Your Ultimate Guide
Since the emergence of Bitcoin in 2009, the crypto industry has been incessantly evolving and rewriting the rules. The new lending format is one of the biggest trends that fascinates crypto enthusiasts in 2022.
While the underlying technology is still nascent, crypto loans are a groundbreaking solution. Investors in need of fiat or cryptocurrencies can get them on demand after pledging their cryptoassets. How does this system work exactly?
Defining Crypto Loans
In essence, crypto loans are similar to conventional collateralized loans. The premise is quite simple: you can pledge your crypto as collateral to take out different loans at predetermined interest rates.
Originally, loans were seen as an alternative to HODLing – that is, holding on to cryptocurrencies to profit from their growth. Through loans, investors can make their assets work and obtain additional capital at the same time.
The key difference between crypto lending and conventional centralized finance is that everything happens on a blockchain. Crypto loans rely on smart contracts and algorithms, so all transactions are decentralized and autonomous.
Does this sound too good to be true? Some people are still suspicious of crypto lending due to its perceived risks. Our guide covers everything you need to know about these services, so read on!
How Crypto Lending Works
These loans are provided by crypto exchanges and specialized lending platforms. The latter connects lenders to borrowers, acting as trusted intermediaries. The borrower pays interest at an agreed rate at regular intervals throughout the life of the loan. Early repayment may also be possible, depending on the platform.
In a sense, crypto lending is a type of crowdfunding. Every loan involves three parties:
This user lends their funds to boost their productivity. Both hodlers and traders become crypto lenders.
This is where the transactions happen. A crypto platform manages interactions between all lenders and borrowers. You can get a loan on a fully autonomous and decentralized platform (DeFi) or a centralized environment managed by a company or group (CeFi). We will provide a comparison of these models further.
Crypto loans are accessible to individuals and businesses. For example, a startup in need of funding can get it through crypto lending. In either case, the borrower’s cryptoassets serve as collateral, guaranteeing that the loan will be paid.
Should You Use Crypto Loans?
Through a crypto loan, you can manage your assets, benefit from their growth, and finance purchases at the same time. It is a hassle-free and cost-effective source of new funding. Crypto loans are suitable for any financial needs, from debt refinancing to property purchases.
Furthermore, crypto lending is an attractive way to diversify your portfolio. Borrowers get their collateral back upon full repayment. Lenders benefit from the interest rates and have confidence in the transaction thanks to collateral.
If you are ready to dive into crypto lending, one of the first considerations is the platform. Sadly, not all apps and websites offering these services deserve trust. Check our in-depth reviews of major brands in crypto lending, such as Nexo and BlockFi.
Pros of Crypto Loans for Borrowers
Loans backed by crypto have multiple advantages. Compared to conventional borrowing options offered by banks, they are faster, more flexible, and more accessible.
When you apply for a traditional loan, the institution checks your credit report and performs other verification procedures. What’s more, credit scores are easy to spoil – missing one payment can make you ineligible for new loans for months.
Scores are not only difficult to raise, but they can also fall due to errors made by banks or credit bureaus. This is why the credit repair industry is so big. The crypto lending model makes credit checks and scores irrelevant, so applications are processed more efficiently.
Secondly, it is the borrower who sets the rules. In the conventional model, banks determine the interest rate, loan amount, and term. A crypto borrower can fine-tune the parameters of their loan as they see fit.
Pros of Crypto Loans for Lenders
Typically, over 100% of the loan amount must be collateralized. High volatility of cryptocurrencies explains the high LTV ratio (proportion of the loan amount to the size of the collateral). Cryptocollateral is more liquid compared to conventional loans.
All these benefits make lending extremely attractive. What’s more, lenders also benefit from the efficiency of quick approval without burdensome checks. The entire process is digitized and takes minutes or hours, as opposed to days in the offline industry.
Today, crypto lending services cover a broad spectrum of assets. Users can switch between them with ease. For instance, you could use Bitcoin as collateral to borrow fiat or another type of crypto on the same platform.
Lending Platforms: CeFi vs. DeFi
The divide between cryptocurrencies and conventional finance is well-known. However, crypto platforms also belong to two distinct types, and the debate between centralized finance (CeFi) and decentralized finance (DeFi) still puzzles beginners.
Any cryptocurrency is decentralized by definition. Unlike the US dollar or the Euro, it is not managed by any central authority. Crypto is creating an environment where people can use digital assets for financial needs with ease.
However, different platforms approach this goal differently, and the question of trust is at the core of this divide. Centralized and decentralized models are based on different premises. Their users trust people or technology, respectively.
Centralized (CeFi) Lending Platforms
As the term suggests, such platforms operate similarly to conventional fintech entities working with fiat. To safeguard users’ assets, they implement Know Your Customer procedures and custodial systems. CeFi platforms can forge business partnerships with financial institutions – for example, to negotiate loan agreements.
Nebeus and Nexo are two prominent examples. The companies behind them determine the interest rates on loans. Typically, holders of cryptoassets with the largest market cap, such as ETH and BTC, get higher returns when they lend them through such CeFi environments.
- Potential higher returns for lenders of big-time assets
- Superior customer experience
- Higher transaction fees
- Third-party participation
- Disclosure of identity information for KYC
Decentralized (DeFi) Lending Platforms
The DeFi lending model exemplified by Compound and AAVE does not involve custody or KYC. The majority of such platforms have flexible interest rates – they change in line with the supply and demand for an asset on the forum. Exceptions are rare – for instance, on Maker, a decentralized governance system sets the rates.
Variable interest may change dramatically depending on the function. Lenders on the dYdX DEX have seen the rates jump by over 30%.
- Only users have full control over their assets
- Faster and more accessible services
- Vague regulatory landscape
- Potential dramatic swings and interest rates
CeFi vs. DeFi: Verdict
The coexistence of CeFi and DeFi is driving the industry forward. Platforms of both types offer quick transactions, attractive yield rates, and increasingly secure infrastructure.
Either way, you will unlock better financial services superior to old-school loans. You can learn more about the CeFi vs. DeFi divide from other posts on Bitforums.
Risks of Crypto Lending
Despite the convenience, speed, and flexibility of crypto transactions, users must still be aware of the risks. Digital currencies are volatile – dramatic ups and downs in this market are still common.
To take out a crypto loan, the borrower must provide collateral according to a certain LTV (loan-to-value) ratio. On some platforms, possible proportions range from 20% to 70%. This means that collateral must be worth more than the principal amount of the loan.
Volatility may cause the value of your collateral to diminish below the required threshold. In this case, you will have to add more crypto to return LTV to a safe range.
The existing liquidation systems provide sufficient protection to lenders. No users have lost their Investments so far. Still, this does not guarantee flawless performance in the future.
Finally, the use of smart contracts adds a technological risk. Crypto lending systems are built on computer code that governs all monetary flows. In theory, hacking in the DeFi space is still possible.
Future of Crypto Loans
BTC, ETH, and other popular cryptocurrencies are cementing themselves as valuable and enduring assets. Digital currencies are not susceptible to inflation or corporate corruption. They are beyond the control of governments, corporations, or individuals. This concept appeals to millions of users around the world. In the future, crypto loans may even overshadow the traditional lending industry.
Where to Begin
If you are a beginner fascinated with crypto and blockchain, choosing the right lending platform is difficult. We will help you navigate the differences between centralized and decentralized finance. Check out our comprehensive reviews of the most popular crypto lending platforms.