Crypto lending and how it works

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What is crypto lending, and how does it work

Cryptocurrencies have evolved beyond serving as means of payment to being used as loans. Crypto loans are secured loans that operate similarly to securities-based loans. Crypto lending involves loaning out your crypto assets to someone else at a fee. It allows investors to loan out their cryptocurrencies to borrowers and get crypto dividends. While HODLers get the chance to receive interest on their assets, borrowers can unlock the value of their portfolio by collateralizing it for a loan. The rates and conditions for lending crypto assets vary from one platform to another.

Crypto lending can be performed on centralized and decentralized platforms, using similar principles. However, decentralized platforms use algorithms and protocols to automate loan repayments. Users can take huge loans without verifying their identities. Centralized platforms offer better interest rates than decentralized ones.

Borrowers can collateralize 50% or more of their portfolio depending on the crypto lending platform to apply for crypto loans. These loans can be either flash loans or collateralized loans. Flash loans are not collateralized and are repaid within a single block. If the amount borrowed cannot be returned with interest, the loan is canceled before it can be verified in a block. The entire process is controlled by a smart contract, ensuring the security of the lender’s assets. They include price arbitrage and collateral swaps. Flash loans can be moved across different blockchains as this would break the one transaction rule.

Collateralized loans require the borrowers to use their assets as collateral. MakerDAO supports this type of crypto loan. The loan-to-value ratio (LTV) shows how much a borrower can get. The fund will be returned to the lender if the collateral falls below the loan’s value. The collateral will be returned when the loan with accrued interest is repaid. Projects like BlockFi, Save, Binance, Abracadabra, Celsius, and Compound offer crypto loans. BlockFi provides credit services for people with limited access to financial products. Aave is a liquidity market protocol that enables crypto lending. It made flash loans popular.

Binance supports simple collateralized loans for numerous assets on its platform. Abracadabra is a multi-chain DeFi project where users can collateralize their crypto assets. Before using a crypto lending platform, it is important to consider interest rates, costs, LTV ratio, geo-restrictions, loan duration, minimum deposit limit, and related risks.

How Crypto Lending works

Crypto lending occurs between a lender and a borrower via a crypto lending (DeFi) platform or crypto exchange. The platform serves as the intermediary that connects the lender and the borrower. The platform is responsible for managing the transaction and can be autonomous, centralized, or decentralized.

Borrowers are the people who need the funds and provide collateral for accessing them. They register on the desired platform and share the amount they want to borrow. Lenders include people who want to grow the output of their assets and those holding their assets for a value boost. They register on the platform and select a specific interest rate for which they would be loaning out their assets. The platform will calculate the amount of cryptocurrency required for collateral before giving a loan, considering their lending rates. The borrowers then deposit the calculated collateral to apply for the loan. The platform validates their deposit and connects them to the lender. The lender offers liquid crypto assets to borrowers and receives interests in return from time to time. When the lender is connected to the borrower, he approves the loan and releases the asset. The borrower won’t be able to use their collateral for anything until the loan has been completely repaid.

Smart contracts oversee sending back the collateral to borrowers and receiving the asset with interest on behalf of the lender. However, borrowers can use flash loans if they don’t have the required collateral, provided the platform offers it. The loan-to-value ratio is used to calculate the amount of the loan and the value of the collateral. A 50% LTV would imply that the borrower will get half of their collateral.

To better understand how crypto lending works, let’s use the example of a borrower that needs DOT but has SOL. He would have to deposit his SOL as collateral to get the DOT. For a 50% LTV, he would get $50 worth of DOT if he collateralizes $100 worth of SOL. The collateralized SOL would be unavailable to him until he repays the loan. According to the platform, upon collateralizing the required amount of SOL, he is connected to a lender who would approve the transaction and release the DOT. Before repayment, he can then use the DOT for anything he wants, including off-chain transactions.

People take out loans to add to a particular position, settle expenses or enter new investments. Although the yearly yield for crypto lending varies across platforms, it is between 3% and 15%, with the asset determining the lending rate. Liquidation occurs when the collateral reduces in value or the value of the amount borrowed increases. To avoid liquidation, borrowers have to either add to their collateral or repay some of the loans.

Before considering crypto lending, note that you will temporarily lose access to collateralized assets. As a lender, you would be handing over your assets to someone unknown. Also, there will be margin calls that may be caused by market conditions, leading to a drop in the collateral’s value. Additionally, ensure to read the terms and conditions of the platform to know about its repayment and LTV ratio.

Crypto lending has several benefits over traditional lending. It offers low-interest rates and access to the asset of choice. Borrowers don’t have to pass a credit check before accessing loans. Crypto loans are granted faster than traditional ones. Crypto lending is scalable and more efficient as smart contracts control it.

As beneficial as it is, it is prone to hacks, leading to loss of assets. It is susceptible to the volatility of cryptocurrencies, affecting loans and collaterals. However, crypto lending is still a better alternative to traditional lending and provides value to borrowers and lenders.