Most traders and investors are familiar with the truism: If it sounds too good to be true, it probably is. Investment opportunities that offer high returns are often accompanied by high levels of risk that many investors fail to take into account. And, cryptocurrencies are no exception to the rule—offers of high returns often come with high risks.
Crypto lending platforms have become increasingly popular over the past several years. By lending crypto that you already own in the form of a crypto loan, these platforms promise interest rates that are above and beyond what’s typical in the conventional financial system.
Let’s take a closer look at the working, risks, and benefits of crypto lending.
What is Crypto Lending?
The conventional financial system relies on a lot of borrowing and lending activity. For instance, commercial banks frequently borrow money from the Federal Reserve System, many traders borrow stock from their brokerage, and of course, consumers borrow from banks. The crypto market has sought to offer these services through Decentralized Finance or DeFi.
DeFi is an ecosystem built on the Ethereum blockchain that has over $7 billion worth of smart contracts. Rather than relying on a centralized infrastructure, DeFi uses immutable smart contracts to power lending crypto platforms like Compound that automatically match borrowers and lenders and calculate interest rates based on the ratio of borrowed to supplied assets.
For example, suppose that a trader wants to bet on a cryptocurrency’s value depreciating over one week. The trader might borrow the cryptocurrency from a DeFi lending platform, sell it for a stablecoin or fiat currency, and buy it back a week later. If they buy it back at a lower price than the sale price plus interest, they realize a profit on the price drop.
At the same time, suppose that a long-term investor lent the cryptocurrency to a short-term trader in exchange for interest. The long-term investor maintains their long position in the cryptocurrency and potentially earned interest on the amount that was above and beyond the interest rates offered by conventional financial institutions.
Crypto lending, hence, not only enables crypto owners to receive interest on their HODLed crypto but also, in fact, enables borrowers to unlock the value of their digital assets by using them as collateral for a crypto loan.
Features of Lending Crypto
Crypto loans are handled by DeFi or CeFi exchanges with a typical interest rate of 1% to 20% APR/APY. This, however, depends on the CeFi or DeFi platform you choose. Check out these features of a typical crypto lending transaction:
- Crypto loans or lending transactions do not need any intermediary to facilitate or manage the transaction.
- The entire process (including the repayment cost and time) is automated by smart contracts specific to the platform you choose.
- You don't need to do any registrations with any governmental agency or regulators to avail of a crypto loan.
- You must put more collateral than you normally would when you take out a crypto loan which means you put more collateral value than you borrowed.
- This happens because crypto lenders don't know to who they are sending the money too (you don't have a Know-Your-Customer verification for crypto loans).
So Why Would Anyone Lend Money Without KYC?
There is one benefit to lending your crypto assets: you get to earn interest from a stagnant crypto if you lent it to someone else. The rate of interest varies but typically fall in the range of 1% to 20%.
Why Should Anyone Borrow Crypto?
Now, that has a set of complicated reasons. Borrowing crypto is beneficial to those who own a large amount of crypto wealth. Sure when the market is high the value of their assets increases but when the moment they put it into use, they will incur taxes. Now, if they put their assets as collateral and borrow crypto, they have cash with them without paying taxes.
This strategy comes with a risk: the collateral will be liquidated if the market collapses. But when the market rises again, they can buy back their collateral with a lower market price and then sell it. This way the borrower earns the difference money.
Crypto Lending Risks?
Most crypto lending is fueled by broker margin lending to speculators. With significant borrower demand and a lack of lender supply, interest rates for borrowing cryptocurrencies can be anywhere from 2% for stablecoins to 10%+ for other cryptocurrencies. These rates are likely to fall as more lenders feel comfortable entering the marketplace.
There are two important risk factors to keep in mind when involved in crypto lending:
- Counterparty Risk: Custodial lenders, such as BlockFi, enable lenders to lend crypto to borrowers on the same platform. The risk is that the platform will break down or an excessive number of borrowers will default.
- Technical Risk: Non-custodial lenders, such as Compound, use decentralized protocols to facilitate lending crypto activity. The risk is that the algorithms will break down or a nefarious actor will be able to game the system.
The crypto industry has experienced its fair share of security breaches. While Bitcoin and a handful of other protocols are rarely exploited, the platforms that facilitate crypto transactions are a different story. The novelty of crypto lending means that many of the algorithms haven’t been vetted as long as Bitcoin or other technologies.
What are Crypto Lending Platforms?
There are many different custodial and non-custodial crypto lending platforms. When choosing between platforms, investors should carefully assess the risks and returns involved to ensure that it fits within their overall investment risk tolerance and requirements. While some crypto lending platforms provide insurance, others entail much higher risk.
Crypto Lending Platforms: Custodial Platforms vs Non-Custodial Platforms
- Genesis Capital: Genesis Capital offers institutions the ability to borrow bitcoin and other digital currencies in large sizes over fixed terms.
- BlockFi: This non-bank lender offers crypto-asset holders USD loans backed by crypto-assets.
- Celsius: Celsius Network is a blockchain-based lending platform that is accessible through a free mobile app.
- Dharma: Dharma Labs is a protocol for generic tokenized debt agreements.
- Compound: Compound is an open-source interest rate protocol that unlocks new financial applications.
- Uniswap: Uniswap is a protocol for trading and automated liquidity provision on Ethereum.
Currently, centralized custodial lenders are the largest players in the market, although decentralized non-custodial platforms are quickly disrupting the market. For example, Compound has already amassed about $1.8 billion in assets across nine different crypto markets, but Genesis Capital had over $2 billion in originations in Q1 2020.
These platforms are also constantly evolving to meet new requirements that could change the interest rates they charge and pay. For instance, decentralized credit scoring or automated insurance solutions that quantify risks could eventually reduce collateral requirements for crypto loans and open up a significant supply for potential borrowers.
The Bottom Line
Crypto lending platforms make it easy to earn interest on crypto holdings. With strong demand for margin trading and a lack of institutional supply, these platforms are offering higher interest rates than many conventional financial products. As counterparty and technical risks subside over time, there will likely be more supply that will push down interest rates.
In the meantime, investors looking for an extra return on their holdings that are willing to assume a little risk may want to consider lending their crypto assets to earn interest. It may be a good way to generate passive income from a portion of a crypto portfolio.
If you’re making complex crypto transactions like these, you may want to consider a dedicated crypto tax solution to ensure that you’re accurately calculating and reporting taxes. ZenLedger automatically aggregates transactions across exchanges and wallets to calculate your capital gain or loss, as well as identify potential tax-loss harvesting opportunities.