What Is Crypto Lending?
Crypto Basics

What Is Crypto Lending?

1 year ago

Getting loans with cryptocurrency can often be less complicated than getting traditional bank loans — what exactly are crypto loans?

What Is Crypto Lending?


What Is Crypto Lending?

The advent of crypto lending was a crucial breakthrough in DeFi. Lenders could suddenly generate passive yields from formerly illiquid assets. Borrowers could immediately receive cash for their crypto without triggering any tax events.

As a result of crypto lending, almost every cryptocurrency now has far more utility, and therefore value, than it did before.

What Is Crypto Lending?

Crypto lending involves one party lending cryptocurrency to another party in exchange for interest payments. At its core, crypto lending works similarly to traditional lending: someone needs more cash than they have on hand, and someone else (usually a bank) lends them this money and charges interest. There are, however, a number of important differences.

For instance, crypto loans are not handled by banks. Instead, CeFi exchanges, like Binance, or decentralized finance (DeFi) protocols like AAVE let us borrow or lend out our crypto in return for interest. The interest rates typically range between 1-20% APY/APR and will vary according to whether you use a DeFi or CeFi platform.
Your typical crypto loan doesn’t require any formal intermediary to manage the loan. Instead, smart contracts automate the entire process, including the repayment timescale and costs, both of which are agreed upon in advance. Another difference is that lending your crypto doesn’t require registration with any regulator or government agency. This lets you lend to, or borrow from, anyone with a Web3 wallet regardless of where they live.

Another notable difference between traditional and crypto lending relates to collateral requirements.

When you take out a crypto loan, you need to put up a lot more collateral than you normally would. In fact, many platforms ask that you overcollateralize, which means put up more value than you want to borrow. This is because crypto loans are permissionless, which means you usually don’t need to pass know-your-customer (KYC) verifications to take out a loan. As such, lenders don’t know who you are and therefore need a guarantee that you won’t skip town without repaying.

This brings us to some important questions: why would someone put up as much or even more money than they want to borrow? And if you can’t take out a loan for more money than you already have, is there any point in crypto lending?

What’s the Point of Crypto Lending?

There’s one obvious benefit to lending your crypto: you earn interest on what would otherwise be a stagnant asset. The interest rates you can earn by lending vary quite a bit, as mentioned earlier, and commonly fall between 1-20% for most cryptos. These rates favorably compare to the average savings account interest rates, which in the US sit at just 0.1% APY.

The reasons for borrowing crypto, on the other hand, are a little more complicated.

Of the various reasons you might want to borrow crypto, releasing liquidity is among the most likely. Those with a large chunk of their wealth in crypto can find themselves in a curiously annoying position when the crypto markets boom. Their assets rising in value is obviously ideal, but as soon as they sell anything, they’re liable to pay tax.

If, however, they use that crypto as collateral on a crypto loan, they can have cash in their pocket without giving up any future price rises — and without paying tax. If the markets dip, however, their collateral is liquidated and they keep their loaned cash. And if the markets rise, they can buy back their collateral for lower than its current market price, sell it and then keep the difference as profit.

Some lending services enable you to trade on margin and gain leverage without going through a centralized exchange.

Here’s how that works: first, you take out a loan by putting up Bitcoin as collateral; then, you use the loaned cash to buy more collateral which you add to your existing loan. You keep doing this over and over again until you can no longer loan any more money. This allows you to grow your position and capture the additional profit that you would have otherwise forfeited. Despite the extra profit, however, margin trading is considered an ultra-high-risk strategy. If your collateral’s price moves the wrong way, your collateral will be liquidated to protect the people who lent you cash. And because you used that cash to put up more collateral, you’ll have nothing left. As such, margin trading is not for the faint hearted.

One final use for crypto lending is flash loans, which let you borrow massive liquidity without putting up any collateral — but only within a single block.

By far the most common use for flash loans is to take advantage of arbitrage opportunities: finding where different exchanges offer varying interest rates. If you take out a flash loan but can’t repay it before the block is validated, the transaction will be canceled, rendering it non-existent and as if it never happened. Given that executing flash loans requires a fair bit of technical knowledge, and arbitrage opportunities arise somewhat infrequently, it’s unlikely that most people will use flash loans.

As we’ve shown, there are a number of unique and useful use cases for crypto lending, despite the overcollateralization requirements for the borrowing side of the equation.

