The cryptocurrency industry has grown by leaps and bounds in the past few years. One of the latest and quite popular offerings is cryptocurrency loans. Decentralized Finance(DeFi) services especially crypto lending and borrowing have grown exponentially since 2020.
Cryptocurrency lending platforms like Celsius enable people to deposit cryptocurrency which is then lent out to borrowers who have to pay interest 0 on the same. There are also DeFi protocols like Aave that eliminate the need for a central entity and rely entirely on smart contracts for the execution of loans. A major advantage of crypto lending is that you can instantly get loans by providing some collateral.
Though riskier, you can also borrow or give uncollateralized loans. The whole lending process on cryptocurrency lending platforms is automated by smart contracts. This makes the process of accessing and disbursing funds easy and transparent. Further, crypto assets can get you higher APYs compared to regular savings accounts.
However, while innovative, crypto lending is still a largely unregulated sector. Apart from the financial risk, the volatile nature of cryptocurrencies makes crypto lending an even more unpredictable venture. Therefore, it is important to know everything about crypto lending protocols, how crypto lending works, various crypto lending platforms, and the risks involved in lending and borrowing via cryptocurrencies.
What is Crypto Lending?
Crypto lending is, in simple words, a borrowing and lending service for the crypto world. Just like in the traditional banking system where you can deposit money and earn interest, you can deposit your crypto coins which are then lent out to borrowers. In return, you are paid regular interest usually in the form of cryptocurrency.
Just like banks make money from the difference between the interest they pay for deposits and the interest they charge on loans, crypto lenders similarly make profits.
In this whole process, a key role is played by cryptocurrency lending platforms that connect lenders and borrowers. These platforms started gaining popularity in 2020 and some of them are now worth hundreds of millions of dollars.
How Does Crypto Lending Work?
Crypto lending is quite similar to mortgage lending. Digital assets are collateralized to disburse a loan which is then to be repaid within the predetermined time period along with the interest.
There are two aspects of crypto lending: the lending portion and the borrowing portion. Lenders give out their crypto assets as loans to earn APYs on holdings that would otherwise be lying idle. Borrowers, meanwhile, use their digital coins as collateral(in most cases) to get instant loans. In case of default, the collateralized crypto asset is liquidated.
This is a win-win situation for both parties as the borrower gets a loan immediately without the hassle of too much paperwork while the lender earns passive income on his crypto holdings. Mostly, crypto lending platforms are used to facilitate this whole process.
Simply put, lenders put their assets in lending accounts with high-interest rates while the borrowers secure loans from these platforms by giving their digital assets as collateral. Different lending platforms have different interest rates for crypto loans. The interest rates can also vary from cryptocurrency to cryptocurrency.
When it comes to cryptocurrency lending platforms, they are generally of two types- centralized and decentralized. The crypto deposit and loan disbursal process is largely the same for both except centralized platforms require lenders and borrowers to register an account while you can simply connect your crypto wallet to a decentralized protocol where everything is automated by smart contracts.
Types of Crypto Loans
Collateralized Loans
As the name suggests, collateralized crypto loans require cryptocurrency to be submitted as collateral after which the loan is disbursed. Most crypto lending platforms go for over-collateralization so that borrowers only get a certain percent of the deposited collateral.
Since cryptocurrency is a volatile asset, your loan-to-value(LTV) ratio keeps changing. Basically, the lower your LTV, the lower the interest rate. Therefore, your LTV increases drastically when the price of cryptocurrency significantly falls down.
It is, hence, important to monitor your loan account during market drops to avoid having to deposit extra collateral. Depending on the smart contract conditions, you may also be asked to pay fines or repay your loan.
Uncollateralized Loans
These are not as popular as collateralized crypto loans and perhaps for good reason. While the borrower does not have to provide any collateral and is allowed to borrow as much as the pool allowed value it also means a higher risk for lenders because there is no collateral that they can liquidate in case of a default.
