What is Crypto Lending?
5 mins read
10 mths ago
Let’s cut to the chase, we know what cryptocurrency is and what it’s used for. Most of us understand that it’s a kind of decentralised digital currency that isn’t subject to control by any central entity. But how is it used to facilitate loans?
Many people take out loans when they’re short on cash. These loans could be from the bank, a mortgage institution, a private company, or an individual, and oftentimes these loans come with interest rates. For the most part, this is how the banks or the private company make money. You put in an application for a loan, your loan request is approved based on your credit score or by how much you are deemed to be able to afford to pay back; your loan is disbursed and at the end of the agreed term, you pay back the loan with interest.
Recently, though with the growing popularity of cryptocurrencies as financial instruments, we have started seeing a new type of lending known as crypto lending. Cryptocurrency lending is pretty much the same as regular lending, but with a few exciting changes and possibilities.
So what is crypto lending?
Crypto lending is an alternative form of investment in the decentralised finance (DeFi) space where investors lend fiat money or cryptocurrencies to other borrowers in exchange for interest payments. In this case, investors or crypto lending platforms lend you cryptocurrency while you deposit a certain amount of your holding on the platform as collateral to back the loans you are given. The amount of cryptocurrency that you deposit is what determines how much of a loan you can get. Once this loan is approved, you receive it either in your fiat or crypto wallet depending on the options you choose while requesting for the loan. After the loan tenure is complete, you pay back the loan with the agreed interest rate and can then withdraw your crypto which had been held as collateral.
How crypto lending works
There are always two main parties involved in this crypto lending:
- The lender, who will receive interest from the borrower in exchange for the loan.
- The borrower, who will deposit crypto assets as collateral to secure the investor’s loan.
The idea of using crypto as collateral is to give lenders a sense of assurance that their investment is safe in the case where a borrower does not pay back their loan. Crypto lending is helpful on a fundamental level because credit and lending markets increase the amount of productive work money in supply by reallocating it from those without an immediate use case to those with one. This increases the utility of that money for all parties, giving borrowers access to capital and giving lenders yield.
This is a massive opportunity for crypto markets and users, that have traditionally had two use cases for crypto: HODL or trade. For hodlers, cryptocurrency has had one function, which is to sit in their wallets. While some may argue that it serves a purpose by limiting supply on the market, we can generally agree that it is not a particularly productive use of a capital asset. With the advent of crypto-asset lending, the utility of those assets has increased significantly. A formerly static investment can now generate passive yield for lenders, and borrowers can either receive fiat without having to initiate a taxable sales event or receive crypto assets for trading, arbitrage or market-making. These are substantial improvements for individual hodlers and major institutional investors alike.
How to use crypto lending
Crypto lending platforms are divided into two categories: centralised and decentralised lending platforms.
- Centralised platforms such as BlockFi, Nexo, and Binance have to follow certain rules and procedures to be regulatory compliant. You’ll have to create an account by signing up for your chosen platform and go through Know Your Customer (KYC) procedures that are in place to prevent fraud and money laundering. These platforms typically have protocols in place to ensure that your collateral is safe. Centralised crypto lending platforms will still record all deposits and withdrawals using blockchain technology, visible to everyone, and offer a great way to earn interest on Bitcoin, alongside many other cryptocurrencies.
- Decentralised lending platforms work without either party having to identify themselves. Instead, the borrower must put up collateral that the lender will automatically receive if the loan is not repaid.
Benefits of crypto lending
- One of the major bonuses many see in a crypto loan is that, unlike traditional banking, you won’t require a credit score to be eligible. This means that lending is more accessible to people who don’t have a financial history, underbanked consumers who don’t have a bank account, and self-employed workers who struggle to access credit because their fluctuating earnings don’t meet a bank’s strict lending criteria. Repayments can also be more flexible.
- Where it can take several days for loans to clear in the old-fashioned financial world, crypto loans are instant. You’ll also be able to make your assets liquid without triggering a taxable event in most cases, plus you can adjust the loan to suit your needs. Users can also deposit different crypto assets, so you could deposit bitcoin, ethereum, USDT, and USDC depending on the platform of your choice.
Risks of crypto lending
There are a few risks involved in crypto lending which are important to take note of.
- Borrowers take on the built-in risk of supplying liquidity if their collateral value drops below the required value to ensure that lenders are always safe. This means that borrowers need to carefully watch their collateral ratio to ensure it stays within a safe range. Thus far, liquidation systems have proven to be robust and lenders have not often lost their investment – but this is not guaranteed. For the decentralised options, however, there is often the issue of low liquidity, such that rates can shift drastically if a large number of capital moves in or out of the system.
In general, the interest rate functions are created to incentivise a fairly stable equilibrium, but volatility does happen.
- Not forgetting taxation, there are tax and regulatory risks involved in using these platforms, especially as one of the major use cases of borrowing relates directly to avoiding a taxable event. In general, many jurisdictions do not have clear guidance on the nature of many of these assets, including stablecoins. This makes it hard for an individual to know the exact tax implications of their crypto-lending activities, and it’s recommended that users speak with a tax consultant before making a decision.
As the crypto industry continues to grow, the lending ecosystem is going to remain a pivotal piece in its success story. And we can expect to see improvements in the present model that will further move the DeFi space towards widespread adoption. Crypto lending, nonetheless, is already a lucrative venture for some who prefer to hodl their cryptocurrency and make it earn them passive income.
Disclaimer: This article is meant to provide general guidance and understanding of cryptocurrency and the Blockchain network. It’s not an exhaustive list and should not be taken as financial advice. Yellow Card Academy is not responsible for your investment decisions.