In this article, I will walk you through all you need to know about how crypto lending and borrowing works.
How Does Crypto Lending Work?
Crypto lending is a form of borrowing and lending using your crypto assets as collateral. The person seeking a crypto-backed loan should back it up with a required crypto asset. Unlike traditional loans which require a long transaction process, crypto loans are automated. This automation is through smart contracts. If you don’t know what I am talking about then at this stage you need to take a step back and read my article that explains Ethereum.
How does crypto lending really work?
Crypto lending is made possible by the existence of enablers and the parties to the transaction. To understand how crypto lending works, it is imperative to know how the enablers and stakeholders involved play a role in making it happen.
The enablers of crypto lending
While there are several enablers of crypto lending, the three main enablers that must exist for crypto lending to be automated are:
- Crypto assets
- Smart contracts
- Financing model (DeFi or CeFi)
- Crypto exchanges (platforms)
Crypto assets that enable crypto lending
Crypto assets are a special type of digital assets that exist on are facilitated through a blockchain network. It is this type of network that brings forth decentralization.
We can categorize crypto-assets into the following main types:
- Cryptocurrencies – these are cryptocurrency assets used in the encryption, regulation, and verification of the transfer of funds. We do have native cryptocurrencies and non-native cryptocurrencies. Native cryptocurrencies are those that are created, hosted, and traded on a particular platform, e.g., bitcoin, ether, etc. Non-native cryptocurrencies are those that are platform-independent.
- Tokens – these are crypto-assets intended to fund projects, compensate service providers, or facilitate decision-making. Though not intended, some are used like cryptocurrencies. They include utility tokens, security tokens, governance tokens, etc.)
- Derivatives (pegged to an underlying asset e.g., stablecoins, futures contracts, call options, etc.,)
- Collectibles (artistic value in the crypto form e.g., crypto kitties, and other forms of non-fungible tokens). You can find out more about NFTs by reading my article on Ape Coin.
Smart Contracts and Crypto Lending
Smart contracts have gained lots of traction as a form of entering into binding contracts. This is primarily due to their fast, efficient, and cost-economic self-executing nature.
Smart contracts are self-executing digital codes that contain algorithmic parameters about predefined conditions that parties to the agreement must meet before it is executed.
Financing Models – DeFi & CeFi
The financial technology (fintech) industry has leveraged blockchain technology to come up with a suite of financial products that have completely cut off middlemen such as banks and thus enhanced peer-to-peer transactions. DeFi is one such line of financial products that advance the peer-to-peer lending mechanism.
DeFi vs CeFi
There are two major types of financing models – Centralized Finance (CeFi) and Decentralized Finance (DeFi).
DeFi is the opposite of CeFi. As you can see, the primary distinctions between the two terms are D (decentralized), and C (Centralized).
While DeFi focuses on decentralizing the financial process, CeFi focuses on centralizing the financial process.
CeFi is the type of institutionalized financial framework that we are traditionally accustomed to. It is where financial transactions flow from one central authority, that is, a bank. These central authorities include central banks, commercial banks, and financial institutions.
DeFi came about to end this centralization and hence monopolization of financial transactions by one entity to the detriment, exploitation, or cost to others that rely on it. Thus, DeFi requires a decentralized platform to operate.
Lending and borrowing cryptos have become a very popular trade. In just about 3 years, this sector has grown exponentially such that it is nearing $1 billion in terms of loans issued.
What motivates someone to lend cryptos?
The primary driver of lending cryptos is to gain passive income without sacrificing capital gains. Cryptos have shown the tendency to create exponential capital gains that, unlike traditional loans, one wouldn’t wish to risk losing such gains. For example, it is not unheard of for a crypto investment to yield a capital gain that is 100 times or even 1000 times the value of an investment within a short span.
Thus, while waiting for capital gains to accumulate, there is no need to let such an asset remain idle. What better way than to lend it? This is the gist of it.
What motivates someone to borrow cryptos?
