Loans are one of the oldest financial instruments used in history; the first records date back to Ancient Mesopotamia in 2,000 BCE. They have evolved and served to finance all kinds of economic human activities and endeavors from expeditions, wars, startups, or entrepreneurship to money laundering, drug trafficking, and other illicit activities.
With the advent of Blockchain and DeFi, we’ve seen a plethora of novelty and useful applications flourish in this unique ecosystem, and one of the best use-cases for digital assets is called “Crypto Lending”, a new type of loan using crypto as collateral.
Crypto Lending Explained
Lending is the activity of providing money for temporary use on condition of repayment with interest. Loans are essential in the creation, development, and growth of businesses and individual projects, and when invested properly, loans can become a powerful tool to achieve financial independence.
Most of the time, loans are channeled through banks or financial institutions, although sometimes governments also promote social assistance programs that tend to facilitate access to loans with affordable interest rates. There’s an old saying: “To get a loan from a bank, you must prove to them you don’t need it.” This means that, ironically, if you need a loan from a traditional financial institution you must present tons of economic warranties and must fulfill dozens of tedious requirements, ranging from a current work situation, past solvency, credit score, current address, and many more.
On the contrary, a Crypto Loan does not require the user to meet all the requirements traditional financial institutions usually request; they’re only required to pass a KYC process (in the case of Centralized Exchanges) and have the digital assets deposited on the platform. That’s it! Because these operations are executed using Smart Contracts, the approval or interference of intermediaries who approve or not the loans is not necessary. This is a completely different and inclusive approach, differing from traditional banking: if you intend to use crypto as an economic instrument, you may have access to a loan without restrictions.
Let’s make an example and imagine for a moment that we have a friend called Jane. Our friend Jane has 2 Bitcoin, and BTC is trading at $50,000 USD, which makes it a total of $100,000 dollars worth of this digital asset. Jane doesn’t want to sell her BTC because she believes it will appreciate with time but she needs money for an emergency. She decides to use her 2 BTC as collateral and takes a loan in a centralized exchange like Binance.
Since cryptocurrencies are highly volatile assets, the norm of every crypto lending platform is the Overcollateralization of digital assets in relation to the funds available to borrow. In the case of Jane, even though she has $100,000 worth of BTC, she can only borrow $50,000 (50% of the collateralized assets, depending on the lender). These lending platforms understand the volatility of crypto and they do this to cover their backs in case of a sharp drop in the crypto price.
Following the example above, if BTC rises to $75,000 after a 50% increase, the value of the collateralized assets will also increase by that percentage to $150,000. The available funds to borrow additionally boost with this rise, while the loan amount and interest rate remain the same. In the worst-case scenario, let’s assume the price of BTC drops 50% and now the value of the collateralized assets is worth $50,000, just as much as the loan is taken originally. At this moment, you’ll enter a process called “Forced Liquidation”, in which your collateralized assets will be sold automatically to repay the loan plus interests. Before liquidating your assets, you might receive what is known as Margin Call, a notification that your collateral will be liquidated if partial or total repayment isn’t made. To prevent a Margin Call and Liquidation, the users must make payments to reduce the principal before the price drops below the threshold determined by each platform.
Jane must pay the loan in full before the term or debt expires. In the case of platforms such as Nexo, loans do not have a specific expiration date or term (in fact they are automatically renewed annually), and they’ll generate interest until the loan is paid off, contrary to Binance for example which requires you to set a specific term up to 180 days. There’s usually no penalty for advanced repayment but if Jane doesn’t pay by the end of the term, the smart contract will execute and liquidate the assets, selling them at market price to repay the loan consequently.
Crypto Lending Platforms
Now let’s talk about where you can get these crypto loans, and first of all, we need to separate the platforms that provide this service. In one corner, we have Centralized Exchanges (CEX) like Binance, Nexo, or BlockFi that allow Crypto Lending with selected digital assets and after passing a Know-Your-Customer process. For those who don’t know this, KYC is the process by which an individual proves his identity through public documents, like valid IDs or Passport. For more information about AML and KYC policies make sure to check our AML/Due Diligence Playbook.
On the other hand, Decentralized Protocols like Aave, Oasis, or Compound allow lending and borrowing without having to pass a KYC process validation, just by having crypto on a web-compatible wallet such as Metamask. On these protocols, everything runs on Smart Contracts, so it is imperative that you do your own research before depositing your assets in protocols that haven’t been audited or have a history of hacks and breaches due to wrong coding.
Users might choose either platform depending on their needs, expertise, and funds available. For newcomers, an interesting option might be using platforms such as CEX, Nexo, or Binance since they’re generally more user-friendly, less expensive because they don’t involve gas fees, and also offer customer service in case of issues. For those investors with higher risk tolerance and more liquidity, DEX may provide quite interesting returns and more freedom when it comes to disposing of your assets, and doesn’t require you to pass a KYC process which might not be possible for certain individuals.
