What are crypto loans and how do crypto loans work?

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Bitcoin is a very volatile asset. In March 2020, Bitcoin saw its price drop below $ 4,000 due to massive sales linked to the pandemic before rising to over $ 64,000 in April 2021.

While waiting for the price of Bitcoin to climb higher, there may be times when you need funds to pay for living expenses like a leaky roof or a flat tire. Selling your Bitcoin at the wrong time can cause you to suffer huge losses or miss out on subsequent large gains.

So how do you remedy this situation? One option available is to obtain a crypto loan by lending your cryptocurrencies. In doing so, you can borrow USD (or your national fiat currency) to pay for the upfront expenses instead of selling your cryptocurrencies for a potentially low price.

Simply put, a crypto loan is a cryptocurrency backed loan that uses your crypto assets as collateral. It works the same way as bank loan backed by securities. Crypto loans can only be obtained from crypto exchanges or crypto lending platforms.

Objectives of crypto loans

There are various reasons to subscribe to a crypto loan facility, such as:

  • Personal emergencies

  • Capital for companies

  • Earn interest on your cryptocurrencies

  • Defer capital gains tax

  • Keep your cryptocurrencies for a potential future rise

Below is a simple illustration of other crypto lending use cases.

Benefits of crypto loans

Crypto loans have advantages over traditional bank loans. Unlike banks that review credit score and income statements, crypto loans ignore these traditional metrics.

Not only that, but taking out a crypto loan is also effortless. It has also become a multi-faceted strategy which helps traders gain more leverage than usual.

The diagram below will help you further illustrate its benefits.

However, note that when taking out a crypto loan, you need to keep a constant eye on your collateral ratio.

Why is this important?

The reason is that your crypto assets will be at risk of liquidation if the value of your assets falls below the required collateral ratio of the loan. If you cannot repay the loan, the collateral will either be partially or fully liquidated. In other words, your collateral can be sold to pay off the debt.

Your crypto assets held as collateral will be returned to you in full upon the full repayment of your loan plus interest.

Types of crypto loans

There are currently two main types of crypto loans available: CeFi and DeFi crypto loans. We will look at the similarities and differences between these two types of crypto loans.

Centrally Funded Crypto Loans (CeFi)

CeFi Where Centralized funding Crypto loans are loans provided by centralized entities. These centralized entities act like pawn shops where they take collateral (cryptocurrencies) and provide a loan in USD.

Centralization itself implies that there is a single point of failure. These centralized entities can fail and you can lose the cryptocurrencies that you store on these platforms as collateral.

How do CeFi loans work?

You can lend or apply for a crypto loan on platforms or centralized exchanges like Nexo, Binance or FTX. If you lend your cryptocurrencies you will earn interest on your coins, while if you borrow you will have to pay interest.

For example, on Nexo, a centralized financing platform:

  • Lenders may receive a daily payment of up to 12% Annual Percentage Rate (APR) for stablecoins such as USDT and USDC.

  • Borrowers can get a loan with an interest rate of 13.9% APR (or 6.9% APR when staking NEXO tokens)

Below are some of the assets and supported rates for lenders on Nexo.

For borrowers, you can use this calculator on Nexo to see how much you can borrow.

Decentralized finance crypto loans (DeFi)

Challenge Where Decentralized finance includes financial applications that run through a blockchain, eliminating the need for users to trust centralized entities. The main advantage of using DeFi is that users control their funds and distribute them as they see fit.

A smart contract is used to automate the execution of a contract. It comes with a programmable transaction that locks in the value of the collateral and the payment terms.

DeFi lending platforms

How do DeFi loans work?

DeFi loans allow users to lend their cryptocurrencies directly to someone else and earn interest on the loan through a loan protocol. Anyone can become a lender on a DeFi loan protocol. This process is done through loan pools that replace traditional bank credit bureaus.

Smart contracts are used to aggregate assets from lenders and distribute them to borrowers. While taking a loan from a traditional bank, collateral must be placed with a loan. For example, in a car loan, the car itself is collateral. If the user stops paying the loan, the bank will have the right to seize the vehicle.

The same goes for decentralized systems. The only difference is that the system is anonymous and does not require any physical property to be used as collateral. To get a DeFi loan, the borrower would often have to offer cryptocurrencies as collateral. The collateral that is deposited must be greater than the loan amount. In other words, the loan is oversized.

Comparison between CeFi and DeFi loans

Now let’s compare the differences between CeFi and DeFi loans:

Are crypto loans safe?

Despite the many advantages of crypto lending, crypto lending is not a risk free business. Crypto loans come with risks that you should be aware of.

Risks associated with CeFi loans

Insolvency risk – Double-digit interest rates are possible with the crypto loan. However, since there isn’t much insurance available, you risk losing all of your cryptocurrencies if the platform provider goes bankrupt. The assets would then become part of the insolvency estate and you would be considered a creditor in the insolvency proceedings. You should be aware of the financial stability of crypto lending platforms and be especially careful with less established platforms.

Counterparty risk – CeFi platforms can use your crypto deposits and lend them to crypto exchanges, hedge funds, institutional investors and over-the-counter (OTC) traders. Your lending platform provider may become insolvent if the counterparties to these transactions do not return the deposits that have been loaned.

Risks associated with DeFi loans

Smart contract bugs and hacks – Smart contracts have the advantage of being completely automated and transparent. However, poorly written code can make the smart contract vulnerable to exploits. For example, the exploit on Cream Finance caused losses of more than $ 34 million in cryptocurrency.

Risk related to administration keys – DeFi protocol developers can control administration keys. If administrative keys are not decentralized or burned, there is a risk that developers will drain the entire protocol fund.

Liquidation risks – Liquidation occurs when the cryptocurrency you have as collateral loses value and your loan falls below the collateral ratio. One example is Black Thursday, March 12, 2020, where the price of Bitcoin fell 45% in one day. This sudden drop in prices can result in your loans being liquidated because they fall below the minimum collateral ratio.

Conclusion

In a nutshell, both DeFi and CeFi play a vital role in servicing the crypto lending market today, each with their strengths and weaknesses. CeFi loans may be a simpler avenue for newcomers, but users are subject to the rates set by these platforms.

On the other hand, DeFi loans give you full control over your collateralization rate and loan management. However, the possibility of smart contract bugs and exploits could mean that attackers might be able to drain protocol funds.

As with anything crypto, consider the risks involved and always do your research before deciding to take out a crypto loan.

Stacy Kew

Stacy Kew

Stacy is a market research intern at Coingecko. She is very fond of cryptocurrency. Big on BTC, ETH, SOL, NFTs, and Japanese cuisine. Follow the author on Twitter @truffefriesx



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