A Primer on Crypto Margin Lending
If you’re not a stellar trader, then you may be a little unhappy with your returns in the cryptocurrency market at the moment. While it is, of course, possible to learn to be a better trader with some effort, not everyone has time for it, and many investors just want to be able to earn a steady interest rate on their cryptocurrency investments like they would at a bank.
The good news is that this hands-off approach to cryptocurrency investing does exist, and it actually provides very favorable terms to investors. It’s a mechanism called margin lending, and it allows you to earn steady interest from your cryptocurrency coins and tokens almost risk-free.
What is margin lending and how does it work?
You’ve likely at least heard of trading on margin, though you may have heard of it more as a warning. While it’s true that trading with money that’s not yours can be pretty risky, it is extremely common that many investors do it every day in order to gain access to additional capital for their trades. However, not many people understand where that funding comes from, and even less know that they themselves can be the lender who provides that capital. For a fee of course.
By providing this service to traders, you’re paid an interest rate for the time they have borrowed your currency. What’s even better is that as the lender, you are in control. That means you get to set your own terms for the loan, including your preferred interest rate. Plus, since the exchange or platform is acting as a middleman, there’s no risk of not getting your money back. The exchange is the overseer, and they simply will not allow traders to not honor their agreements.
In the ideal scenario, as shown above, the trader will borrow funds from you, likely in a popular cryptocurrency like Bitcoin, and then make his trades. After reaching profitability, he’ll pay back the loan and interest to you, and then pocket the remainder of his profits earned using said capital for himself.
Notice to keep things simple, the example used throughout this article assumes traders borrow USD to buy BTC. One could use the same mechanics to borrow BTC to buy ETH or to borrow BTC to short it, pretty much between any trading pairs. The exact same logic applies.
The benefits of becoming a margin lender
There’s a lot of benefits to participating in margin lending. Here are some advantages that you might consider if you’re thinking about adding margin lending to your investment strategy.
- High-yield interest rates
- Interest is paid daily
- Interest is paid in the same cryptocurrency
- Almost risk-free for lenders
- Allows you to earn income on your long holds
- More tax favorable than trading
What happens if the trader losses big time on their trades?
If a trader does happen to make a bad play, that’s no concern of yours. Margin lending has built-in fail-safes which are meant to protect your capital. For starters, you can’t just get a loan with nothing to offer. Traders need to have a certain amount of their own cryptocurrency to use as collateral for the loan. This acts as a safety net if their trades don’t go as well as planned.
Every loan agreement also has a liquidation level, and when that point is reached the trader will be forced to sell their holdings in order to preserve the capital of the lender. In our illustration above, you can see what happens when liquidation is triggered. Our trader has unfortunately taken a 15% loss, triggering a forced liquidation. The exchange returns the initial loan in full to the lender, and the trader also must pay the agreed upon interest rate.
Is margin lending risk free for lenders?
Not entirely, no.
While it is one of the safest methods of collecting a profit off of your cryptocurrencies, just like any investment, there are still risks involved, though they are minor ones. For example, there is a risk of there not being enough liquidity to execute a trade once the liquidation threshold is reached, and if this happens there could theoretically be a loss of capital. There’s also the minor concern of the platform itself shutting down without notice, which has certainly stung cryptocurrency investors in the past.
However, these risks are very small, and investors who choose to lend their cryptocurrency can sleep soundly knowing that they will be earning an attractive interest rate without needing to drown themselves in market noise.