What Is Crypto Lending? Explained
Updated: Jan 4, 2021
All of us have heard about the meteoric rise of cryptocurrency in the past decade and how it is supposedly going to change the way financial ecosystems work in the modern world. With the rise of cryptocurrencies and faith around it among financial institutions and audiences, comes the opportunity of crypto lending - the trend bringing an opportunity for crypto players and is stated to be powering Ethereum's decentralized financial ecosystem.
What Is Crypto Lending?
Crypto lending is a very basic concept: Borrowers can use their crypto assets as a guarantee to get loans in the form of fiat currency or stable coins, and the lenders give the assets required for the loan at an interest rate that is ok with both of the parties. It can also work in another way round, where borrowers can use fiat currency or stable coins as a guarantee to borrow crypto-based assets.
You would have noticed that there is nothing special here. They are simply guaranteed loans but lending and credit are quite powerful components of the financial world that open up a lot of new avenue of benefits and usage for institutions, businesses, and traders. One such new use case derived from crypto lending is the flash loan. In flash loans, a user can utilize atomic transactions to borrow up to a platform's full liquidity as long as they can pay it back in the same transaction.
Lending Platform Types: Centralized And Decentralized
There are numerous lending platforms available in the crypto world and they can be generally divided into two groups- centralized and decentralized platforms. The main point of distinction between the two is mainly around "what or who is handling the borrowing and lending process".
Centralized lending platforms act like normal financial institutions that are dealing with cryptocurrency. They follow standard financial institution procedures like knowing your customer procedure, have a system to protect your assets, and forming traditional business partnerships with the institutions. These kinds of platforms usually offer interest rates laid down by the company, therefore often result in a higher return for lenders of assets like Bitcoin and Ethereum.
On the other hand, decentralized lending platforms operate as protocols that can be accessed by anyone at any time without any kind of KYC. These kinds of platforms have a variable rate of interest which is usually determined by the demand and supply for an asset on the platform. Some of the decentralized lending platforms available in the market are Compound, dYdx, xCoins, etc.
Importance Of Lending In Markets
We all know that lending and credit markets improve the utilization of money by reallocating if from those without immediate needs to those with immediate needs. This improves the utility of money for all the parties, giving borrowers access to capital and lender profit.
This is an interesting opportunity for crypto users, to use their crypto in options other than trade and hodl. Mainly for hodlers, crypto has had one use case i.e to sit in their wallets. With the rising of crypto lending, the utilization of those assets can be increased significantly, which will result in the generation of passive income for lenders and borrowers can receive a loan without having to receive crypto assets for trading or arbitrage. Apart from these utility improvements, this is one of the cases where crypto provided a better direct analogue to the financial institutions when lending returns and saving account interest s are compared.
As of now, most of the crypto lending platform gives an interest rate of around 8% for lending, whereas on the other hand most of the saving accounts in the United States give less than 1% return on the USD. But it doesn't offer the full value of true credit, as all the crypto loans are overcollateralized, which means that you need to have the capital to receive a loan, which ultimately hampers the growth of the crypto lending market.
Risks Of Crypto Lending
While crypto lending is a very promising component of the crypto world, but it's very important to understand that it comes with its own set of challenges and risks. One of them is newer and riskier platforms compared to highly regulated traditional financial institutions. None of these platforms, including the centralized lending platforms, are federally insured institutions.
Borrowers take on the risk of supplying liquidity in case of their collateral value drops below a certain value to make sure that lenders are not taking any loss. Therefore as a borrower, you need to carefully watch your collateral to ensure that it stays within the safe limits. Until now, this liquidation system proved to be working fine and lenders have not lost their investments, but there is no guarantee of how long this can go in the future.
On the other hand, in decentralized lending platforms, there is a technological risk of hacking with smart contracts. Apart from this, there is at times an issue of low liquidity, such that rates can change drastically if a large number of currency moves in or out of the platform. Usually, the interest rate functions are used to incentivize a stable equilibrium but still, volatility happens.
Apart from the above-mentioned issues, there are regulatory and taxation risks, especially in the case of borrowing to avoid taxation. There is no clear jurisdiction guideline regarding the natures of many of these assets which makes it hard for users to know the clear tax implications of their lending activities. Many of the decentralized platforms are operating without KYC disclosures and licenses, which makes their regulatory future very unpredictable.
As the crypto market continues to grow, the crypto lending ecosystem is going to be an important part of its growth and acceptance all over the world. Currently, the crypto lending ecosystems offer various interesting and unique opportunities for crypto users to increase the utilization of their assets and gain liquidity which seems to be quite useful.
We hope that this post has provided you with some interesting and useful information about the world of crypto lending and how you can navigate through it in a better manner.
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