Nansen provides an introductory guide to crypto lending
Money lending is a familiar concept to many - from mortgages, lines of credit, personal loans, and more, many aspects of our lives hinge on these financial transactions. Now with web3 flourishing, crypto lending and borrowing is becoming an essential strategy for enthusiasts to gain exposure to digital currencies, generate passive income, and strengthen their portfolios.
But for those that are newer to the space, how does crypto lending and borrowing work? What risks are involved? What platforms are available? These are all important questions that this article will answer, in addition to sharing insights on how to get started and how to find the best opportunities to develop your knowledge.
Crypto lending applies the age-old concept of credit and loans in the web3 space. Borrowers can take out a loan by offering up their crypto assets as collateral. There are also other types of loans available, such as uncollateralized and flash loans, but the majority are collateralized and will be the focus of this article. On the flip side, crypto lenders can loan out digital assets to receive interest as passive income, much like an interest or savings account offered by traditional banks.
Crypto borrowing and lending occur in both DeFi (decentralized finance) and CeFi (centralized finance) landscapes. In DeFi, there is no central authority governing financial services and products, which are built on the blockchain. Transactions are controlled by smart contracts and only a crypto wallet is required for interactions. Contrasting with this is CeFi, where crypto trades are routed through a central exchange. CeFi companies are responsible for accounts and transactions through KYC (know your customer) regulations, and require users to create an account to gain access to their platform. The difference boils down to whether centralization and system regulation exists. Both systems have their respective benefits and drawbacks and offer a multitude of crypto lending platforms.
The principle of operation for crypto lending is relatively straightforward. To obtain a loan, collateral in the form of digital assets (such as tokens, cryptocurrencies, stablecoins, etc) is required. The exact amount is determined by the loan-to-value (LTV) ratio, which is the loaned sum divided by the collateral's market value. Crypto loans are overcollateralized, meaning LTV ratios are low and the amount lended out is less than the value of the assets. Borrowers pay interest on their loans and the repayment period can vary.
To lend crypto, users deposit their assets with a lending platform and wait for borrowers or investors to take out a loan. The lenders receive interest, with rates that vary depending on type of asset and platform.
DeFi and CeFi lending differ due to the nature of their respective operations. DeFi lending and borrowing is handled by smart contracts, which automate and control the flow of funds. Consequently, variable interest rates are dictated algorithmically and rapidly reflect changes in the market. CeFi interest rates are determined by a third party and tend to be more stable, since loaned funds are usually lent out to borrowers and institutions with fixed repayment terms. Moreover, rate changes from small fluctuations in the market can be propped by a CeFi platform’s own capital.
Crypto lending rates depend on the platform and the type of asset. CeFi lending platforms usually have much higher yields, and stablecoins/fiat deposits tend to earn higher interest compared to other assets like coins. APY (Annual Percentage Yield) refers to the amount of interest that's earned over the course of a year and is used to compare different rates offered.
For coins like ETH and BTC, CeFi platforms rates typically range from 2% - 6% APY, compared to DeFi platforms rates (often 0% - 1% APY). For stablecoins, CeFi offerings range from 10%-12% whereas DeFi rates vary wildly.
Decentralized lending platforms have exploded in popularity over the past few years. There are no financial intermediaries on these platforms and transactions are governed by smart contracts. Moreover, users aren't subject to an approval process since no credit checks are required. We'll cover a few of the big players in this article, like Aave, Compound, and MakerDAO.
Aave is a DeFi lending platform initially deployed on the Ethereum blockchain in 2017. It’s best described as a system of lending pools, where lenders deposit assets into liquidity pools to earn interest and borrowers draw from these pools when they take out a loan. The amount that can be borrowed depends on the posted collateral and the liquidity available.
As it currently stands, Aave supports 17 cryptocurrencies and has two native tokens: aTokens and AAVE tokens. aTokens are issued to liquidity providers, and represent another asset (ex. aBTC, aETH), and are used to represent collateral and earned interest. AAVE is a governance token that allows holders to vote on decisions affecting Aave’s future and can also act as collateral. Moreover, Aave offers both fixed and floating (variable) interest rates and the option to switch between them.
Users can gain exposure to different cryptocurrencies by posting collateral in one coin and borrowing in another. Another unique feature is the offering of flash loans, which require no upfront collateral and must be repaid within the same transaction.
Compound is another DeFi crypto lending platform that runs on the Ethereum blockchain. Similar to Aave, users can deposit digital assets into lending pools to earn interest or take out crypto loans from these pools.
