Crypto Lending: An Innovative Form Of Credit Using Cryptocurrencies

Dec 24, 2020 06:17 PM ET
Crypto Lending: An Innovative Form Of Credit Using Cryptocurrencies

What is crypto lending, and what makes it unique? Crypto lending is part of the decentralized finance innovation where financial procedures can occur cheaply, efficiently, and swiftly without any third-party control.

Imagine a lending system where no lengthy credit checks nor the presence of a bank exist. Enter cryptocurrency lending, an experimental form of a credit facility in the realm of DeFi (decentralized finance).

This article will cover what a crypto loan is, how it works, the reasons people use this type of credit, and the unique advantages and risks involved.

How does crypto lending work? 

The process of crypto lending, like conventional loans, involves two main parties: the lender and the borrower. In most cases, a lending platform acts as the intermediary between both by facilitating the whole transaction. 

However, ERC20 tokens, for example, native to Ethereum, can execute smart contracts that eradicate the need for a middleman. Most crypto loans require the borrower to stake a certain amount of cryptocurrencies as collateral to the lender (though a few others can demand other physical assets). 

Since no credit checks exist, the platform carries out typical KYC (Know Your Customer) procedures. Once the platform has determined the interest rate, loan length, and other vital terms and conditions, the lender receives the loan. 

Assuming all is in good standing, the borrower should return the loan with interest and receive back their collateral from the lender.

Collateral in crypto lending

Most loans need the lender to stake more collateral than the value of their loan to offset the volatility of cryptocurrencies. Plentiful services enforce an LTV (loan-to-value) ratio that doesn’t go beyond 50% (a few can be higher), which effectively means borrowers receive a loan equivalent to 50% of their collateral. 

For example, if one wanted to borrow $10,000 in fiat money, they would need to deposit $20,000 worth of a specific digital currency compatible with the loan provider. The same scenario applies to a crypto-to-crypto loan. This ‘over-collateralization’ can be a double-edged sword.

A practical example of collateral in crypto lending

Let’s assume one wanted to borrow $2,000 in cash where the lending platform needed $4,000 worth of BTC as collateral. During the loan, if Bitcoin went up in value, this would be favorable for the borrower.

However, if the coin went down in value up to a certain point, to bring the loan back in order, the borrower would either pay the penalty or the provider can liquidate the collateral to protect the lender. 

In rare but slowly growing cases, some services using ‘off-chain’ data platforms like Chainlink allow for borrowers to use physical assets like real estate, cars, and other goods for collateral.

Why do people use crypto lending? 

The number of reasons people consider crypto lending is intriguing. One of the expected motivations is improving something in their personal life, like paying for an emergency or buying a new smartphone. However, there are a few other interesting reasons, mostly concerning speculating, hedging, or arbitrage:

  • From a lender’s view, loaning out part of their cryptocurrencies allows them to gain interest and still retain ownership.

  • Through the lens of a borrower, they can use a crypto loan to buy a cryptocurrency they believe will rise in price in the short term. Alternatively, a borrower may want to gain additional exposure to a specific cryptocurrency they imagine will be valuable soon.

  • Some even use crypto loans for arbitrage purposes where they spot opportunities to profit off the small price differences between different exchanges.

Pros and cons of crypto lending 

Like many other DeFi applications, pioneers of crypto lending believe it should operate without an intermediary like a bank, extra transaction fees, long approval times, and exorbitant interest rates. 

Despite the benefits that such a credit system aims to deliver, there are still some drawbacks that may not be viable for everyone. The list below will detail some of the pros and cons.

Pros

  • From both the perspectives of the lender and borrower, there is some risk management in the form of collateral. Should the borrower default, the lender keeps the digital assets. 

This option is more secure from the lender’s perspective than an unsecured loan. Hence, this reason is why crypto loans have better interest rates for borrowers than traditional credit.

  • From the lender’s perspective, it is an incentive to borrow since they receive better interest rates than typical savings accounts. They don’t have to sell their coins while still earning interest on them. Furthermore, they can shift some of the volatility risks of cryptocurrencies towards the lenders. 

  • There are no conventional credit checks as with regular loans. As much as first-time users have much higher chances of getting credit than in the traditional system, the discretion is still up to the lending platform based on their requirements. Over time, borrowers do build up credit history internally, which affects the terms of future loans.

Cons

  • Most crypto loans require the borrower to ‘over-collateralize’ (as explained previously), which may be impractical for some. The alternative is looking for platforms that allow other forms of security. 

In a traditional financial system, you can often receive unsecured or non-collateralized loans (albeit with higher interest rates). Even when you provide collateral, this should equal the value of the loan.

  • Adding to the previous point, most cryptocurrencies are volatile, explaining the need to ‘over-collateralize.’ Conversely, you may also be fortunate enough that your crypto assets have also risen in value. To circumvent this problem, it may be wiser to borrow using stablecoins. 

  • Although collateral loans are risk-centric, the concept as it relates to cryptocurrencies can be complex and needs thorough research.

  • Currently, most crypto loans are for short-term periods, ranging from one week to a maximum of 3 months.

The future of crypto lending

Crypto lending is still a relatively novel concept, with no more than three years in complete existence. However, it is the fastest-growing DeFi (decentralized finance) innovation aiming to continually disrupt traditional finance by providing quick, efficient, cheap, and decentralized credit.

Despite these technologies, crypto lending still carries high risk. Aside from the collateralization, analysts fear there could be a credit bubble within crypto lending since no background checks exist for borrowers.

It will also be interesting how cryptocurrencies perform in the near future since any so-called crash like in 2018 will undoubtedly affect the rate of crypto loans.

Conclusion

Cryptocurrencies are truly a revolution as not just digital money, but for decentralized applications like crypto lending that can operate swiftly without the need for a third party. 

Loans using digital currencies as a concept is unprecedented, and the reasons why people use them goes beyond just traditional credit. Although the idea is still in its infancy, with enough adoption and support, we could see it becoming the norm.


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