Cryptocurrencies have generated a variety of opportunities for investors to make money. Perhaps the most common one is the commercialization of mining, which by itself is rewarding, but the overhead costs can sometimes exceed the rewards.
Apart from mining, investors can engage in other profitable operations either linked to the dynamic crypto market, or those that are similar to the conventional economy.
A good example is the crypto lending concept, which is similar to traditional lending, only that it has the potential to generate higher interest rates. So, how is this concept beneficial to the lender and borrower? Before we answer that, let’s understand how cryptocurrency lending works.
The Basics of Crypto Lending
Essentially, crypto lending is a practice of lending digital assets to borrowers who then pay back at a predetermined interest rate. It’s usually done in a peer to peer platform where the borrower must put up some collateral, either fiat currency or digital assets, in order to be approved for a loan. The borrower will then repay the lender using their own tokens or fiat currency after a specific duration of time set by the lender.
More often than not, crypto-based lending is done for margin trading purposes. In this case, a borrower can either take a long or short position. With a long position, the borrower believes that the price of a certain crypto asset will certainly go up. As such, they’ll request to lend some of your funds through the platform to increase their capital and enjoy bigger profits. It should be noted that the interest rate and payback period is set by the lender.
For example, say, you are a borrower with $2,000 worth of Bitcoins, which is currently priced at $20,000. This means that you have 0.1 BTC. Now, let’s say you take a long position and borrow $500 against your $2,000 holdings. You’ll now have 0.15 BTC. If the BTC price indeed increases by say 10% to $22,000, your total holdings, including the borrowed amount, will be $2,750. Once you pay back the loan, you’ll have earned more profit – about 25% – than you could have earned with your initial amount.
Taking a short position works pretty much the same way, only that now you’ll be betting on the falling prices. As such, you borrow the coins when the price is high and sell them when the price is still high. Once the price has fallen, you buy back the coins and refund them to the lender plus the interest. The price difference is your profit, while the interest paid back is the lender’s profit. So, both parties win.
Is Crypto-lending Safe?
Like any other form of peer-to-peer lending, crypto-lending comes with its risks. The biggest concern arises from whether there is a guarantee of lenders getting their money back or not.
To solve this, crypto lending platforms require all borrowers to put up collateral worth more than the amount they intend to borrow. Typically, this concept is referred to as the loan-to-value ratio, which ranges between 60 to 70%, meaning a borrower can only take an amount worth less than the set percentage limit.
Also, if the prices go contrary to what a borrower anticipated, and the loan amount is lower than the margin limit, all their holdings will be liquidated to ensure the lender receives their full lent amount. This goes a long way toward protecting the lender from market volatility.
Other safeguarding measures put in place include lending the platform your holdings directly. This way, you’ll have peace of mind since you’re lending the exchange and not an individual.
Advantages and Disadvantages of Cryptocurrency Loans
In an ideal scenario, cryptocurrency loans are profitable to both the lender and the borrower, but they still come with their own pros and cons. Here’s a look at some of them;
One of the biggest advantages of crypto-lending is that it’s easy to set up an account and get started. As such, there are no skill-sets required, unlike mining or trading.
Also, compared to mining, lending, and borrowing crypto-asset loans is a more affordable way of earning returns. Also, it doesn’t require you to check on your funds regularly since there aren’t any fast actions involved. In fact, as a lender, some platforms allow you to automate your lending account, such that you receive the paybacks without necessarily monitoring your account.
On the downside, however, there are no unified taxation and regulatory policies governing the lending process. This makes it hard for individuals to know the tax implications of their lending activities. In the same vein, should there be any dispute, it will be solved according to the regulations of both users and the platform’s jurisdiction.
Besides the regulation hurdle, some platforms tend to charge high commission rates out of the interest rates paid back by the borrower. What’s even worse is that the commission amounts are set daily and not over the full course of the loan. As a lender, this means that your profit amount is never guaranteed.
Choosing the Right Platform
Generally, there are two types of crypto-lending platforms to choose from – centralized and decentralized.
- Centralized Lending Platforms
Centralized crypto lending platforms are similar to traditional fintech companies that deal with digital assets. This means that they operate under regulations set by a central intermediary who also manages the loan matching process as well as keeps the custody of all assets.
The platform usually sets the interest rates which are favorable to both the lender and borrower.
- Decentralized Lending Platforms
As the name suggests, these platforms aren’t controlled by an intermediary or central authority. They don’t follow the Know Your Customer (KYC) processes, nor do they keep custody of the digital assets.
Also, except for a few, most decentralized platforms have variable interest rates, depending on the demand and supply of the asset on the platform. So, it would be safe to assume that decentralized crypto-lending platforms can be more profitable to a lender than their counterparts.
If you hold a substantial amount of cryptocurrencies but don’t have immediate intention to use or sell them, investing them in a crypto-lending platform can be a sound investment. This way, you’ll earn passive income while still holding your initial crypto amount. Well, the earned interest may not be much but think of crypto loans as a diversification investment tool. More so, you can leave the interest to accumulate to significant amounts or re-invest it to earn more returns.