As the financial world is rocked by geopolitical tension and global economics are brought once more to the forefront of uncertainty, alternative assets and money lending has been brought into light again. With the increased adoption and intrigue of decentralised finance (DeFi), crypto lending might be the secret weapon of financing without inflated interest rates amidst economic uncertainty. In this, we explore what crypto lending is.
What exactly is crypto lending?
It might sound overly simple, but at the core of cryptocurrency lending, there are lenders who are able to provide assets, such as fiat or stablecoins, to borrowers who use their crypto assets as collateral or the other way round, where lenders provide cryptocurrency assets to borrowers who put up fiat as collateral.
These are not dissimilar to collateralised loans, but with blockchain as the basis. Instead of credit giants and financial firms offering the lending, the peer-to-peer nature of blockchain-based assets means that any user with assets can lend and any user who needs can borrow. This opens up access to a much wider audience to borrow and lend without the financial red tape that might be found with banks and traditional financial firms.
The benefits of crypto lending
Crypto lending creates a significant opportunity for cryptocurrency markets and users to transact and use the currency beyond investing (or HODLing) and trading. It means the alternative asset class can be used by lenders to generate a way to use their assets as something that can generate a passive way to profit beyond investing – by charging an agreed-upon interest rate, the lender makes money on their lending. Most cryptocurrency lending platforms offer major rewards to lenders for providing liquidity to the platform offering up to 8% for lending stablecoins. In contrast, savings accounts in the United States generally provide less than a 1% return for storing money in the bank.
Furthermore, it allows more people to borrow money without the need of taking out high-interest rate credit and getting locked into a system that is designed to create debt. If you are a borrower in the crypto-lending process, you are using some form of asset as collateral which secures you from suffering from the pitfalls of the credit system.
The risks of crypto lending
With a nascent industry, not all things can be positive for users. There are still associated risks with cryptocurrency lending that are worthwhile knowing about.
If you are a cryptocurrency borrower, you ultimately undertake the risk of supplying liquidity if your collateral drops value below the required price. This means that the collateral ratio is important to watch to keep it in a safe range and not lose on the investment.
Smart contracts, while smart at the core of it, also pose a technological issue if there is a crack in the code that might let a hacker in to exploit. While blockchain-based transactions are secure and immutable once signed, if a hacker manages to attack a platform or a contract before it is signed, the result would be unfavourable for both parties involved.
With decentralised platforms, addressed below, there is also the possibility that low liquidity might effect the interest rates in a large way. If liquidity is provided, the lending system will remain stable, but should it drop, the platform and users are likely to face volatility with lends.
Using a cryptocurrency lending platform
There are two different types of cryptocurrency lending platforms:
- Centralised lending platforms, and
- Decentralised lending platforms.
Centralised lending platforms
These function a little more like traditional fintech companies that offer cryptocurrency. They tend to follow the necessary regulations to operate, such as Know Your Customer (KYC) protocols and have a custodial system. Centralised lending platforms generally offer interest rates that are determined by the platform, which might be dictated by partners that work with them, and offer higher returns for lenders of higher performing and dominant crypto assets like Bitcoin and Ethereum.
Decentralised lending platforms
On the other side, decentralised platforms operate using systems that work without KYC and custodial services. Unlike their centralised counterparts, decentralised lending platforms tend to have fluctuating interest rates that shift according to the supply and demand for assets on the platform. Users who are able to lend low-supply but highly demanded assets might enjoy the profits from massive interest rates, while borrowers would suffer from more expensive charges on the borrowed asset.