Lending and borrowing money has been a staple of economic exchanges for centuries, with modern banking giving lenders the opportunity to collect interest on loans, and borrowers the chance to purchase large assets like homes or cars they otherwise wouldn’t be able to afford. 

The modern advent of cryptocurrency presents a new opportunity to circumvent traditional channels like banks. In many ways, crypto lending and borrowing closely resembles traditional channels, but the decentralized nature of the exchange creates some key differences. Let’s explore the practice of crypto lending and the opportunities it offers to those on both ends of the exchange.

What is crypto lending & borrowing?

Crypto lending is the practice of lending cryptocurrency investments to a borrower in exchange for interest payments called crypto dividends. Like in traditional loans, they’re usually protected by collateral offered by borrowers. In the case of crypto lending, however, this collateral usually comes in the form of crypto coins.

Let’s say, for example, you hold 100 Ethereum coins and you’d like to profit from them passively. You can deposit these coins into a crypto lending wallet and receive periodic interest. Different coins offer different interest rates on different platforms, with less stable coins typically featuring lower rates than stable coins. 

Unlike other types of lending, borrowers can attach their own cryptocurrency as collateral. In the event of nonpayment, lenders can then sell that currency to cover losses. It allows borrowers to utilize the potential liquidity of their own crypto assets without cashing them out and dealing with complications like paying taxes on gains, assuming they pay back the loan on time.

How does it work?

Crypto lending and borrowing involves three parties. The first is the lender, who is typically an individual or institution holding a large quantity of long-term crypto assets they wish to make passive income from. The second party is the borrower, often a business or individual seeking funding for various projects. They have some amount of cryptocurrency they don’t wish to spend. The third party is the lending platform which facilitates the exchange.

Lending starts when a borrower requests a crypto loan from a third-party platform. If the loan request is approved, the borrower stakes his or her crypto collateral as soon as possible. That collateral is then locked away until the borrower is able to fund back the entire loan. Lenders who have invested their cryptocurrency into a lending wallet then fund the loan, though in most cases they can’t see the details of the loan itself. Lenders then receive periodic interest payments. If and when the loan is fully paid back, the borrower receives his or her collateral back. If not, the collateral is liquidated and sold to make up for lost funds.

Interest rates are determined by the crypto lending platform, so both borrowers and lenders should research different choices before making a decision on which platform they want to use. Most crypto coins feature an interest rate between 3% and 8%, but stable coins can yield rates as high as 10% and 18%.

Borrowers should choose a platform based on more than just interest rates. The most important factor in a decision is how safe and secure the platform is. It’s also important to make sure the platform you choose supports the coins you’re dealing with. 

Crypto loans are much easier to secure than traditional loans. The amount you are allowed to receive is based on the value of the collateral you can offer. This value is called LTV, or loan to value ratio. If you can provide $50,000 worth of crypto collateral, and the loan you receive is worth $40,000, that is an 80% LTV ratio. Due to market volatility, crypto loans are typically only allowed with low LTV ratios. This depends, however, on the chosen platform.

Like borrowers, lenders should start by investigating potential platforms and choose one based on an attractive interest rate and trustworthiness. Next, they should decide which coins they want to lend. It’s important to only put coins in a lending wallet that won’t be needed in the near future. The current condition of the market and personal risk tolerance should also be considered.

What’s the incentive & risk for lenders?

The incentive for lenders is simple: profit. If you lend out your crypto, you’ll collect periodic interest payments that can be extremely lucrative depending on what the currency is and how much you’re willing to lend.

However, that isn’t to say there are no risks. Most notably, the price of leading cryptocurrencies like Bitcoin and Ethereum are extremely unstable, and by locking your coins up in a lending wallet, you limit your ability to liquidate in the event of a market crash. If you were planning to hold through market plummets, though, this might not be a deterrent anyway.

