The rapid growth of the cryptocurrency market has introduced innovative financial strategies, one of which is crypto lending and borrowing. These mechanisms offer investors new ways to leverage their cryptoassets, access liquidity, and earn interest.
Unlike traditional banking systems, crypto lending operates through both centralized and decentralized platforms, enabling users to either lend their digital assets for a return or borrow against their crypto holdings. While their potential rewards can be luring, crypto lending and borrowing also carry significant risks, including market volatility and lack of adequate regulation. Therefore, having a proper understanding of how these concepts work is a must for anyone looking to participate in this growing segment of decentralized finance (DeFi). In this article, we explore how crypto lending and borrowing work, the benefits they offer, the risks involved, and how investors can practice these strategies safely and effectively.
What is crypto lending and borrowing?
Crypto lending and borrowing is a DeFi practice where cryptocurrency holders lend their assets to borrowers in exchange for interest payments. It is similar to traditional lending but facilitated by blockchain technology. It operates through platforms—centralized and decentralized—that connect lenders and borrowers.
On decentralized protocols, the crypto lending and borrowing process is largely managed by smart contracts, which automatically enforce the terms of the loan, including interest rates and collateral management. In the case of centralized platforms, the entity acts as an intermediary between lenders and borrowers, managing the process while offering custodial services.
Moreover, the concept allows lenders to earn interest on their idle assets, while borrowers can access liquidity without selling their cryptoassets, preserving their holdings for potential future gains. However, it involves risks such as collateral volatility, platform failures, and market fluctuations.
How does crypto lending and borrowing work?
Typically, crypto lenders deposit their cryptoasset into a platform, which is then used by borrowers who provide collateral (usually in cryptocurrency) to secure loans.
Lenders deposit their cryptoasset into the platform’s lending pool. The platform then locks these funds in smart contracts (for decentralized platforms) or holds them in a custodial wallet (for centralized platforms).
To access these locked cryptoassets in the form of loans, borrowers must deposit cryptocurrency as collateral. The collateral amount typically exceeds the loan amount to protect the lender in case the borrower defaults (over-collateralization).
Once the collateral is posted, the borrower can take out the crypto loan. The loaned funds are transferred to the borrower’s wallet, with interest rates determined by the platform. In decentralized platforms, rates may fluctuate based on the supply and demand for particular crypto assets.
Notably, lenders begin earning interest immediately once their assets are loaned out. This interest is typically paid in the same cryptoasset that was loaned or a stablecoin, depending on the platform.
Meanwhile, borrowers are required to repay the loan and interest by the end of the loan term. Once repayment is complete, the platform releases the borrower’s collateral. If the borrower fails to repay or the collateral value drops below a set threshold, the platform can liquidate the collateral to cover the loan.
In case the value of the collateral falls below a specific level (due to market volatility), the platform issues a margin call, requiring the borrower to either repay part of the loan or provide more collateral. If the borrower fails to act, the collateral may be liquidated.
Read also: What is Decentralized Finance (DeFi) and How To Benefit from Its Ecosystem?
Benefits of crypto lending and borrowing
Here are some of the benefits of lending or borrowing your cryptoassets:
1. High returns for lenders
One of the biggest benefits of crypto lending is the potential for high yields. Depending on the platform and the cryptoasset loaned out, lenders can earn significantly higher annual percentage yields (APYs) than traditional savings accounts. Some platforms even offer double-digit returns, attracting investors looking to earn passive income.
2. Flexibility and accessibility
Crypto lending platforms, especially decentralized ones, offer flexibility in terms of loan amounts, repayment schedules, and supported assets. Borrowers can access loans without a lengthy approval process, and lenders can deposit a variety of cryptocurrencies.
3. Liquidity without selling cryptoassets
For borrowers, crypto lending offers an opportunity to access liquidity (cash) without selling their cryptoassets. It allows them to retain their cryptoassets while expecting their value to appreciate over time, especially in bull markets.
4. Quick access to funds
Compared to traditional loan processes, crypto loans are much quicker to access. Borrowers can use decentralized platforms to obtain loans within minutes by using their cryptoassets as collateral, without undergoing credit checks or long approval processes.
3. Lower interest rates (in some cases)
In many instances, crypto loans may offer lower interest rates compared to traditional loans, especially for well-collateralized loans. Decentralized platforms sometimes provide more competitive rates due to the absence of traditional financial intermediaries.
4. No credit checks
Crypto borrowing allows individuals to secure loans without needing to go through credit checks. This makes the borrowing process more inclusive for people who might not have a high credit score or are excluded from traditional banking systems.
Read also: What is Smart Contract and Its Use Cases?
Read also: What is Yield Farming and How does a Crypto Investor Benefit?
What are the risks associated with crypto lending and borrowing?
Crypto lending’s ease and flexibility, combined with the potential for high returns, make it a growing segment of decentralized finance (DeFi). However, it’s not without risks, including collateral volatility, over-collateralization, potential platform vulnerabilities, margin calls and liquidation, amongst others.
Cryptocurrencies are highly volatile, meaning that the value of collateral assets can fluctuate dramatically. This makes collateral volatility one of the most significant risks associated with crypto borrowing. If the value of the borrower’s collateral drops below a certain threshold, crypto lending platforms often issue a margin call, requiring the borrower to provide more collateral or risk liquidation. This can expose both borrowers and lenders to significant financial losses.
Notably, a margin call occurs when a user’s account value falls below the platform’s required maintenance margin, prompting the platform to demand additional funds to bring the account back to the minimum margin level. If the investor cannot meet the margin call, the platform may liquidate the user’s assets to cover the shortfall.
Also, there is a risk that the lending platform itself could fail. Centralized lending platforms could face regulatory crackdowns, insolvency, or even hacking incidents, leading to losses for both lenders and borrowers. Decentralized platforms, while offering more control to users, are still vulnerable to bugs in smart contracts. If there are bugs or vulnerabilities in these contracts, they can be exploited by hackers, leading to significant financial losses.
Illiquidity is also a major concern in crypto lending and borrowing. In some cases, borrowers may not be able to withdraw their funds instantly due to a lack of liquidity on the platform. If too many users want to withdraw or repay their loans at the same time, the platform might not have enough assets available, leading to delays or even losses for lenders.
Furthermore, on decentralized platforms, interest rates are determined by supply and demand. Rates can fluctuate, potentially reducing lenders’ returns or increasing the cost for borrowers unexpectedly. Likewise, on centralized platforms, lenders face the risk that the borrower may default on the loan—counterparty risk. Even though these platforms often require over-collateralization, in extreme market conditions, there could be a shortfall, leading to losses for lenders.
Meanwhile, let’s not forget that crypto lending is a relatively new space, and regulations surrounding it are still evolving. Therefore, in the case of platform failures such as Celsius, Voyager Digital etc., users may never recover their funds completely.
Conclusion
Crypto lending and borrowing provide a unique set of opportunities, enabling users to earn high interest on their cryptoassets or access liquidity without liquidating their holdings. But don’t be mistaken; while their associated benefits can be luring, their associated risks can be fatal, too. The bottom line is, therefore, to tread with caution.
Ndianabasi Tom A crypto journalist and content writer who has been talking about cryptocurrency and blockchain technology since 2018, Ndianabasi is a Writer at Crypto Asset Buyer (CAB).