Flash Loans
Flash loans are uncollateralized crypto loans that are given and repaid in the same transaction. The transaction is canceled before validation if the original loan amount plus the interest is not returned on time. These are very high-risk loans and you need to complete your transactions in a flash to take advantage of them.
Line of Credit
It is a type of collateralized loan but with certain modifications. While loans are given up to a percentage of the collateral deposited unlike traditional collateralized loans, crypto lines of credit have no set repayment terms. Interest is charged only on the amount that is withdrawn from the account.
Risks of Crypto Lending
Crypto lending and borrowing is an inherently risky venture because it is subject to the whims of the volatile crypto market. While things move quickly here, it is also a very new and largely unregulated area of finance and hence, full of risks and uncertainties.
Margin Call
Most crypto lending platforms require collateral for loans. The LTV has to be within an acceptable range but if the LTV goes out of this range due to a fall in the collateral asset’s value, a margin call is triggered. In such a situation, you have to either deposit more assets as collateral or face the risk of liquidation.
Loss of Liquidity
When you deposit crypto assets on a lending platform, they often become illiquid i.e. they lose their liquidity. This is because most crypto lending platforms have a lock-in period for deposited assets. You cannot withdraw your crypto assets before this period is over which essentially turns your deposited assets illiquid.
Unclear Regulations
Crypto lending is a new thing even in the cryptocurrency space. Compared to older, established methods of lending, there are no clear regulations and guidelines for cryptocurrency-based lending. Therefore, there is no legal recourse if you lose your assets due to crypto lending programs.
Unregulated Platforms
A related but separate issue is that while crypto lending platforms like Aave and Celsius are becoming popular, none of them is regulated by any authority. It is a wild west out there and assets parked in crypto lending programs do not get the same protections as bank deposits. Hence, there is no way to recover your funds if the platform becomes insolvent.
Vulnerabilities in Smart Contracts
While smart contracts automate the whole lending process and ensure transparency in the same, it should be remembered that these are not legally binding contracts. Security or functionality flaws in smart contracts are a bigger issue in DeFi because there is no human oversight. You cannot contact anyone for support if a smart contract vulnerability causes you financial loss.
Cyber Attacks
Crypto lending may seem like an attractive option but it is also vulnerable to cyber attacks. Two of the most common types of attacks are Rug Pull schemes and Flash Loan Attacks.
In rug pull scams, DeFi developers create a new token, pair it with a popular leading cryptocurrency, and set up liquidity pools. High yields are promised on these pools and users are encouraged to deposit tokens in them. After collecting a substantial amount of tokens, the developers use smart contracts to mint new coins and exchange them with popular coins leaving the pool worthless and disappearing themselves.
As discussed in the previous section, flash loans are a type of short-term uncollateralized loans that are easy to access. They are especially targeted by attackers due to their ease of access. These attackers use flash loans to borrow large sums of money and then use them to manipulate the market.
Is Crypto Lending a Good Idea?
If we look at all the factual data available, while crypto lending offers high returns and flexible repayments, it is also a risky venture. Apart from its unregulated nature, there is also the fact that your assets are essentially locked up for a certain time period and the platform where you deposit your cryptocurrency holds the key to them.
Keeping this in mind, it is not a good idea to recklessly jump into crypto lending. You need to do your research and make sure that you are clear about the process of crypto lending, asset eligibility, and the risks associated with crypto lending. You also need to thoroughly research your shortlisted lending platforms, their policies, and smart contracts including their auditing standards for smart contracts.
Due diligence is the key to a successful crypto borrowing and lending experience. Be aware of your strengths and weaknesses and don’t jump heedlessly into any project just because it is trending.
The Bottom Line
Crypto lending is a world full of potential but it is also a loosely regulated sector. While you can earn pretty high interest on your deposits, it is also quite easy to lose all your assets on a poorly managed platform. Therefore, you should not walk blindly into crypto lending.
Be aware of the perils of crypto lending verify the reliability of your selected lending platform and confirm the specifics of your lending account and the loan terms before committing to lending cryptocurrency.