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How Does Crypto Lending Work? Understanding the Crypto Lending Market

Find out how crypto lending works and why the market is growing rapidly.

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Since the pandemic, the entire DeFi market has grown from virtually zero to nearly $90 billion, an absolute record dating back to May this year. One of the drivers for this upsurge is crypto lending, which has become increasingly popular over the past year and a half. According to DeFi Pulse, which tracks the total value locked (TVL) in the smart contracts of popular DeFi applications, the lion’s share of DeFi’s value belongs to crypto lending.

Total Value Locked in DeFi Lending
Total Value Locked in DeFi Lending

Crypto lending in DeFi looks like a win-win solution for investors:

  • Interest rates are usually in double digits, which is much higher than traditional finance.
  • Borrowers need to put up collateral with value that exceeds the loan itself.
  • Smart contracts ensure funds will only be released once the predetermined conditions are met, so lenders and borrowers can loan and borrow safely.

If you’re wondering if crypto lending is the right investment for you, this article is for you! We’ll be covering:

  • How does crypto lending work?
  • How does crypto lending offer such high interest rates?
  • Who borrows crypto at such high interest rates?
  • What’s the difference between Centralised Lending and Decentralised lending?

What are Crypto Loans?

Crypto lending enables individuals to securely lend and borrow cryptocurrency. Anyone can become the lender and earn interest from lending out their funds, and anyone can borrow as long as they provide the crypto collateral required for the loan amount. 

A typical transaction on a crypto lending market looks as follows.

How Crypto Lending works
How Crypto Lending works
  1. The borrower announces they require a DeFi loan.
  2. The borrower locks their crypto collateral on the platform.
  3. The lender provides the borrower with the requested loan, say, a bitcoin, manually or automatically.
  4. The lender then receives interest payments from the borrower under the conditions agreed upon or according to the smart contract’s settings.
  5. When the loan term elapses or other trigger conditions occur, the borrower repays the loan to the lender and gets their collateral back.

Crypto Lending vs Bank Lending

Bank lending is traditionally a lengthy process where the borrower has to prove their credibility in line with the laws and legal frameworks that keep borrowers from defaulting on their loans. In addition, every business’ credit risk is individually assessed based on their financial statements, and extensive customer support adds to the bank’s operating costs. In the case of personal loans, credit ratings are based on the individual’s past payment history, with interest rates adjusted depending on one’s creditworthiness.

Crypto lending removes the institution from the equation and automates the process. Instead of laws and an operations team conducting “know your customer” checks to prevent borrowers from defaulting, there are smart contracts and over-collateralisation to protect the lender. To qualify for a loan, the borrower has to deposit a specific amount of crypto that exceeds the value of the original loan as collateral (the exact over-collateralisation factor varies from platform to platform). Smart contracts will then lock the collateral until the loan and interest is repaid. 

Moreover, removing the institution and its related costs from the equation leads to a larger portion of profits that can be shared with users in the form of higher interest rates.

Who Needs Crypto Backed Lending?

For the lender, the incentive to issue crypto loans is pretty straightforward. It is a moderate-risk investment strategy that allows them to make their crypto assets work to bring in profits instead of just ‘HODLing.’ 

Things, however, are different for the borrower. There are several reasons for one to borrow crypto and collateralise the loan with crypto. They include the following:

  • Speculating/hedging
  • Trading/arbitrage
  • Operating working capital
  • Retail borrowing

The Speculative Trader

First of all, it is a good move for a speculative trader. Instead of selling a specific asset to go short on a different trading pair, they may borrow the desired amount of the crypto coin, thus accessing two assets in one move with leverage. Even considering the interest rates, the margins are usually high enough to make this strategy worthwhile. Similarly, traders can use those assets for arbitrage, i.e. traded at different exchanges to profit from differences in exchange rates. Most of the demand for crypto loans comes from speculators, and this also drives up the interest rate. 

A Source of Operating Capital

Some users, however, prefer using borrowed funds as their operating capital.  In certain jurisdictions such as the United States, operating borrowed capital is tax-exempt, allowing borrowers to save more than they spend on paying out the interest. For example, a crypto miner might be reluctant to sell their coins when prices are low, and they may opt instead to borrow working capital against their coins as the expected rise in value will override the cost of interest.

Regular Retail Borrowers

Finally,  a relatively small portion of crypto borrowers treats their crypto loan as regular retail credit. For example, one may not want to sell their assets for good in the hopes that they will gain price over time. Instead, they use those funds as collateral to access spendable funds that they can exchange for fiat and make the desired purchases and then repay the credit together with interest rates. In this case, a borrower does not have to undergo scrutiny at banks or show a commendable credit history.

Crypto Lending Risks

Of course, there are risks attached to lending and borrowing cryptocurrencies. 

  1. Trading at cryptocurrency exchanges can be unsuccessful, and the losses from a transaction gone wrong will add up to the original loan’s amount plus interest. 
  2. Cryptocurrencies are extremely volatile, so a sudden market swing may devalue the collateral or the loan. 
  3. Technical risks such as bugs in smart contracts that can be exploited, resulting in stolen cryptocurrency.

While it is impossible to predict such a turn of events, an expert can estimate the riskiness of a loan and make the safest bet possible. For that purpose, Cabital has a threefold system of analysis and decision-making to ensure only the safest transactions and the most efficient investment strategies are enforced for all portfolios.

Why is the Crypto Lending Market Popular?

There are several likely causes for the increasing popularity of crypto loans.

