What is Crypto Lending?
- Real Vision
- August 18, 2022
- 6:16 PM
Crypto lending is the process of lending out crypto assets to a borrower for a certain period of time. A borrower pays a fee for the loan and the lender earns interest. Crypto lending is available on DeFi lending and borrowing protocols and centralized cryptocurrency exchanges.
Lending platforms pay the lenders interest payments in crypto. They pay out these payments daily, weekly, or monthly. The interest rates and thus the yields will vary from platform to platform.
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How does crypto lending work?
In crypto lending, there is a lender, a borrower, the platform that connects the two, and the exchanged crypto asset. The lender deposits crypto, which the platform lends to borrowers. In collateralized lending, to access a loan, borrowers put up other crypto assets as collateral. These digital assets remain locked and inaccessible during the loan period. The collateral acts as a security deposit in case the borrower fails to repay the loan. If this happens, the platform liquidates the collateral and repays it to the lender.
Where to lend
You can lend cryptocurrencies directly either through centralized exchanges or through decentralized protocols. The underlying infrastructure of the platform determines if the crypto-lending platform is decentralized or centralized.
Lending on centralized platforms
Centralized platforms operate like traditional financial institutions. They are regulated and observe know-your-customer (KYC) and anti-money laundering (AML) regulations. These platforms have custody over the crypto assets deposited by their users, meaning they’re also responsible for the safety of these assets. They use cold storage solutions to secure their users’ assets and some may even provide insurance on deposits.
Although centralized lending involves an intermediary that facilitates the process, crypto transactions occur on the blockchain. Centralized players are usually categorized under centralized finance (CeFi) or centralized decentralized finance (CeDeFi). However, both terms can be seen to have the same meaning. These players incorporate the regulatory aspect that is lacking in DeFi platforms. While they are not fully regulated, they are either registered or licensed. Be aware of the fact that there are differences between these categories. Examples of centralized crypto-lending platforms are Nexo, Binance, BlockFi, and CoinLoan.
Crypto lending on centralized platforms requires users to deposit assets into their accounts on the centralized platform. The platform then uses these deposits to offer borrowers collateralized loans. Borrowers cannot access their collateral throughout the loan duration. This protects the lender from incurring a loss if the borrower declines to repay the loan.
Crypto-lending platforms use a loan-to-value (LTV) ratio to establish how much collateral is required based on the loan given. Lenders receive interest payments in crypto daily, weekly, or monthly. Earnings depend on the platform’s annual percentage yield (APY). Some centralized platforms take a portion of the users’ funds and deposit them in DeFi lending protocols to earn interest.
Lending on decentralized platforms
Smart contracts facilitate crypto lending on decentralized platforms replacing intermediaries. That means the entire lending process takes place on the blockchain. DeFi lending protocols are non-custodial and do not adhere to AML and KYC laws.
Users of DeFi lending protocols deposit their crypto assets into a lending pool through a smart contract. Anyone can borrow against these funds by getting a loan. At the same time, a borrower has to provide collateral to receive loans from a smart contract. The collateral needs to be worth more than the loan itself to provide overcollateralization. This ensures that there is a puffer, helping the borrower avoid margin calls and get liquidated.
On the lending protocol called Aave, for example, the amount that someone can borrow depends on the liquidity in the pool and the value of their deposits. Moreover, borrowers repay loans in the same asset they borrowed. For instance, if you borrowed 1 ETH, you’ll pay back 1 ETH + accrued interest. This happens automatically as this amount is deducted from the collateral you provided. Lenders on the other hand earn yield and receive it at the frequency the protocol has specified. The interest is calculated using the protocol’s APY. If you deposit 1 ETH on Aave, you’ll receive 1 aETH token, which will increase as you get interest payments. Aave and Compound are popular DeFi lending and borrowing protocols.
Some decentralized-lending platforms also offer collateral-free loans known as flash loans. These loans are repaid within a single block. Hence, if the borrower fails to repay the loan plus interest, the blockchain network does not carry through with the transaction before nodes confirm and add it to the block. Flash loans can be used in arbitrage trading or refinancing and restructuring a portfolio.