Unlike traditional borrowing, borrowing cryptos or fiat currency is secured against cryptos. Then, why would crypto holders offer cryptos as security for crypto loans instead of simply selling the cryptos? Again, the primary motivator is the desire to not lose the likelihood of earning exponential capital gains. Thus, when you use your cryptos as collateral, you do not lose capital gains. But, when you sell your cryptos, you sacrifice this potential to earn capital gains.
Thus, unlike traditional lending and borrowing, the key motivator that drives crypto lending and crypto borrowing is the need to preserve capital gains.
Crypto lending platforms
These are platforms that provide crypto lending services. They earn an exchange commission on transactions as their reward. There are two main types of crypto lending platforms – the CeFi lending platform and the DeFi lending platform.
CeFi lending platforms
CeFi platforms operate more or less like a bank as far as centralized services are concerned with the exception that the collateral for loans is in crypto form. The loan products can be either in fiat or crypto, depending on the particular platform.
Top 7 CeFi lending platforms
The 7 most popular CeFi lending platforms are:
- Nexo. This company is based out if Bulgaria. On social media many accuse Nexo that it will soon fail. However, it is one of the few centralized lending platforms that has not gone bankrupt.
- Celsius Network. Update: Celsius is now bankrupt.
- BlockFi. Update: BlockFi is also bankrupt
- YouHodler. This is a smaller lender and last I checked they did not have a money services license in the US.
DeFi lending Platforms
A DeFi lending platform is a decentralized exchange platform that removes the need for traditional intermediaries – a primary characteristic of the CeFi mechanism. Governments, traditional banks, and traditional financial institutions – their bureaucracies and exploitations are done away with. Instead, crypto borrowers and crypto lenders interact directly via a peer-to-peer (P2P) mechanism. Apart from network costs, lenders get the full profit of their sacrifice without their gain being siphoned off by intermediaries.
Top DeFi lending platforms
Some of the most popular DeFi lending platforms are:
How to invest in crypto lending
You can invest in a cryptocurrency lending business and thus earn income in addition to the potential capital gains. You don’t have to let your crypto assets lie idle when they can generate for you passive income.
The following are the main steps involved in crypto lending:
- Choose the right platform
First of all, you have to decide whether you want to use the CeFi exchange (CEX) platform or the DeFi exchange (DEX) platform. If you are new to crypto lending, CeFi is more beginner-friendly. Furthermore, different platforms have a host of different cryptocurrencies on offer and exchange. Your preferred platform should match your preferred cryptocurrency.
- Have the right loan product
Some loan products only allow you to receive fiat money against your collateral. Others allow you to receive cryptocurrency in addition to fiat currency. Yet, like all loan products, interest rate matters. As an investor, you would like to earn the highest possible interest rate. However, if you are a borrower, you would like to be charged the lowest possible interest rate. But, don’t forget that interest is a factor of risk. Unlike traditional collateral where only lenders are exposed to risk, in the crypto world, even borrowers are also exposed to risk. Thus, it is important to consider the risk exposure of your crypto assets as collateral.
Types of crypto loans
There are three main types of loans:
- CeFi loans
- DeFi loans
- Flash loans
The first two are quite obvious as they are tied to the type of protocol used to issue them. That is, CeFi lending protocols and DeFi lending protocols. Both types of Crypto loans are backed up by crypto collateral.
The third type is rather unconventional.
While both DeFi and CeFi loans are collateralized, Flash loans are collateral-free loans. Why? Because the repayment guarantee is etched into the smart contract. The amount issued automatically reverses to the lender immediately before the expiry of the contract. As such, the borrower has no control over the decision to repay.
Factors to consider while seeking a crypto loan
When seeking a crypto loan an amalgamation of factors comes into play. You must not rely on just one or two factors but a balance of several factors to decide on whether to take up the crypto loan being offered or not. You must also practice due diligence in the process of considering these factors.
