At its core, an economy is simply the sum of the transactions that make it up. Credit, the term that describes the relationship between borrowing and lending, is the single most important part of an economy. Lenders typically want to make more money, and borrowers want money in order to make a transaction they otherwise could not afford.
Borrowers promise to repay the amount they borrow, called “principal” plus an additional amount called “interest”. The moment the borrower receives the money it turns into debt, which is a liability for the borrower and an asset for the lender. These ideas are as old as recorded history, with the Sumerians extending credit as early as 4,000 BC.
It is unsurprising that the emergence of cryptocurrency has heralded new approaches to borrowing and lending. Starting with BTCJam and Bitbond in 2013, cryptocurrency lending has since evolved into one of the most diverse arenas in the field of distributed ledger technology.
As we’ll see later, borrowing and lending in cryptocurrency has many significant advantages and may well be an important factor in attracting new users and driving adoption throughout the entire industry.
The purpose of this article is to provide an overview of cryptocurrency lending and provide more details about our upcoming Loans Marketplace.
In the introduction we briefly touched on the two parties that lending requires: the borrower and the lender. How these parties meet, perform the transaction and repay the debt depends on a multitude of factors.
Typically, the borrower and lender will “find each other” on a crypto lending platform. Dozens of platforms exist and each has its own little idiosyncrasies. Broadly speaking we can split them up into two categories: 1) Centralized and 2) Decentralized. Let’s look at these in more detail.
Companies like Lending Club and Prosper where the first to popularise alternative forms of fiat lending. For cryptocurrency platforms at the beginning of the 2010s, they were the role models to be emulated.
When a platform is centralized, it typically takes responsibility for onboarding users, checking their KYC, providing a custody solution and managing payments. Centralized crypto lending platforms are usually businesses; Coinloan and SALT Lending are two prominent examples.
From a customer perspective centralized lending platforms differ meaningfully from decentralized platforms. First of all, centralized platforms typically offer an on and off-ramp with at least one fiat currency. This allows users to deposit or withdraw cash in exchange for crypto.
On the flipside, the user gives up data when using such a platform. KYC information, credit card numbers, and postal addresses are just some of the data points that users have to share.
Nevertheless, this does not seem to be troubling users. Genesis Capital, one of the largest players in the space, originated $3.1B in 2019 and $1.1B in Q4 of 2019. For such a young industry these are staggering numbers.
As we’ve seen, centralized cryptocurrency lending platforms are akin to their fiat role models. Decentralized platforms on the other hand are completely different.
Platforms like dYdX use Ethereum’s smart contract functionality to automate the distribution of loans and repayments. Typically KYC information is not collected and neither is any additional data.
Borrowers simply connect their cryptocurrency wallet, define terms and wait for a lender who agrees to them. This makes decentralized platforms significantly faster and cheaper.
That being said, there is usually little-to-no customer support and new crypto community members may be overawed by the lack of handholding. As mentioned previously, these platforms do not typically provide fiat trading pairs, meaning that only digital assets are available to both borrowers and lenders.
According to the data analysis platform LoanScan, decentralized crypto lending originated just over $1.5B in loan volume, comprising more than 550,000 loans, over the last 12 months.
Whether you decide to go with a centralized or a decentralized lending platform the basic tenant stays the same: Borrowers deposit collateral in order to receive fiat or digital assets in return.
By focusing on collateral-based lending, platforms save themselves the headache of assessing the creditworthiness of borrowers and consequently risking high default rates.
Users benefit from this approach because they are free to use the money for any purpose they choose. Traditional lending platforms, dictate how the loan must be used. Crypto lending platforms do not.
On the other hand, the necessity to deposit collateral changes the nature of the loan. Crypto lending can better be understood as a short-term injection of liquidity, rather than as a business loan for example.
People who need to pay-off unexpected bills or want to make a big purchase right now, can deposit their crypto in return for cash. Once the principal plus interest is repaid, the collateral is returned to the borrower. This has proven particularly attractive to day traders.
That being said, it’s also attractive to lenders because of the typically generous loan-to-value (LTV) ratio. This ratio describes the relationship between the amount that is borrowed and the amount of collateral that is provided.
In the case of SALT Lending for example, borrowers can access between 30% and 70% of their collateral’s cash value. The higher the LTV the higher the annual interest rate, and the more expensive the loan.
To illustrate this point, we can imagine a borrower asking for $10,000 over 12 months with LTV of 70%. This would require collateral worth $14,286. The interest rate would amount to 11.95%, leading to the loan costing $11,337.
Under the same conditions but with an LTV of 30%, the borrower would need collateral worth $33,333. The interest rate would be around 5.95% and the total cost of the loan would come down to $10,737. Ergo, the more security the borrower provides the lower the interest rates and the lower the cost of the loan.
It’s worth noting that centralized platforms, like SALT Lending, typically have their own token which offers more attractive interest rates.
Any introduction to Cryptocurrency lending needs to give a brief overview of the fees and interest rates both borrowers and lenders can expect. Please note however, that these change regularly, so please check the respective website before commiting to one.
“Liquidation” is a key term in the cryptocurrency lending space. It describes the scenario in which the value of the collateral drops below a specified amount, and the platform or protocol is forced to sell it.
This process is designed to protect lenders from significant losses during times of heightened volatility. One can imagine a situation in which a lender provides $10,000 in return for the equivalent in ETH, when suddenly the value of ETH plummets. The borrower is now no longer incentivized to repay the $10,000, because the deposited amount of
ETH is now worth significantly less.
Therefore liquidations are a common practice on both centralized and decentralized crypto lending platforms, and a term which all beginners should understand.
With all this innovation in the space it’s easy to forget how young the crypto lending industry is. Previously unknown attack vectors have been used to drain platforms and protocols of their money.
Perhaps the most notable example occurred in February 2020, when an unknown attacker drained $350,000 worth of Ether from bZx. A few days later the attacker absconded with another $633,000.
The attack leveraged so called flash loans, which allow for instant borrowing and repaying with no collateral. The idea is that I lend you as much money as you want for one single transaction. At the end of the transaction you need to repay the loan in full. If you’re unable to do so, the smart contract automatically revokes your transaction.
In this case, huge amounts of ETH were borrowed and then threaded through a sequence of vulnerable protocols. This resulted in the extraction of hundreds of thousands of dollars in stolen assets, which were then used to repay the ETH loans.
The Defi flash loan attack sent shockwaves throughout the industry, but the bZx team quickly rectified the issue and these should no longer be a danger to new users. Nevertheless it’s a great example of how new technology will be abused and how cryptocurrency lending still needs to mature.
As we’ve discussed in this article, cryptocurrency lending is a very young but increasingly important area. Although key concepts are still emerging, developers have been quick to learn from their mistakes. The result is a thriving and maturing industry which is likely going to see rapid growth in the years to come.
SelfKey’s upcoming Loans Marketplace will give you a handy overview of the best rates and terms for your needs. Download the SelfKey Wallet today and be the first to try our Loans Marketplace when it launches.