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What is Crypto Lending and How Does it Work

What is Crypto Lending and How Does it Work?

A process of lending and borrowing wherein the hassle of paperwork and a regulating central authority is eliminated sounds too good to be true, isn’t it? Envisioning the same, the concept of decentralized crypto lending has been brought to the table for everyone to enjoy financial freedom via cryptocurrencies. Crypto lending is a way for crypto asset holders to earn passively while allowing the borrowers to get tokens for various purposes without much hustle. For borrowers, it is a great way to access finance, albeit a decentralized one and hence called DeFi, without the hassles of, say, getting a loan via a conventional bank. Let’s get more into this topic and learn ‘what is crypto lending.’ 

What Is Crypto Lending?

The crypto lending method is similar to the traditional loan system. But unlike the traditional loan system, there is no requirement for either lenders or borrowers to disclose their identity or register with some regulatory body. CeFi exchanges like Binance or DeFi protocols like AAVE provide the required platform for crypto lending, and the interest rates usually vary from 1% to 20% APR/APY. Unlike traditional loans, there is no requirement for intermediates, as smart contracts automate the whole process. Terms of the loan, repayment schedule, the cost to the borrower, etc., are all agreed upon in advance. So, the depth of this mechanism leads to questions like how to lend crypto and is crypto lending safe.

Is Crypto Lending Safe?

When it comes to borrowers, there is always a risk of their collateral getting liquidated due to a dip in the market. The lenders have to take the risk of lending by trusting the borrowers, which may sometimes lead to a ‘default’. Of course, there is a margin requirement in crypto lending, too (for secured loans or collateralized loans), but that varies from platform to platform and may go as high as 90%. 

Crypto lending is two-faceted; one side is the extra interest you earn on your lending than it would have been in a traditional bank account or a wallet. While on the other hand, crypto lending platforms sometimes have the authority to lock your funds, which might result in impermanent loss especially when timing is very important when it comes to trading/investment. Regulating bodies like the SEC also look into the decentralized crypto lending market suspiciously on account of scams and rug-pulls plaguing DeFi ecosystem. They argue that since DeFi is not regulated like tradional finance, it is difficult to assess risks and take risk mitigations for the protection average users”.

Types of Crypto Lending

Types of Crypto Lending
Source: Capital / Processes of different crypto loans explained

1. Collateralized Loan

This is the most popular type of crypto loan wherein the borrowers must surrender one token as collateral to the lenders. Most of the time, lenders ask for over-collateralization. After the borrowers have taken up the loan, they can only access a certain percentage of the collateral posted. The loan-to-value ratio (the loan being borrowed to the asset’s market price) typically decides the interest rate, repayment schedule, and other parameters.

2. Crypto Line Of Credit 

A crypto line of credit in decentralized crypto lending works in a similar fashion to a typical line of credit works in the traditional banking system. Here, a there are no set amount of loan disbursed to the borrower; rather, they can withdraw the funds from a credit limit assigned to them whenever the need arises. The borrowers can also withdraw up to a certain percentage of the collateral. The interest is charged only on the amount borrowed.

3. Uncollateralized Loan 

With a higher risk of loss for the lenders, this crypto loan is not very popular. The whole purpose of crypto lending is to maintain anonymity, while with uncollateralized loans, the borrowers must fill out an application, pass the review test, provide identification and get creditworthiness to get the loan approved.

4. Flash Loans 

As the name suggests, these are fast loans wherein the borrower takes the loan and instantly repays it. Typically, lending platforms supply such loans. It is put to use by borrowers to take advantage of instances like arbitrage opportunities.

Risks Of Crypto Lending 

1. Margin Calls

The risk of deposited collateral falling in value poses a major risk to the borrowers. When the deposited tokens crash in value and the overall worth falls below the asked collateral, the lenders ask borrowers to deposit additional funds/tokens as collateral.

2. Illiquidity 

When the borrowers deposit funds as collateral for the crypto loan, they become illiquid and cannot be accessed by the borrowers. Even though some platforms grant access easily, it is still a higher risk for the borrowers since they already have to deposit more than they owe.

3. Unregulated

Another risk of crypto lending for the lenders and borrowers is that crypto lending platforms are not regulated. This means they do not offer protection say against a market crash, or notably against cyber thefts.

4. High-Interest Rates 

It is common to see lenders exploit the lack of identification and over-collateralization by asking for a very high-interest rate. Users sometimes even have to pay 20% APR against their loans which is very high compared to its traditional peers.

How To Lend Crypto?