  • In the previous decade, widespread lending was virtually absent from the crypto market for technological reasons, save a handful of companies. As lending through different mechanisms becomes more available, the supply finally moves towards the demand.
  • Crypto lending and yield farming are acceptable to institutional players who had previously abstained from dealing with cryptocurrencies for legal reasons.
  • Earning interest is an attractive and relatively simple option for those who could not become an investor before. 
  • Crypto lending enables one to trade cryptocurrencies without selling the assets they are ‘HODLing.’

There’s also the potential for change, as globally, 1.7 billion adults lack a bank account and its accompanying financial history records. This leaves them with few options to lend and borrow. Crypto loans, however, are available wherever the internet is present, and stablecoins like USDT and USDC offer the potential for payments.

With the demand for crypto lending, there are numerous options on the market appealing to different audiences with different risk appetites.

Centralised Crypto Lending Market (CeFi)

Centralised crypto lending (also known as CeFi lending) refers to platforms that issue loans themselves. Those loans, however, are not necessarily denominated in crypto, though collateral usually is. For that reason, such loans are sometimes called ‘crypto-collateralised lending.’

In CeFi, companies have KYC (know your customer) procedures in place and are regulated. They can offer you a loan in fiat money that you collateralise with crypto. Instead of relying on smart contracts, such companies have custodial solutions. 

CeFi platforms usually boast appealing interest rates and individual approaches to their customers, as well as a selection of options like margin lending suitable for crypto traders. 

On the downside, the lending process is prone to human errors, can take a while, and there is some red tape to deal with. On top of that, they have a single entry point so they are easier to hack.

CeFi Crypto Lending Platforms:

  • Celsius (London), $93.8m of funding. Celsius Network is a platform that offers lending and borrowing services across multiple cryptocurrencies and fiat, with special rates for users who hold the native token CEL.
  • Nexo (Switzerland), $52.5m of funding. Nexo provides lending, borrowing, buying and exchange services across multiple cryptocurrencies and fiat. They offer higher interest rates to users who choose to hold a portion of the native NEXO Token.

While holding native tokens can offer bonus rewards and discounts, they are also exposing users to the risk of volatility, where a plunge can offset all promised earnings through preferred rates. 

Decentralised Crypto Lending Market (DeFi)

In DeFi loans, protocols govern all processes underpinned by smart contracts. They require no KYC or any other paperwork but are strictly limited to cryptocurrencies. The entire process is usually more transparent as the source code is open and the blockchain is explorable. Still, interest rates vary depending on market conditions and specific features of the platform. 

Unlike CeFi, where the centralised institution usually sets aside a provision for extreme unexpected events and the infrastructure provider offers insurance policies that cover assets in storage, transfer and E&O, DeFi insurance options are less comprehensive. There are insurance protocols that offer DeFi users the option to buy protection from smart contract risk, exchange hacks, and more, but this is purchased separately and the claim validity is decided by token holders of the DeFi insurance platform. 

P2P lending

  • The lender and the borrower contact each other directly using the platform as means of communication and facilitator of transactions. Therefore, they can agree upon whatever conditions they deem appropriate.
  • In other cases, lenders and borrowers pre-set their conditions and wait for someone to find them appropriate and strike a deal.
  • The entire process is governed by a smart contract which also secures the loan.
  • Typical risks include failure to repay the loan, market swings devaluing collateral, or bugs in smart contracts leading to security breaches.

Liquidity pools (yield farming)

  • In this scenario, lenders deposit their funds in a liquidity pool. Effectively, they provide liquidity to the platform and obtain rewards and interest in return.
  • Getting those rewards is called yield farming. Usually, these rewards are in the form of the platform’s native tokens that one can trade, sell, or invest in. 
  • The platform uses the liquidity it obtains from users to issue loans secured by the functioning of the pool itself.
  • Typical risks here include: losing USD value compared to just ‘HODLing', impermanent losses of any extent, as well as possible smart contract bugs or sudden protocol changes if the project is governed in a centralised way.

DeFi Crypto Lending Platforms:

  • Aave (Switzerland), $30m of funding. The DeFi protocol enables its users to make loans in fiat with crypto collateral.
  • Compound (USA), $41m of funding. A p2p DeFi lending platform on Ethereum that has its own protocol to help developers borrow tokens in their applications.

CeFi vs DeFi Summary

Summary table of CeFi vs DeFi
Summary table of CeFi vs DeFi

Cabital Helps You Earn Without Direct Lending

Decentralised crypto lending may seem incredible at first glance, with stories of 100% interest rates and yield farming miracles. However, these are interspersed with horror stories about rug pull scams, faulty smart contracts, market swings killing off entire platforms, and other investor nightmares. 

A reasonable alternative to this high risk/high reward model is a crypto savings solution that reduces risks to the possible minimum while retaining a relatively high reward. Cabital's crypto savings plans ensure that your assets remain safe and generate interest around the clock.

Cabital’s solution frees you from keeping all considerations in mind while investing and leaves you with confidence and steady passive income. To ensure that, we lend exclusively to heavily over-collateralised platforms with audited smart contracts that have minimum risk factors. In addition to that, we perform economic and technological cross-checking with a dedicated committee consisting of veteran investors and experts from different areas as an additional layer of security for our customers.

Cabital has no preconditions, so it’s easy to try out our Fixed and Flexible Savings plans. To see how it works, all you have to do is to invest a small sum of USDT into Cabital’s 7 Day Fixed Savings plan and watch your money grow.

Get started with Cabital today

This article has been prepared by Cabital Fintech (LT) UAB  (the “Company”) and is general background information about some of the Company’s activities at the date of this presentation.

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