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Crypto Loans: How Does Cryptocurrency Lending Work?

4.9
| by
Stacy Kew
-

What are Crypto Loans?

Crypto loans are cryptocurrency-backed loans works similarly to bank loans backed by securities, the only exception here is that these loans use your cryptocurrency assets as collateral. Due to the nature of crypto loans, they can typically only be obtained from crypto exchanges or crypto lending platforms.

Let's take Bitcoin as an example. Bitcoin is a volatile asset. In March 2020, Bitcoin saw its price dip below $4,000 due to pandemic-related market sell-offs before going on a price run-up to over $64,000 in April 2021. While waiting for Bitcoin’s price to climb higher, there may be instances where you may need funds to pay for living expenses like a leaky roof or a flat tire. Selling your Bitcoin at the wrong point may result in you incurring huge losses or missing out on subsequent large gains. 

So how could you remedy this situation? One option available is to obtain a crypto loan by lending out your cryptocurrencies. By doing so, you get to borrow USD (or your national fiat currency) to pay for immediate expenses instead of selling your cryptocurrencies at a potentially low price. 

Purposes of Crypto Loans 

There are various reasons to take up a crypto loan facility, such as:

  • Personal emergencies

  • Capital for businesses

  • Earn interest on your cryptocurrencies

  • Defer tax on capital gains

  • Hold on to your cryptocurrencies for future potential upside 

Below is a simple illustration of other use-cases of crypto loans.

Advantages of Crypto Loans

Crypto loans have advantages over traditional banking loans. Unlike banks that look at credit rating and income statements, crypto loans do not look at these traditional metrics.

Not only that but taking up a crypto loan is also effortless. It has also evolved into a multifaceted strategy that helps traders get more leverage than usual. 

The diagram below will help illustrate more of its advantages. 

However, do note that when you take up a crypto loan, you must keep a constant eye on your collateralization ratio.

This is important because your crypto assets will be at risk of liquidation if the value of your assets falls below the required collateralization ratio of the loan. If you cannot pay back the loan, the collateral will either be partially or fully liquidated. In other words, your collateral may be sold to pay off the debt.

Your crypto assets held as collateral will be released back to you in full upon the full repayment of your loan plus interest.

Types of Crypto Loans

There are currently two main types of crypto loans available: CeFi and DeFi crypto loans. We will look at the similarities and differences between these two types of crypto loans.

Centralized Finance (CeFi) Crypto Loans 

CeFi or Centralized Finance crypto loans are loans provided by centralized entities. These centralized entities act like pawn shops where they take collateral (cryptocurrencies) and provide a USD loan. 

Centralization itself implies that there is a single point of failure. These centralized entities may fail, and you may lose the cryptocurrencies that you store on these platforms as collateral.

How do CeFi loans work?

You may lend or apply for a crypto loan at centralized platforms or exchanges like Binance. If you lend out your cryptocurrencies, you will generate interest on your coins, while if you borrow, you will have to pay interest. 

For example, on Nexo, a centralized finance platform: 

  • Lenders will be able to receive a daily payout of up to 12% Annual Percentage Rate (APR) for stablecoins such as USDT and USDC.

  • Borrowers can get a loan with an interest rate of 13.9% APR (or 6.9% APR when staking NEXO tokens)

 Below are some of the supported assets and rates for lenders on Nexo.

For borrowers, you may use this calculator on Nexo to see how much you can borrow.

Decentralized Finance (DeFi) Crypto Loans 

DeFi or Decentralized Finance comprises financial applications that operate through a blockchain, thereby removing the need for users to trust any centralized entities. The primary benefit of using DeFi is that users control their funds and allocate them as they wish.

A smart contract is used to automate the execution of a contract. It comes with a programmable transaction that locks in the value of the collateral and the payment conditions.

DeFi Lending Platforms

How do DeFi Loans work?

DeFi loans allow users to lend their cryptocurrencies directly to someone else and earn interest on the loan through a lending protocol. Anyone can become a lender on a DeFi lending protocol. This process is done through lending pools that replace the loan offices of traditional banks.

Smart contracts are used to pool assets from lenders and distribute them to borrowers. While taking a loan from a traditional bank, collateral is required to be placed with a loan. For example, in a car loan, the car itself is collateral. If the user stops paying the loan, the bank will have the right to seize the vehicle. 

The same goes for decentralized systems. The only difference is that the system is anonymous and does not require any physical properties to be used as collateral. To get a DeFi loan, the borrower would often need to offer cryptocurrencies as collateral. The collateral that is posted must be higher than the loan amount. In other words, the loan is overcollateralized.

Comparison between CeFi and DeFi loans

Let’s compare the differences between CeFi and DeFi loans. The primary difference between CeFi (Centralized Finance) and DeFi (Decentralized Finance) loans is that CeFi loans does not provide a transparent view towards their transaction details, access to funds relies on a centralized custody, which increases the risks associated with the company. However, the upside of taking up a CeFi loan is the accessibility to a broader range of insurance options.

Are Crypto Loans Safe?

Despite the many benefits of crypto loans, crypto lending is not a risk-free endeavor. Crypto loans come with risks that you need to be aware of.

CeFi Loan Risks

Insolvency Risk - Double-digit interest rates are possible with crypto lending. However, since there is not much insurance available, you may lose all your cryptocurrencies if the platform provider goes bankrupt. The assets would then become part of the insolvency estate, and you would be considered a creditor in the insolvency proceedings. You should be aware of the financial stability of the crypto lending platforms and be especially cautious with less-established platforms.

Counterparty Risk - CeFi platforms may use your crypto deposits and lend them to crypto exchanges, hedge funds, institutional investors, and over-the-counter (OTC) traders. Your lending platform provider may become insolvent if the counterparties to these trades fail to return the deposits that were lent out.

DeFi Loan Risks

Smart contract bugs and hacks - Smart contracts have the advantage of being completely automated and transparent. However, poorly written code may make the smart contract vulnerable to exploits. For example, the exploit on Cream Finance caused losses of over $34 million in cryptocurrency.

Admin keys risk - Developers of DeFi protocols may control admin keys. If the admin keys are not decentralized or burnt, there is a risk that developers may drain the entire protocol fund. 

Liquidation Risks - Liquidation occurs when the cryptocurrency you have as collateral loses value and your loan falls below the collateral ratio. An example of it is on Black Thursday, 12th March 2020, where the price of Bitcoin dropped 45% in a day. This sudden price drop may result in your loans being liquidated for falling below the minimum collateral ratio.

In Summary

DeFi and CeFi both play an essential role in servicing the crypto lending market today, with each having its strengths and weaknesses. CeFi loans may be a more straightforward avenue for newcomers, but users are subject to the rates set by these platforms.

On the other hand, DeFi loans allow you to control your collateralization ratio and loan management fully. However, the possibility of smart contract bugs and exploits could mean that attackers may be able to drain the protocol’s funds. 

As with all things crypto-related, do take into consideration the risks involved and always do your research before deciding to take up a crypto loan.

Interested in learning more? Watch a video instead.

 

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Stacy Kew
Stacy Kew
Stacy is a market research intern at CoinGecko. She's very much into cryptocurrency. Big on BTC, ETH, SOL, NFTs, and Japanese food. Follow the author on Twitter @trufflefriesx

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