How Does Crypto Lending Work? Full Updated Guide

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How Does Crypto Lending Work? Full Updated Guide

Since its inception, the crypto market has been growing in leaps and bounds. With hundreds of features, thousands of tokens, millions of investors, and billions of dollars, it is clear that the problems of decentralization, anonymity and cross-border payment it solves are seen as valuable. These questions have quickly arised: what is crypto lending, and how does crypto lending work? Let’s discuss.

What is Crypto Lending and how does it work?

Crypto lending is one of the many features of the DeFi, and it stands as a worthy rival to traditional lending means. Instead of the known way of making profits from cryptocurrency by leaving your tokens in your wallet till the price appreciates, you can lend your tokens to earn dividends through a process known as crypto lending.

Crypto lending is one of the two arms of crypto financing. The other is crypto borrowing. Like traditional banks that allow you to put your assets as collateral to get a loan, crypto borrowing will enable you to put your tokens as collateral to get loans in fiat or crypto. Still, unlike the traditional methods, you don’t need any documentation or processing fees. Doesn’t that sound amazing? That way, you do not lose out when your tokens increase.

From the lenders’ perspective, crypto financing helps earn interest by giving you the platform to lend to institutional borrowers. The appeal of 7% -17% made by crypto lending is much more than traditional banks’ meager percentage (0.5-3%).

We can guess the question on your mind is ‘How are they able to maintain such interests?‘ Very simple. These institutional borrowers use your tokens to get more leverage on their trades. They can use it to earn more while predicting if the price will go up or down. The process explained above is known as CRYPTO LENDING. Having seen what crypto lending is and how crypto lending works, let’s talk a bit about the advantages and disadvantages that come with crypto lending.

Pros of Crypto Lending

We’ve exampled how does crypto lending work – now let’s look at the pros and potential rewards in store.

Speed and Accessibility

It’s a common saying that ‘no one gets a loan urgently.’ Why? Traditional finance has very rigid rules and a lengthy process for loan collection. A credit score, proof of income, a means of identification, and bank statements are just some out of many documents you’ll be required to provide, and these do not guarantee you will get the loan amount you want.

With crypto lending, these processes are circumvented. You do not need to wait for weeks before getting your loan or even after the opportunity you needed the loan for, has passed.

There is also no geographical barrier to accessing lending, and unlike fixed repayment from banks, repayment here is flexible.

More Interest For Lenders

Crypto lending is gaining more prominence in the DeFi world, where it stemmed from, and in the traditional finance sphere. Why? Many investors are beginning to see that the loan interest it promises is much more than if you put the same amount in the bank, with a similar level of safety of funds. Why earn 1% annual interest from banks when you can earn 7% from crypto lending?

Dynamic Functionality

Although there are some limitations, you do not need to lock your funds as you would with bonds. You can get your money back after a short request. Also, the terms and duration for repayment are flexible on most platforms. All these are posed to lure investors from the stiff-necked traditional finance.

Cons of Crypto Lending

The pros are fully covered. Let’s delve into the cons and risks of: How does crypto lending work?

Unclear Government Regulations

With the prolificating impacts of cryptocurrency, most governments are drawn back on how to tax profits. Many governments – including the tech-savvy USA – do not have a vague idea of creating laws on cryptocurrency assets. Will these taxes make Traditional investing better? It is yet to be known.

Insurance and Margin Calls

None of the crypto lending platforms available is insured, and this might pose a challenge when the company fails as funds could be lost without any recourse. Most platforms give up to 50% of your portfolio value, with some others going much higher. To maintain a loan-to-value ratio, there is a threshold you would need to have. Due to the volatility of the crypto market, there is a high chance your collateral could drop below the threshold. In this case, the platform can require additional collateral to meet up to the threshold or, in extreme cases, sell some of your tokens to keep the loan-to-value ratio healthy.

Safety and Security (potential risks)

The DeFi space is largely unregulated, and there are certain risks you should be aware of in understanding how crypto lending works.

Impermanent Loss

An impermanent loss occurs in liquidity pools. It is a term used to explain the loss realized when the price of assets in a pool changes and creates an unrealized loss than if they had been left alone in a wallet. These changes occur regularly in volatile tokens and are often offset by trading fees earned by liquidity providers. The best way to avoid impermanent losses is to trade less volatile tokens.

This ad promotes cryptocurrency within the EU (by eToro Europe Ltd. and eToro UK Ltd.) & USA (by eToro USA LLC); which is highly volatile, unregulated in some EU countries and the UK., no EU consumer protection. Investments are subject to market risk, including the loss of principal.
This ad promotes cryptocurrency within the EU (by eToro Europe Ltd. and eToro UK Ltd.) & USA (by eToro USA LLC); which is highly volatile, unregulated in some EU countries and the UK., no EU consumer protection. Investments are subject to market risk, including the loss of principal.

Technological Risks

Smart contracts govern everything in the DeFi space, and crypto lending is no exception. Since smart contracts are written codes online, they may come under attacks from hackers.

Flash Loan Attack

Exclusive to decentralized finance is the flash loan. In simple words, it refers to loans executed on a smart contract with its main aim targeted at mitigating the risks with traditional finance. There is no limit to the amount that can be borrowed, and it also comes with zero collateral. Flash loans are meant to be done within seconds and are primarily used for arbitrage (leveraging on the difference in the price of tokens on two different platforms)

When scammers leverage on the flaws of DeFi by borrowing large sums and using them to manipulate protocols in their favor, it is called a ‘flash loan attack.’ Projects hit by the flash loan attack hardly ever gained the confidence and trust investors had in them.

