A Quick Guide to Crypto Lending for Traders and Investors
The blockchain has introduced innovative financial solutions that aim to revolutionize the daily lives of people around the world.
It has become a real competitor to traditional institutions, with decentralized exchanges, borderless payments, and crypto lending transforming the finance world. Celsius, a leading DeFi firm, facilitated over $2.2 billion in crypto loans in less than two years and estimates suggest the growth is not stopping anytime soon.
In today’s post, we’ll look into how crypto lending works as well as its downsides and benefits.
How Does Crypto Lending Work?
Stablecoin-Backed Lending
The properties of the blockchain and smart contracts make it convenient for individuals to lend and borrow cryptoassets. Transaction fees are low compared to traditional loans and they remain the same no matter where users are in the world. Someone in Brazil can borrow stablecoins from a trader in Singapore in less than a minute while only paying $0.01 in fees.
Providers like ETHLend, SALT, and Nexo enable this by allowing users to lend their cryptoassets easily. Lenders receive attractive interest rates (some going as high as 10%) and they earn more the longer their assets remain in the ecosystem. Each provider has its payout schedule, with some offering weekly interest rates while others have standard monthly payments.
Since the contracts are backed by Ethereum smart contracts, lenders can close their contracts anytime and receive their assets back as long as there is enough liquidity. Most cryptocurrencies (e.g. BTC, ETH, LTC) can be lent and the DeFi space is always developing to provide decentralized loans for all cryptoassets.
For borrowers, they can generate stablecoins depending on their collateral value. For example, a user who deposits the equivalent of $100 of ETH can mint up to 50 DAI, a popular stablecoin in DeFi. The borrower can only recover the collateral if the loan plus interest is repaid in full. However, there are no deadlines or interest hikes for late repayments, unlike traditional loans.
Collateralized Debt Position (CDP)
A collateralized debt position (CDP) is one of Maker’s most popular products (Maker was one of the earliest DeFi companies). To open a CDP account, users need to deposit collateral (only ETH and BAT are available for now) into Maker’s portal.
Users can then generate up to 66% additional DAI based on the dollar value of their collateral. For example, depositing $1,000 worth of ETH allows users to generate a maximum of 666 DAI. To get back the collateral, users have to repay their debt as expected. The generated DAI can then be taken out of the platform to be used as a normal stablecoin — say, for trading or usage.
Let’s say ETH experiences a bull run and the initial collateral value of $1,000 has now risen to $3,000. If the user closes the CDP by repaying the debt, he or she will recover an extra $2,000 worth of ETH due to the price increase. This is why CDPs are popular: because they allow investors to long trade ETH with less risk compared to standard leverage trading.
Like other crypto loans, there is no time limit to repay the loan. However, there is a 150% liquidation ratio minimum — essentially an account’s risk level. The dollar value of a CDP account’s collateral must be worth 150% more than the total value of DAI generated. Any account that falls below this level will be liquidated automatically to cover the debt as well as a liquidation penalty.
Borrowers are advised not to generate the maximum amount of DAI as they’ll be liquidated even if the price of ETH drops by a cent. Maintaining a ratio of anywhere between 200–300% is recommended for safety in case the price of ETH goes down. The ratio can be raised by repaying the debt or adding more collateral to the CDP.
A common strategy among CDP users is to buy more ETH with their additional DAI and depositing their purchase back into the CDP. This will increase the ratio while allowing users to increase their ETH stack safely. The only risk of liquidation is if ETH suffers a major price drop — as it did on March 12th when crypto markets crashed 40% within an hour — and the liquidation threshold is triggered.
The Pros and Cons of Crypto Lending
Advantages
- Speed: Setting up accounts on crypto lending platforms takes minutes at most. There is no need for bank accounts, identity verification (except centralized companies), credit checks, or application processing delays.
- Ease of mind: Borrowers don’t have to worry about how their money is spent. They can close their accounts and recover their assets anytime as long as there is enough liquidity. Interest rates are also paid automatically without borrowers having to do anything.
- Transparency: All loan information is displayed without censorship thanks to the blockchain. DeFi companies are also very proactive in sharing information like performance, product updates, and even negative news.
- Passive income: Most providers offer attractive interest rates of 5–8% monthly interest which far exceeds the rates of traditional loans, making passive income a realistic goal.
Disadvantages
- Risk: Crypto markets are known for being volatile and while it has improved in recent years, prices can crash dramatically, which will cripple loan providers. Security breaches are also possible although security auditing in DeFi companies is among the most comprehensive in the software world.
- Fluctuation: Interest rates are reset every day based on market fluctuations. Borrowers will earn, but they won’t realize the same gains consistently.
- Regulations: Laws surrounding crypto loans are in a grey area for now. That said, the situation is improving as institutions and legislators realize the potential benefits of DeFi in the real world.
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Crypto lending will continue to grow as consumers seek alternative financial solutions, particularly in underbanked communities. As an investor, keeping up with the latest DeFi updates is important to make informed market decisions. However, we understand that doing so can be tedious and time-consuming.
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