Most crypto lending platforms use stringent risk control protocols to protect the integrity of loans. The often-steep requirements for collateral—sometimes 200% of the loan itself or more—insure lenders for the most part. After all, the platforms have incentives to protect the loans. They themselves are businesses who want to attract more users. Loans can be automatically liquidated if prices fall below a given threshold. Platforms can also issue margin calls which require borrowers to pay up immediately if needed.

Despite these protections, crypto loans are still arguably less secure than traditional ones. This is due to the fact that the industry isn’t regulated to the same degree that banks and brokerages offering traditional loans are. Protections like FDIC bank insurance and SIPC brokerage insurance aren’t available in the crypto industry.

What’s the incentive & risk for borrowers?

Would-be crypto borrowers are attracted to crypto loans because they offer the potential for liquidity without selling an asset that they may believe will appreciate in value. If you own 5 Bitcoins and the price is on the rise, selling for liquidity means missing out on potentially massive gains. Taking out a crypto loan means you can take advantage of the current unrealized liquidity of your asset while letting it continue to appreciate in value. If you have an unexpected expense or need cash for a business or personal venture, you’re covered.

Like lending crypto, borrowing has its fair share of risks. Crypto markets are always at risk of a crash in value, and a crash while your crypto is being used as collateral is far more disastrous than when you’re simply holding it. A crash could lead to a margin call, which could make you default on your loan and lose your asset entirely.

There’s also a risk in not being able to pay back the loan, which would also lead to you losing your collateral asset. This could be particularly painful if you were right about it appreciating in value. Imagine posting $10,000 worth of Ether as collateral only to watch its value skyrocket to $100,000, but you default on your loan and lose it all.

NFTs as collateral?

NFTs are newer to the crypto space than cryptocurrency itself, but their coexistence on the blockchain means they can be used for collateral too. While it isn’t as common, there are plenty of instances of borrowers and lenders doing exactly this. Things get a little more complicated when using NFTs, however, because their value isn’t quite so cut and dry. At any given moment, one Ether coin has an exact corresponding value in US Dollars. An NFT is worth whatever someone is willing to pay for it. Therefore, lenders must agree to the NFT in question based on recent sales of similar NFTs.

On most platforms, borrowers link their crypto wallets which contain their NFTs. The platform automatically displays these NFTs and asks the borrower which ones they intend to use as collateral. Then they can enter their desired loan amount, duration, etc. Lenders must then accept or decline the borrower’s terms.

Though arguably riskier than a loan using cryptocurrency as collateral, these types of deals are becoming increasingly common, especially as NFTs grow in popularity. 2021 saw $44 billion in sales, and lenders are warming up to their staying power.

March 1st, 2022 saw the largest NFT-backed loan to date. An anonymous borrower successfully took out an $8 million loan using 101 Cryptopunks as collateral. The lender was likely convinced by the fame and popularity of these NFTs. Only 10,000 total Cryptopunks exist, and they were all randomly generated in 2017 and initially given to anyone with a crypto wallet for free. However, they’ve sold for insane amounts since then. In early 2022, one was sold for $24 million worth of Ether.

A couple months before this loan, an NFT collector called Silver Surfer got a $1.25 million loan against 10 of his personal NFTs. It’s likely we’ll see more and more of these loans being taken out as the popularity of NFTs continues to spread. This is good news for NFT buyers and collectors. Not only do they gain legitimacy as long-term financial investments, they give collectors the opportunity to access liquidity that previously wasn’t available to them.

-

Explore more DeFi related topics in these articles from enter.blog:

What is DeFi? - How do you differentiate decentralized finance from traditional, and what are the advantages? 

Centralized vs. Decentralized - Have a closer look at the pros and cons of the decentralized vs. centralized worlds. 

What is blockchain? - Bring it back to basics with this educational piece about blockchain as a whole. 

$NFTART - Staking & Farming - Explore staking and farming with $NFTART.

Introducing enter.market - Learn more about our upcoming marketplace enter.market and what solutions that are in the works.