One of the advantages of investing in cryptocurrencies is that you can use your crypto positions as collateral for a loan, even if your holdings are small. In the conventional economy, a similar practice is called securities-based lending, but it is typically off-limits to all but wealthy clients of private banks and large financial institutions.
Crypto loans are much more accessible and allow investors a way to gain liquidity from their investments without selling them. In this post, we will discuss the basic information about crypto loans.
What are crypto loans?
With a cryptocurrency loan, traders can get liquid funds without selling their cryptocurrency. In this case, they use their cryptocurrency as collateral for a cash or stablecoin loan.
The individual may choose to take out a crypto loan because they expect the value of their crypto asset to increase or because they want to hold the asset long enough to avoid short-term capital gains taxes.
What are the types of crypto loans?
Centrally Managed Crypto Loans (CeFi).
Centralized crypto loans (CeFi) are fiduciary in nature. That is, a centralized entity holds the collateral. In this context, a trader cannot access its collateralized assets. The lender controls the private keys of the assets. The consequence of this is that crypto loans, although much more accessible and affordable than traditional loans, still depend on a central provider. Around 80 percent of crypto loans are currently in escrow, but this is changing rapidly.
Decentralized (DeFI) crypto loans.
Decentralized (DeFi) loans are not fiduciary loans. No central organization is needed to enforce the terms of the loan; instead, they depend on the smart contracts. The trader who takes out a DeFi crypto loan retains control over the private key of his assets. This is the case if he does not default on the loan. No fiat currency can be lent directly on DeFi platforms. The trader receives stablecoins, which he can then exchange for cash. Interest rates on DeFi loans are usually higher than those on Cefi loans.
What are the risks associated with crypto loans?
As with traditional financial institutions, crypto accounts are not covered by government insurance. For this reason, there is no government insurance for crypto assets in the event that an exchange goes bankrupt. This means that there are three primary types of risk associated with crypto loans.
The risk of protocols failing due to a technical problem or hacker attack is present in all cryptocurrency transactions. These risks are slightly higher for centralized crypto loans, as all DeFi activities are fully algorithmically controlled.
All traditional banks must maintain a certain level of liquidity. Crypto loan providers are not subject to this requirement. In the event of a market collapse, an unexpectedly large number of customers defaulting on their loans, or if a platform fails or is manipulated, the platform may run out of liquidity.
Margin calls and forced liquidations
To prevent illiquidity during market downturns, crypto platforms will issue margin calls or conduct forced liquidations. That is, if the value of a cryptocurrency falls to a level where the LTV of many borrowers is too high for the platform, the platform will inform borrowers that they must increase the value of their collateral or risk liquidation.
If they do not comply with this request, the platform may liquidate enough collateral to bring the LTV ratio of an account back to the maximum allowed ratio. In this case, the trader has forfeited the portion of their deposit and may be charged transaction and brokerage fees.
Examples of use
- Liquidity – For investors or hodlers who wish to hold crypto assets in their account, access to crypto loans against their collateral, provides the best opportunity to avoid taxes on short-term gains.
- Centralized platform for crypto asset lending – Crypto loans are among the most effective and widely used aspects of the crypto lending markets.
- Arbitrage Trading – Crypto loans allow you to engage in arbitrage trading, where you borrow an asset from one platform and lend the asset on another.
- Margin Trading – By obtaining a crypto loan, a user can gain leverage by buying additional collateral, etc., without the need for a centralized exchange.
- Flash Loan – To execute other transactions, a user can borrow what is called a “flash loan”, which they then pay back at the end of the entire transaction.
DeFi Loan Platforms
Compound is among the largest DeFi platforms. Users of the platform provide cryptocurrency to support the protocol and receive interest on their deposits. The amount provided is represented by cTokens, whose value increases over time. However, one can also use this cToken balance as collateral for a loan.
Compound’s lending rates are usually a bit higher than other providers. However, Compound is not only fee-free, but also has a lower liquidation threshold and will only liquidate 50% of an under-collateralized loan, with the liquidation penalty set at 8%.
The Aave protocol is an innovative protocol with a wider range of loan options. As with Compound, users post collateral that is used to support the protocol. Their deposits are represented in aTokens.
Anyway, in addition to regular DeFi loans, AAVE offers flash loans. The company was the pioneer in this field, offering fixed-rate loans. To that end, it boasts a larger loan-to-value ratio than other major competitors and very low loan rates. It also accepts 24 different coins as collateral.
Aave is among the highest rated DeFi loan projects due to its perceived dynamism and innovation.
CeFi lending platforms
Celsius Network is among the most popular lending platforms with over $10B in assets and 485,000 users. This is due in part to the extremely low lending rates, which start at just 1%. 25 coins are supported and flexible loan rates are offered, although they are capped at 50%.
BlockFi is a major CeFi player based and regulated in the U.S. and backed by major financial institutions such as Valar Ventures, Winklevoss Capital, Galaxy Digital, Susquehanna, Akuna Capital, and Fidelity. American financial services provider Motley Fool describes BlockFi as a good choice for beginner and intermediate investors who want to connect traditional finance and cryptocurrencies.