What is crypto lending?
Crypto lending stands for crypto-secured lending because not all loans are denominated in crypto assets. Holders of crypto assets use their positions as collateral for cash loans for working capital or investment purposes.
Holders who wish to earn a yield on their crypto assets are crypto lenders. They could be individuals or funds who want to supplement any potential gain and forgo the flexibility of being able to trade their holdings. According to industry insiders, some investors hold long positions on crypto-assets for the yield only and protect against price downside in the derivatives market.
Differences between crypto lending and traditional lending
Crypto lending is very different from traditional lending, not only in the innovation in the technology that powers smart contracts or new types of collateralized assets but also in flexibility and relative security of credits. Here are some of the operational differences between the two.
Variety and speed
Crypto lending involves a vast range of instruments. It confers a flexibility on market participants, while only a few traditional finance platforms offer yields on such vast ranges of assets. It is possible to lend a variety of traditional securities and submit an even wider range of assets, including art and real estate, for a loan or collateralization. However, crypto lending involves less paperwork, lesser middleman, and lower fees.
Users of both centralized and decentralized lending platforms can switch between assets with comparative ease. For example, depositing Bitcoin to take out a Stablecoin loan or using their Ether stake for a Bitcoin loan allows them to fund an exchange account to buy more Ether. This can be done within seconds.
Collateral deposited for loans from these platforms is in crypto assets always because they are more liquid than most types of collateral in traditional markets. Moreover, now most platforms insist on the collateral of over 100%, sometimes as much as 150% offset predictable asset price volatility. Given the relative liquidity of these assets like jewelry and yachts, the loan-to-value ratio may decline, and lenders can sell the collateral in the markets. In theory, this would stem from their potential losses.
Crypto lenders are not yet considered banks. So, they do not require special licenses. While this may be restraining for many potential participants because of a lack of trust, it enables lending businesses to concentrate on developing a strong reputation through service and selective transparency. It also allows them to keep costs down for users because of low reporting requirements.
Advantages of crypto lending
When lending cryptocurrencies, you can enjoy the following advantages
Lending can bring extra income to crypto asset holdings. Lending services allow holders of crypto assets to supplement the capital gains potential with interest income. When it is combined with the comparatively attractive yields on crypto assets than traditional assets, it can entice a wider range of investors into the crypto asset class. As a result, it boosts volumes and strengthens liquidity, as well as infrastructure.
A gateway to short selling
Another benefit of crypto lending is the increased facility to sell short. In this, a pessimistic trader borrows an instrument so it can be sold on the market with the aim of buying it back at a lower price. It is important to have the ability to short an asset for reliable price discovery.
If traders who think that price will go down do not have a way to participate in the market, the market will reflect a buyer’s bias. A lively derivatives market and selling short both are ways to express a negative opinion. You can use them in a lot of ways and in various cases because platforms adopt features that make it almost as simple as trading futures.
The biggest advantage of crypto trading perhaps comes from additional liquidity. There are many traders and investors who deposit their crypto holdings as collateral to borrow cash or other crypto assets and increase their crypto holdings with it. It introduces leverage into the sector effectively but stimulates liquidity through additional trading.
Disadvantages of crypto lending
Revolving around one of the most volatile financial market sectors, crypto lending does have certain disadvantages you should be aware of.
One of the risks inflected by the growth of crypto lending is the “over-financialization” of the market. Crypto lending should not increase the supply of a token, the emergence of layered claims on a holding, or the issuance of securities. Because of these, the bearer characteristics of crypto assets can blur, as well as the rights of the original holders.
Another disadvantage is the counterparty default that is present in all centralized financial services. Crypto lending performances are still uninsured and unregulated. However, some of them have custody insurance. If a significant lender collapses, it will make the whole system doubtful because actual ownerships and eventual recoveries of deposited tokens will be unclear.
Transparency also becomes a risk with decentralized platforms. On-chain lending suggests that others can see transactions. Even if identities are hidden, forensics can uncover them. It means that trading strategies and other information can be disclosed and used for malicious purposes.
Managed-investment contracts and smart contracts that move funds are a comparatively new technology. Errors can indeed be patched, but funds can be misdirected in the meantime. Moreover, if these transactions are registered on a blockchain, it can be very difficult to correct the errors.
Another threat to this sector is regulation. The term is “Investment contract.” It is in the form of a string of code that runs on a decentralized protocol. It means that regulators will most probably start paying attention to DeFi risks when the sector takes off.
Even centralized platforms may need to improve their transparency, which will result in increased costs and business risks because it would become easier to replicate their terms and conditions. Moreover, most of the main platforms delegate the safekeeping of their clients’ assets to reputable crypto custodians with insurance. However, many may find that they need to change their practices to make sure that the users’ funds are protected.
Crypto lending is as highly-beneficial as it is risky. Knowing the potential risks involved will help you minimize losses. However, that is just the theoretical foundation of your success.
Constant learning, studying the market trends, and applying the detailed technical analysis tools to monitor those trends will lay the path to your success in crypto lending.