Cryptocurrency Loans and Lending Explained

Cryptocurrency loans and lending are garnering more interest, primarily due to the increase in the number of individuals and corporations who now hold cryptocurrencies.

Credit and lending are part of any healthy financial ecosystem, and as the crypto space matures, opportunities for new forms of lending are inevitable.

In essence, loans are mutually beneficial arrangements, whereby capital or assets are reallocated to someone with an immediate use case, from someone without. Capital is released to the borrower, while the lender uses the capital they don’t immediately need to earn interest.

What is Crypto Lending?

Essentially, crypto lending is where, subject to an agreed-upon interest rate, borrowers use their cryptocurrencies as collateral to borrow fiat or stablecoins. The reverse is also sometimes the case, where the borrower might use fiat or stablecoins to borrow other cryptocurrencies.

What are the advantages of taking a cryptocurrency loan?

There are a number of obvious reasons as to why one would want to take a loan against their cryptocurrency.

• A person may need fiat currency to complete a substantial purchase, but not want to sell their cryptocurrency as it would deminish the size of their investment. Using cryptocurrency as collateral gives them the opportunity to release some of the value of their portfolio, while retaining their investment.
• Selling cryptocurrency creates a taxable event. Some hodlers opt to take a loan against their crypto rather than to incur the taxes at that time.
• It opens opportunities for individuals who hold cryptocurrency, but have a bad credit score and therefore are unable to obtain a loan from a traditional financial institution.

Types of Crypto Lending

Cryptocurrency lending can be broadly broken down into two distinct areas:

• Centralized Finance (also known as CeFi Lending) and
• Decentralized Finance (commonly called DeFi Lending).

What is CeFi Lending?

These are centralized platforms that allow borrowers to deposit their cryptocurrency and use it as collateral against a loan. These entities are usually “fintech” firms, which take custody of the borrower’s assets and adhere to more traditional lending practices.

For example, users are required to complete Know Your Customer (KYC), and the interest rates are set by the company are usually fixed within a range.

Investors can also earn generous interest for depositing their cryptocurrencies, stablecoins and even fiat with CeFi platforms. Nexo, for example, offers up to 12% for certain stablecoins.

With CeFi, users enjoy some of the benefits of both traditional and crypto lending.

Some examples of CeFi lending platforms are:

• Nexo
• Blockfi
• YouHodler
• Celcius Network

What is DeFi Lending?

Over the past 24 months or so, the decentralized finance (DeFi) space has exploded, and recent estimates put the value of assets locked in DeFi at over 200 billion dollars. DeFi aims to offer users open, intermediation-free, and decentralized alternatives to traditional financial products including insurance, investing, and loans.

DeFi loans allow users to pool their assets and provide loan offerings, without an intermediary. The terms of the loan, such as the interest rate, are programmed into a smart contract (i.e. code that is programmed to execute once pre-defined conditions are met).

Most DeFi loan protocols are built on the Ethereum network. Some examples of the most popular DeFi crypto lending protocols are MakerDAO, Compound and Aave.

Like the CeFi loans discussed above, borrowers have to use their cryptocurrency as collateral against the loan. As an example, if you wanted to borrow one bitcoin on the MakerDAO protocol, you would have to deposit an adequate amount of DAI (the stablecoin of MakerDAO).

Are there risks associated with cryptocurrency loans?

In short, yes there are risks associated with both CeFi and DeFi cryptocurrency lending. This financial ecosystem is still in its infancy and, while it has opened up financial opportunities to many, it’s important to be aware of the potential risks involved.

Insolvency Risk

There is a degree of risk involved when you deposit your cryptocurrency onto CeFi platforms. Deposits with traditional financial institutions are generally guaranteed in part by some form of government deposit guarantee scheme, in the event the institution fails. There are no such guarantees for crypto platforms if they become insolvent. However, most CeFi platforms, such as Nexo, have insurance to guarantee your assets in the event of theft or loss.

When Smart Contracts Go Wrong

As discussed above, DeFi lending protocols operate without an intermediary and therefore rely on the execution of smart contracts to function properly. If there is a flaw in the code, the protocol could be vulnerable to hacks or attacks. The code for DeFi protocols is open-source, so it can be read by anyone with the technical know-how. However, those of us who are not smart contract literate need to be extremely vigilant, especially when it comes to new and largely untested DeFi protocols.

Violent Market Swings and Collateral Liquidation Risk

If the value of the cryptocurrency acting as collateral drops substantially, there is a risk that the collateral could be liquidated. While the CeFi platform generally requests repayment first, there have been examples of liquidations, when the market drops dramatically and unexpectedly.

In December 2020 Ripple was sued by the SEC, and as a result, the value of its digital asset XRP lost more than 50% of its value within minutes. CeFi platform Nexo quickly liquidated clients’ XRP collateral without prior notice.

Barriers to Entry

Cryptocurrency loans are over collateralized. In simple terms, this means that the value of the collateral has to be more than the value of the loan. On certain platforms, the requirement might be up to 200%. For example, if you wanted to borrow $100,000, you would need to collateralize it with $50,000 worth of cryptocurrency.