As the cryptocurrency industry grew and expanded with the introduction of several structured components, developers sought to broaden the possibilities of what could be done and the use cases. Cryptocurrency lending and borrowing is one such innovation, following a pattern similar to what traditional financial institutions offer but with distinct advantages.
Crypto lending and borrowing involve investors — referred to as lenders — depositing their crypto assets through certain DeFi platforms to earn an expected APR/APY generated from borrowers who take out loans.
The approach to taking out a cryptocurrency loan or providing liquidity for a loan as an investor takes a different turn than what you might be accustomed to with traditional financial institutions. This article explains comprehensively all there is to know about these loans.
Understanding The Dynamics of Crypto Lending and Borrowing
Rather than treating crypto lending and borrowing as separate entities, it’s beneficial to approach them from the same standpoint since, in most cases, both activities take place on the same platform. This platform is usually a third-party service, which can be either a centralized or decentralized platform. These intermediaries are typically known as crypto lending and borrowing platforms.
In simple terms, for crypto lending to be complete, a user must deposit their cryptocurrency into the chosen platform, which then manages the deposit. Subsequently, another user comes to take out a loan by providing collateral. This doesn’t operate like an order book scenario, which requires the borrower to place a matching order with the lender. Instead, a centralized or decentralized intermediary manages and facilitates the entire process.
For a decentralized lending platform like AAVE, the process is automated using smart contracts. Here, lenders deposit their crypto assets into a pool managed by smart contracts. Conversely, borrowers deposit collateral into a smart contract; once accepted, they can take out a loan from the platform. The smart contract determines the rates for both the lenders and borrowers. For a centralized platform, the process is similar, except that a centralized entity for both lenders and borrowers manages it.
Selecting between a centralized or decentralized entity depends solely on your preference and research. We will cover more factors to consider later in this article. For now, let’s discuss one of the unique features of every crypto-lending platform: the structuring of loans.
Types of Cryptocurrency Loans
As a borrower venturing into the crypto-lending arena, you should be aware of certain aspects, such as the different types of loans available to you. There are two main types of loans accessible to borrowers: collateralized and uncollateralized loans. Let’s explore each of these types of crypto loans.
Collateralized Crypto Loans
These types of loans are straightforward. They require borrowers to put up collateral in specific crypto assets before proceeding to take out a loan. Some of the collateralized loans you’ll find include margin loans, which traders use as leverage to increase their trading position or account size; undercollateralized loans, where borrowers deposit less in collateral than the amount they borrow; and overcollateralized loans, where the collateral provided is more than the loan amount.
The overcollateralized crypto loans are the generally accepted type of loan, mainly because of the security they provide to lenders. In overcollateralized loans, the borrower deposits more in cryptocurrency than the amount of the loan received; thus, the loan-to-value (LTV) ratio is low — the LTV usually ranges between 50-75%. In practice, it works like this: If a borrower needs a loan of $100,000 worth of token A, they would only be able to take out $50,000 to $75,000, depending on the LTV.
This arrangement protects the lender. Once the loan is received, it can be used freely. However, suppose the value of the deposited collateral drops to a certain threshold. In that case, it’s immediately liquidated, and the lenders repay their assets, while the borrowers lose their collateral but can keep the loan they took out. This type of loan provides a safety net and protects the lender from losses.
You might wonder if uncollateralized loans are possible in the cryptocurrency landscape. The answer is yes. This concept is unique to the cryptocurrency industry and has no direct counterpart in traditional financial institutions, where most cryptocurrency innovations are advancements made through decentralization. The most common example of these types of loans is flash loans.
Flash loans are cryptocurrency loans where borrowers take out a loan that must be paid back with interest before the transaction block is completed. You’ll use the loan to complete a desired transaction before completing the main transaction. Due to the speed, the name Flash Loans came up.
If the loan isn’t paid back — meeting all requirements — before the block of transaction is completed, then the entire transaction is reversed. These types of loans don’t require collateral and solely rely on smart contracts to execute this type of transaction. Borrowers, usually developers, set the rules for their transactions in a smart contract. This smart contract is responsible for executing the flash loan on the selected platform.
Why flash loans, you may ask; typically, the interest paid back on flash loans is typically meager, some can be 0.09%, making loans cheaper also due to their fast nature, and also used to take advantage of arbitrage trading opportunities that collect flash loans from a platform sell for higher on another platform.