How To Lend Crypto
Source: Medium / How crypto loans are lent

Think of decentralized crypto lending as putting your funds into a high-return savings bank account. The whole process of lending crypto is very easy. You must sign up on a crypto lending platform and deposit your funds. Over a centralized exchange, you will be paid interest, sometimes in kind (the crypto you lent out) or sometimes in the native token of the exchange. While on a decentralized exchange, the interest is always paid out in kind. You will need to research which platforms you can trust, and once you deposit funds for lending, the investors add their funds to lend out in bulk, usually in liquidity pools. Such investors then share interest over the amount you added to the loan.

How To Get A Crypto Loan? 

This is a seamless process since you must find a trustworthy centralized or decentralized platform. Register on the exchange. You can then choose from various tokens to borrow, the type of loan, and the kind of collateral you will submit. After this, you must ask for the loan; first, submit the collateral into the platform’s wallet, and then the loan is instantly transferred to your account.

How is Money Made by Lending Crypto?

How Do You Make Money Lending Crypto
Source: Bankrate.com / Earn money through crypto lending

Think of this as the same process in which banks have been earning money. Investors store their funds with the exchanges, and the exchanges then lend out these extra funds to borrowers. This way, the exchanges who store lender assets for crypto lending can earn money, which is shared with the lenders as appropriate. You won’t typically see an intermediary clearing and settling payments to lenders here as the process is automated through smart contracts. In the decentralized crypto lending procedure, it is not uncommon to see high interest rates offered for the loan you lend to the borrowers.

What Is Decentralized Crypto Lending? 

Decentralized crypto lending is usually the lending procedure where no central authority regulates the loan reimbursement. Instead, smart contracts work to set the repayment schedule, interest procedure, transfer of funds, collateral security, etc. Decentralized loans are very easy to acquire and lend out as well. The users have to connect their digital wallets with the DeFi platform. Most platforms ask for over-collateralization, and the lenders start to earn interest almost instantly on their funds lent.

Which Platforms Offer Crypto Loans?

Certain exchange platforms offer a crypto lending option where the lenders can add their excess funds to the crypto wallet or sign up using a simple procedure. Centralized exchanges usually ask for funds to be deposited into their wallet, which is mixed with other invested funds, and the loans are provided on a larger scale. Decentralized exchanges ask lenders to add their digital wallets from which the exchange can transfer lent-out assets. There are several CeFi and DeFi apps that offer crypto loans; some of them are:

1. CeFi Lending Platforms 

  • Blockfi offers crypto loans at attractive prices, and the borrowers need to deposit collaterals in terms of BTC, Litecoin, Ethereum, or PAX. The interest rates start at 4.5% and vary from token to token.
  • Coinbase is a crypto exchange that offers crypto lending products. Here the users have to just sign up on the platform, pass some KYC procedures, and then be eligible to lend and borrow.
  • Binance is another popular platform that allows lending from both its website and app.

2. DeFi Lending Platforms 

  • AAve allows users to lend their funds by storing them in a Web3 wallet. In exchange for stored funds, they transfer some tokens as a receipt. For the borrowers, the collateral needs to be submitted first.
  • MakerDAO is another DeFi platform that lends crypto loans easily, and the lenders are promised high interest rates in return.
  • The Compound offers a liquidity pool in which lenders add funds while the borrowers can take out loans.

Advantages of Crypto Lending

  • Loans are offered at competitive rates, and at times, lower than traditional credit cards, mortgages, personal loans, etc
  • Lenders can earn passive yield from funds that would otherwise stay in a wallet.
  • Decentralized platforms do not even ask for any security checks or KYC from the users to transfer the loans. The exchanges only require collateral as a security.
  • The loans and interest both get transferred almost immediately. All the loans are recorded on a blockchain which helps to maximize protection

Disadvantages of Crypto Lending 

  • Some exchanges would not allow the lenders to access their funds easily.
  • Illiquidity of the collateral submitted can affect the borrowers’ financial security, and lenders’ funds may get wasted.
  • There is a risk of Ponzi schemes surfacing since the decentralized crypto lending market is not regulated.
  • High collaterals and margin calls are a big disadvantage.
  • Hackers can target the source code of CeFi and DeFi platforms which are usually open-source.

Crypto Lending Rates

Every centralized or decentralized platform has a different rate of interest regarding crypto lending. The ROI for lenders depends on how the loans have been performing on the platform and the repayments from the borrowers. The borrowers usually get a loan at 4% to 20% APR. Specifically, the loans start at 3% to 8% for crypto coins, while for stablecoins, the rate is around 10% to 18%. This is subject to changes as per the market conditions.

Conclusion 

So, after learning what is crypto lending, how to lend crypto, is crypto lending safe, and various other concepts, you will be clear about why it is a crucial sector of the crypto market and has great potential to serve the internet masses in the future. If the whole lending and borrowing process is performed responsibly, then it is a great way to earn passive income and get emergency funds. Always choose a trusted platform for crypto loans and be responsible for your funds and collateral.

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