Investors can borrow or lend cryptocurrencies with the help of crypto lending. There is a fee or a rate of interest involved in such activities. Getting a loan is fairly easy. All you need to do is provide collateral to start your investment journey. You can apply for crypto loans via a DeFi application or through a crypto exchange. To prevent the liquidation of your investment, make sure your collateral is at the minimum required level. If it falls below it, you should balance it by adding more to the collateral. When you’re ready to return your loan along with the interest and the fee, you can access your capital. Visit multibank.io
It is also possible to get loans without any collateral. These are known as flash loans that must be returned within the same transaction. If you fail to do so, the lending transaction will be reversed before it gets finalized. Lending crypto or borrowing crypto have both become much simpler with crypto loans. The entire process is automated with the help of smart contracts. Do bear in mind that crypto lending also comes with its own set of financial risks. You may have used a rather volatile token as collateral. In this case, it is always possible that you face liquidation overnight. Another reason why you may face losses is hacking. Smart contracts may get hacked or exploited which may lead to major losses.
Read more: Fiat vs Cryptocurrency: Know the Similarities & Differences
How does crypto lending work?
Essentially, crypto lending involves lending crypto to one investor who would further provide it to another investor for a certain fee. How this loan is managed is something that varies from one platform to another. While the main principle remains steady, there are crypto lending services on centralized as well as decentralized platforms.
If you choose to not be a borrower, you may even try and lock your crypto in a pool that takes care of your funds. This is a good way to earn a passive income and earn interest at the same time. The risk involved would depend directly on the smart contract you’re using and it may be because the borrower has used collateral.
There are three different parties in crypto lending:
- Lender
- Borrower
- Decentralized Finance (DeFi) platform or a cryptocurrency exchange
It is usually not possible to borrow any crypto until collateral has been put up. The borrower could also choose to use a flash loan. Then you also have the option of exploring smart contracts that basically make stable coins. Another interesting option is to go for a platform where you can pool your cryptocurrency. The platform would then manage these funds on your behalf and share a cut of the interest with you.
Types of crypto loans
Flash loans
You do not need any collateral for flash loans. They’re named so because the loan issued has to be repaid within the same block. If it becomes impossible to repay the loan with interest, the transaction is nullified before it can be verified by the blockchain. It basically implies that no loan was ever processed and added to the blockchain. The interesting part is that the entire process is controlled by a smart contract and therefore there is zero human involvement.
Read more: Factors affecting crypto volatility
The ability to act fast is a must with flash loans. This is why smart contracts are important as with smart contract logic, it is possible to create a high-level transaction that includes sub-transactions. In case any sub-transactions do not fall through, the top-level transaction will also not be executed.
Picture this: There are two tokens, one trades for $1 in a liquidity pool X while another trades for $1.10 in liquidity pool Y. You want to buy funds from pool X and sell to pool B but you lack the funds. You then use a flash loan to make the most of this option within a block. So thus, our first transaction would be to use a 1,000 BUSD flash loan from a DeFi platform and pay it back. This process can further be broken down as:
- Your wallet receives the borrowed funds
- With those funds, you buy $1,000 of crypto from pool X
- You sell those tokens in pool Y and earn $1,100 in total
- You return the flash loan along with the fee to the flash loan smart contract.
In case any of the above sub-transactions are not processed, the lender will negate the loan before it is processed. With this approach, flash loans can be profitable and the risk involved can also be minimized. Collateral swaps and arbitrage pricing are some good opportunities to explore flash loans.
Collateralized loans
A collateralized loan allows the borrower more time to utilize the funds they receive for providing the collateral. Investors have the option of providing multiple crypto to pump their loans. Remember that cryptocurrency can be extremely volatile and thus the loan-to-value (LTV) ratio is more likely to be low, almost at 50% in some cases. It indicates that the value of your loan would only be worth half the collateral value. This value difference becomes important as it takes into consideration any negative price movement that may occur in the collateral’s value. If your collateral’s value goes below the value of the loan, it is sold and transferred to the lender.
Read more: Crypto staking: benefits & risk
So if you borrow $10,000 BUSD at 50% LTV, you would have to deposit Ether worth $20,000 USD as collateral. When the value goes below $20,000 USD, you would have to pump more funds and if it drops to as low as $12,000, you will face liquidation.
As you borrow, chances are that you receive freshly minted stablecoins or perhaps crypto tokens that have been lent by another investor. Lenders could put their assets in a smart contract that would seal their funds for a certain period. As soon as you receive the funds, you’re at the liberty to use them as per your requirement. But to prevent liquidation you have to keep topping up your collateral so its required value is maintained.
