How does Crypto Lending and Borrowing Work?
More than 40 million people have ventured into cryptocurrency since its evolution, and with each passing day, more people are venturing into digital currencies. In fact, as of November last year, the crypto world has exceeded about $3 trillion in market capitalization. And researchers have also speculated that it might double or triple by the year 2025.
Price volatility and an unpredictable market remain major drawbacks. People often come into the space to invest and make money, whether in the short or long term, and such a tilt away from that notion leads to an increment of losses which makes them skeptical about being part of the trend. Bitcoin, for example, doubled tremendously in market value last year, only for its profits to go down the drain within these past months.
Nonetheless, to navigate this risk, people are now using their digital assets as collateral for loans in the form of crypto lending.
Understanding Crypto Lending
Crypto lending is the process of taking crypto from one user and providing it to another for regular interest payments. Payments are made in the form of cryptocurrencies, plus the methodology of managing loans differs from platform to platform.
Crypto lending services occur on both centralized and decentralized platforms, but the fundamentals are the same: they both require borrowers to provide collaterals in order to access a crypto loan. Also, they both offer access to high-interest rates, which are oftentimes up to 20% APY (annual percentage yield) depending on the smart contract and protocol.
Opportunities abound in cryptocurrency lending platforms. Investors can earn an income which is in form of crypto rewards by depositing their crypto assets in a pool and lending it out to borrowers. And there’s usually little or no risk of losing funds because borrowers have to provide collateral, and giant centralized finance platforms are often involved with the management of funds.
How Does Crypto Lending Work?
Investors can earn money via crypto lending functions in two ways: cryptocurrency loans and deposit accounts. Whereas deposit accounts exist in similar terms as bank accounts and people deposit cryptocurrency in a bid to get paid interest by the platform managing the pool, crypto loans exist as collateralized lending products that prompt users to provide a specific percentage in crypto collateral to borrow funds.
Crypto lending runs through the aid of three players: the lender, the borrower, and a crypto exchange or Defi platform that manages the transaction. To access a loan, the borrower must provide some collateral, or make use of flash loans that do not require collateral. On the other hand, people may run their lending services on a smart contract that mints stablecoins or a platform lending out funds from another user.
Types of Crypto Loans
Collateralized loans are the most popular type of crypto loan. Not only do they require deposited cryptocurrency to be used as collateral for the loan, but they also give a borrower ample time to use their funds in return for providing collaterals. Most platforms, however, give in to over-collateralization, which simply means that borrowers can access a certain percentage level of deposited collateral, below a 90% LTV (loan-to-value). The higher the LTV, the higher the interest rate. For instance, a 5% LTV loan of $10,000 CRFI will require you to provide up to $20,000 FIL (Filecoin) as collateral, much that any drop below $20,000 will liquidify funds and give funds back to the lender.
Uncollateralized loans are not as popular as collateralized loans. Before borrowing or lending, people have to supply answers to identity verification tests and fill out the loan application, which will be reviewed and approved. There’s a greater risk of loss for investors or lenders since there’s no collateral up for liquidation when a loan defaults.
Flash loans eliminate the need for collateral while borrowing funds. They are loans that are available in crypto exchanges. Loans are borrowed and repaid on the same block because smart contracts control the whole process. Flash loans offer peculiar opportunities for price arbitrage and collateral swaps. Since they offer market arbitrage opportunities where cryptocurrency is bought at a lower price in one market and sold for a higher price in another in a single transaction, they are very risk-prone.
The Bullet Point
Despite the numerous advantages of crypto lending, ranging from easily accessible capital to scalability and efficiency, and as a source of income, it’s a very risky endeavor for both borrowers and lenders. This is because the loans and deposited funds are tied to the crypto market with its volatile nature. Take the recent Celsius debate into consideration, where billions of dollars in deposits were frozen overnight, and throw people off towers and skyscrapers. Some of these notable risks include margin calls, illiquidity, and high-interest rates. The precautionary measure, however, is to tread with caution.
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