Looking to take out a crypto loan? Here’s what you need to know
Cryptocurrency-based lending has become a mainstay in the decentralized finance (DeFi) universe since smart contract-based lending/borrowing platforms started offering the service to crypto users. The Ethereum network, the first blockchain that scaled smart contract functionality, sees most of the total value locked (TVL) on DeFi protocols dominated by cryptocurrency lending platforms.
According to data from DeFi Pulse, the top 4 out of 10 DeFi protocols are lending protocols which account for $37.04 billion in TVL, or only 49% TVL of the entire DeFi market on the Ethereum blockchain. Ethereum leads as the most widely used blockchain for the DeFi market and TVL on the network. Maker and Aave are the biggest players here, with a TVL of $14.52 billion and $11.19 billion, respectively.
Even on other blockchain networks like Terra, Avalanche, Solana, and BNB Chain, the adoption of cryptocurrency-based lending has been one of the primary use cases for smart contracts in the world of DeFi. According to DefiLlama, there are approximately 138 protocols that provide users with services based on crypto loans, with a total TVL of $50.66 billion. Besides Aave and Maker, the other top players in this category of protocols on blockchain networks are Compound, Anchor Protocol, Venus, JustLend, BENQI, and Solend.
Johnny Lyu, CEO of crypto exchange KuCoin, spoke to Cointelegraph about choosing blockchain networks for crypto lending. He said:
“I would say that the ideal blockchain for lending and DeFi does not exist, because each has its own advantages. At the same time, Ethereum’s leadership is undeniable due to many factors.
However, he did not deny the possibility of the emergence of a truly ideal blockchain for DeFi. Kiril Nikolov, DeFi strategist at Nexo – a cryptocurrency lending platform – supported this view. He told Cointelegraph:
“The short answer is no.’ Most blockchains are compatible with crypto lending, however, some of the primary properties to look out for include liquidity and reliability, while a secondary determining factor could be network fees.
Considering that the liquidity and reliability of the Ethereum platform is currently the highest because it is the most widely used blockchain within DeFi, one could consider taking advantage of it and making it the blockchain of choice.
To get started, a borrower must choose between the major lending protocols on the network such as Maker, Aave, and Compound. Although there are a plethora of crypto lending platforms, in this article the most important ones are considered for ease of explanation and relatability.
Cryptocurrency lending basically allows users to borrow and lend digital assets in exchange for a fee or interest. Borrowers must post collateral that will instantly allow them to take out a loan and use it for their portfolio purposes. You can take loans without any collateral, called flash loans, on platforms like Aave. These loans must be repaid within the same block transaction and are primarily aimed at developers due to the technical expertise required to execute them. In addition, if the amount lent is not returned plus interest, the transaction is canceled even before being validated.
Since crypto-based loans are fully automated and simple for the average retail investor and market participants, they generally offer an easy way to earn annual percentage returns on the digital assets they host or even to access cheap lines of credit.
An important aspect of secured loans is the loan to value (LTV) ratio. The LTV ratio is the measure of the balance of the loan compared to the value of the collateral asset. Since cryptocurrencies are considered highly volatile assets, the ratio is usually on the lower end of the spectrum. Considering Aave’s current LTV for Maker (MKR) is 50%, this essentially means that you can only borrow 50% of a loan’s value against the collateral posted.
This concept exists to provide leeway for the value of your collateral in the event that it declines. This results in a margin call where the user is asked to replenish the collateral. If you fail to do so and the value of the collateral falls below your loan value or another predefined value, your funds will be sold or transferred to the lender.
The scope of impact of cryptocurrency-based lending extends beyond the DeFi market as it enables access to capital for individuals or entities without credit checks. This brings a massive population of people across the world who have bad credit history or no credit history. Since lending and borrowing are all governed by smart contracts, there is no real age limit for the younger generation to get involved, which is traditionally not possible through a bank due to lack of credit history.
Related: What is crypto lending and how does it work?
Considerations and Risks
Given that the adoption of DeFi-based lending has now increased to such an extent that even countries like Nigeria are taking advantage of this service and El Salvador is exploring low-interest crypto lending, several considerations and risks are worth noting for investors looking to dabble in this space.
The primary risk with crypto lending is smart contract risk, as there is a smart contract in play that manages capital and collateral in every DeFi protocol. One way to mitigate this risk is to implement robust testing processes by the DeFi protocols deploying these assets.
The next risk you need to consider is liquidity/liquidation risk. The liquidity threshold is a key factor here because it is defined as the percentage above which a loan is considered under-secured and therefore leads to a margin call. The difference between LTV and Liquidity Threshold is the safety cushion for borrowers on these platforms.
For lenders, there is another additional risk associated with temporary loss. This risk is inherent in the Automated Market Maker (AMM) protocol. This is the loss you incur when you provide liquidity to a lending pool and the underlying price of the deposited assets falls below the price at which they were deposited into the pool. However, this only happens when the fees generated by the pool do not compensate for this price drop.
Nikolov pointed to another risk with DeFi lending platforms. He said that “another is a bad list of guarantees which could cause disruptions to the entire platform. So, if you are not ready to take these risks, we recommend that you borrow from a platform like ours which guarantees you certain protections such as insured custody and overcollateralization.
There have been several cases of hacking since the rise in popularity of DeFi, including Cream Finance, Badger DAO, Compound, EasyFi, Agave, and Hundred Finance.
Additionally, both cryptocurrency lending and borrowing platforms and users are subject to regulatory risk. Lyu mentioned that the regulatory framework on this issue has not been fully formed in any major jurisdiction, and everything is changing before our eyes. It is necessary to separate borrowers from each other — private borrowers and corporate borrowers.
Essentially, the risks highlighted require you to exercise extreme caution when deploying your capital in crypto loans, whether as a borrower or as a lender. Paolo Ardonio, the chief technology officer of crypto exchange Bitfinex, told Cointelegraph:
“It is important that those involved in crypto lending on DeFi platforms are aware of the risks in what is still a nascent area in the digital token economy. We have seen a number of high-profile security breaches that have put the funds of borrowers and lenders at risk. Unless the funds are secured in cold storage, there will inevitably be vulnerabilities for hackers to exploit.
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The future of DeFi lending
Despite the risks mentioned, cryptocurrency-based lending is one of the most evolved spaces in DeFi markets and is still experiencing constant innovation and growth in technology. It is evident that the adoption of this DeFi category is the highest among the many others that are growing in the blockchain industry. The use of decentralized identity protocols could be integrated with these user verification platforms to prevent the entry of scrupulous players.
Ardonio spoke in more detail about the innovation expected in DeFi lending this year, saying, “I expect to see more innovation in crypto lending, especially in terms of the use of digital tokens and assets. as collateral in loans. We are even seeing non-fungible tokens being used as collateral in loans. This will be an emerging trend this year.