While crypto lending and credit may be new, lending itself has existed in various forms throughout history. Here we look at the future of decentralized cryptocurrency lending, its pros and cons.
Whether in the form of a merchant lending a farmer gold, with the expected harvest as collateral – called “tokens” back then, as told in The Richest Man in Babylon – lending is nothing new, and crypto lending just a new twist. Over time, merchants have evolved into banks, companies and even individual businesspeople, while gold has evolved to fiat and most recently cryptocurrency. A lot has changed, but the fundamentals remain. In this piece, we take a look at crypto lending and credit solutions in the decentralized finance ecosystem.
What is crypto lending?
Crypto lending is the borrowing of funds (fiat or crypto) using crypto and other digital assets as collateral. Crypto lending and credit come in two variants, peer to peer (P2P) or B2B (business to business) and B2C (business to consumer) lending services. Crypto lending can be crypto-to-crypto or crypto-to-fiat, but rarely fiat-to-crypto.
How does crypto lending work?
In fact, it’s very simple and straightforward. Users deposit their crypto on the crypto lending platform after passing KYC. Users then proceed to set up their loan conditions by selecting their preferred interest rate and loan term, loan fund option – fiat currency or cryptocurrency – and loan amount. Once the desired loan conditions are set, the user then makes a loan request and wait for the approval. Users who set a high interest rate are more likely to get a faster response/approval, but each crypto lending platform has different terms and conditions. Loans are issued based on a loan to value (LTV) ratio. We will elaborate on this when comparing crypto lending with traditional lending. Depending on the loan conditions previously set, the user can choose to pay off the loan as agreed, or at a future date. With interest rates compounding, of course.
Crypto lending vs. traditional lending
Crypto lending has several advantages over traditional lending. The most obvious one is the usual lack of a credit check before a loan is approved, as the loan is asset-backed and the loan amount is proportional to the market value of digital assets locked.
Loan to value (LTV) ratio refers to the ratio between the loan amount and the collateral’s market value at the time the loan is approved. Here’s an illustration: to borrow US$ 10,000 at an LTV ratio of 60%, the user will need to deposit about 0.5BTC on the crypto lending platform.
Traditional lending by banks and financial institutions is usually for large amounts of money. It would be ridiculous to borrow US$ 200 from your bank using your house as collateral. However, there are pawnbrokers who lend out these small amounts, and with online lending, they are now popular. They are exceptions to the general rule. In crypto lending, standard loan amounts can be very small, some platforms may have a minimum though.
Interest rates in crypto finance
When talking about the health of crypto-economics, one significant metric increasingly being considered is interest rate. This could potentially drawe institutional investors into the cryptosphere and draw out crypto assets in cold storage into a hot, active market. As we would see later in how crypto lending platforms make money, interest rates are the main incentive for these platforms to be in business. It is also the main incentive for an individual to sign up and lend crypto assets on a platform, since it is better to have your digital gold work for you rather than leaving it idle in storage.
As different platforms have different terms and conditions, interest rates in crypto finance also vary, even within the same platform. Volatility, an unstable market and differences in platform business models also contribute to this. Credmark reports that US$ 16m in crypto loan interest was generated in the third quarter of 2019 from a US$ 900m approved loan amount.
Benefits of crypto lending
As mentioned earlier, the lack of a credit check on most crypto lending platforms is the main reason for increased interest in this sub-sector of DeFi, drawing in both individuals and institutional investors. But there are other benefits.
Crypto lending platforms offer instant liquidity, as loan amounts are usually paid in fiat to the user’s bank account directly or in another digital asset. In fact, the need for this service, after the crypto boom and gloom of 2017, which saw bitcoin go from US$ 1,000 to US$ 20,000 and then plummet, led to the growth of the crypto lending industry. The other side of the coin is that the users’ digital assets remain unspent, although locked. Since funds are locked, where the market is good, the user gets to earn interest on locked funds. This applies to both borrowers and lenders who sign up.
A common marketing refrain of crypto lending platforms is that they help users hedge their funds when the market is bearish. During the gloom days after the boom of 2017, crypto investors were in a dilemma. They were short of funds, yet selling their holdings would have resulted in massive loss. Crypto lending services offered the much-needed reprieve. They don’t have to spend their digital assets and still get instant liquidity.
Risks in crypto lending
Market volatility, platform hacks and uncertain regulations are a few of the risks associated with crypto lending. The crypto market is a 24/7 bazaar that never sleeps, which means wide swings in price are a daily occurrence. Both lender and borrower bear this risk, although most crypto lending platforms protect themselves by capping the LTV ratio and including additional terms whereby funds could be sold off (liquidated) or more capital requested if the value goes below a certain percentage.
How do crypto lending platforms make money?
Interest is one major way crypto lending platforms make money. Others include investing locked funds, since it is in their custody, and refinancing old loans.
Top crypto lending platforms:
2. bZx Protocol
3. Celsius Network
8. DrawBridge Lending
11. Helio Lending
12. Genesis Capital
20. Unchained Capital
As with the general crypto ecosystem, regulations are uncertain in most countries. Crypto regulatory policies vary depending on how a particular government chooses to classify crypto assets. Some have chosen to categorize crypto as a commodity, others as currency and still others as securities. As a result, it is likely that most platforms operate on an unregulated basis and could face problems with loan recovery. Also, some platforms have made significant efforts at staying regulated by obtaining licenses and certifications from appropriate authorities like FinCEN.
Future developments in crypto lending
Decentralized finance, an ecosystem that allows for personal tokens, stablecoins and high interest rates on savings, is rapidly going mainstream. Crypto lending can be said to have facilitated this development. As issues of interoperability, low volume, market volatility and interest rates variance are resolved, the crypto lending industry could mature.