Crypto Lending: What It Is and How It Works

Key Takeaways

• It’s possible to borrow against cryptocurrencies. Like any other loan, a borrower gains access to funds provided by the lender with the promise to repay the loan plus interest.

• The Washington Post says crypto lending is big and growing fast. Celsius, Unchained Capital and BlockFi Inc. have collected more than $35 billion in cash from individuals funding crypto-backed loans. 

• Borrowers and lenders should ensure they understand the terms of a loan to achieve benefits for both from crypto lending. 

The world of cryptocurrencies has grown by leaps and bounds since the most popular one, Bitcoin, was launched in 2009. According to Statista, the market cap for cryptocurrencies has grown from zero in 2009 to $1.7 trillion today. Along with that growth has come a variety of investment opportunities, one of which is lending against cryptocurrencies. 

Here’s an overview of crypto lending, what it is and how it works.

What is Crypto Lending?

Some people may be surprised to learn it is possible to borrow against cryptocurrencies. The process works like any other loan, in that a borrower gains access to funds provided by the lender with the promise to repay the loan plus interest to reward the lender for granting use of their capital. 

In turn, borrowers pledge their crypto holdings as collateral to take loans in fiat currencies. Just as with any other form of collateral, the borrower still owns the crypto they pledge, however, in this instance they’re restricted from using it until the loan is repaid in full. 

Why Invest in Crypto Lending?

For a crypto investor whose primary concern is holding on to their position in the digital currency for as long as possible, borrowing against their holdings enables them to liquify some of them without forgoing potential growth the currency might achieve over the course of the loan. In fact, it is very possible for the borrower to make money on the loan if the value of the collateralized currency increases in relation to the currency borrowed over the life of the loan. 

On the other side of the transaction, lenders can earn upwards of 9% on the fiat currencies they provide. Moreover, if the value of the collateralized crypto currency falls over the course of the loan, a borrower must put up more crypto to ensure the value of the collateral remains proportionate to the amount of the loan. 

How Big is Crypto Lending Today?

The Washington Post notes crypto lending is big and growing fast. A few companies have already been established to facilitate these loans. Three such firms, Celsius, Unchained Capital and BlockFi Inc. have collected more than $35 billion in cash deposits from individuals willing to fund crypto-backed loans. 

It is reported that these investors are seeing returns of 9% and greater. Perhaps predictably, traditional financial institutions are finding fault with these companies, saying the loans are riskier than investors believe them to be. Moreover, some regulators are looking closely at the practice out of concerns it may be illegal.

How Does Crypto Lending Work?

As covered above, borrowers pledge a percentage of their holdings in exchange for a loan in traditional currency. This can be an attractive alternative to traditional borrowing as crypto loans typically carry a lower interest rate than mainstream loans. 

Depending upon the policies of the exchange, borrowers may get between 50% and 90% of the value of their holdings. However, borrowers would be well advised to avoid taking a 90% loan because of the volatility of cryptocurrencies. 

Remember that $1.7 trillion market cap we quoted earlier? Back in April of 2021, that figure stood at $2.1 trillion. When the value of collateralized digital currency diminishes, the borrower has to make up the difference to maintain their loan to value ratio. Failure to do so could result in defaulting on the loan and losing the holdings they pledged.

Borrowers can generally designate the fiat currencies in which they’d like their loans denominated. Credit checks are minimal at best, which makes this an appealing option for people with extensive crypto holdings but little to no — or even a negative — credit history. Funds are transferred quite rapidly. Once approved, a borrower can have the cash within hours. 

Lenders need to be cautious though. These loans aren’t backed nor are they overseen by any regulatory agency. You’ll get their crypto if a borrower defaults, but you could still lose much of your investment if it’s devalued. 

Legal Considerations for Crypto Lenders

There are a number of other considerations lenders should make before investing in crypto lending. As we mentioned earlier, one of the most important is the lack of regulatory oversight. As of this writing (February 2022) there is little in place to protect lenders. 

Therefore, it is critical to understand every aspect of the lending agreement you enter into with a loan-originating platform. One of the most important things upon which to gain clarity is that you’ll have a first-ranking security interest over the crypto assets pledged as collateral.

Volatility is a subject we can’t broach often enough when discussing anything cryptocurrency related. Stability in the asset class is minimal at best. You’ll have to make sure you’re protected against declines in the value of your collateral.

Another key point upon which to have clarity is the right of usage the borrower has of the pledged assets while the loan is still active. The assets are usually frozen until the loan is repaid. However, this must be stipulated in the loan agreement. 

You’ll also need to be aware of how the collateralized assets will be stored. You must make sure it is properly secured and protected from hackers. In most cases your best bet may  be a cold digital wallet that is not connected to the internet to minimize the likelihood of intrusion by would-be thieves. There could also be blockchain related issues with which to contend such token swaps, rollbacks and forks. All of which can have an effect on the currency backing the loan. 

Legal Considerations for Borrowers

In taking a crypto-backed loan you are putting a portion of your digital assets at risk. You’ll have to trust the borrower, the exchange, or a smart contract to safeguard them. Hacks and scams do happen. You might also run into a time delay when it’s time to regain custody of your currency.

It’s important to remember you’ll forgo control over the pledged assets until the loan is repaid. This means any potential opportunities that come up in the marketplace while the funds are committed will be missed. You must also keep a watchful eye on the nature of the market. Should the value of your crypto assets drop precipitously you could be called upon to shore them up. You could lose them altogether if you’re unable to do so.

The exchanges facilitating these loans aren’t insured. Should the platform you choose go under, your crypto assets will likely vanish with the exchange. Moreover, some exchanges have preferred currencies, so you’ll need to make sure the exchange you’re thinking of using accepts deals denominated in the particular digital assets you’d like to use as collateral. 

In Summation

It’s critical that both borrowers and lenders conduct research to ensure they understand the terms of a loan — and that they’re working with credible individuals all around. Done right, there are many benefits to be derived from crypto lending for both borrowers and lenders. 

Borrowers can liquify a portion of their holdings to achieve gains in other areas without surrendering them altogether. Lenders can realize gains from the interest paid on the loans. Again though, at the risk of overstating this point, volatility is a very real concern when it comes to crypto. This is especially important when you’re considering crypto assets as an alternative investment with which to diversify your portfolio.  

Meanwhile, there are a number of other alternative investment opportunities to consider that have been proven over time. Yieldstreet, for example, offers a curated selection of alternative investment opportunities that were previously only available to institutions and the ultra-wealthy. These can be used to generate income, grow your overall portfolio value, or achieve some combination of both. 

You’ll find opportunities in asset classes such as Real Estate, Legal Finance, Marine Finance, Commercial and Consumer Finance, as well as Art Finance.