not want to sell their cryptocurrencies to generate the funds needed. They may consider crypto loans.

In crypto lending, market participants lend their assets to other parties for a specified period in exchange for rewards or compensation. Crypto lending is similar to traditional lending; however, the former is facilitated by digital asset entities, while banks and other kinds of lending platforms run the latter.

So, crypto lending offers market participants opportunities to earn passive income from their cryptocurrencies and create liquidity in cash or crypto for certain transactions without selling their holdings.

How Does Crypto Lending Work?

Crypto lenders can make their assets available to borrowers by depositing them on crypto lending platforms or smart contracts. Like traditional lending models, borrowers have to deposit collateral before taking out loans; however, this collateral is cryptocurrency.

Simply put, crypto lending works when an investor deposits their digital assets on designated platforms and other traders pledge their holdings to obtain loans to be paid over time from the deposited digital currencies. Deposit accounts can be likened to bank accounts; lending platforms pay interest to the depositors while lending out the cryptocurrencies to borrowers.

Due to the volatile nature of digital assets, crypto lending can be tricky – most platforms require borrowers to deposit at least 100% or even 150% in collateral for the loans. Some also restrict lending to high-profile cryptocurrencies such as Bitcoin, Ethereum, Solana, and stablecoins. This is to ensure there is enough cushion for the loan-to-value ratio in the event of the collateral losing significant value, and also that the asset has sufficient liquidity for large scale liquidation and market movements.

The collateral coverage ratio for each loan varies across platforms, with some having a higher ratio than others, so it is important to know the different types of entities offering lending services.

Types of Crypto Lending Platforms  

The crypto lending space comprises centralized and decentralized platforms, each with risks and benefits. 

• Centralized Crypto Lending Platforms

Centralized crypto lenders operate like traditional banks and are intermediaries between lenders and borrowers. These entities provide the infrastructure for lenders to deposit their crypto assets and for borrowers to obtain loans. They also facilitate the payment of interest to lenders based on the agreed annual percentage yield (APY). 

Examples of centralized lending platforms include Binance, Kraken, and Nexo. 

• Decentralized Crypto Lending Platforms

Decentralized platforms make decentralized finance lending (DeFi) lending possible. These operate directly on blockchains and use smart contracts to facilitate lending and borrowing. Decentralized crypto lending platforms enable peer-to-peer transactions, eliminating the need for a centralized authority.

Examples of decentralized crypto lending platforms are Aave and Compound.

Types of Crypto Loans

• Collateralized loans

As stated earlier, most crypto lending platforms require collateral before users can take out loans. However, the volatile nature of digital assets has led to over-collateralization, which involves providing collateral worth more than enough to cover potential losses to avoid defaulting on the loans.

When users provide their holdings as collateral, they retain ownership of the assets but become unable to sell or trade them. If the borrower defaults on the loans, the lending entities can choose to sell or retain the collateral to recover their losses. Collateralized loans are the most popular, and over-collateralization provides an extra layer of security for both lenders and borrowers.

• Uncollateralized loans

Uncollateralized loans exist, but they are not as popular as collateralized loans. They pose a higher risk for lenders, as there is no collateral to liquidate if a borrower defaults. These loans require users to fill out applications and verify their identities so the lenders can pursue the borrowers legally if they default. 

Hence, uncollateralized loans are more like personal loans. Even so, some defaults may never be fully recovered from, with the BlockFi and Celsius multi-billion dollar collapse in 2022 being classic examples.

Besides, since one of the perks of the crypto industry is privacy and anonymity, uncollateralized loans may appear unattractive to traders because they would expose their identities.

• Flash loans

Flash loans allow traders to take uncollateralized loans and repay the lender (plus interest) in one transaction. These kinds of loans are high-risk and are often used to take advantage of arbitrage opportunities, such as discrepancies in the price of an asset on different trading platforms.

For instance, ether (ETH) is worth $3,200 on Binance but is changing hands at $3,010 on KuCoin. A trader can use a flash loan to buy ETH on KuCoin and sell it on Binance in a single transaction. Market participants—often sophisticated traders—make this possible by creating a series of smart contracts that programmatically execute the transaction. 

The tricky part of flash loans is that the transaction is reversed if the loan is not repaid within the same transaction block. This means the funds return to the lender, and it is as if the trade never happened.

• Crypto Line of Credit

Crypto loans often have short timelines, with some lasting between a few days and several months. However, with a crypto line of credit, users can borrow up to a certain percentage of deposited collateral with no set repayment terms. Since lines of credit are open-ended debt, users can borrow and repay crypto as long as the collateral is in good standing.

Pros of Crypto Lending

The crypto lending sector has proven to be profitable, allowing users to make money while holding their digital assets. Here are some pros of getting involved in the sector.

• Transparency: This is often seen in decentralized lending platforms because their smart contracts are publicly auditable, making the transactions more transparent. 
• No Intermediaries: The lack of intermediaries in DeFi lending platforms enables traders to engage in lending activities without revealing their identities or paying exorbitant interest rates.
• Low Interest Rates: This depends on the crypto lending platform a borrower chooses to take loans from. Average interest rates range from 0.5% to 30%. Although interest rates are low and reasonable across most platforms, other entities can offer higher rates.

Cons of Crypto Lending

One major disadvantage of crypto lending is the volatility of cryptocurrencies. Digital assets experience fluctuations in their value, causing their prices to drop or rise quickly. This risk applies to both borrowers and lenders because the former’s collateral could lose its value and get liquidated, while the latter could lose all or some of their assets. Besides volatility, other cons include:

• Illiquidity: When borrowers use their crypto assets as collateral for a loan, they lose the right to sell or trade them, and as a result, the digital currencies cannot be accessed quickly.
• Margin Calls: A margin call is triggered when a collateral experiences a drop in value. The loan-to-value ratio of a crypto loan drops below an agreed level, and borrowers are faced with either depositing more collateral or getting liquidated.
• No Insurance: Most crypto lending platforms are not insured, primarily due to the lack of regulation in the sector. So users could lose their deposits if the entities fail or go bankrupt. 

Summary

Armed with knowledge of how crypto lending works, traders can be wary of the risks of navigating the sector. It is important to note that each crypto lending platform has risks and benefits, so doing due diligence before choosing a lender is paramount.