Lending in a traditional bank
Lending is the process of giving someone money with the hope and expectation that they’ll repay it later. Lenders receive compensation via recurring charges paid by the borrower until they repay the due amount. The lender receives a percentage of the money borrowed in exchange for lending the money, which is an interest rate.
When a lender allows someone to borrow their money, they’re essentially taking a risk, as there’s a chance they might not get it back. However, their reward for risking their loaned money is the interest rate, so when the borrower repays their money, they’ll make a profit.
Consider the following situation: You want $2,000 to buy that new laptop you’ve been eyeing but are short on funds, so you ask a friend to loan you the money. They agree on the condition that you pay them back within two years at a 5% interest rate. Here, you’re the borrower, and your friend is the lender. The $2,000 you’re asking for is the amount you’ll borrow or the amount your friend will loan you. The interest rate is 5%, which you’ll have to repay within two years. This period is called the repayment term.
Banks function similarly. When you want to save money, you put it in a bank, and the bank stores your money for you. While your money sits in the bank, it starts generating interest depending on the bank’s interest rate. When you return to withdraw your money over a fixed period, you’ll receive a total amount on your initial deposit and make a profit.
What’s crypto lending?
Bank customers earn interest on their initial deposits in fiat currencies––like the U.S. dollar, the British pound, or the euro––through their bank accounts. Similarly, crypto users deposit their cryptocurrency with crypto lenders via their crypto wallets and earn money back, commonly in cryptocurrency.
While traditional banks pay meager returns owing to historically low-interest rates, crypto lenders provide substantially larger returns. These can go up to as much as 20%, although rates this high usually means there’s high risk. In general, they’re far higher than the sub-1% rates one can get on deposits from the bank.
Interest rates vary depending on the cryptocurrency you deposit. Crypto lenders earn money by charging a fee on their loans. These fees often fall in the range of 5-10%. Investors and large corporations usually borrow from crypto lenders for various purposes like speculation, hedges against inflation, or working capital, among others.
Why is crypto lending important?
Crypto lending is an important process in the financial landscape. It allows users to earn interest in a previously only available way through risky measures and systems monopolized by large institutions and corporations. Crypto lending, in a way, gives the power back to the people.
The process has exploded over the last few years, as have DeFi (decentralized finance) systems in place to promote crypto lending and other crypto-related systems that allow users to bypass traditional financial institutions. These platforms are more accessible than traditional banks, as users go through less paperwork during the lending and borrowing process.
Crypto lending is important because it allows people to earn relatively low-risk yield at a far higher rate than traditional savings accounts. This previously was only available to big banks and centralized authorities.
Lenders and borrowers
There are generally three parties involved in crypto lending, i.e., lender, borrower, and DeFi platform such as Compound and AAVEe. Before borrowing any cryptocurrency, the borrower must usually put up some sort of collateral. In some cases, however, flash loans don’t require collateral (more on that in a bit).
Both parties can also agree to use smart contracts that generate stablecoins or provide a platform that lends funds to the borrower—lenders deposit funds in a crypto pool that oversees the entire process. The lender then pays the pool a portion of their profit. It isn't necessary to be a borrower, either. Users can earn passive income by staking (or locking) their crypto coins in a pool and withdrawing their deposits with interest when they wish.
The smart contract itself is a way to safeguard the lender's interest to ensure repayment, as it’s a digital document that autonomously activates when the conditions are met. These conditions are predetermined by both parties to ensure a fair agreement. Thus, if the borrower’s value drops low enough such that they’re at risk of not being able to repay, they’re automatically liquidated by the protocol.
Collateralized loans and flash loans
Collateralized loans
Collateralized loans are the most common type of loan. Here, the borrower is required to deposit any given cryptocurrency or digital asset as a form of collateral, which acts as a form of security or accountability for the borrower. The borrower is even granted additional time to use and repay the loan.
Many DeFi platforms ask borrowers for over-collateralization, meaning the borrower is required to provide collateral worth more than the borrowed amount in case they can’t repay the loan. The additional collateral will cover any potential losses.
Besides these benefits, these loans have a drawback, which is the absence of credit scores and the ability to secure overcollateralized loans. This prevents individuals from receiving larger loans as the lender will demand far more collateral than the borrower has. Some like Goldfinch are trying to address this issue, although it may prove challenging.
This is also exceptionally important as most people today don’t have money required to pay for the asset they’re receiving in a loan. People can’t pay for a house upfront. This must be solved over the long term if crypto lending will become mainstream.
Flash loans
Flash loans offer an immediate alternative to borrowers by allowing users to borrow digital currency without collateral. These loans are provided and repaid within the same transaction in a single block on the blockchain.
If the borrower can’t repay the loan amount with its interest, the transaction is terminated before being added to the block. This implies that the loan never went through because it was never verified and validated on the blockchain. To do this, both parties must agree to use a smart contract, which manages the entire transaction, eliminating the need for human involvement.
People use flash loans as it allows them to borrow funds without providing collateral. Flash loans also remove the involvement of intermediaries. This opens up new ways for people to take loans in ways that weren't possible with traditional banking.
Decentralized crypto loans vs. centralized crypto loans
We know crypto users can enjoy the benefits of DeFi through decentralized platforms. However, there’s another choice available––centralized crypto loans. While decentralized crypto loans usually take place on a decentralized exchange (DEX), centralized exchanges (CEX) allow for centralized finance (CeFi). Let’s look at their differences.
Decentralized crypto loans
Decentralized crypto lending platforms rely on smart contract functionality. These contracts are designed to automate the lending and borrowing process and ensure the delivery of repayment with interest.
DeFi networks are often non-custodial, don’t need Know Your Customer (KYC) identity verification, and only accept cryptocurrency. Interest rates vary based on buyers and sellers but are often less than those on CeFi platforms. DeFi platforms offer more transparency than CeFi platforms due to their open-source, decentralized nature built on blockchain technology.
Centralized crypto loans
Centralized crypto lending works on CeFi platforms where intermediaries are required to oversee transactions. Traditional financial institutions like banks manage the user's onboarding process through KYC verification and need crypto-to-fiat currency versions through custodial systems to secure the parties' crypto holdings.
CeFi platforms also tend to be more adaptable in creating partnerships with other organizations and arranging bespoke financial arrangements. They promise to increase the production of their cryptocurrencies safely and securely. While some CeFi platforms offer favorable interest rates and better margins, they aren’t as transparent as decentralized loans and require human interaction and verification.
Many CeFi platforms such as Celcius and BlockFi have run into significant problems as the prices of cryptos have fallen. DeFi borrowing and lending platforms, on the other hand, are functioning as designed.
Crypto lending vs. banking
Crypto lending provides greater flexibility and transparency and doesn't require human involvement. It offers users a higher-yield alternative to depositing their money in a traditional bank and guarantees that loans will be paid back through overcollateralization and forced liquidations.
Crypto lenders and banks ultimately offer the same service, i.e., loans. However, crypto lending has many advantages over traditional financial systems, mainly that it is more transparent, fair, and available to everyone.
The crypto space offers plenty of choices to users, with an increasing number of cryptocurrencies introduced daily. Each has a unique functionality and purpose—you don’t have to take a loan or give anything away. Cryptocurrency companies like Worldcoin give away a share of their cryptocurrency for free, so no borrowing or lending is involved.
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