A Short Introduction to Crypto Borrowing
Out of all the sectors, the traditional financial market is one that is being challenged the most by cryptocurrencies, particularly the lending and borrowing market.
With competitive interest rates for lenders, and an easier and freer process for borrowers, crypto lending and borrowing is definitely worth taking a look at.
How Does Crypto Borrowing and Lending Work?
The way cryptocurrency lending platforms work will differ between different platforms, however the basic principles are essentially the same as peer-to-peer lending. Lenders deposit cryptocurrency which is used to fund loans. Lenders often use their cryptocurrency as collateral while taking out a loan in fiat or a “ stablecoin ”.
Some platforms act as a marketplace where lenders can list their offers and borrowers can take out loans directly.
Other platforms are more centralised, screen borrowers themselves, and share the profits with lenders. This is similar to how banks offer loans and give interest rates on savings accounts.
The biggest and most important difference between traditional and crypto lending is that borrowers can use cryptocurrency as collateral, typically with a 50% LTV ratio.
The option allows borrowers to keep an immediate financial need separate from long-term crypto investment as well as evade a taxable sale of their crypto funds.
For lenders, this arrangement means there’s plenty of collateral which significantly reduces their risk. Due to the nature of cryptocurrency, the collateral can be quickly and easily liquidated if required. Furthermore, it can be sold off incrementally, as needed, at fair market rates.
With borrowers essentially using one form of money as collateral for a smaller loan, there is almost zero risk of borrowers defaulting.
For lending platforms this means there’s much less costs involved. As Zipmex explains, bitcoin transactions are fully traceable, so there’s no real need for credit and background checks on borrowers. With crypto as collateral, debt collectors will hardly ever be required, and payment plans are less important. With less for lenders to do, costs are reduced. In fact, some crypto lending platforms have begun automating the entire process.
With less risk for borrowers, it might seem like that would result in better rates for borrowers. However, crypto borrowers pay for the lessened risk, and instead, crypto lenders are reaping the gains of this new industry.
As with all things, there are pros and cons to cryptocurrency lending and borrowing and these will differ depending on what end of the deal you find yourself.
The Pros and Cons for Lenders
The pros for lenders of cryptocurrency based loans definitely make it an attractive investment.
- High returns: Most obviously, lending crypto is a way to earn interest on your assets. Typically this interest earned is going to be significantly more than traditional interest rates, especially in a world affected by a global pandemic.
- Minimal risk: As discussed earlier, the unique features of cryptocurrency lending means there's minimal risk involved for lenders, largely due to having crypto as collateral.
The cons for lenders mainly revolve around the lending platforms themselves.
- Lack of regulation: In this relatively new market, there’s a significant lack of regulation. This lock of regulation leaves lenders open to some risk. If something goes wrong, or the platform in question is a scam operation, you may never see the funds you send again.
- Custody issues: Additionally, having custodial ownership of your crypto keys is crucial. As with some crypto exchanges, lending platforms will require lenders to deposit funds and entrust the platform with their assets. Again, if something goes wrong, recovering your funds may be difficult.
The Pros and Cons for Borrowers
The pros for borrowers also make this an attractive option.
- Crypto as Collateral: The ability to use cryptocurrency as collateral is something most traditional institutions don’t allow. This means borrowers don’t have to liquidate their long term investments in order to meet short term financial needs.
- Fast approval and access: Crypto loans are typically approved with little conditions. These platforms approach loans with a mostly “no questions asked” mentality. Rather than credit checks, lending platforms take your collateral as proof of “creditworthiness”. This makes it easy for borrowers to get the cash they need. And when borrowers need access to the funds, loans are often approved much faster than traditional services.
The cons for borrowers are similar to that of lenders, in that the industry is still largely in its infancy.
- Lack of regulation: The lack of regulations means the risk of scams and unrecoverable funds do exist.
- Poor rates: The rates are very poor for borrowers, especially when there’s such little risk to lenders.
- Volatility: The volatile nature of cryptocurrency means there’s a risk your collateral can lose its value which will require a top up. Your collateral could also be liquidated.
Cryptocurrency borrowing and lending, while in its infancy, poses a somewhat legitimate alternative to more traditional methods of borrowing. The pros and cons will affect individuals differently and so individual circumstances should be taken into account.