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What Exactly Is Crypto Lending and How Does It Work?

Users may borrow and lend cryptocurrency for a charge or interest via crypto lending. You may acquire a loan and start investing right away by supplying some collateral. This might be accomplished via the use of a DeFi lending DApp or a cryptocurrency exchange. When the value of your collateral falls below a specific threshold, you must top it up to prevent liquidation. Your capital is unlocked when you repay your loan plus a charge.

You may also get collateral-free loans, sometimes known as flash loans, which must be repaid in the same transaction. If you are unable to do so, the financing transaction is cancelled before it can be finished. Smart contracts entirely automate the borrowing and lending procedure using cryptocurrency loans. For many, it’s a simple way to earn APY on crypto assets they own or get access to low-cost financing.

However, crypto lending, like any enterprise, smart contract, or investment on the blockchain, has financial risk. If you utilise a volatile cryptocurrency as collateral, for example, you may be liquidated overnight. Smart contracts may potentially be hacked, attacked, or abused, resulting in significant losses.

Understand that you will lose custody of your coins if you borrow or lend. This takes them out of your hands and decreases your liquidity. Take note of any loan terms and conditions to understand when you may access your cash and any fees that may apply.

Introduction

Volatile pricing and frantic marketplaces may spring to mind when considering crypto profits and losses. However, it is not the only method to profit from the blockchain. Crypto lending is a simple service that allows you to lend your money with no risk. On the other side, you may easily get borrowed digital assets at cheap interest rates. Taking out and offering loans is typically simpler, more efficient, and less expensive with crypto, making it a viable alternative for both sides in a loan.

What exactly is crypto lending?

Crypto lending works by transferring cryptocurrency from one user to another for a charge. The precise manner of handling the debt varies per platform. Crypto lending services are available on both controlled and decentralised platforms, but the fundamental concepts remain the same.

You don’t even have to be a borrower. You may make an income and earn interest by putting your cryptocurrency in a pool that manages your finances. There is typically minimal chance of losing your cash, depending on the stability of the smart contract you utilise. This might be because the borrower put up security, or because the loan is managed by a CeFi (centralised finance) platform like Binance.

How does cryptocurrency lending work?

Typically, three parties are involved in crypto lending: the lender, the borrower, and a DeFi (Decentralized Finance) platform or crypto exchange. Before borrowing any cryptocurrency, the borrower is usually required to put up some collateral. You may also employ no-collateral fast loans (more on this below). On the opposite side of the loan, you might have a smart contract that generates stablecoins or a platform that lends money to another user. Lenders deposit their crypto into a pool, which oversees the whole process and pays them a percentage of the interest.

Crypto loan types

Flash loans

Flash loans enable you to borrow money without putting up any collateral. Their name comes from the fact that the loan was provided and returned in a single block. If the loan amount plus interest cannot be refunded, the transaction is terminated before it can be confirmed in a block. This effectively indicates that the loan did not occur since it was never verified and put to the chain. A smart contract manages the whole process, eliminating the need for human intervention.

To utilise a flash loan, you must act quickly. This is where smart contracts come into play once again. You can use smart contract logic to generate a top-level transaction that contains sub-transactions. If any of the sub-transactions fail, the top-level transaction will fail.

Consider the following example. Consider a token that is worth $1.00 (USD) in liquidity pool A and $1.10 (USD) in liquidity pool B. However, you do not have enough money to buy tokens from the first pool and sell them in the second. As a result, you may attempt using a flash loan to finish this arbitrage opportunity in one block. As an example, Assume that our main transaction will get and repay a 1,000 BUSD flash loan through a DeFi platform. This may then be divided into smaller sub-transactions:

1. The amounts borrowed are transferred to your wallet.

 

2. You buy $1,000 in cryptocurrency from liquidity pool A. (1,000 tokens).

 

3. You sell 1,000 tokens for $1.10 each, for a total of $1,100.

 

4. You deposit the loan amount plus the borrowing charge into the flash loan smart contract.

 

If any of these sub-transactions fails, the lender will cancel the loan before it is completed. You may earn from flash loans using this strategy without putting yourself or your collateral at danger. Classic flash loan options include collateral swaps and price arbitrage. However, since shifting money to a different chain would violate the one transaction restriction, you can only spend your flash loan on-chain.

Collateralized loans

In exchange for providing security, a borrower receives extra time to spend their cash with a collateralized loan. MakerDAO is one example, since customers may back up their loans with a variety of coins. Because cryptocurrency is volatile, you will most likely have a low loan-to-value ratio (LTV), such as 50%.

This number indicates that your loan will be just half the value of your collateral. This disparity gives wiggle space for the collateral’s value if it falls. When the value of your collateral falls below the loan’s or another specified value, the funds are sold or handed to the lender.

