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What is Crypto Lending?

2020-11-30 02:47:09

Crypto lending is the process of lending cryptocurrencies to borrowers with a predetermined interest rate. It allows lenders to earn a consistent profit on unused cryptos and borrowers to use these funds for other potentially profitable financial activities.

Although the fundamental actions of borrowing and lending are the same as in traditional finance, crypto lending has revolutionized the practice in multiple ways. To understand these innovations let’s briefly review how bank lending works.

Crypto Lending V.S Bank Lending

Banks have always functioned as essential components in the financial infrastructures of modern societies. Overall, they take on the role of intermediaries that connect lenders with borrowers in a secure manner. Before approving any loans, a bank will carefully review the borrower’s financial and credit history to minimize the risks of a person or company not paying them back. In the worst-case scenario, if a party is unable to repay, a bank will generally be aware of any collateral that can be seized and sold to recover losses. Because of these precautions, their historical endurance, and the maturity of these institutions, they’re seen as safe options to deposit and earn standard interest rates in local fiat currencies. Of course, in exchange for providing such services, banks collect various fees.

1. Digital currencies

The first and most obvious difference between traditional banks and crypto lending is the currency used. As implied, crypto lending is conducted with cryptocurrencies such as Bitcoin. This simple change in currencies already leads to multiple differences.

2. Price Volatility

One of the major implications of using Bitcoin is price volatility. It is not uncommon for BTC to experience price swings of thousands of dollars within a single day, hour, or even minute. This means that regardless of interest rates, both borrowers and lenders can instantly experience significant unexpected gains or losses. Cryptocurrencies are also relatively new assets with much lower liquidity than fiat currencies. This somewhat restricts participation in crypto lending and makes loans much more limited in size.

3. Entirely Digital

Nevertheless, crypto lending still offers benefits that traditional banking cannot. For example, the process of evaluating a person’s financial background along with standard application forms or procedures is quite cumbersome. With crypto, anyone that possesses some tokens can participate in lending or borrowing almost instantly. While banks still rely heavily on paperwork, crypto lending is entirely digital. In fact, crypto lending uses different mechanisms to ensure repayment waiving the need for credit scores or background checks completely. Once again, this makes access to crypto loans much more simple and accessible.

Next, let’s examine the different types of crypto lending services available and their unique characteristics.

Centralized V.S Decentralized Crypto Lending

Both centralized and decentralized platforms offer users a way to earn interest on their crypto. However, depending on which one is used, the process and risks can be quite different.

What are Centralized Crypto Lending Platforms?

Centralized crypto lending platforms are financial companies that specialize in cryptocurrencies. They are very similar to traditional banks in many respects. Like banks, these platforms will take care of coordinating the movement of funds between lenders and borrowers. The company will determine appropriate interest rates for each party and automatically process payments. It will also be up to these platforms to enforce and follow their own procedures to ensure repayment. Because of these burdens, users must comply with their terms of services which may often include Know Your Customer (KYC) procedures. The company, in turn, profits through the collection of different fees.

However, given that they specialize in cryptocurrency, the process of depositing and borrowing cryptos is quite simple as it can all be conducted online. Likewise, registration processes are largely effortless when compared to brick and mortar banking. As long as users can trust in a platform’s ability to keep assets safe and make payments without delay, these will remain much more accessible and lucrative alternatives to fiat banks. Nevertheless, the higher interest rates offered through crypto lending are offset by some risks. A user that must rely on a centralized platform to maintain custody of their funds is exposed to a single point of failure. If the company acts maliciously or falls victim to a hack, a user can experience irredeemable losses. Furthermore, crypto-related financial organizations are not as regulated as banks and do not enjoy government insurances.

What are Decentralized Crypto Lending Platforms?

Decentralized crypto lending platforms are essentially protocols that employ DeFi (Decentralized Finance) smart contracts to automate the lending process. Through these contracts, lenders can connect with borrowers in a more direct manner that does not require the supervision of a third-party. Recall that these smart contracts are unchangeable pieces of codes or instructions that execute as intended and without fail once certain conditions are met.

Let’s explore the unique mechanisms of decentralized crypto loans further by walking through an example. As a lender in the DeFi space, rather than depositing your money at a bank you would instead select a loan pool at one of these platforms. These pools are essentially like accounts where lenders store or pool their money together and make it available to borrowers. Each pool has its own set of rules dictated and enforced by smart contracts. Such rules or requirements include what cryptocurrencies will be allowed in the pool, how long lenders must store their funds, and the percentage of fees that borrowers will have to pay back.

