Crypto Lending, Explained

What is crypto lending?

Unless you have been living in the dark, dark cave of purely traditional finance, you have probably at least heard of crypto lending — the trend opening up opportunity for crypto players big and small, and is powering Ethereum’s decentralized finance ecosystem to over $1 billion in locked value.

At the core of crypto lending is a fairly simple concept: Borrowers are able to use their crypto assets as collateral to obtain a fiat or stablecoin loan, while lenders provide the assets required for the loan at an agreed-upon interest rate. This can also work in the reverse, where borrowers use fiat or stablecoins as collateral to borrow crypto assets.

You’ll likely notice that there is nothing groundbreaking here — they are simply collateralized loans — but credit and lending are powerful financial primitives that open up a wide range of applications and benefits for businesses, institutions, traders and users. Additionally, in the growing DeFi space, this primitive has been unlocked for permissionless, open and composable lending access. This leads to new use cases like optimized rates across platforms and “flash loans,” in which a user can utilize atomic transactions to borrow up to a platform’s full liquidity as long as they pay it back in the same transaction — but more on that later.

How important is lending in markets?

At a fundamental level, credit and lending markets increase the amount of productive work money does by reallocating it from those without an immediate use case to those with one. This increases the utility of that money for all parties, giving borrowers access to capital and lenders yield.

This is a massive opportunity for crypto markets and users, which have traditionally had two options regarding how to use their crypto: hodl or trade. Particularly for hodlers, cryptocurrency has had one function — i.e., to sit in their wallets. While some may argue that serves a purpose by limiting supply on the market, we can generally agree that it is not a particularly productive use of a capital asset.

With the advent of crypto-asset lending, the utility of those assets has increased significantly. A formerly static investment can now generate passive yield for lenders, and borrowers can either receive fiat without having to initiate a taxable sales event or receive crypto assets for trading, arbitrage or market-making. These are substantial improvements for individual hodlers and major institutional investors alike.

In addition to these utility improvements, this is also one of the few cases in which crypto provides an improved, direct analogue to the financial system when comparing lending returns to interest savings accounts. At the time of writing, most crypto-lending platforms provide an interest rate of around 8% for lending stablecoins; in comparison, most savings accounts in the United States provide less than a 1% return on the dollar.

While this is a great improvement to the crypto ecosystem, it does not offer the full benefits of true credit — as in their current form, all crypto loans are overcollateralized. This means that you must already have capital at your disposal to receive a loan, which means the crypto-lending market is not “growing the pie.” This is particularly disappointing when it comes to the world’s under- and unbanked populations, who most need increased financial access.

Types of lending platforms: Centralized vs. decentralized

Since 2018, a number of lending platforms have cropped up within the crypto industry and can generally be grouped into centralized and decentralized platforms. At the core of the distinction is essentially who or what is handling the lending and borrowing process — a business or a protocol.

Centralized lending platforms act more like traditional fintech companies that happen to work with cryptocurrency — they follow Know Your Customer processes, have a custodial system to protect your assets, and can form traditional business partnerships with institutions, such as negotiating specific loan agreements. These platforms tend to offer interest rates determined by the company, which often include notably higher returns for lenders of crypto assets like Ether (ETH) and Bitcoin (BTC) than their decentralized counterparts.

Decentralized lending platforms, including projects like Compound, Maker and dYdX, operate as protocols that can be accessed by anyone at any time without KYC or custody. With the exception of Maker, whose decentralized governance system determines the interest rates, these decentralized platforms have variable interest rates determined by supply and demand for an asset on the platform. Depending on the interest rate function, this can at times lead to large swings in interest rates, with dYdX at times spiking over 30% for lenders.

What are the risks of crypto lending?

While crypto lending does often get compared to traditional savings or interest accounts, it’s important to recognize that these are much newer and riskier platforms than highly regulated traditional banks. None of these, including the centralized players, are federally insured institutions — though there are some insurance efforts in DeFi through Nexus Mutual and Opyn. And of course, we are dealing with new technologies.

Borrowers take on the built-in risk of supplying liquidity in the event that their collateral value drops below the required value in order to ensure that lenders are always whole. This means that borrowers need to carefully watch their collateral ratio to ensure it stays within a safe range. Thus far, liquidation systems have proved to be robust and lenders have not lost their investment, but this is not guaranteed to continue into the future.

Within the decentralized space, there is also technological risk with smart contracts. As computer code in the form of smart contracts governs capital flow within the system, it’s theoretically possible for a hacker to attack the platform through a bug or exploit.

Additionally, for the decentralized options, there is at times an issue of low liquidity, such that rates can shift drastically if a large amount of capital moves in or out of the system. In general, the interest rate functions are created to incentivize a fairly stable equilibrium, but volatility does happen.

