Last updated on May 29th, 2023 at 11:16 am
Crypto lending is an element of the crypto ecosystem that allows individuals to borrow and lend cryptocurrencies. Crypto enthusiasts can borrow and lend cryptocurrency for various purposes and incentives, much like in the traditional finance space.
Let’s assume a crypto trader wants to make a trade but does not have the appropriate token, they can borrow from a crypto lending platform, deposit collateral instantly, and then pay interest and principal at the end of the loan term. Traders obtain crypto loans for a variety of reasons.
This article analyzes different aspects of crypto lending, and what lenders stand to gain from offering their idle funds to borrowers.
What is Crypto Lending?
Crypto lending is a service that connects cryptocurrency lenders and borrowers. Crypto enthusiasts may have idle funds in their wallets that they are not trading or staking and decide to offer them as liquidity to a crypto lending platform. In return, the crypto lending platform pays them the interest earned from lending funds to borrowers.
Every crypto lending service operates under different parameters.
A crypto lending service may take the form of a Decentralized Finance lending platform, which requires borrowers to always ensure that their collateral amount is above a particular threshold to avoid liquidation. If borrowers want to access their collateral, they must pay both the loan and the interest. The over-collateralization model is prevalent in DeFi lending services.
Unlike the loans mentioned above, certain loans do not require collateral and are referred to as flash loans. Flash loans guarantee payment on the same transaction. If a user is unable to pay in the same transaction, their loan transaction is reversed.
What Are The Types of Crypto Lending Platforms?
Crypto enthusiasts who are well-versed in the space are likely to come across the numerous crypto lending options available in the blockchain ecosystem. Some of which include:
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Collateralized loans
A collateralized loan is a type of cryptocurrency loan in which borrowers must deposit collateral before they can access the loan. Typically, the borrower is expected to monitor the collateral amount to ensure that it does not fall below a specified level to avoid liquidation.
Borrowers are given more time to utilize their funds as they see fit and are required to repay both the capital and the interest before they can access their collateral.
Typically, lenders deposit their idle funds into the liquidity pool, making them available to borrowers. Lenders are compensated with interest for their efforts. MakerDAO is an example of a collateralized loan platform.
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Flash Loans
Flash loans are the polar opposite of collateralized loans in that they are unsecured, instant, and must be repaid in the same transaction. If this does not occur, the lending transaction is instantly reversed. Because the loan is unsecured, the borrower is not required to deposit any collateral and must repay the loan immediately. Everything is done in the context of a transaction.
Traders may opt for a flash loan to capitalize on arbitrage opportunities and pay back the loan instantly. Some traders use this form of borrowing to speculate on the potential value of a token without committing capital.
The origins of flash loans can be traced to Marble, an open-source bank that invented the feature in 2018.
Aave created its version on the Ethereum blockchain and took it mainstream, becoming a household lending option for crypto enthusiasts.
Though flash loans offer some advantages, they also have some downsides. History is replete with cases of flash loan protocols being attacked and losing millions of dollars. An example is the 2020 attack on Harvest Finance which resulted in a $34 million loss.
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Centralized Lending Platforms
Some crypto platforms offer centralized lending features to their users, and an example is BlockFi.
In general, centralized lending systems have stricter regulations than their decentralized counterparts. This is related to government regulations that compel these centralized platforms to incorporate processes such as the Know Your Customer (KYC) system, Anti-Money Laundering features, etc.
Before anyone can borrow or lend on this type of lending platform, they must sign up and undergo the KYC process, which involves uploading their details and identification documents.
This is designed to reduce the cases of clients utilizing the features for fraud or other criminal activities.
With the large amount of funds that these platforms hold, advanced security protocols are usually incorporated to safeguard them, such as storing a major portion of the crypto assets in cold storage that is inaccessible to hackers or insuring the funds.
CeFi lending platforms are appealing to traditional users since they have access to a regulated environment and a customer service team to whom they can air their grievances when they experience difficulties.
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Decentralized lending platforms
Decentralized finance lending platforms, as the name implies, are decentralized, which means that the ecosystem’s operations are managed by smart contracts.A good example is Aave.
DeFi lending protocols lack the common elements seen in CeFi lending protocols. Users, for example, are not required to go through a KYC process before they can utilize the features.
They operate in a trustless manner, without the need for a centralized authority. Smart contracts are typically in charge of the operation. It operates in a censorship-free environment, which means that no one is given preferential treatment over another.
Lenders can make huge returns by seamlessly injecting their idle tokens into liquidity pools.
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Permissionless lending
It is governed by smart contracts, which allow anyone with a cryptocurrency wallet to obtain loans or inject liquidity into pools to earn profits. Users do not need to seek permission or go through the KYC procedure to do this.
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Non-custodial
Defi lending platforms allow users to control their assets, instead of keeping them with a custodial authority. They can decide when to remove their liquidity from the pool or inject more.
What Are The Benefits and Disadvantages of Crypto Lending?
Crypto lending has both advantages and disadvantages. It also has inherent risks that should be considered before participating.
Benefits of crypto lending
- Loans are fully automated. Many crypto lending platforms automate the entire lending and borrowing process, making it more efficient.
- Users can easily access capital. Users can easily obtain loans as long as they can provide collateral. The KYC process is not required in DeFi lending platforms. All the user requires is a cryptocurrency wallet and collateral. A flash loan does not require collateral, but the funds must be repaid in the same transaction.
- It provides lenders with access to a passive income stream. Crypto lending platforms offer returns to lenders that offer their idle funds for the process.
Drawbacks
Crypto lending platforms pose some drawbacks for both borrowers and lenders.
- There is the risk that the smart contract may be attacked and the lender may lose their tokens to hackers. Hackers hunt for vulnerabilities in the code and exploit them to their advantage.
- Borrowers are exposed liquidation risks, meaning that if the size of their collateral falls below a certain level, it can be liquidated. This is a significant risk given the level of volatility in the crypto space.
In Conclusion,
- Crypto Lending services act as a bridge between lenders and borrowers of crypto.
- Lenders are rewarded with interest for offering their idle tokens to crypto lending platforms.
- Borrowers are expected to deposit collateral before they can obtain loans in a collateralized lending ecosystem.
- In a flash loan, borrowers do not need collateral, but they must repay the loan in the same transaction.
- Before opting for a crypto loan, it is imperative to conduct due diligence.
- Before utilizing a crypto lending platform, it is advisable to read and understand its terms and conditions.
- It is also a good idea to study reviews on the protocol and how existing users feel about it.
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