The following are key factors ranked in their order of priority:
1. Platform reputation
Due to the high risk of hacking and platforms collapsing, it is important to consider mature platforms that have stood the test of time. How long the platform has been operating, the volume of transactions, security features, hacking history (thwarted hacking attempts, successful hacks, remedial action after successful hacking, etc.), and reviews (you should consider industry reviews, independent professional reviews, and customer reviews) are important reputational parameters to consider.
2. Disclosure requirements
Whether the platform has KYC (Know-Your-Customer) and AML (Anti-Money-Laundering) requirements and to what extent that exposes your privacy. While KYC and AML requirements help fish out bad actors, excessive KYC and AML requirements can breach your privacy and endanger your digital assets beyond the platform.
3. Collateral requirements
The collateral-to-loan (C2L) ratio is important. Some platforms require a 1:1 ratio while others require a 2:1 ratio. The higher the ratio, the more your crypto assets are locked up and hence more exposed to the risk of hacking. Some platforms quote this in terms of loan-to-value ratio (LTV ratio). The ltv (L2V) ratio is the inverse of the C2L ratio. For example, if C2V is 2:1, then L2V is 1:2, and vice versa.
Some platforms have low liquidity which means that it is harder to get loans. Those platforms with high liquidity mean that it is easier to get loans. A platform can increase its liquidity by increasing the liquidity pool portfolio by encouraging and incentivizing more crypto holdings.
5. The interest rate
The interest rate is the actual cost of your loan. Different platforms charge different rates. A higher interest rate means a more expensive loan. On the other hand, a lower interest rate means a less expensive loan. If you are a borrower, how much in terms of interest payments will depend on the interest rate and the total value of the loan borrowed. On the other hand, if you are a crypto lender, this will depend on the value of your collateral. Thus, it is important to factor in the Annual Percentage Rate (APR rate) if you are a borrower and the Annual Percentage Yield (APY) if you are a lender.
How to acquire a crypto loan
While each crypto lending platform may have its own unique loan acquisition procedure. Nonetheless, the following are the general procedures applicable to most platforms:
1. Do a thorough research
By doing thorough research, you will be able to identify:
- The best crypto assets to acquire
- The best wallet to store your crypto assets
- Your preferred APY and/or APR
- The best platform to buy your crypto assets
2. Open a crypto wallet
Once you are satisfied with your research and ready to acquire crypto assets, open a crypto wallet where you will keep your purchased crypto coins or tokens.
Top 5 crypto wallets to keep your crypto assets
- Meta mask – best hot wallet
- Coinbase wallet – best for beginners
- Electrum – best Bitcoin wallet
- Exodus – best altcoin wallet
- Mycelium – best mobile wallet
The first step is to register with your preferred crypto lending platform so that you can open an account.
In the registration process, you will need to:
- Verify your identity
- Verify your collateral
- Provide other details and take other actions as may be needed
After this, some platforms may assign you a ‘trust score’ based on the assessment of your verification and compliance.
Upon successful registration, you will be provided with an account where you can transact on the platform.
- Select a loan product
Once your account is active, the next logical step is to scout for your desired loan product. Your desired loan product will depend on the terms of the loan, which include:
- Collateral requirement
- Interest charges
- Other factors
After choosing your loan product, you submit your application for a loan using the platform’s prescribed application form.
On successful submission of your loan application, you will start receiving loan offers from lenders.
- Accept offer
Compare the various offers. Select the best offer. Accept it.
- Receive the loan
Upon acceptance of the best offer, you will get the loan amount almost instantly to your account.
Crypto lending opens a new world of lending opportunities. Gone are the days when a few fiat bureaucrats held your financial fate under their stranglehold. In the crypto world, you have both financial sovereignty and financial freedom. The ark of an open economy is already at your fingertips. Get on board and save yourself from being drowned by the titanic bureaucracy.
Compound finance is a decentralized lending and borrowing platform for cryptocurrencies.
Just like a bank where you can deposit your money and earn interest on your savings, with Compound crypto you deposit your cryptocurrency tokens to earn a return.
And just like a bank can use your deposits to lend to others so too can Compound Finance lend to borrowers. Read more.