For a practical example of how this works, consider the following scenario:
Imagine there are two decentralized exchanges, Exchange A and Exchange B. Both offer trading between Ethereum (ETH) and a stablecoin (USDC), but due to differences in liquidity and trading volume, ETH is priced at $2,000 on Exchange A and $2,010 on Exchange B.
- Initiate Flash Loan: You initiate a flash loan, borrowing 10 ETH from a lending platform that offers flash loans.
- Buy Low, Sell High: With the borrowed 10 ETH, you purchase 20,000 USDC on Exchange A (since 1 ETH = $2,000 on Exchange A). Then, you immediately sell the 20,000 USDC on Exchange B to receive 9.95 ETH (assuming 1 ETH = $2,010 on Exchange B and considering a 0.05 ETH transaction fee for simplicity). This step is executed via a smart contract.
- Repay Flash Loan: Within the same transaction block, you repay the 10 ETH flash loan to the lending platform.
- Profit: After repaying the loan, you retain a profit of 0.95 ETH, minus any additional transaction fees and flash loan interest or fees.
While flash loans can be profitable, they are not without risk. Like other aspects of decentralized finance (DeFi), they are also susceptible to smart contract vulnerabilities.
This tweet explains how flash loan was used to make a profit:
PS: The transaction fee is hypothetical and included for simplicity. In real-world scenarios, the transaction fees can vary and affect the profit margins.
Pros and Cons of Crypto Lending and Borrowing
Some advantages and disadvantages come with using crypto loans for both lenders and borrowers. Being aware of both can set you apart, allowing you to take full advantage of crypto loans.
Pros of Crypto Loans
Provision of Passive Income
For lenders, crypto loans offer a method to earn passive income with attractive APR/APY on their crypto assets without the need for active trading.
Accessibility to Liquidity
One of the significant advantages of crypto loans is the ease with which they can be accessed. These loans can often be processed within minutes, facilitated by the efficiency of smart contracts. As long as you have collateral, you can quickly obtain a loan.
Retain Asset Exposure
For borrowers, crypto loans provide a means to access funds while still maintaining their exposure to the potential appreciation of their deposited collateral.
Managed By Smart Contract
Crypto loans are orchestrated and executed entirely by smart contracts, which are inherently decentralized and eliminate the need for traditional credit checks. Also, because the process is carried out on the blockchain, the transaction is fully transparent and immutable.
Cons of Crypto Loans
The cryptocurrency market’s volatility affects both lenders and borrowers, but it can be especially difficult for borrowers. If a borrower’s collateral value falls below a certain threshold due to market fluctuations, the lending platform may liquidate the loan to protect itself and its lenders.
Smart Contracts Risk
As with any technology in the broader cryptocurrency market, crypto lending platforms are subject to the security risks associated with their smart contracts. If these smart contracts have vulnerabilities, they could be exploited, leading to losses for lenders and borrowers alike.
The regulatory environment for cryptocurrencies and crypto loans still evolves and varies between jurisdictions. This can lead to challenges for borrowers and lenders as they participate within an uncertain legal framework.
There are two types of interests in crypto: fixed and variable interest. Variable interest means they fluctuate based on market conditions. If the change in interest rate is significant, it can impact a borrower’s ability to repay.
If the loan-to-value (LTV) ratio is very low, it might be unfavorable for borrowers since they’ll have to lock more in collateral than they’ll receive in return.
Factors to Consider Before Taking a Crypto Loan
Before deciding to take out a crypto loan, it’s important to consider various factors, including the platform you choose for the loan. Here are some key points to think about before committing:
Loan-to-Value (LTV) Ratio
Most crypto loans require depositing crypto assets with a higher value than the loan amount. Being comfortable with the LTV ratio and understanding its implications for your assets is important. Typically, the LTV ratio ranges from 50% to 75%, so determining your desired range is important.
Assess whether the interest rate offered is fixed or variable. With variable rates, there is a risk that they could increase drastically, potentially affecting your repayment plan. Calculate all the variables involved, such as the total cost of the loan and the interest rate, to ensure they align with your financial goals.
Smart Contract and Operational Risks
Verify whether the platform’s smart contracts have undergone rigorous auditing and if any vulnerabilities have been identified. CertiK and PeckShield are two prominent firms conducting Web3 audits — obtaining validation from them can be reassuring. An additional safeguard is checking if the assets on the platform are insured.