Once you’ve selected a pool that accepts the cryptocurrency you wish to lend with interest rates or terms that you’re happy with, you can instantly transfer your funds into this pool. Unlike banks or centralized platforms, there is absolutely no type of registration or identity verification process required. In addition, your funds are safely stored in these pools that are not owned by specific private entities. Every transaction is transparently recorded and easily viewable on the blockchain. This is a benefit that you often do not get with centralized platforms as they manage their own internal transactions.

Say you have selected a BTC/ETH pool. This means that as long as you transfer your BTC to the pool and comply with the requirements dictated by the smart contract, you will automatically earn the predetermined interest rates.

At this point, you may be wondering why there is a second cryptocurrency (ETH) associated with this pool. To understand this, let’s now switch to the perspective of the borrower. If you’re someone trying to borrow funds from a bank, as previously mentioned, you will either need an acceptable credit score or enough assets for collateral. The concept of collateral is also applied to decentralized crypto lending. To borrow BTC from this BTC/ETH pool, the smart contract requires you to first offer up an amount of ETH equal to or higher than the amount of BTC you wish to borrow. This is how the pool ensures that even if you never repay the BTC back, lenders will still be compensated. If you wish to borrow $100 worth of BTC, most pools will require you to first deposit $150 worth of ETH. Once you’ve completed your financial activities employing the borrowed BTC, you can transfer the original amount plus the agreed-upon interest back into the pool at any time. The smart contract would then immediately release your collateral ETH back to you. Your additional interest payment is automatically distributed to all the lenders in proportion to how much BTC each has contributed to the pool.

Risks of Decentralized Crypto Lending Platforms         

Once again, one of the primary concerns with decentralized crypto lending services is volatility. Significant price swings can easily lead to unstable returns or even losses for lenders. In addition, as powerful and innovative as smart contracts are, they are not perfect instruments. They’re only as good as the person who wrote them. There have been multiple instances of hackers exploiting bugs or flaws in the code to maliciously extract funds from pools in unintended ways. Finally, interest rates are generally determined based on the liquidity of these pools. With volatility, vast amounts of cryptos can move in and out of these pools within short periods of time. As this happens, interest rates may become increasingly unfavorable especially when considering opportunity costs.

Uses for Crypto Lending

For someone with unused funds seeking profits, crypto lending is an excellent option to earn a passive income through interest payments. However, because crypto lending requires collateral upfront, it may be hard to imagine when or why someone would want to borrow funds in this manner if they already have alternative assets that can be used. The reality is that there are multiple creative and lucrative ways to leverage these types of loans.

  1. Interest Rate Arbitrage – The large number of both centralized and decentralized crypto lending options available means a wide variety of interest rates for all cryptos. Often, a person may find that a coin can be borrowed at a low-interest rate in one pool but can be lent to earn a higher interest rate in another pool. This, of course, assumes that the crypto used as collateral also has a lower earning potential than the borrowed fund.
  2. Price Speculation – Imagine you find a BTC/USDT pool and you believe the price of BTC will soon fall. You could deposit your collateral USDT to borrow $100 worth of BTC. You immediately sell the BTC and if the price drops by 50%, you can purchase back the BTC for $50. When you return the original amount of borrowed BTC, you will have made a $50 profit minus the interest fee.
  3. Flash Loans – This is a new and unique innovation in the crypto loan industry that allows users to borrow funds without collateral. Instead, a smart contract is programmed in such a way that the borrowed funds must return back into the original account within one single set of transactions. For example, you borrow 100 USDT through a flash loan with a smart contract that has multiple steps. Such steps may include a number of interest rate arbitrage transactions to yield a profit while still ending up with the original 100 USDT going back into the lending account. If any of the steps in between cannot be executed in a way that would allow for the money to return, the entire loan never initiates. Through this multi-step smart contract, the lender can always ensure the safe return of funds plus interest. The main disadvantage of this method is the coding knowledge required to interact and set up these contracts properly. For now, it is an option that will remain unusable for average crypto borrowers.

For now, crypto lending is still in its infancy, but the current set of available options already offer significant advantages over traditional banking. As technology and investment into this sector increases, so will the benefits for all crypto holders.

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