What Is Crypto Lending And How Does It Work?

Introduction

Cryptocurrency trading is a decade-old investment market that is under development. In most cases, investors tend to stay away from trading schemes that involve making massive profit percentages in small durations. However, some trading techniques can create returns for the investors to this effect providing a massive risk factor.

Crypto lending is such an option for investors who are looking to make big bucks in a limited duration. This article will share various aspects of crypto lending with the reader inclusive of its pros and cons.

What is Leveraged Trading?

Many investors must have heard about the term called leveraged trading time and again. The term refers to a type of trading position, where the investor can increase their spread by borrowing funds for investing. It means that an investor stands to make bigger investment bets by lending trading capital from lenders in the market.

Therefore, a position that has been created using lent funds is known as leveraged position. Many short-term traders take advantage of leveraged trading to increase their profit percentages. However, leveraged trading can require a considerable amount of trading experience and risk appetite.

How does Leveraged Trading Work?

With Leveraged Trading, an investor is looking to borrow funds for investing in a particular asset class of a basket of asset classes. For this purpose, the lender must create a lending account and present the collateral amount. The collateral amount is like a warranty for the lending investors that the borrowers are under financial obligation to return their funds.

In case the borrower is unable to return the funds, the lender can absorb the collateral. Another feature of collateral is that the borrower must maintain the value of the collateral reserve to a specified level.

During the leveraged trading process, if the value of the collateral account decreases from the desired amount at any point, it can trigger a margin call. A margin call means that the lenders can freeze the leverage trading account until the borrower replenishes the agreed-upon value of the collateral reserve.

In addition to collateral requirements, the borrowers must also pay attention to the timely return of the borrowed amount in addition to interest rates. All leveraged positions come with a fixed or variable interest rate that entails that the borrower returns the lent amount with higher returns.

What is Crypto Lending?

Just like regular lending, Crypto lending is much the same process with the exception that the odds of leveraged trading in crypto shift dramatically. Cryptocurrency investors can use dedicated lending protocols for borrowing funds for crypto trading.

Investors can take advantage of lending services provided by centralized and decentralized crypto enterprises and exchanges. Cryptocurrency investors who have undertaken short-term trading techniques such as scalping and Day Trading can generate considerable profits using crypto lending options.

How does Crypto Lending Work?

Crypto lending works in much the same way that any other type of leveraged trading works. The borrower needs to lock their collateral amount in a smart contract and maintain its required value to avoid a margin calls.

In the case of crypto lending, the collateral can be present in the form of other asset classes such as NFTs, stablecoins, or other cryptocurrencies. If the spot price of the leveraged cryptocurrency goes down, they can face the threat of a margin call.

Furthermore, volatility is ideal for leveraged trading because it can allow investors to make more profits in smaller durations. However, the high frequency of volatility is also going to increase the percentage of risk for the investors. In case of unprecedented market changes, the borrower is always facing the threat of an impending margin call.

Furthermore, a small percentage of spot price movement can wipe out all the profits for leveraged positions and turn them into massive losses. In the case of lending, the investors have to face massive losses because they are also required to return the loaned funds with an obligation of compounding interest rates.

Types of Crypto Lending

When it comes to Crypto Lending, the lending protocols have the freedom to offer several types of crypto lending options on account of peer-to-peer trading and smart contracts. Some of the most common types of Crypto lending options are given as under:

Collateral Loans

Collateralized loans are an option that is much like the traditional form of leveraged trading practices. It entails that the borrower is allowed to access a small percentage of the collateralized amount that is often less than 90% of the loan-to-value or LTV.

The collateral amount is the reserve fund that works as a warranty for the lender that the borrower is going to return their loaned funds. In most cases, a small LTV means that the interest rates are also going to be relatively smaller. At the same time, a small LTV can also represent a lesser risk of a margin call.

