Crypto Lending: What Is It & How does It Work?

Cryptocurrencies have given birth to a whole new ecosystem of decentralized finance. Nowadays crypto trading is considered one of the best alternatives for higher returns. Moreover, cryptocurrencies also enable peer-to-peer, instant and cheaper transactions. Compared to fiat currencies and old financial models, the crypto based Defi sector is transforming our lives.

One crucial part of Defi that is rapidly gaining popularity is crypto lending. Crypto loans have come out as a boon for people who are in need of instant cash. In the Defi crypto lending model, you do not have to go through a lengthy documentation process and banking complexities for a loan. 

A Crypto loan is a win-win situation for both borrower and the lender. While the borrower enjoys the perks of instant loans by collateralizing his crypto, the lender makes a profit from higher interest rates.

Crypto lending presents itself as an attractive solution. However, many of us still don’t clearly understand the concept. 

That is why today we are here to help you understand crypto lending and its working mechanism and types.

What Is Crypto Lending?

Crypto lending is the process where you get loans on your cryptocurrencies. You can understand it as a mortgage loan where you use your crypto as collateral to get cash.

You do not have to sell your cryptocurrencies. You are just using them as collateral to get an instant loan in fiat or stablecoin. Once you repay the loan within the predetermined time as per the contract, you get your cryptocurrencies back.

The best thing with crypto loans is that you can keep your entire crypto or some specific currency in a certain amount as collateral. It majorly depends on the loan amount you need.

Advantages of Crypto Lending:

  • Easily accessible capital
  • No lengthy process
  • Fast loan processing
  • Fast loan approvals
  • Automated smart contract based process
  • Low interest rate

There are several Cefi and Defi lending and borrowing platforms where you can get crypto loans. You can even avail of crypto loan services on crypto exchanges like Binance and Coinbase. Popular examples of Defi crypto lending platforms are Aave and Abracadabra. 

You can too build your own Defi lending and borrowing platform by partnering with us. We will help you launch a robust, secure and fully functional Defi crypto lending platform for seamless crypto lending and borrowing.

Loan amount vary on different crypto lending platforms. Some allow you to borrow 50% of the value of your collateralized crypto. While other platforms may allow more or less.

Additionally, interest rates also vary on different crypto lending platforms. Another major factor in determining the APR for crypto loans is the crypto or stablecoin you are using as collateral. 

As a lender, you can earn up to 8% on major crypto lending platforms like Celcius Network and Nexo. While on Defi platforms like Compound Finance, the APR for DAI and USDC is 12% and 9% respectively.

How Does Crypto Lending Works?

Crypto loans are popular in the Defi sector due to their accessibility, lower interest rate, and fast funding. In crypto loans, no one will check your credit score or other documents. Anyone in need of a loan can borrow and anyone with enough crypto or cash can fund the loan. 

Apart from all these, it serves as a good option to earn passive income. You can lock your crypto in a pool that manages your funds while you relax and enjoy the profits.

Similar to a securities-based loan, crypto lending collateralizes digital currencies. In simple words, if you have cryptocurrencies and you need instant cash, a crypto loan is the best option.

One thing that you need to understand in crypto lending is that you do not completely lose control over your collateralized crypto. You still hold its ownership rights. It’s just that you no longer have the right to make a transaction using those cryptos.

The best advantage of crypto loans is that it’s decentralized and transparent. The entire process is automated through coded smart contracts. These are digital contracts that self-execute themselves as per the per-set terms and conditions of the agreement.

Working Mechanism Of Crypto Lending 

We have talked before that you can avail crypto lending services on both Cefi and Defi platforms

Let us now understand in detail how each one of them works.

In a crypto lending model, there are two participants: the borrower and the lender. The borrower deposits its crypto to secure his loan. He then gets a loan in return for his crypto assets. While the lender enjoys passive income on interest rates. If the borrower fails to pay back the loan with an interest rate in time, his crypto assets are liquidated. 

The working mechanism is the same for both Cefi and Defi with just minor differences.

Cefi Crypto Loans 

Centralized crypto lending platforms work similar to the traditional banking system. Major Cefi lending platforms are BlockFi, Nexo, Binance and Coinbase. These platforms implement KYC and AML verification processes in their regulatory protocols.

How does crypto lending work for borrowers on Cefi platforms?

  • As a borrower, you register on the Cefi platform and apply for a crypto loan.
  • The platform will then calculate the amount of crypto needed as collateral as per the interest rate.
  • You will then have to deposit the collateral and apply for the loan.
  • The Cefi platform will verify your collateral.
  • When the lender approves the loan, the amount is transferred to your account.

How does crypto lending work for lenders on Cefi platforms?

  • First, you will have to register on the Cefi platform.
  • Then select a specific interest rate.
  • You will then have to stake your crypto assets for a given time period.
  • In return, you will receive bonds on an annual percentage depending on the amount of crypto you have staked.
  • As the borrower pays interest, you will receive additional bonds.
  • After the predetermined time period, you will have to submit all the bonds to recover the funds.
  • Smart contract facilitates a smooth process of sending back the bonds and releasing the cryptocurrency staked.