Rug Pulls

Since it is largely unregulated, the DeFi space operates solely on trust. From buying to selling to lending to staking, trust is one defining factor in DeFi. When this trust is breached- as it often is-, it is called a rug pull.

In crypto lending, developers can create a new token, pair it with a stablecoin, set up a liquidity pool, and embark on mass publicity. When these pools have many deposits of the stablecoin, the developers exploit the backdoor they put in the smart contract to mint millions of their new tokens. This causes a shortage of stablecoin. Rebalancing the pool will mean the new token would be as good as worthless. The founders disappear into thin air with millions or more.

Surprisingly, all these risks can be avoided if investors run basic checks before putting their tokens or fiat in lending platforms. Checks such as:

  1. Running a background check on the founders online (social media accounts, past projects, etc.). A founder not seen online should be treated with caution.
  2. Watch for red flags via how much they spend on marketing if a third party has critiqued their project and the interests they promise.

Can You Borrow Against Your Crypto?

Yes, most lending platforms allow you to borrow other tokens or fiat from them, provided they are your wallet providers. With this, you both manage risks without disrupting the growth of your crypto. Most times, instead of paying fiat, lending platforms pay stablecoins In the currency of the borrower. The terms and duration of the loans depend on the providers showing a significant advantage in how crypto lending works.

Which Coins To Lend?

Having understood how crypto lending works, the next question you may want to ask is ‘what coins can you lend?’ Despite the thousands of tokens that have been launched, only a few dozen can be borrowed or lent. Stablecoins form the majority of tokens that can be loaned, but a few others like Bitcoin and Ethereum are also available on some platforms. Before choosing which coins to lend, it is vital to consider the expected market returns, your risk tolerance, and the current market conditions.

This ad promotes cryptocurrency within the EU (by eToro Europe Ltd. and eToro UK Ltd.) & USA (by eToro USA LLC); which is highly volatile, unregulated in some EU countries and the UK., no EU consumer protection. Investments are subject to market risk, including the loss of principal.
This ad promotes cryptocurrency within the EU (by eToro Europe Ltd. and eToro UK Ltd.) & USA (by eToro USA LLC); which is highly volatile, unregulated in some EU countries and the UK., no EU consumer protection. Investments are subject to market risk, including the loss of principal.

Are there a few tips to consider before venturing into crypto lending? Yes, there are.

How does Crypto Lending Work? Full Tips For Lending & Things To Consider

Security is crucial – The first thing to look out for in a cryptocurrency lending platform is not how much the yields are or how many people are getting into the hype but how secure your funds are. It is essential to check for red flags and also be sure your private keys are safe. Remember, the first rule of investment is capital preservation.

Ensure to work with trusted platforms – Check the developers and their past works before you devote your tokens. Any shady information is not to be taken with a pinch of salt. How does crypto lending work? With trust. Always remember that scammers are always looking to exploit this as quickly and as well as possible.

The grass isn’t always greener on the side with greater returns. Or is it? – In traditional finances, the higher the dividend you are expected to receive on a stock, the riskier the stock is believed to be. The cryptocurrency world is the exact opposite. Stablecoins with less volatility has more yield than crypto tokens. Different market cycles make the price of tokens fluctuate, but stablecoins stay true to their name (they remain stable)

Before choosing which lending platform you want to go with, you must consider a few things. Let’s see the best platforms for crypto lending and what makes them unique.

Best Cryptocurrency Lending Platforms

BlockFi

BlockFi is a crypto lending platform that is best suited for beginners. Deposits can be made via stablecoins, Bitcoin, or ethereum, and there’s an option for one free monthly withdrawal. More than one withdrawal will attract some minor charges. The rates are attractive ( 8% on stablecoins, 5% on Ethereum, and between 3-6% on Bitcoin). Loans can be in either cryptocurrency or USD, but you need to put up some tokens as collateral for your loan.

If this sounds interesting, we’ve written an article comparing BlockFi to Coinbase, where we cover all the major differences, such as limits, fees, account types, bonuses, features, customer service, and more.

MakerDAO

Operating on the Ethereum blockchain, Maker ranks high as a DeFi lending platform. It is also one of the few platforms that have gotten the hang of counterparty risk for both lender and borrower, and this made it have massive adoption when it newly came into the DeFi space. Maker (MKR) is the platform’s token, while DAI is its stablecoin. ETH is the widely used token collateral, and the minimum DAI you can generate is 100DAI. It is essential you know your loan’s collateralization ratio and ensure that it stays above the threshold to avoid liquidation. After you pay back your loan, you can withdraw the ETH you used as collateral.

Aave

How does crypto lending work on Aave? Quite simple. Aave is different from other lending platforms because it allows peer-to-peer lending where the lender and the borrower agree on the loan terms. Created in 2017 and running on the Ethereum network, Aave has established itself as one of the world’s most reliable and reputable crypto lending platforms.

Uniswap

There wasn’t an escape route for new tokens from huge listing fees until Uniswap came in. Operating on two smart contracts; Factory smart contract and Exchange smart contract, Uniswap has a well-designed automated platform. Similar to Aave, Uniswap’s ease and security rank them as one of the best crypto lending platforms in the world. How does crypto lending work on Uniswap? Being an automated market maker, Uniswap uses liquidity pools for pairing tokens, and liquidity providers earn interest.

The crypto lending space is still evolving, but the progress so far makes us very optimistic about what the future holds.

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