What Is Crypto Lending and How Does It Work?

Imagine this - you’ve bought a house in a great neighborhood, and in the next 5 years, you know for a fact that the house will be worth double what you paid for it. Instead of letting it sit empty, you decide to rent it out to a tenant. The tenant gets to live in your house, and you get the money every month. What happens in the future, after 5 years?

You still own the house.

Its net worth will be way more.

You made extra money from rent the entire time.

Now, you might wonder - how is this relevant to crypto lending?

Replace the newly bought house with digital coins. You are simply ‘renting’ them to other people on the internet. The rent is the interest paid by your buyers for using your coin. The best part is that the coins will still be yours, and you can earn extra money by lending cryptocurrency. Now let’s get into the technical deets. 

Crypto Lending Explained

Crypto lending connects borrowers and lenders, often thanks to common platforms that have sprung up, almost as old as the industry itself. The whole thing is a financial transaction where the lenders offer crypto in exchange for compensation (interest). You can enjoy various versions of this particular service in centralized exchanges and DeFi protocols-  the underlying mechanics differ but the concept is largely the same.

• DeFi platforms: Smart contracts automate the entire crypto lending process.
• Centralized platforms: The exchange acts as an intermediary, managing the collateral requirements and interest distribution.

Crypto lending earnings are between 1-20% APY/APR and very dependent on the type of cryptocurrency and platform involved. 

How Does Crypto Lending Work?

• Choose a Lending Platform: There are many crypto lending platforms on the market. To pick one that works best for them, people factor in their support for different crypto assets, company reputation, LTV, interest rates, security, terms and conditions, etc.
• Deposit Collateral: A borrower will post their crypto as collateral on the platform to obtain the loan.
• Get Loan: Most of the time, the loan will be in stablecoins or fiat and usually doesn’t require a credit check.
• Repay Loan: While repaying the loan in installments, the borrower will also have to pay an interest rate. As long as the loan is fully paid back, the lending company will have every right to hold your collateral.
• Get Your Crypto Collateral Back: After repaying the loan, the borrowers will get their crypto collateral back.

Here’s a situation you might face: if your crypto collateral’s value drops too low, you will have to face liquidation or probably replenish it.

What Are the Different Types of Crypto Loans?

Flash Loans

A flash loan is a form of crypto borrowing with no collateral. A single blockchain transaction handles all operations, including repayment and loan sanction. If the borrower fails to repay the loan, the smart contract will cancel all operations within the blockchain transaction. For a deeper look at how they work, read this post on understanding flash loans on the Delta Exchange blog.

Collateralized Loans

Collateralized loans let borrowers borrow funds for a set period, as long as they set aside collateral. These collateralized loans are probably the most common type of crypto lending. The loan-to-value, or LTV ratio, like 50% for instance, tells you how much you can borrow compared to the actual value of what you’ve put up.

What Are the Risks of Crypto Lending

Before you take out a loan or deposit funds, it’s important to understand the risks of crypto lending. Check them out:

• Liquidation risk: If the value of the collateral drops significantly due to market volatility, the position can be liquidated.
• Smart contract risk: The entire lending protocol functions through a smart contract. Bugs, vulnerabilities and third-party oracle attacks can lead to massive liquidations.
• Counterparty and platform risk: Interacting with traditional crypto lending platforms leaves you at the mercy of the counterparty if it withholds or freezes funds. The default of Celsius and BlockFi in 2022 showed just how quickly a lending protocol can default and leave users unable to liquidate their positions. The SEC’s 2022 action against BlockFi also covered its retail crypto lending product and related registration requirements. 
• Custody risk: Sending your crypto assets to a lending platform or a smart contract makes them inaccessible until withdrawn. Additionally, some platforms utilize a “lock-up” period, rendering deposited crypto unavailable for several months.
• Regulatory risk: Depending on the jurisdiction, crypto lending services and products may be illegal. In the United States and the EU, there’s definitely some regulatory pressure to ban yield-generating crypto services.

Things to Consider Before Using Crypto Lending

Before deciding to lend or borrow crypto, these are the different things to consider:

• Custody and access: Once deposited into a lending contract, your funds may not be available for withdrawal. Some platforms impose lock-up periods, while others could freeze withdrawals due to negative market movements.
• Market conditions: Lending crypto in a highly volatile market is not advisable, as the value of your crypto could drop significantly, putting you at risk of getting liquidated. When borrowing, a volatile asset used as collateral may also be liquidated if its value drops below the threshold.
• Protocol history: More established protocols with a higher total value locked (TVL) and third-party security audits have a proven track record of withstanding attacks, but this does not mean that they are completely safe.
• Loan terms: The interest rates of decentralized finance (DeFi) loans are not fixed and can fluctuate constantly depending on the supply and demand of the specific blockchain loan pools. Research the current supply-demand dynamics for the relevant blockchain before opening a position. 

In case you’re comparing crypto lending vs. staking, all you have to do is understand the sheer difference between how returns are generated and the risks involved. It will help you make an informed decision. 

For a broader look at ways crypto holders can potentially generate returns from their assets, read this blog on earning passive income with crypto on the Delta Exchange India blog. The guide also covers centralized, decentralized, and peer-to-peer crypto lending. 

How Can You Start Crypto Lending?

• Select a crypto lending platform that completely aligns with your needs
• In the lending platform’s wallet, deposit your cryptocurrencies.
• Set your lending terms such as loan duration or compensation rates.

Complete these three steps, and your crypto will be ready to be borrowed.

The Bottom Line

Crypto lending can be promising and risky at the same time; one must pay attention when interacting on such platforms. Issues like DeFi drawbacks and volatility are not something you can overlook. If you are a lender looking for passive income or a borrower looking for liquidity, crypto lending is indeed an excellent idea.