We continue our series of articles on crypto loans. You can read the previous one here. Now let’s talk about what types of crypto loans exist and how they differ from the idea of banks.
The method of lending cryptocurrencies to borrowers at a set interest rate is known as crypto lending. It helps lenders to make a consistent return on unused cryptos while still enabling borrowers to use these assets for other potentially beneficial financial operations. Although the fundamental actions of borrowing and lending are the same as in traditional finance, crypto lending has revolutionized the practice in many ways.
Yes, let’s start with traditional banks. In all industrial economies, banks have played an important role in the financial infrastructure. In general, they act as trusted intermediaries who bind lenders and borrowers safely and securely. Before approving any loans, a bank will carefully review the borrower’s financial and credit history to minimize the risks of a person or company not paying back.
In the worst-case scenario, if a party is unable to repay, a bank will generally be aware of any collateral that can be seized and sold to recover losses. As a result, banks are commonly known as stable places to bring money and receive regular interest rates in local fiat currencies. For instance, banks charge a range of fees in return for offering those services. Yes, that’s right. So, how does crypto lending vary from traditional bank lending?
The currency used is the first and most noticeable distinction between conventional banks and crypto lending. Crypto lending, as the term suggests, is achieved using digital assets including Bitcoin. Price instability is one of the most important effects of using Bitcoin. BTC can see market fluctuations of thousands of dollars in a single day, hour, or even minute. This ensures that, regardless of interest rates, all investors and lenders will face substantial unanticipated profits or losses at any moment. Cryptocurrencies are also younger commodities with substantially reduced liquidity than fiat currencies. This limits the number of individuals that can engage in crypto loans and limits the amount of money that can be lent.
Crypto lending, on the other hand, tends to have advantages that conventional banking does not. History checks and filling out registration forms, for example, will take a long time. Anyone with some tokens will engage in lending or borrowing almost immediately with crypto. While banks still rely heavily on paperwork, crypto lending is entirely digital. In fact, crypto lending uses different mechanisms to ensure repayment, getting rid of the need for credit scores or background checks completely.
So how can we lend our crypto? Can you do it on any platform? Yeah, you can lend your crypto on centralized or decentralized platforms. Both centralized and decentralized platforms offer users a way to earn interest in their crypto. However, the method and risks can vary significantly depending on which one is used. Financial firms that specialize in crypto assets are regarded as centralized crypto lending services.
In several cases, they are similar to conventional banks. These networks, including banks, will be in charge of organizing the flow of funds between lenders and borrowers. The business will calculate appropriate interest rates for each group and process transfers automatically. These platforms will also be responsible for implementing and adhering to their own rules to ensure repayment.
Users must abide by their terms of service, which often require Know Your Client or KYC protocols, as a result of these pressures. The business earns as a result of the numerous commissions it receives. However, since they specialize in blockchain, depositing and borrowing cryptos is a breeze and it is handled digitally.
When opposed to conventional banking, the registration process is still relatively easy. As long as consumers have confidence in a platform’s ability to keep investments secure and make purchases on time, they will be much more open and efficient than fiat banks. The higher interest rates offered by crypto loans, on the other hand, are offset by certain threats.
A user that depends on a centralized platform to keep track of their money is vulnerable to a single point of failure. A customer can incur permanent damages if the business behaves maliciously or falls victim to a hack. Furthermore, crypto-related financial institutions are not governed in the same manner as banks are, and they are not covered by government insurance.
For instance, the most well-known CeFi platforms are:
Decentralized crypto lending platforms are basic protocols that simplify the lending process using DeFi (Decentralized Finance) smart contracts. Lenders may communicate with borrowers more straightforwardly through these arrangements, without the need for third-party oversight.
Note that smart contracts are static pieces of code or instructions that, after those requirements are fulfilled, execute as planned and without fail. Let us send you an example. Rather than depositing money at a bank, a DeFi lender will prefer a loan pool at one of these sites. These pools are similar to bank accounts in that they allow lenders to pool their funds and make them available to borrowers. Smart contracts dictate and execute each pool’s own set of rules. What cryptocurrencies would be permitted in the system, how long lenders must keep their money, and what proportion of payments borrowers would pay back are all examples of regulations or conditions? Once you’ve selected a pool that accepts the cryptocurrency you wish to lend with interest rates or terms that you’re happy with, you can instantly transfer your funds into this pool. Unlike banks or centralized platforms, there is absolutely no type of registration or identity verification process required.