Crypto Line of Credit

Line of Credit is a unique type of lending contract. In traditional lending, the investors are bound to transfer the whole loaned amount to the borrower in one go and for a specified duration. However, with lending, the lenders are allowed to establish a line of credit for the borrowers without any specified terms of returns or interests.

It is also a collateralized loan that enables the borrower to borrow following the set percentage of their collateral submission. However, the repayment terms are highly subjective and the lender is only obligated to charge interest from the borrower whenever they make a withdrawal from their trading accounts.

Non-collateralized Loans

Uncollateralized loans are not that common. It means that the borrowers can apply for a trading loan without having to commit a collateral reserve. However, for this type of lending the borrower must complete the rigorous process of creditworthiness that could entail a proven track record of borrowing history and an excellent credit score.

The burden of trading risks in this type of lending is greater on the lender rather than the borrowers. In case of a loan default, the lenders have no access to liquid funds meanwhile there is also no way to track the risk of leveraged positions without margin call control. Therefore, uncollateralized loans are mostly reserved for high stake investors and private financial institutions.

Flash Loans

Flash loans are a type of specialized uncollateralized loans that are possible with blockchain and crypto trading networks. In simple words, a flash loan means that the investors intend to complete the whole cycle of borrowing and returning the funds in one go or a single block transaction.

Cryptocurrency investors can use flash loans to take advantage of the massive volatility or arbitrage trading options. With flash loans, the investors are required to place the main transaction which is a borrowing request. Within the main transaction, some sub-transactions are executed to perform the entire cycle of selling and borrowing.

In case, that the flash loan is unable to successfully generate profits and return funds, the smart contracts will cancel the whole transaction and not add it to the blockchain.

How does Crypto Lending Work on Centralized Platforms?

Centralized Exchanges and crypto platforms have some degree of security requirements added to them. For example, the borrowers and lenders need to complete the KYC (Know Your Customer) process on them. Furthermore, the investors must use verified crypto trading platforms that are regulated in their local areas such as Binance, Coinbase, BlockFi, etc.

The next step is to navigate into the lending protocol of the said exchange or service provider. The dashboard of different crypto lending forums can offer different types of lending options for their consumers.

For example, some platforms can grant exposure for investors to perform p2p lending through smart contracts. Meanwhile, others make the process of lending more random using liquidity pools. With liquidity pools, the borrowers and lenders are not dealing with each other directly.

At centralized crypto lending platforms, users can choose how much cryptocurrency they wish to borrow, for what duration, what are the refund policies, and what are the internet rates, etc. As soon as the request of a borrower matches the query of a lender, the crypto trading platform can allow the contract to take place.

The crypto lending platforms can issue bonds or yield tokens for the lenders that they can redeem at any time to realize accrued interests and reclaim their staked funds.

How does Crypto Lending Work on Decentralized Platforms?

Decentralized platforms do not require any type of KYC verification and they are also free from the red tape obligations of the regulated banks. When dealing with banks, a borrower may have to submit a myriad of documents regarding their educational, income, family, and residential background.

The bank can assess the loan request of a candidate and process it after a considerable time. However, with DeFi lending there the process of loaning is instant. In most cases, DeFi protocols require over-collateralization of the funds of the borrowers to ensure the safety of the lenders.

Therefore, most DeFi protocols adopt an over-collateralization policy which means that borrowers need to back their loaned funds with 110% backup reserves. In addition, interest rates are governed by the forces of demand and supply. Some of the most famous DeFi protocols are AAVE, Compound, and MakerDAO.

However, in MakerDAO the interest rates are decided by the community voting process. The users of the DeFi lending protocols can also audit the code of smart contracts before committing funds using manual options.

Furthermore, the leveraged positions are under the full control of the investors. The only downside is that in case of a hack attack, the investors cannot demand a refund from the DeFi protocol developers legally.

Factors to Consider Before Crypto Lending

A smart investor should ask: What are the most important factors to consider before lending crypto. To answer this question, here are some important points:

Custodial Rights

Custodial rights have become one of the most hotly debated topics within cryptocurrency circles these days. After the FTX saga, a majority of the investors are moving out their cryptocurrency reserves out of the custody of cryptocurrency exchange to self-custodial wallets.