The pros and cons of crypto lending
Pros:
- Attractive rates — Crypto lending offers better rates than the traditional financial system, particularly with stablecoins. For example, Nexo still provides lending interest rates as high as 10%.
- Passive income — Crypto lending allows investors to put their idle crypto assets to work, earning them a passive income.
- Overcollateralization — DeFi lending protocols protect lenders by requiring borrowers to overcollateralize their loans. If borrowers default on their loans, the protocol can liquidate their collateral and pay it back to the lenders. Centralized crypto-lending platforms may not necessarily provide this protection to lenders.
- Credit history isn’t required — Unlike traditional financial institutions, decentralized crypto-lending platforms don’t need your credit history to determine your eligibility for a loan.
- Fast loans — DeFi lending platforms transfer loans when transactions receive enough confirmations on the blockchains. This means there is an almost instant settlement. In traditional financial systems, however, customers may wait for days or longer to get their loan applications approved and dispensed. On the contrary, the speed at which you’ll receive a loan on a centralized crypto-lending exchange depends on your KYC/AML checks and how fast centralized financial institutions like banks can process fiat transfers.
Cons:
- Counterparty risk — Centralized crypto-lending comes with counterparty risks like a lack of transparency into how depositors’ funds are allocated. Also, the custodial nature of centralized crypto-lending platforms may prevent users from withdrawing their funds, especially during a liquidity crisis. Celsius, BlockFi, CoinFLEX, and other crypto-lending platforms have faced liquidity issues.
- Risk of losing assets — You could lose your crypto assets if you’re lending on a centralized platform that hasn’t insured funds in interest accounts. If the platform fails, you could lose all your digital assets.
- Interest rate volatility — Decentralized lending protocols may experience interest rate volatility when a lot of capital moves in or out of the lending pool.
- Smart contract risk — Smart contracts used in DeFi lending may have bugs that hackers can exploit to steal funds.
- Not all digital assets are eligible — Crypto-lending platforms usually support only a few crypto assets.
How to earn money with crypto lending?
Here is a step-by-step guide on how to earn money with crypto lending on a centralized platform like Binance:
First, you have to deposit money or crypto on Binance by funding your wallet:
- Step 1: Open the Binance exchange on your browser. Log into your account. If you don’t have one, register and verify your information.
- Step 2: Deposit the crypto asset you want to lend by clicking the “Wallet” tab.
- Step 3: Next, select “Funding Wallet.”
- Step 4: Search for your preferred coin in the search bar, then click “Deposit.”
- Step 5: Copy the deposit address. You can choose to receive your assets in the Binance spot or funding wallets. Pay attention to the minimum deposit amount and number of confirmations needed before your coins arrive in your wallet. Also, check the minimum amount required to lend by going to the tab labeled “Earn” and then clicking on “Savings.” This will help you know how much to deposit.
- Step 6: Paste the address in your external wallet and confirm the transaction to transfer crypto to your Binance wallet.
How to Lend Your Coins
Now that you have funded your Binance wallet with coins, you can go ahead and lend them out.
- Step 1: Click the “Earn” tab and select “Savings.”
- Step 2: You can lend through flexible or locked savings. Choose flexible savings if you want the freedom to always be able to redeem your principal, i.e., the initial amount you have lent out.
- Step 3: Assuming you’ve picked flexible savings, search for a coin, then hit “Subscribe.”
- Step 4: Enter the subscription amount. The estimated interest will appear on the right side of the box.
- Step 5: Check the box to agree to the Binance Savings Service Agreement and hit “Confirm.” You’ll start earning interest the next day.
- Step 6: If you select the locked savings option, your coins will be locked for a specified period. So, choose the coin you want to lend and click “Subscribe.”
- Step 7: Pick out a lock-up period and enter the amount. Binance will display the expected interest in the summary section.
- Step 8: Click “Confirm” and wait for your first interest payment.
If you want to use a decentralized lending protocol like Aave instead, follow this guide here.
Crypto lending is an opportunity to earn money on your crypto holdings. However, there’s a financial risk involved that demands caution from investors. Hence it’s important to conduct thorough research before lending crypto assets on any platform.