But regardless of whether you want to lend or borrow, it’s important to understand how CeFi and DeFi lending platforms differ: even though both aim to achieve the same goal, they offer these services in quite different ways.

How Does CeFi Crypto Lending Work?

CeFi platforms ask you to jump through some hoops that DeFi exchanges don’t. First and foremost, you’ll need an account with an exchange that offers crypto lending services, like Coinbase, Binance and BlockFi. You’ll also need to pass KYC verification, which involves submitting identity documents and bank details.

Once you have an active exchange account, you can find the platform’s crypto lending rates by navigating to the lending area, which can go by different names depending on which platform you use. The image below is taken from Binance’s Crypto Loans area.

If you’re interested in borrowing, you can usually find out how much collateral you would need to put up and the payable interest rates by playing around with the input fields. The repayment rates will fluctuate based on your loan term, which crypto you borrow,and how much collateral you put up. If the loan term meets your requirements, you can then submit a request to the platform which will then verify your collateral. As soon as the exchange approves the loan, your borrowed cash will arrive in your account.

Lending through CeFi platforms, as opposed to borrowing, works a little differently. Rather than lend all your money to just one individual, CeFi exchanges use liquidity pools to lend your money out to multiple users simultaneously. You won’t know to whom you’re loaning money, but rest assured that your funds are quite safe. The platform gives you a bond which underwrites your loans. Once the loan expires, you can return the bonds to recover your funds and any accrued interest.

How Does Decentralized Crypto Lending Work?

Decentralized lending is available through numerous DeFi platforms, including AAVE, MakerDAO and Compound. When using DeFi, there’s no third party actively managing the lending process; only smart contracts that pay out loans and liquidate collateral automatically. This means you keep custody of your tokens at all times, which some argue is safer than handing them over to a CeFi exchange. Smart contracts also approve or deny loans near-instantly as well, as there’s no need for a human to rubber stamp loans one by one.

Most DeFi lending protocols require borrowers to overcollateralize by at least 110%, and their interest rates are almost universally governed by supply and demand.

There are a few exceptions, one of which is MakerDAO, whose members determine its borrowing rates through votes.

DeFi lending is entirely permissionless (unlike CeFi lending) which means there’s no KYC verification to lend or borrow crypto. This makes DeFi protocols comparatively more open than their CeFi counterparts, as anyone with an internet connection can partake. They’re also trustless, in that you don’t need to trust people to run the service as expected; you (or a knowledgeable expert) can manually audit its code before you commit any funds. However, remember that if a coding bug or group of hackers breaks the platform’s code, its developers aren’t financially liable for your lost funds.

Advantages and Disadvantages of Crypto Lending

As we’ve shown, both CeFi and DeFi lending have their upsides and downsides, and neither is objectively “better” than the other. Which you should use, therefore, is situational and dependent on your personal risk appetite as well as your technical knowledge. But regardless of which you use, there are some general advantages and disadvantages to crypto lending that you should know.

Advantages of Crypto Loans

1. They have low interest rates compared to most credit cards and some personal loans, although mortgage and car loan interest rates are generally lower.

2. You can earn passive revenue quickly and easily from assets that you otherwise couldn’t.

3. You can choose the currency in which you receive your loan from a wide range of options, and not just the local currency.

4. You don’t need to pass any credit checks before you get a loan, and decentralized platforms don’t require an account or any KYC checks at all.

5. Loaned cash usually arrives within a few hours, and most DeFi loans land within a matter of minutes. This benefits both borrowers and lenders: the former can access cash faster, and the latter can accrue interest on their idle assets earlier than they otherwise could.

6. There’s no decision-making bias. Whether you obtain a loan depends solely on financial factors. Nobody is denied a loan because of their race, gender, religion or any other protected characteristic.

6. All crypto loans are permanently recorded on a blockchain, which eases some regulatory compliance burdens and increases transparency in the broader financial sector.

7. Although CeFi crypto loans require an account and KYC verification, DeFi crypto loans are permissionless; they don’t require any identity or banking verification on your part.

Disadvantages of Crypto Loans

1. Some lending platforms don’t let you access your funds as fast as you might like. This illiquidity can negatively affect your financial security, especially if too much of your capital is tied up in loans, meaning that  you cannot quickly withdraw it.

