What Is Crypto Lending and How Does It Work?
Many cryptocurrency enthusiasts believe that they can profit by buying, holding, and selling cryptocurrencies. However, many people are unaware that they can use their crypto holdings to obtain loans or even lend out cryptos for additional profit.
For cryptocurrency users who aren't concerned with short-term volatility because they're in it for the long haul, their digital assets are now being used as collateral for loans.
Here's what you should know about crypto lending, as well as some advantages and disadvantages to consider.
What Is the Difference Between Crypto Lending and Borrowing?
Crypto lending allows cryptocurrency owners to lend their coins to borrowers. They will gain some profit as a result of this. It's more like putting money in a savings account that earns interest.
A cryptocurrency loan can be given or received through a cryptocurrency exchange or decentralized finance (DeFi) lending platform. Interest rates and terms of lending differ from one crypto lending platform to the next.
How to Borrow or Lend Cryptocurrencies
Three parties are involved in the lending of cryptocurrencies: the lender, the receiver, and the decentralized exchange (DEX) or centralized crypto exchange (CEX) that provides the service. The lender is the person who makes the crypto loans; the receiver is the borrower; and the exchange is the platform that makes the transaction possible.
We'll take a quick look at how these parties interact throughout the process.
To obtain a crypto loan, the receiver (borrower) must deposit funds that will serve as collateral for the loan. The user would then apply for a loan through the crypto lending platform. The lending platform connects the lender and the borrower once the terms are met using smart contracts.
The lender will then begin to receive interest on the loan from time to time. However, the borrower will not be able to access the amount used as collateral until the loan is completely paid off.
Using the example of a borrower who wants to trade Ether (ETH) but lacks the necessary funds, if he also has an investment in, say, MBG tokens, he could use the MBG token position as collateral to obtain a loan to invest in ETH. He won't be able to access his MBG tokens until he repays the borrowed loan. Also, keep in mind that the borrower is free to use the borrowed loan as he sees fit, including withdrawing it for use outside of the platform from which he borrowed it.
The collateral that the borrower deposits is usually greater than the loan charge. You may be wondering why you should take out a loan if you have to provide collateral worth more than the loan amount. Most people who take out crypto loans do so to add to a specific position they have been holding, to meet expenses without affecting their current trading positions, or to make new investments.
The expected annual yield for cryptocurrency lending varies by platform, but it is typically between 3% and 15% per year. The rate is also determined by the digital asset you are lending. In addition, the lending platform usually adds information about the expected yield per coin. Not all platforms have cryptocurrencies available for lending; you must conduct research to determine whether your desired cryptocurrency is available and the expected annual return.
Liquidation can also occur when the borrower's collateral can no longer cover the loan value—if the collateral loses value or the amount borrowed gains value against the collateral. To keep a borrowed loan active, the loan amount must always be less than the collateral value. Borrowers must ensure this by increasing their collateral or repaying a portion of their loan when it decreases.
Types of Crypto Loans
There are two kinds of crypto loans: flash loans and collateralized loans.
Flash Loans
With flash loans, you can borrow money for a short period of time without requiring collateral. They require that the liquidity be returned within one transaction block. To accomplish this, you must create a contract that requests a flash loan, executes the necessary steps, and repays the loan plus interest all within the same transaction.
A flash loan requires technical knowledge to execute, making it more suitable for developers. However, tools such as CollateralSwap and DeFiSaver enable users to benefit from flash loans without requiring coding knowledge.
Collateralized Loans
Collateralized loans are the most common type of loan in the crypto space. They are more accessible to regular crypto users. They require collateral and allow users to borrow funds for a longer period of time. Borrowers are typically approved for loans of up to 50% of the amount used as collateral.
Crypto-Lending Platforms
There are several cryptocurrency lending platforms. Some of these will be discussed further below.
Aave
Aave is a non-custodial, decentralized liquidity market protocol where users can lend or borrow cryptocurrencies. The protocol is completely open-source, allowing users to interact on the Ethereum network openly. Because the protocol is open-source, users can create third-party services that interact with it.
Compound
Compound is another DeFi lending and borrowing platform. It is also Ethereum-based and makes use of smart contract functionality for transactions.
Advantages of Crypto Lending and Borrowing
Now that you understand what crypto lending and borrowing are, you should be aware of some of their advantages. The following are some of the benefits of crypto lending and borrowing.
Fast and Easy Procedures
Borrowers will easily secure a loan as long as they can provide collateral. That's all there is to it. The procedure is not rushed and does not necessitate lengthy procedures as the traditional banking system does. Once approved, you could have your loan funds in a matter of hours.
High Yield for Lenders
Banks do not pay high-interest rates on savings accounts. So, keeping your money in a bank for an extended period of time will only cause it to decline due to inflation. On the other hand, a crypto lending platform provides a similar saving method with higher interest rates than banks.
Low Transaction Fees
A one-time service fee is usually charged for lending and borrowing transactions. It is sometimes lower than the interest rates charged by traditional banks.
Loan Currency Selection
Depending on the platform and what you require, you can generally obtain loan funds in the form of US dollars or select cryptocurrencies.
No Credit Check
Typically, cryptocurrency platforms make loans without conducting credit checks. To obtain a loan, you only need collateral. You'll have the loan once you can provide that. In other words, it means that when you apply, most crypto lending platforms and exchanges will not run a credit check, making it an extremely appealing financing option for people with bad credit or no credit history.
Disadvantages of Crypto Lending and Borrowing
Even though crypto lending can be a profitable activity, there are some drawbacks to consider. We'll go over a few of them below.
Hackers' Activities
Because lending and borrowing occur online, your assets are vulnerable to the actions of hackers and cybercriminals. Hackers can compromise a smart contract or exploit poorly written code, resulting in a loss of funds. Learn how to protect yourself from crypto hackers and what steps you can take to limit the activities of hackers.
Margin Calls
Margin calls happen when the value of your collateral falls below a certain threshold and the lender requires you to increase your holdings in order to keep the loan. In some cases, the lender may even sell some of your assets to reduce the loan-to-value ratio. Because cryptocurrencies are extremely volatile in the short term, the likelihood of this occurring is high.
Liquidation
We've already said it, but we'll say it again. Liquidation occurs when the collateral price falls to the point where it can no longer cover your loan. Because the cryptocurrency market is volatile, the price of your collateral may drop unexpectedly, resulting in the asset's liquidation.
Volatility
One of the disadvantages for lenders is volatility. The value of the cryptocurrency you lend out may fall, resulting in losses that exceed interest earnings.
Interest Account Funds Are Not Insured
Interest account funds are not insured. Unless you lend your own digital assets, funds in a crypto interest account are not insured in the same way that money in a bank account is. As a result, if the exchange fails, you may lose everything.
Repayment Terms Can Vary
These loans are typically structured like traditional installment loans, and depending on the crypto lending program, you may have as little as a year to repay what you borrowed. In other cases, you can devise your own repayment plan. With shorter repayment terms, it's critical to know whether you can afford the payments ahead of time.
Disclaimer: The views and opinions expressed in this article are solely the author’s and do not necessarily reflect the views of MultiBank Group. No information in this article should be interpreted as investment advice. MultiBank Group encourages all users to do their own research before investing in cryptocurrencies.