Illustration by Angela Zillich.
Crypto lending is a growing trend within blockchain, specifically decentralized finance (DeFi). With crypto lending, investors can lend out their cryptocurrency holdings to borrowers. In return, the lender earn interest payment. So, instead of just passively hodling crypto, you could earn by activating your capital through crypto lending. Often, the act of lending out crypto to borrowers can earn you much greater yields than staking your holdings. Crypto lending is one of many processes where you can earn crypto and effectively money through blockchain protocols, exchanges, and specialized crypto lending platforms. The latter is what I will write about in this article, trying to answer the question of "what is a crypto lending platform?"
With the collapse of FTX and other actors like 3AC and Celsius, I wanted to better understand what a crypto lending platform does, what better way to learn than by writing about it? And, of course, sharing it with readers of this crypto blog. So, here we go!
As I wrote in the intro, crypto lending is a form of decentralized finance that allows investors to lend out their crypto holding to borrowers in exchange for interest payments. Most platforms that provide lending and borrowing offer it on major crypto, ALT coins, and stablecoins.
With the rise of DeFi in the last years, crypto lending has emerged as a lucrative investment opportunity for regular holders. As we all know, blockchain and crypto is still in its infancy, with only 3-4% of the world's population having ever invested in these digital assets. Due to its short life span, there are not many ways to earn outside of trading crypto, or by buying, holding, and later selling with a potential profit. Due to the limited availability of blockchain products that produce yield, crypto lending has gotten a strong footing and is becoming increasingly more popular.
For example, if you hold one Bitcoin and want to generate a steady passive income through that Bitcoin you own. You can deposit the Bitcoin to the crypto lending platform. Then, depending on the platform, you can earn different levels of interest on that Bitcoin by lending it out. The payment interval may vary, but usually, the interest is paid out on a weekly basis. The interest rates can span from 3% to as high as 20%+. When choosing a crypto trading platform you should get blinded by high rates, it's equally important to consider security and how legitimate the platform is. As is evident by happenings during 2022 when many crypto lending platforms went bankrupt, not all actors in the field are equal. In this article I won't write about the best crypto lending platform, I will save that for later, and a separate article that would tackle that question.
More often than not, borrower are also required to stake their crypto as collateral for the loan, as a way of guaranteeing repayment of the loan. In the case of a default payment, that is the borrower failing to pay back the loan. The investor then have the option to sell the borrowers staked assets to recover the losses they endured by lending that resulted in defaults. Often, the minimum requirement for staking as collateral is up to 50% or higher of the total loan amount. This serves as an effective safeguard for the lender in case the borrower defaults on the repayments.
Crypto lending involves three parties: lenders, a crypto lending lending platform to facilitate, and borrowers. Lenders may be individuals or businesses who hold onto cryptocurrencies and want to generate additional income by lending them out. The crypto lending platform acts as an intermediary, connecting lenders with borrowers and facilitating the lending transaction, along with infrastructure and security. Borrowers are typically businesses or individuals who need access to funds and are willing to pay interest in exchange for the use of the lender's cryptocurrencies. This is one form of leverage that a crypto trader can use to increase the potential returns of their capital.
The process of crypto lending typically follows these steps:
There are inherent risk with both lending and borrowing crypto, I'll outline that below in the next section. The process described above about crypto lending is a generic description. Each crypto lending platform can have different procedures where the steps vary, same as their interest rates and requirements. In a later article about how to choose a crypto lending platform I will outline in greater details the different processes and requirements for the best crypto lending platforms out there.
On a crypto lending platform, there are two main participants:
Then there's the service provider which facilitates the platform where the borrowing and lending takes place. Different tyopes of crypto lending can be availble on different platforms.
Loans that are collateralized, or secured, by deposited cryptocurrency are the most common types of crypto lending. Such loans generally require the borrower to deposit more cryptocurrency than the loan amount, a practice known as overcollateralization. This means that the borrower can typically only borrow up to a certain percentage of the value of the deposited cryptocurrency, usually less than 90%. The interest rate for these loans are generally lower.
Loans that are not collateralized, or secured, by an asset are known as uncollateralized loans. They operate in a similar way to personal loans, requiring the borrower to fill out an application, provide identity verification, and undergo a creditworthiness review in order to be approved. Because there is no collateral that can be sold to cover the lender's losses in the event of a default, these loans carry a higher risk for lenders.
Cryptocurrency line of credit is a type of collateralized loan that allows users to borrow up to a certain percentage of their deposited collateral. You receive of a pool of credit which you can tap into when you need. Unlike traditional loans with fixed repayment terms, these lines of credit have no predetermined repayment schedule. Interest is only charged on the funds that are actually withdrawn from the pool, rather than on the full amount of the loan.
Flash loans, which are typically offered on cryptocurrency exchanges, are short-term loans that are borrowed and repaid in a single transaction. These loans are considered to be very risky, as they are usually used for taking advantage of market arbitrage opportunities. For example, a trader might use a flash loan to buy cryptocurrency at a low price in one market and sell it immediately at a higher price in another market, all within the same transaction.
To get a cryptocurrency loan, users can either sign up with a centralized platform like Binance or connect their digital wallet to a decentralized lending platform like Compound. After choosing the collateral to be deposited and the type and amount of the loan they wish to borrow, users will need to deposit the collateral on the platform. The funds will then be transferred to the user's account or digital wallet. The amount that a user can borrow will depend on the type and value of the collateral they have deposited.