Furthermore, the assets are kept secure in these pools, which are not operated by any private individuals. On the blockchain, any transaction is transparently registered and readily available. This is an advantage that centralized platforms only have when it comes to handling internal transfers.
Here are the examples of DeFi platforms:
Say you have selected a BTC/ETH pool. This means that as long as you transfer your BTC to the pool and comply with the requirements dictated by the smart contract, you will automatically earn the predetermined interest rates. At this point, you may be wondering why there is a second cryptocurrency (ETH) associated with this pool. To understand this, let’s now switch to the perspective of the borrower. If you’re someone trying to borrow funds from a bank, as previously mentioned, you will either need an acceptable credit score or enough assets for collateral. The concept of collateral is also applied to decentralized crypto lending. To borrow BTC from this BTC/ETH pool, the smart contract requires you to first offer you an amount of ETH equal to or higher than the amount of BTC you wish to borrow. This is how the pool ensures that even if you never repay the BTC, lenders will still be compensated. If you wish to borrow $100 worth of BTC, most pools will require you to first deposit $150 worth of ETH. Once you’ve completed your financial activities employing the borrowed BTC, you can transfer the original amount plus the agreed-upon interest back into the pool at any time.
The smart contract will then refund your collateral ETH to you directly. Your extra interest rate is immediately allocated to all lenders about their BTC allocations to the fund. Volatility is, yet again, a big problem for decentralized crypto lending services. Therefore, CoinRabbit is a centralized service.
Significant market fluctuations will quickly result in unpredictably poor returns, if not outright losses, for lenders. Smart contract code can also contain glitches. Hackers have taken advantage of glitches or vulnerabilities in the code to drain funds from pools on many occasions.
Finally, interest rates are generally determined based on the liquidity of these pools. With volatility, vast amounts of cryptos can move in and out of these pools within short periods. As this happens, interest rates may become increasingly unfavorable, especially when considering opportunity costs. For someone with unused funds seeking profits, crypto lending is an excellent option to earn a passive income through interest payments.
However, since crypto lending needs upfront leverage, it’s difficult to understand whether or why someone would want to borrow money in this way if they do have other investments. The fact is that there are several imaginative and profitable ways to use these types of loans.
There are three major ways that can help people to earn more crypto via lending. A large number of both centralized and decentralized crypto lending options means a wide variety of interest rates for all cryptos. Frequently, a person can discover crypto that can be borrowed at a low-interest rate in one pool but lent at a higher interest rate in another. For instance, this means that the cryptocurrency used as security has a lower earning potential than the borrowed capital.
Imagine you find a BTC/USDT pool and you believe the price of BTC will soon fall. You could deposit your collateral USDT to borrow $100 worth of BTC. You immediately sell the BTC and if the price drops by 50%, you can purchase back the BTC for $50. You would have made a $50 profit without the interest fee as you repay the initial volume of borrowed BTC. This is a modern and unique breakthrough in the crypto lending business, enabling people to borrow money without having to put up any collateral.
A smart contract, on the other hand, is configured in such a manner that the borrowed funds must be repaid to the original account in a single series of transactions. For example, suppose you take out a 100 USDT flash loan with a multi-step smart contract. Such steps may include some interest rate arbitrage transactions to yield a profit while still ending up with the original 100 USDT going back into the lending account. If any of the steps in between cannot be executed in a way that would allow for the money to return, the entire loan never initiates.
Through this multi-step smart contract, the lender can always ensure the safe return of funds plus interest. The main disadvantage of this method is the coding knowledge required to interact and set up these contracts properly. You have to be very knowledgeable when it comes to this option. For most crypto borrowers, this is not gonna be something they would do. For the time being, crypto financing is only in its infancy, but the latest range of viable solutions already offers major advantages over conventional banking. The rewards for all crypto investors will grow as infrastructure and funding into this field progresses.
CoinRabbit is an instant crypto lending platform that allows you to borrow stablecoins for 14% APR for an unlimited term against Bitcoin, Ethereum, Bitcoin Cash, NANO collateral and others. Act smart!
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