Lastly, there are taxation and regulatory risks involved in using these platforms, especially as one of the major use cases of borrowing relates directly to avoiding a taxable event. In general, many jurisdictions do not have clear guidance on the nature of many of these assets, including stablecoins. This makes it hard for an individual to know the exact tax implications of their crypto-lending activities, and it’s recommended that users speak with a tax consultant. Additionally, many of the decentralized platforms are operating without license and without KYC disclosures, meaning their regulatory future is unpredictable.

Crypto lending use cases — From beginner to expert

Perhaps the best way to understand how these platforms and markets work is to run through the various ways in which users can participate in them, starting from the most basic and progressing to the most advanced.

  1. Single-platform, single-asset lending

This is the most basic and most commonly used aspect of crypto-lending markets: lending. It’s helpful to check rates across platforms using a tracker like CoinMarketCap’s interest rate tool to find the best returns for the asset you wish to lend. In general, decentralized platforms tend to see high stablecoin interest rates (7%–15%) and lower rates for crypto assets like ETH and BTC (0%–1%), while centralized platforms offer more favorable rates for those crypto assets (2%–6%).

  1. Non-taxable dollar denominated liquidity

For crypto hodlers, there may be a sizable portion of wealth in their portfolio, but selling that crypto when they need cash triggers a taxable event. While this is not tax advice and you should consult a tax consultant for your specific needs, using your crypto as collateral to receive a dollar-pegged loan can be a great way for hodlers to gain liquidity to cover expenses while not losing investment exposure or needing to pay taxes on your gains.

  1. Rate arbitrage

Once again looking at CoinMarketCap, we can see opportunities for interest rate arbitrage, in which you borrow an asset from one platform and lend the asset on another. For instance, at the time of writing, you could borrow ETH on Aave for a 0.55% variable rate and lend on for 6.0%, netting a 5.45% annual ETH profit. This does come with a number of risks, however, as Aave’s variable rate shifts with the market and could shift its rate, potentially eliminating your gains.

Another interesting option here is supplied by CoinLoan, one of the only platforms available that gives you the option to specify lending/borrowing terms on your loan, such as the asset, duration and interest rate. CoinLoan also allows for crypto–crypto borrowing, which opens up additional possibilities over the more standard crypto–stablecoin options offered by other centralized players. This increased customization could be a great way to ensure that your interest rate arbitrage operates more predictably, though CoinLoan does also offer an interest account that provides a simple, no-hassle user experience to earn up to 10.5% on your assets. It also stores your assets in certified, insured and SEC-approved custodians and have their own liquidation system to ensure all parties are protected.

  1. Margin trading/leverage

The rise of crypto lending has also led to the ease of access to leverage, without having to go through a centralized exchange. A user can gain leverage by essentially taking out a loan, purchasing additional collateral and increasing their loan amount on a loop until the limit is reached. This acts as a “long” investment on whatever collateral you’ve chosen. For example, if I use ETH as collateral and sell my loaned, dollar-pegged stablecoin for more ETH, and the price of ETH rises, I still only have to pay back the original dollar amount — even though the ETH has increased in value. This allows me to capture additional profit. Platforms like dYdX make this simple and build it directly into their user interface, allowing you to go either long or short on up to 5x leverage. This is obviously a higher risk strategy, and if the price of ETH moves the wrong way, your collateral might be liquidated to protect lenders.

  1. Flash loans

Flash loans have gained significant attention lately after their usage in the bZx DeFi hack. These flash loans are a financial innovation enabled only through properties of decentralized finance and have a number of interesting use cases. With a flash loan, the user can borrow up to the full amount of free liquidity on a lending protocol, use that loan to execute other operations, and then pay back the loan at the end of the full transaction. If the borrower is unable to repay the full amount, none of the transactions will execute. This is enabled by the database principal of atomicity, in which one failed operation in a series will cause the entire operation to fail. Flash loans can be used for arbitrage opportunities or to shift collateral on a platform like Maker or Compound. To execute a flash loan does require some technical knowledge and ability to compose atomic transactions.

  1. Liquidations

For the even more technically savvy, there is the opportunity to act as a liquidator in the DeFi ecosystem. Liquidators run bots that identify loans that have fallen under the required collateralization ratio and liquidate that collateral to pay back the lender, earning a fee for their services. This is a competitive arena, but there are sizable profits to be made here.

What is the future of crypto lending?

While liquidations are saved for last because of the limited opportunity, it’s important to recognize liquidations are a key part of the crypto-lending ecosystem and critical to the system’s efficiency. Crypto functions as a fantastic collateral because of its ease of sale and liquidity. In comparison to a mortgage, in which a foreclosure and liquidation is an extremely lengthy process, crypto liquidations take mere seconds. As the crypto industry continues to grow, the lending ecosystem is going to remain an absolutely pivotal piece in its success story.

In the immediate term, however, this ecosystem offers a number of unique opportunities for crypto participants to earn yield, gain liquidity and increase the productivity of their assets.

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