A crypto lending is a process of lending virtual currency to a borrower based on a pre-determined interest rate. Borrowers earn a steady stream of unused cryptocurrencies, and borrowers can engage in potentially profitable financial activities with the borrowed funds. Although the basic behavior of lending is the same as traditional finance, crypto lendings are revolutionary in many ways. To understand those innovations, let’s take a quick look at how bank lending works.
Crypto Lendings VS Bank Loans
Banks are functioning as essential elements of modern social financial infrastructure. Overall, it acts as an intermediary that provides a firm connection between borrowers and borrowers. Before approving a loan, banks carefully review a borrower’s financial and credit history to minimize the risk of overdue or bad loans. In the worst-case scenario, in the event of insolvency, the bank also recognizes collateral that can recover its losses through foreclosures and auctions. Because of the precautions, historical persistence, and maturity of these institutions, they are considered a safe option to deposit in local fiat currency and earn standard interest rates. Of course, in return for providing such services, banks are charged various fees.
1. Digital Currency
The biggest and most obvious difference between traditional banks and crypto lendings is the type of currency they use. As you can see from the description, crypto lendings are implemented with cryptocurrencies such as Bitcoin. It’s simply changing the currency, but a lot of differences are already starting to appear.
2. Price volatility
What can be inferred from the use of Bitcoin is price volatility. Thousands of dollars in price swings happen casually in beats in a day, an hour, or even a few minutes. This means that borrowers and borrowers can experience significant and unexpected gains or losses immediately, regardless of interest rates. Cryptocurrencies are also relatively new assets with much lower liquidity than fiat currencies. Because of this, participation in crypto loans is somewhat limited, and the size of the loan is much more limited.
3. Fully Digital
Nevertheless, crypto lendings still offer advantages that traditional banks cannot. For example, the process of assessing an individual’s financial background, along with a standard application form or procedure, is quite cumbersome. With crypto, anyone who owns a token can participate in a loan or borrow almost instantly. While banks rely heavily on documentation, crypto lendings are completely digital. In fact, crypto lendings use a completely different mechanism to guarantee repayment and completely eliminate the need to review your credit score or credit background. Again, this makes accessing crypto lendings much simpler and easier. Next, let’s take a look at the different types of crypto lending services and their unique characteristics.
What is a Centralized Crypto Lending Platform?
Centralized Crypto Lending Platform is a financial company specializing in cryptocurrency. In many ways, it is very similar to traditional banks. Like banks, these platforms are responsible for coordinating the movement of funds between borrowers and borrowers. The company sets the appropriate interest rate for each party and automatically proceeds with the payment process. It is also platform dependent to ensure reimbursement by implementing and following its own procedures. Because of this burden, users strictly abide by the Terms of Service, which often include Know Your Customer (KYC) procedures. Instead of providing services, businesses make money by charging different fees. However, given that they specialize in cryptocurrencies, the deposit and loan process is pretty simple enough that both are done online. So, compared to a real bank, the registration process is generally very easy. As long as users believe the platform is capable of keeping their assets safe and repaying them without arrears, it will be a viable alternative to both access and return versus fiat banks. Nonetheless, there are some risks that offset the high interest rate returns you can get from crypto lendings. Users who rely on a centralized platform to keep their funds in custody are exposed to a single point of failure (SPF). If a company becomes the target of a malicious attack by hackers, users will experience uncompensated losses. In addition, cryptocurrency-related financial organizations are not as tightly regulated as banks and cannot receive government insurance benefits.
What is a decentralized crypto lending platform?