Understanding the Terms and Conditions
Every crypto lending platform has unique terms and conditions, including repayment and liquidation policies. It is crucial to understand these fully before using the platform.
Be aware of the fact that fluctuations in market conditions can lead to a decrease in the value of your crypto assets. This is particularly important for borrowers, as they face the risk of potential liquidation if the market value drops sharply.
Examples of Crypto Lending and Borrowing Platforms
Your decision to trade a lending platform depends on your preference for a centralized or decentralized platform.
Decentralized Crypto Lending and Borrowing Platform
As one of the pioneering decentralized lending platforms, formerly known as ETHLend, Aave allows users to lend out their tokens by providing liquidity. Borrowers can secure loans provided they meet the borrowing criteria. Aave also features a governance token, AAVE, which grants holders the right to participate in and influence the platform’s decision-making processes. It is well-known for introducing the concept of flash loans.
Compound Finance allows users to deposit tokens into the platform’s pools, providing liquidity in exchange for interest. Similarly, borrowers can obtain loans from this liquidity pool with the obligation to repay the principal with interest by a specified date. The platform uses an over-collateralization strategy to safeguard lenders’ interests. Compound’s governance token, COMP, enables holders to participate in the platform’s decision-making processes.
Centralized Crypto Lending and Borrowing Platform
This well-known centralized cryptocurrency exchange offers crypto-based services, including lending and borrowing. Users can tap into liquidity across various cryptocurrency pools, and borrowers can secure loans subject to certain conditions. It’s important to note that access to these services requires completion of Know Your Customer (KYC) procedures, and the requirement varies across different jurisdictions.
Formerly known as OKEx, OKX provides a wide array of crypto-related financial services akin to Binance. Participants can lend out their crypto assets to earn interest, and borrowers may acquire loans by collateralizing their crypto holdings. As a centralized entity, OKX manages the entire process and mandates the disclosure of personal information as part of its KYC protocol before users can take advantage of their offerings.
Crypto lending and borrowing are unique concepts in the cryptocurrency space that completely challenge traditional institutions’ approaches. These services offer a convenient way to provide liquidity for passive income and an easier route to taking out loans. Like many parts of the cryptocurrency ecosystem, crypto lending and borrowing come with risk, so doing your research will safeguard you.
Frequently Asked Questions
What Types of Crypto Loans are Available?
Basically, two types of crypto looms are available: collateralized and uncollateralized loans. In the first type, collateralized loans, the borrower must deposit crypto, which tends to be more than what’s to be borrowed. For uncollateralized crypto loans, borrowers do not possess any form of collateral before receiving a loan; for example, the flash loan is the most common uncollateralized crypto loan.
What is a Flash Loan?
A Flash loan is an uncollateralized cryptocurrency loan where the borrowed amount is used and paid back within the same transaction block. This process is completed with the help of a smart contract and is mostly used for arbitrage opportunities.
What are the Risks Associated with Crypto Loans?
Like several aspects of the cryptocurrency market, cryptocurrency loans have associated risks. Some of the key risks include market volatility, smart contract vulnerabilities, regulatory uncertainty, interest rate fluctuations, and the requirement for over-collateralization in some loan types.
Is Crypto Lending and Borrowing Safe?
While risks are associated with crypto lending, conducting thorough research and understanding the terms and conditions can help avoid these risks. It’s important that you are comfortable with the platform’s security measures and the inherent risks of lending and borrowing in the crypto space.
How is Crypto Lending and Borrowing Different From Traditional Lending?
There’s a significant difference between both; for the most part, crypto-lending platforms rely on cryptocurrency, and traditional lending platforms don’t. Crypto lending operates on blockchain technology, utilizes smart contracts for decentralized platforms, and offers quick access to loans without traditional credit KYC procedures. It also provides unique loan types, such as flash loans, which have no equivalent in traditional finance.
How Does a Crypto Lending and Borrowing Work?
Crypto lending is a straightforward process that involves two participants: the lender and the borrower. First, the lender deposits crypto assets into the lending platform for an expected return, which is provided by the borrower who takes out the crypto loan. The smart contract determines the interest earned or paid in decentralized finance, but a centralized entity takes a different approach.