For example, a $50,000 BUSD loan with a 50% LTV will demand you to deposit $20,000 (USD) in ether (ETH) as collateral. If the value falls below $20,000, you must add additional dollars. If it goes below $12,000, you will be liquidated, and the loan will be repaid.

When you take out a loan, you’ll primarily get freshly created stablecoins (like DAI) or crypto that someone else has given you. Lenders will place their assets in a smart contract, which may also lock up their capital for a fixed period of time. Once you get the cash, you can do anything you want with them. To prevent your collateral from being liquidated, you must top it up with the price change.

You may also have to pay penalties if your LTV ratio goes too high. The procedure will be managed by a smart contract, making it transparent and efficient. You will retrieve your collateral upon repayment of your loan plus any interest owed.

The Benefits and Drawbacks of Crypto Loan

For years, crypto loans have been widely utilised instruments in the DeFi market. However, despite their appeal, they have certain drawbacks. Before you decide to experiment with lending or borrowing, be sure to take a balanced view:

Advantages

1. Easy access to finance. Anyone who can offer collateral or refund the cash in a fast loan is eligible for a crypto loan. This makes them simpler to get than a regular financial institution loan, and there is no credit check required.

2. Loans are managed using smart contracts. A smart contract automates the whole loan and borrowing process, making it more efficient and scalable.

3. It is simple to get passive money with minimal effort. HODLers may store their cryptocurrency in a vault and earn APY without having to handle the loan themselves.

Disadvantages

1. Your collateral has a high risk of liquidation. Even with heavily collateralized loans, crypto values might decrease unexpectedly, resulting in liquidation.

2. Smart contracts are susceptible to attack. Back-door exploits and poorly designed programming might result in the loss of your lent cash or collateral.

3. Borrowing and lending might enhance your portfolio’s risk. While diversifying your portfolio is a smart idea, doing so through loans introduces additional risks.

Things to think about before taking out a crypto loan

You’ll have the highest chance of success with a crypto loan if you choose a reputable lending platform and reliable assets as collateral. But, before you lend or borrow, keep the following points in mind:

1. Understand the hazards of transferring custody of your cryptocurrency holdings. Once the funds leave your wallet, you must rely on someone else (or a smart contract) to manage them. Projects may be the subject of hackers and frauds, and your funds may not be instantly available for withdrawal in such situations.

2. Consider market circumstances before lending your cryptocurrency. Your coins may remain frozen for an extended length of time, making it unable to respond to crypto market downturns. Lending or borrowing with a new platform may be dangerous as well, and you may be better off waiting until it gains more trust.

3. Carefully read the loan terms and conditions. There is a plethora of options for where to get loans. You should seek for lower interest rates as well as more advantageous terms and circumstances.

Well-known crypto lending initiatives

Aave

Aave is an Ethereum-based DeFi system that provides a variety of cryptocurrency loans. You may lend and borrow, as well as participate in liquidity pools and use other DeFi services. Aave is likely most known for popularising quick loans. You put your tokens into Aave and get aTokens in exchange for lending cash. These serve as your receipt, and the interest you get is determined by the cryptocurrency you lend.

Abracadabra

Abracadabra is a DeFi initiative that enables users to place interest-bearing tokens as collateral. When users deposit money in a lending pool or yield optimizer, they get interest-bearing tokens. Holding the token gives you access to your initial contribution as well as any interest received.

You may increase the value of your interest-bearing tokens even more by pledging them as collateral for a Magic Internet Money (MIM) stablecoin loan. Depositing stablecoins in a yield-farming smart contract and then using the interest-bearing tokens to produce MIM is one option. The odds of liquidation are minimal as long as your stablecoins do not suffer volatility.

Binance

Binance, in addition to its exchange services, provides a variety of additional crypto financial products enabling users to lend, borrow, and earn passive income. If you don’t want to maintain a DeFi wallet or use DApps, choosing a CeFi (centralised finance) alternative may be considerably simpler. Binance provides access to easy crypto-collateral loans for a variety of tokens and currencies, including Bitcoin (BTC), Ethereum (ETH), and Binance Coin (BNB). These loans are funded by Binance users who wish to earn interest on their HODLed coin.

 

Final thoughts

When used correctly, crypto lending services benefit both the borrower and the lender. Investors may now harness the potential of their assets by using them as collateral, giving HODLers another way to make passive income. Understand the constraints involved and emphasise utilising a reputable platform whether you pick a DeFi or CeFi project to handle your loans. Blockchain technology has made it simpler to obtain and give credit than ever before, making crypto loans a strong tool for individuals who are interested.

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