The decentralized crypto lending platform effectively automates the lending process through a protocol that utilizes the DeFi (Decentralized Finance) smart contract. These contracts allow borrowers to connect with borrowers more directly without requiring third-party supervision. You may remember we described these smart contracts as immutable pieces of code or instructions that execute as intended without errors once certain conditions are met. Let’s explore the unique mechanism of decentralized crypto lending in more depth by looking at an example. The borrower in the Defi space puts my money in the bank instead of depositing money, you choose one of these platforms as your loan pool. These pools are like physical accounts where borrowers store their funds together and are available to borrowers. Each pool has its own set of rules dictated and executed by the smart contract. These rules and requirements include which cryptocurrencies to include in the pool, how long the borrower must keep the asset, and what percentage of the commission the borrower pays. When I select a pool that accepts virtual currency at the desired loan interest rate or terms, I immediately move my assets to the pool. Unlike banks or centralized platforms, there is no set registration form or required identity verification process. Furthermore, the pools that safely hold these funds are not owned by any particular private company. Transactions are recorded transparently and can be easily verified on the blockchain. This is an advantage that cannot be easily enjoyed in a place that is self-managed as an insider transaction, such as a centralized platform. For example, let’s say you set it to Bit/Ether pool. This means that if you move the bits you have into the pool and follow the smart contract requirements, you can automatically earn the pre-arranged interest rate. At this point, some of you may be wondering why the secondary cryptocurrency (Ether) is linked to this pool. For the sake of explanation, let’s switch to the borrower’s point of view. If you are going to get a loan from a bank, as already explained, you need a decent credit score or sufficient collateral. The collateral concept also applies to decentralized crypto lendings. When borrowing bits from the Bit/Ether pool, the smart contract first requires that you provide Ether equal to or greater than the amount of Bits you wish to borrow. In this way, in the event of a failure to repay the bit, the borrower will still be able to get a repayment. Most pools require you to first deposit about $150 in Ether when you want to borrow $100 in bits. When you have used all the borrowed bits, you now transfer the loan principal and interest at the agreed-upon interest rate back to the pool. Then, the smart contract immediately releases the Ether held as collateral. The additional interest paid is automatically distributed according to the deposit ratio to those who have deposited bits in the pool.
What Are the Risks of Decentralized Crypto Lending Platforms?
Again, a fundamental concern with decentralized crypto lending is volatility. Significant price swings can also occur, leading to unstable returns or loss of borrowers. Moreover, although smart contracts are powerful and innovative, they are not perfect institutions. The ability of the contract creator determines the completeness of the contract. There have been several attempts by hackers to extract funds from pools in unexpected ways by exploiting bugs or flaws in the code. Finally, interest rates are usually determined based on the liquidity of this pool. Due to volatility, huge amounts of cryptocurrencies can repeatedly enter and exit these pools, even for short periods of time. This puts interest rates at a disadvantage when considering opportunity costs.
Leverage Crypto lendings
If you have unused assets and want to make a profit, crypto lendings are a great option for passive income at interest rates. However, since crypto lendings require collateral in the first place, it is difficult to predict when and why you might want to lend money in this way, when there are alternative assets available to do so. In reality, there are many creative, high-yielding ways to leverage this type of loan.
- Interest Rate Arbitrage
- Both centralized and decentralized crypto lendings utilize different levels of interest rates across cryptocurrencies. Occasionally, one pool lends at a lower interest rate and then finds out that the other pool could have loaned it out at a higher rate. Of course, it can be assumed that this is because the virtual currency used as collateral is less profitable than the loaned assets.
- Price Speculation
- Let’s say you found a bitcoin / tether pool, and you have a feeling that the price of bits is going to drop soon. You can borrow around $100 in bits by depositing USDT as collateral. If you sell the borrowed bit right away and the bit price has dropped by about 50%, you only need to pay $50 worth of bits to repay. So, when I complete the bit repayment, my profit will be $50 less interest rate fees.
- Flash lendings
- A new and unique innovation in crypto lending that allows users to borrow funds without collateral. Instead, it is programmed that the funds borrowed on the smart contract must be repaid to the original account within a single transaction. For example, let’s say you borrow 100 USDT through a multi-step smart contract with a flash lendings. These steps involve several interest rate arbitrage transactions, yielding a profit while still repaying the original 100 USDT to the borrower’s account. If any of the intervening steps cannot be executed in a way that allows the principal to be repaid, the full loan execution will not take place. This multi-level smart contract ensures that borrowers are always guaranteed safe principal + interest repayment. Among the major drawbacks is that coding knowledge is required to properly interact with and build these contracts. At this time, this option is not available to regular cryptocurrency borrowers.
Although crypto lendings are just getting started now, given the options already available, they offer significant advantages over traditional banks. As more technology and investment flows into this sector, the return available to all cryptocurrency holders will also increase.