Cefi crypto lending model includes various risks as it involves human intervention. One major drawback of Cefi crypto lending is that the custody of the collateralized, as well as staked crypto, remains with the centralized platform. Another setback with the Cefi crypto lending platform is that these platforms put depositors’ (lenders’) funds in high-risk cases without their knowledge.

In some cases when the borrower fails to repay the loan or the cryptocurrency suddenly collapses, the lending platform fails to pay back the depositors (lenders) as the borrowers failed to repay them. Thus, investors end up losing all their cryptocurrencies.

Similar situation happened when Terra LUNA collapsed. Major Cefi platforms issued loans to large VC companies or hedge funds. The borrowers had invested funds in LUNA believing its potential price surge. 

However, when the crypto crashed, borrowers lost all their sums. Then, leading Cefi lending platforms failed to pay back their depositors(lenders). 

Defi Crypto Loans

Defi P2P crypto lending model solves all the issues of the Cefi model by eliminating the role of third parties. Defi facilitates peer-to-peer direct crypto lending and borrowing between the borrower and the lender.

The entire crypto lending and borrowing take place through automated smart contracts. It makes the entire crypto lending system 100% decentralized, secure and fast.

Firstly, in Defi crypto lending, the borrower has to maintain the value of the collateral above the margin call. If not, the smart contract automatically liquidates the collateral to pay back the lender. Thus, it saves you from a credit crisis or sudden cryptocurrency market collapse.

Secondly, in the Defi P2P lending and borrowing model, the collateralized cryptocurrencies are deposited in an escrow vault. No institution or third party has custody of the borrower’s collateral or the investor’s crypto funds.

How do Defi crypto lending and borrowing work?

Lender’s Process

  • Defi lending process is completely decentralized, transparent, peer-to-peer and open-source.
  • The lender can issue loans to anyone he wishes on the platform.
  • The smart contract verifies and authorizes the borrower to initiate the lending process.
  • When the conditions are met the smart contract deploys by itself.
  • Then the transaction takes place and the data is recorded over the ecosystem.

Borrower’s Process

  • The borrower can easily apply for a loan on the platform using his crypto assets as collateral for the loan.
  • The loan is certified and issued only when both the lender and borrower agree to all terms and conditions.
  • The loan disbursement is done only when both parties consent.
  • The collateral is returned to the borrower only when he returns the loan amount with interest as per the terms of the contract.

Understanding The Types Of Crypto Loans

There are two types of crypto loans:

  • Flash Loans
  • Collateralized loans

Let us discuss each one of them in detail.

Flash Loans

If you are worried about keeping your crypto as collateral, flash loans are here for your rescue. 

Flash loans allow you to take loans without collateralizing your cryptocurrencies. These loans are issued and repaid within a single block. 

If the borrower fails to repay the loan amount with interest, the transaction is cancelled even before it can be recorded on the block. Thus, it will appear as if the transaction never happened. 

The entire process is carried out using smart contracts that include top-level transactions and sub-transactions. If the sub transactions fail, the remaining top-level transactions will not be validated. 

Let us take an example. A token is selling at $1.00 in pool A and $1.10 in pool B. You see an arbitrage opportunity but you do not have the funds to purchase the tokens. So you decide to take a flash loan. 

Now we will consider a 1000 BUSD flash loan as the top level transaction. This top-level transaction will include several sub transactions. The sub-transactions will be:

  • As a borrower, as you apply for a 1000 BUSD loan, the fund will be transferred to your account.
  • Now you will buy 1000 tokens worth $1000 from pool A.
  • Then you will sell those tokens in pool B earning $1100.
  • After selling the tokens, you will repay the loan amount along with the borrowing fee into the flash loan smart contract.

If any of the above sub transactions fails, the lender will cancel the loan. It will mean that the top level transaction of 1000 BUSD flash loan will be invalid.

Collateralized Loans

In a collateralized loan, the borrower gets a loan depending upon the quantity and value of his crypto assets. In such loans, you have a low loan-to-value (LTV) ratio. Mostly you get a 50% loan of the value of your collateral.

Due to crypto market volatility, if your loan amount falls below the value of your collateral, it will be liquidated and transferred to the lender. That is why you need to top up your collateral as per its price change to avoid liquidation.

If the LTV ratio becomes too high, you might also have to pay fines. After the complete loan repayment with interest, you will get back your collateralized crypto. 

In this model, the lenders deposit their crypto finds in a pool (smart contract). Their funds are also locked up in the smart contract for a specific time. 

The entire process is carried out through smart contracts making it transparent and secure.

Conclusion

Crypto lending is a safe and simple solution for both borrowers in need of instant cash and lenders looking to earn passive income. However, in both cases, one must be cautious and do in-depth research before indulging in it.

If you are looking to tap into the Defi world by launching your own crypto lending platform, get in touch with our experts. 

Leverage our Defi development services to build a reliable Defi P2P lending and borrowing platform embedded with high security protocols and advanced features for hassle-free crypto lending and borrowing.

Talk to our experts today.

September 1, 2022

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