Compound also offers two native tokens: cTokens and COMP. cTokens (ex. cETH, cDAI) are pegged to a crypto asset and can be obtained without restriction by lenders who deposit into liquidity pools. However, they are only redeemable for the specific asset locked into the protocol. COMP is used in user interactions with the Compound market, and lenders receive COMP depending on the amount of cTokens in their wallet. Compound only offers variable interest rates that are inversely proportional to the liquidity in the market.
Compound allows users to gain access to various currencies, much like Aave. In addition, anyone that holds COMP can influence the future direction of the platform – this includes being able to propose and to vote on changes to the protocol, which incentivizes users to hold the token.
MakerDAO is one of the most widely used platforms on the Ethereum network. Maker has two native tokens: DAI and MKR. DAI is a stable currency pegged to the US dollar and is issued to borrowers who have deposited collateral. MKR is the governance token that grants holders the right to regulate future platform development.
It also has the Maker vault, where DAI tokens are created and destroyed every time collateral is deposited or withdrawn. This flexibility allows DAI's peg against the USD to be maintained.
CeFi lending platforms have a central authority acting as custodian of its users' digital assets. Standard services include wallets, crypto loans, and trading. Some platforms also offer a crypto credit card or its own native currency. Much like DeFi platforms, holders of native tokens gain additional benefits, such as user discounts, loan limit increases, and better rates when lending/borrowing.
Interest rates vary depending on the amount deposited, asset demand, and loan terms. Additional unique features include the option to lend fiat currency, flexibility in currency for interest payments, or using NFTs as collateral.
However, several CeFi platforms have faced recent issues with insolvency. Notably, Celsius filed for Chapter 11 bankruptcy after recently suspending all withdrawals in order to maintain liquidity and stabilize operations. Voyager fell in a similar fashion after 3AC's liquidation. Due to a lack of federal regulations, it's still not clear if clients can recoup any or all of their funds, adding a layer of risk to users who opt for centralized lending services.
There are numerous risks with crypto lending, with one of the most significant being market volatility. Since loans are overcollateralized, market movements can multiply user losses in the event of a liquidation or margin call. When large amounts of money flow through a DeFi system, issues relating to low liquidity and interest rate changes might occur as well. On the lender side, there is always the risk of protocol-wide insolvency, though the protocols have various systems in place to mitigate this risk.
Moreover, crypto lending platforms aren’t subject to the same rigorous regulations that traditional financial institutions are. Tax implications of crypto lending and borrowing are unclear, and significant losses aren’t federally insured. This is a double-edged sword – while crypto loans are much easier to acquire and interest rates are attractive, it’s inherently riskier than traditional lending.
Compared to other DeFi strategies like HODLing, borrowing/lending does carry higher risk due to the potential for margin calls or defaults. Yield farming has higher loss potential but can provide better returns.
Researching and choosing a reliable platform with strong financial backing is essential to minimize risk. The security of the lending platform is crucial, especially in DeFi applications where code vulnerabilities can lead to hacks and exploits. Another consideration is whether the platform has any type of insurance policy. For CeFi, the responsibility of asset management falls onto the exchange, so it’s worthwhile to look into investors backing any lending platform. Due diligence should include understanding a platform’s business model/white papers, researching the user base and community, and looking for any history of breaches or hacks.
To start with crypto lending, the first step is to do your research and choose a lending platform.
After choosing a platform, getting a crypto loan can be summarized into a few steps:
For lending out crypto assets, the process is also very straightforward.
Crypto lending has already established itself as a linchpin of the crypto landscape and is here to stay. However, the regulatory future is still murky and unknown. As it currently stands, there aren’t clear laws governing the nature of lending/borrowing of crypto assets, and there may be more government involvement further down the line. In the meantime, there are unique opportunities to diversify your crypto holdings, earn passive income, and explore the web3 space by leveraging crypto lending.
Hopefully by this point, you've gotten a good grasp on the basics of crypto lending and are now on the hunt for opportunities. Discord and Twitter are good sources for up-to-date news about big movements in the crypto landscape. Some key metrics to keep in mind include interest rates, deposit/withdrawal limits, supported assets, lending duration, fees, and platform risks (including insurance coverage).
For more in-depth analytics, Ape Board has fantastic tracking to see open lending positions of a particular wallet. For example, the screens below show a sample wallet with a position in Compound.
Ape Board also offers a comprehensive overview, in-depth history, and detailed analytics for any given wallet. To see more, check out our website here.
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