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. 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, 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 how crypto lending works and the risks that investors should keep in mind before lending any of their crypto assets.
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 platforms like Compound that automatically match borrowers and lenders and calculate interest rates based on the ratio of borrowed to supplied assets.
Compound Platform - Source: Consensys
For example, suppose that a trader wants to bet on a cryptocurrency’s value depreciating in price over a one-week period. 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 drop in price.
At the same time, suppose that a long-term investor lent the cryptocurrency to the 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.
What Are the Key Risks of Crypto Lending?
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:
- Counterparty Risk: Custodial lenders, such as BlockFi, enable lenders to lend 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 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.
Types of 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. Some platforms provide insurance while others entail much higher risk.
Genesis Capital Cumulative Originations – Source: CCNews24
- Genesis Capital: Genesis Capital offers institutions the ability to borrow bitcoin and other digital currencies in large sizes over fixed-terms.
- BlockFi: BlockFi is a secured non-bank lender that offers crypto-asset-backed USD loans to crypto-asset owners.
- 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 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.