- KYC/Due Diligence
All Crypto projects must take into consideration the KYC/AML policies published by the Financial Action Task Force (FATF) to prevent money laundering and funding of illicit activities.
As mentioned before, platforms CEX will require their customers to identify before using their services but on the contrary, DEX doesn’t require anyone to personally identify themselves. This situation might alarm some people who think this might be irrational but consider this: more than 1 billion people worldwide don’t have identification and therefore, can’t access traditional financial services. They can’t open a savings account to store their money. They can’t take out any type of credit, not even a small loan. They’re basically invisible to banks and lending institutions as they’re not credit-worthy.
We understand the importance of preventing money laundering and financing of terrorism but Blockchain and Crypto are tools for financial inclusion. Transferring ideas and principles of traditional financial institutions would be absurd and frankly, catastrophic; financial markets have changed drastically over the past 100 years. Regulators need to be more open to new ideas and alternatives surging from this novel environment.
Every single investment asset has risks and disadvantages imbued to them. The most obvious risk of Crypto Loans is undoubtedly the high volatility of digital assets and how price fluctuations could lead to margin calls and liquidations.
If you decide to go for a DEX loan, you have to do your own research and consider other conditions different from if it were a CEX alternative. First of all, it might be needed to perform a checking, to see if there’s an existing Whitepaper within the project. This is the document that contains all the information related to the project and you are obliged to read it if you want to deposit your funds in a decentralized protocol. Check for audits and expert reports that have been carried out on the code. Hackers will try to exploit these bugs and try to drain the assets deposited in these protocols if they find any flaws.
Other important indicators to look after are Total Value Locked (TVL), Volume, Daily Active Users (DAU), and Blockchain deployed. Depending on these variables, a lending platform could be considered or not as suitable to borrow money from.
- Parties Obligations
The loan agreement is a widely used civil contract, so the rules and principles that govern it are predetermined from centuries ago. It consists of two parties: lender and borrower. The borrower makes their digital assets available by depositing them on the lender’s platform and the latter proceeds to lend an amount of money.
After repayment of the principal owed plus interest, the assets pledged as collateral are returned to the borrower. Needless to say, all the legal clauses and conditions that we find in traditional loan contracts are found in this type of crypto loan (parties, amount owed, interest rate, term, and penalties).
- Data Protection
According to Data Protection regulations like GDPR, users must have control over their personal data managed by data controllers, including financial information which includes assets, liabilities, income, expenses, equity, or cash flow of individuals.
Although not considered as sensitive data, the importance of any financial information is unquestionable and requires lenders to dispose of security tools necessaries to ensure an effective and shielded management of personal data, without their privacy being affected. We must also be considered that citizens have data protection rights that must be guaranteed and able to exercise, regardless of the platform on which it is developed.
Crypto Loans without Collateral
We mentioned Aave before as one of the preferred decentralized lending protocols by the users and it shows in the Total Value Locked (TVL) in the platform which ascends to $8.94 Billion according to DappRadar.
Aave offers a peculiar product called “Flash Loans”. These types of credits are described as loans without collateralized assets. These loans are marketed toward developers because the way they work is very particular and requires extensive knowledge or expertise to execute them.
Flash Loans allow users to borrow any available amount of assets without putting up any collateral, as long as the liquidity is returned to the protocol within one block transaction. To do a Flash Loan, you will need to build a smart contract that requests a Flash Loan. This smart contract will then need to execute the instructed steps and pay back the loan plus interests and fees all within the same transaction.
As financial instruments evolve over time, the lending and borrowing process should also see a progression and adaptation to new technologies such as Blockchain and DLTs. Loans can be vital tools for personal and business development, but they can also ruin lives if they are taken irresponsibly.
Cryptocurrencies are often accused of not having any use case, that nothing can be done with them except speculate on the price but Crypto Loans shows that owning digital assets can provide an instant credit line whenever you want, becoming a powerful mechanism to achieve financial freedom.
Pro Tip: When thinking about taking a crypto loan, it could be a good practice to check if the price of the collateral is rising or after breaking All-Time High. When the price of the asset drops and corrects (it will at some point), the value of the collateral may be reduced accordingly, and this could lead to a margin call and consequently a forced liquidation of your loan, in case of a sharp fluctuation.
- “A Brief History of Lending” Funding Circle. [website] https://www.fundingcircle.com/us/resources/history-of-lending/ (accessed 22 February 2022).
- “What is a Flash Loan?” Aave Protocol. [website] https://docs.aave.com/faq/flash-loans, (accessed 23 February 2022)
Disclaimer: This article contains the author’s personal opinions and should not be considered as financial, investment, or legal advice. Readers must always do their own research.