It means that in case, the said cryptocurrency exchange fails the investors would not have to lose their cryptocurrency positions.

The same is the case with lending protocols, the platforms that offer custodial rights for their users are preferred over those where investors have to depend on keeping their cryptocurrency reserves under the ownership of their service provider. In this manner, the investors will remain out of danger in case of a bank run, hack, financial collapse, etc.

Market Conditions

Investors must always pay close attention to the market dynamics before performing committing their funds as collateral or borrowing from a liquidity pool. For the duration of their staked positions, the investors would not be able to take out their funds despite any financial catastrophe.

On the other hand, predicting marker patterns is a difficult job, and dealing with leveraged positions can increase the risk percentage for the investors by many folds. Therefore, the investors must only depend on calculative deliberation before engaging as lenders or borrowers.

Terms and Conditions

It is of prime importance that the investors must read all the terms and conditions of the lending protocols beforehand. Otherwise, they can be surprised by the loopholes that the other investors can come up with.

Furthermore, the changes made in the smart contracts can also pop up as an unaccepted surprise for investors who are using crypto lending services. The investors must conduct research and test and recheck their trading strategy before carrying it out.

Liquidity

Lack of liquidity is the worst nightmare for any investor. The same can be the case for crypto lending protocol users. Even if an investor has managed to register profits with their leveraged positions, the lack of liquidity can burn down all their profits. The more delay the investors face in cashing out their positions, their chances of incurring losses can deepen.

Therefore, the investors must always add alternative options for cashing out such as stablecoins and transferring funds to swaps, etc. Many crypto exchanges are publishing Proof of Reserve reports for their users. Investors should trust the ones with a complete account of liabilities and reserves. Furthermore, look for digital signatures for authentication.

Interest Rates

Interest rates can be fixed or variable. If the investors are not careful the exponential amount of interest rates can devour their profits. Therefore, the investors must always take into consideration the interest rates and how they will affect their profits until the leveraged position is closed. It will help them to create a realistic trading strategy.

At the same time, the investor must also beware of the transaction costs, exchange fees, and other hidden charges to help them calculate everything in advance rather than getting hit with a rude awakening later.

Technical Audit

The funds of the investors are safe as long as the crypto lending firm is technically sound. There are many cases, where cryptocurrency investors end up losing their collateral reserves or liquidity positions on account of an exploit or hack attack. To avoid such as situation, investors should work with self-custody accounts as much as possible.

At the same time, the investors must make sure that the crypto service they are using conducts regular technical audits. Crypto firms hire a suite of cyber security firms to discover any technical mishap or uncover a programming blind spot before hackers find them. The chances of getting hacked for firms with regular technical audits are considerably lower.

Limitations of Crypto lending

When dealing with Crypto lending, investors must never overlook the possible risk associated with leverage trading. Here are some of the most important risks that all investors must prepare for:

Risk of Lapse: The over-collateralized funds face the danger of losing their value in the spot market. Therefore, if the collateralized cryptocurrency has lost its value, it means that the leveraged position can liquidate automatically or trigger a margin call frequently.

High-Interest Rates: The investors must always measure the invested interest rates till the end of their leveraged positions. The terms of interest rates should preferably be clearly defined. The investors must also account for a possible lapse in return and the compounding interest rates to make preparations to avoid it.

Trading Costs: Investors should pay attention to all the major and minor trading charges they have to make. At the same time, they should account for any regulatory changes in their region that could outlaw crypto lending platforms resulting in instant losses for them.

Conclusion

Crypto Lending is a type of trading that can help investors get a leap ahead to achieve financial freedom and independence. However, at the same time, it can also expose the investors to considerable risks. By understanding the dynamics of crypto lending investors can gain experience and make sure that they can incorporate contingency plans and adopt methods to mitigate risks.