In this example I will use Binance as it's an overall great platform for all crypto needs. To open an account with Binance and start lending or borrowing cryptocurrency, follow these steps:
You will need to have funds or cryptocurrency available in your Binance account in order to lend or borrow on the platform. To deposit money or cryptocurrency into your Binance account, follow these steps:
By lending your cryptocurrency through this service on Binance per the scenario above in step 3, you can earn interest. Your crypto will then be lent to margin traders, who will use it as collateral for their trades. You will earn interest on your cryptocurrency as long as it is lent out, and the interest will be credited to your account when the lending period ends.
For lending, Binance generally offers a variable interest rate that is based on the market demand for the lent cryptocurrency. The interest rate is displayed on the lending page and is updated in real-time. You can choose to lend your cryptocurrency at the market interest rate or set a custom interest rate, although this may result in your cryptocurrency not being lent out if the rate is not competitive compared to the other offers on the market.
Binance charges a 15% fee on the interest earned from lending. This fee is deducted from the total interest earned at the end of the lending period.
Both interest and fees differ depending on which crypto trading platform you use.
There are several risks involved with crypto lending. In short, yes it is safe to both lend and borrow, both on the side of the lender and the borrower. However, you need to do due diligence on safe crypto lending platforms. There are many options available when it comes to borrowing crypto and lending crypto, do some research and make sure you not only get the good interest rates, but also the best security.
One of the main risks associated with crypto lending is the volatility of cryptocurrency prices. Cryptocurrencies can fluctuate significantly in value, which can lead to a lower return on investment for lenders. For example, if you lend 1 Bitcoin (BTC) when it is worth $60,000 and the loan is not paid back until the price of BTC has dropped to $42,000, the value of what you gave out has declined.
To manage this risk, it is important to be aware of the potential for price fluctuations in the cryptocurrency market and to make informed investment decisions. Keeping track of financial news and developments that may impact the value of cryptocurrencies can also help you make more informed investment decisions.
In most developed countries, bank deposits are insured by government-backed insurance that guarantees compensation to depositors if the bank becomes bankrupt. This means that when a lender deposits money with a bank for loan purposes, the risk of losing all the money is low.
In contrast, crypto deposits are not insured by any federal deposit insurance, and you may lose all of your money if the platform provider goes bankrupt. Centralized crypto lending platforms like Binance typically pose lower risks than decentralized lending platforms like Compound. In the later, in the case of insolvency, the crypto assets of lenders and borrowers become part of the insolvency case, which would be reflected in legal proceedings. A centralized crypto lending platform on the other hand, is easier to hold accountable and salvage since it is a traditional legal entity.
Although centralized platforms are less risky, there are fresh examples of insolvent platforms.
Counterparty risk refers to the potential for external parties, such as hedge funds, cryptocurrency exchanges, and institutional investors, to default on loans from centralized (CeFi) crypto lending platforms. This can expose both the lending platform and the lenders to default risks. Centralized platforms may reduce this risk by over-collateralizing the assets they lend out, but these transactions may not always be transparent and may not always involve sufficient collateral. Decentralized finance (DeFi) lenders do not lend assets to third parties and are therefore not exposed to counterparty risks. To manage this risk, it is advisable to invest in DeFi platforms with high liquidity and a large, diverse community, and to research the liquidity and insolvency track records of any lender before investing.
Counterparty risks played a part in the bankruptcy of several crypto lending platforms and lending protocols in 2022.
Cryptocurrency lending platforms, both centralized and decentralized, are vulnerable to cyberattacks and security breaches. With lending protocols such as Compound, the custody, and security risks are the responsibility of the user. These platforms do not hold assets or provide insurance, so users must manage their own cryptocurrencies in a wallet connected to the platform. If proper security protocols are not followed, the assets could be stolen or the user could be locked out by losing access to their crypto wallet.
Centralized crypto lending platforms generally do not store all invested funds on their own platform, and instead lend a significant portion out to borrowers and third parties. Some larger platforms may work with professional digital assets custody providers to store cryptocurrencies off-platform in cold storage, but even these providers are not immune to security breaches. This means that there are always security risks. Most centralized platforms have insurance policies in place to cover some of these risks, such as theft, but these policies typically only cover a small portion of assets and do not address insolvency or counterparty risks that I outlined above.
Flash loans are a type of short-term, unsecured loan available in decentralized finance. Flashloans do not require collateral and are typically disbursed and expected to be repaid quickly. Typically, there are no limits on how much can be borrowed and no credit score checks or other screenings are required. However, the ease of access to flash loans makes them a target for attackers who can use them to manipulate markets or exploit vulnerable DeFi protocols for financial gain. An example of this is the attack against Alpha Homora that took place in February 2021. The Alpha Homora protocol suffered a hack resulting in a loss of $37 million. The hack was intricate, involving multiple steps, and involved heavily manipulating HomoraBank v2's sUSD pool.
Crypto lending platforms allow you to either borrow capital or earn interest on your idle digital assets by lending it. Most platforms use a peer-to-peer lending model, which means that you can borrow or lend directly with other users without going through a traditional bank or financial institution. If you're ready to start earning a return on your cryptocurrency investments, you can quickly get started with a crypto lender such as Binance.