2. Crypto lending is, for the most part, unregulated. As such, when a platform is  outed as an elaborate Ponzi scheme, your money isn’t protected by any financial regulators.

3. When your collateral drops in value, your lender will issue a margin call. You must then deposit more collateral by a certain time. If you don’t, the lender will liquidate your collateral. If this happens you will incur a loss, but you do keep your borrowed cash.

4. The high collateral requirements for crypto lending greatly increases your chances of defaulting on your loan.

5. CeFi and DeFi lending services operate exclusively online, which renders them prime targets for hacking groups. As such, your money is comparatively less secure than it would be in a typical bank.

Is Crypto Lending Safe?

For the most part, yes, crypto lending is safe because your money is lent out through smart contracts. These contracts are publicly auditable and verifiably secure; or at least as safe as the platform providing them. And whenever you lend out crypto, your funds are protected by the high collateral requirements.

There are, however, a few caveats we should discuss. First and foremost, crypto lending is largely unregulated. As such, if a platform-breaking bug or a nefarious hacker group shuts down a platform through which you lend crypto, you’re on your own. There’s no regulator or agency that can or will help you recoup your funds. And in times of extreme market conditions, some firms will even lock your funds into their platforms to prevent their platform going down, as seen with Celsius. In extreme cases like these, you can find yourself far up a creek without a paddle.

Which Platforms Offer Crypto Loans?

Below are some current CeFi and DeFi platforms through which you can borrow and lend your crypto.

CeFi Lending Platforms

BlockFi is an exchange that supports crypto borrowing and lending. However, recent regulation blocked access to some features for U.S. residents. If you want to borrow through BlockFi, you’ll need to put either Bitcoin, Ethereum, PAXG, or Litecoin as collateral. In exchange, BlockFi will give you up to 50% of your collateral’s value. The repayment interest rates vary from crypto to crypto and start at 4.5% APR.
Coinbase is another CeFi platform that supports crypto lending. Its lending services are available in most countries and about twenty U.S. states. Borrowing through Coinbase is fairly straightforward; you just need to set up an account and pass a few KYC checks. Once you have an account, you can borrow money for up to a year and Coinbase will deposit your loaned cash into your PayPal or bank account, whichever you prefer. A Coinbase-specific lending program was planned a few years ago, but it was discontinued after American regulators complained. However, you can still lend crypto through Coinbase using its app, which then connects you with various DeFi lending DApps.
Binance allows you to borrow and lend numerous cryptos directly from both the website and app. You can also trade on margin using the Binance Margin feature. For up-to-date information on Binance’s borrowing and loaning rates, check out the Binance loan page. From there you can play around with the input fields by choosing different cryptos and adjusting the collateral requirements and repayment schedule, all of which will affect your interest rate.

DeFi Lending Platforms

Aave is an Ethereum-based DeFi protocol through which you can borrow or lend out your crypto. Before you borrow or lend, you first need to deposit crypto into the platform using your Web3 wallet. In return, you’ll receive some aTokens that serve as a receipt for your funds. If you lend out your funds, you can withdraw them later with any accrued interest. If you want to borrow money, you first need to enable your deposited funds as collateral within the platform. You can then choose a token to borrow and an interest rate: either stable or variable.
MakerDAO, which markets itself as a decentralized global reserve bank, is best known for its Dai stablecoin. Dai is created whenever someone deposits crypto into the Maker Vault. Doing so allows you to buy other cryptocurrencies and diversify your portfolio without triggering a taxable event. You could also accrue interest by locking your borrowed Dai into the platform. The quantity of Dai you can borrow depends on which crypto you use as collateral. As a general rule, the better-established the crypto, the more Dai you can borrow — and with lower interest payments. Maker also has a margin feature called Multiply, through which you can leverage your borrowed Dai to buy more collateral and increase your position by up to 100%.
Compound is a DeFi protocol dedicated to crypto lending. By depositing crypto into Compound, you can lend or borrow a range of cryptocurrencies and stablecoins, including DAI, ETH, USDC, BAT and USDT. Your deposited funds go to Compound’s liquidity pool through which others borrow against their own collateral. When you deposit crypto, you’ll receive CTokens that you can exchange to retrieve your funds whenever you want. If you want to borrow through Compound, your interest rate will vary according to which crypto you borrow, your collateral’s stability, and any recent volatility in the global crypto market.

Disclaimer: this article was updated in general on August 2, 2022.

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