Lending is a basic part of traditional finance, implying loaning out assets and gaining interest in return. Crypto landing gained traction in 2018 and has become a powerful alternative to traditional finance. Cryptocurrency lending allows digital asset holders to earn interest on their assets instead of holding them idle in wallets.
While traditional lending relies on banks and financial institutions, crypto lending may take place on centralized and decentralized platforms. For a beginner, it is crucial to understand all the pitfalls of the lending process, the peculiarities of its types, and the process itself. Let's get into it.
CeFi stands as one of the most accessible gateways for those willing to engage in crypto lending. In this case, there is a centralized entity — a crypto institutional lending platform or an exchange that offers lending tools — acting as a middleman connecting borrowers and depositors.
A depositor is an entity or a person that deposits their assets into custodian wallets on the platform, while the borrower is the side that borrows assets from the platform, often providing collateral. The size of the collateral depends on the platform, while the amount that can be borrowed is calculated with the Loan-to-Value (LTV) ratio. This metric helps determine the proportion of the loan in relation to the size of the collateral. The platform is responsible for managing the deposited funds, matching the users from both sides, and ensuring repayments. The platform also liquidates the process if the asset price crushes and the LVT rate crosses the pre-set level.
The advantage of centralized crypto lending lies in its predictability. The user may pick a plan (or a program) with the chosen asset, amount, the length, and the fixed interest rates offered by a platform. Such an option is suitable for users who require stable returns and predictable costs. Another advantage is simplicity — centralized platforms often offer a user-friendly interface and cope with the arising complexities. KYC verification is a must in the centralized environment, which is also a plus.
With DeFi crypto lending, no intermediary has control over the process but users themselves. DeFi lending protocols are based on smart contracts that manage the process automatically with no third-party involvement. Collateral, interest rates, and liquidation terms are also performed automatically in smart contracts. Anyone can become a part of DeFi lending — just connect the wallet! No KYC, no centralized oversight.
What differentiates DeFi lending is passive income earning through pouring liquidity into liquidity pools. In return, depositors earn interest, earned by the borrowers on the other side of the deal. Who determines the interest rates? — They are automatically adjusted depending on the supply-demand ratio, making the process purely driven by the market dynamics and present environment.
With greater transparency and autonomy of DeFi lending, there’s still risk connected with smart contract vulnerabilities, impermanent loss, and oracle manipulations.
While the advantages are obvious, one should also comprehend the risks associated with crypto loans:
To reduce these risks, it’s worth choosing reliable and reputable lending platforms with a solid track record, customer support, and security checks. It would also be wise to diversify your activity — engaging a part of your funds in CeFi lending, and another portion in DeFi; some assets may just stay idle on cold wallets long-term, and the portion, for example, put in staking.
For borrowers, it’s crucial to track the collateral value and stand ready to add funds or repay it partially in the price fall. Lenders, in turn, should track macro trends that could push scale liquidations.
Following the market movements, keeping up with the updates and news background, and changes in regulations is a must, for knowledge is your first defence against the risks we discussed in this article.
The information provided in this article is for educational and informational purposes only and should not be construed as financial advice. Trading, lending and mining cryptocurrencies involves significant risk and can result in the loss of your invested capital. Readers should conduct their own research and consult with professional financial advisors before making any investment decisions. The author and publisher are not responsible for any financial losses or damages resulting from the application of the information discussed in this article.
