In our latest article on Crypto Basics, we’ll look at crypto lending. Borrowing and lending are some of the most basic functions of finance, and as crypto becomes a more widely held asset globally, crypto lending is increasing in popularity.
Crypto lending works in several different ways. The process can seem very similar to how assets are lent out in traditional finance (TradFi), except that protocols that lend crypto nearly always require some form of over-collateralization from a borrower.
Why is Over-collateralization Necessary to Borrow Crypto?
Lenders have traditionally demanded that borrowers put up collateral such as real estate or other assets to secure a loan. This guarantees a lender can recoup the value of a loan if a borrower cannot repay what they have borrowed.
For example, a bowling alley wants to renovate, and the owners need cash to pay for equipment and construction. The business itself or the property of the bowling alley can be used as collateral to secure a loan from a bank, and if the loan is not repaid, then the bank ends up owning a bowling alley, which it can sell to regain its cash.
Some projects like MakerDAO are making forays into lending against real-world assets (RWAs), but the average user wouldn’t be able to secure one of these loans. Most people who borrow crypto from a crypto lending platform have to deposit a greater value of crypto than what they are borrowing.
If the value of the crypto assets a user borrows becomes greater than the value of the tokens they have deposited, then a lending protocol couldn’t survive. Since crypto can be such a volatile asset, over-collateralization ensures that liquidations can be executed in time, so no capital is lost to a bad loan.
Why Would Users Take on Over-collateralized Crypto Loans?
Just as there are many ways to borrow crypto, there are many reasons why borrowers take on over-collateralized loans. Usually, there is an economic advantage behind depositing one asset for the right to borrow another. These advantages include but are not limited to avoiding taxes, shorting the market, or making DeFi plays that necessitate borrowing.
Selling crypto is a taxable event, but borrowing is not, and the rates paid to borrow can also be written off in some circumstances. So, instead of selling crypto assets, many users deposit the tokens they’d like to hold for a long time to borrow stablecoins or fiat.
Using Solend on Solana or the Aave lending platform on multiple chains, users can short tokens with directional exposure to the market by borrowing them. For example, a user can borrow 1,000 $DOG tokens worth $1,000 and swap them for $1,000 in stablecoins; after a month, $DOG token drops in value by 10%, so it takes $900 to acquire 1,000 $DOG tokens and repay the loan, netting the user $100 profit.
Users might also borrow tokens to participate in decentralized finance (DeFi) to earn fees and rewards from their activities. For collateralized debt position (CDP) stablecoins like USDH and DAI, users borrowing these tokens is the primary way they enter the crypto ecosystem.
What Differentiates One Crypto Lending Protocol from Another?
Crypto can be borrowed from a vast number of lending platforms. We’ve already mentioned TradFi and DeFi in passing, but another variety of crypto lenders provide services in a sector called centralized finance, or CeFi.
CeFi Lending Protocols
Many users who have yet to dive deep into DeFi have been attracted by lending platforms that more closely resemble TradFi banks, and they can also provide credit card or bank account onramps for acquiring crypto. These lending platforms require KYC (know your customer/know your client), but the transparency required of users isn’t equally returned.
Examples of a CeFi crypto lending platform include Nexo crypto services and Celsius crypto services. The latter of these two, Celsius, has recently declared bankruptcy and may have had financial troubles for years without telling its clients.
A CeFi lender may participate in DeFi on behalf of its users, but unlike a DeFi platform such as the Solend Solana lending protocol, a CeFi lender’s activities cannot be verified on-chain. On the other hand, DeFi lending protocols operate with 100% transparent data that can be checked anytime.
DeFi Lending Protocols
One interesting facet for APY-minded individuals is that DeFi lending protocols rely on users to provide the assets for borrowing. Anyone can deposit their tokens for other users to borrow, and in return, these users act as lenders and receive income from fees as their tokens are borrowed.
DeFi lending protocols are run entirely by smart contract code. Therefore, they rely on the DeFi community to provide assets for lending as well as help liquidate bad debt when a loan’s collateral drops in value.
Usually, DeFi loans have no due dates or maturation periods. As long as the value of collateral backing a loan is above a certain threshold, the loan can remain open and can be repaid at any pace and time.
What Should Users Look for When Borrowing from Crypto Lenders
Borrowers should do their due diligence before taking on a crypto loan. Unfortunately, it can be quite difficult to fully vet a CeFi protocol for financial solubility, since they act as a black box.
Paying attention to fees for borrowing is also an important factor. CeFi lenders can adjust their rates manually, but DeFi lending protocols like Solend rely on algorithms to decide borrowing and lending rates, which will automatically change according to supply and demand.
The reasons why a user borrows crypto will also determine whether they borrow from a money market, like Aave lending platforms, or a CDP platform like Hubble Protocol or MakerDAO. In addition, the market outlook can also determine borrowing behavior, since borrowing an asset that can appreciate in value during the life of the loan can make repaying the loan more expensive.
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