What is cryptocurrency lending and how does it work?

The COVID-19 pandemic has had a severe negative impact on the returns of traditional investment vehicles such as stocks, gold and real estate, prompting investors to turn to cryptocurrencies in droves. Both individual and institutional investors want to try their luck in this industry. Even during a global recession that has shocked many investors, the industry has delivered solid returns.

Despite the heated debate surrounding the rapidly growing fortunes and wildly volatile volatility that cryptocurrencies bring, there's no denying that the crypto industry has grown rapidly over the past two years. It's still innovating, trying different ideas, and breaking down more barriers in the process. One area that is breaking through is cryptocurrency lending.

What is Cryptocurrency Lending?

Cryptocurrency lending is a novel financial tool that can quickly obtain the cash you need because it allows you to collateralize your cryptocurrency to obtain a loan. Crypto-collateralized loans allow borrowers to use their crypto assets as collateral to obtain loans in fiat or stablecoins.

This allows you to obtain funds without selling tokens, use cash to achieve your goals, and then pay back to recover crypto assets. Crypto loans allow you to use your digital assets to generate dividends by lending out some or all of your holdings.

Crypto lending platforms play a key role in originating such loans. Generally, you can borrow up to 50% of the value of your digital assets, although some platforms may allow you to borrow more. Crypto loans usually have no concept like EMI, and the borrower can make timely repayments before the end of the fixed term. As for the interest rate, the interest rate on the non-stablecoin cryptocurrency popular on Celsius Network is around 4%.

The question of whether cryptocurrency lending is profitable depends on a number of factors. If you default on your debts, you will end up losing your crypto assets. The inconsistency of crypto assets has led to more acceptance of stablecoin loans. On Celcius Network and Nexo, stablecoin lenders can earn 8 percent in profits, while on decentralized cryptocurrency lending platform Compound Finance, Dai and USDC loan annual percentage rates (APR) are 12 percent and 9 percent, respectively.

How does stablecoin lending work?

In terms of interest rates, the peer-to-peer (P2P) lending model is closely influenced by supply and demand scenarios. A lot of lending combined with a low supply of lenders means high returns for lenders. However, if the demand for cryptocurrency loans is low and lenders' supply is high, then borrowers' interest rates will be lowered to attract more borrowing.

If you are thinking about why stablecoins have high interest rates, this might give you quite a bit of information. The double-digit annual rate of return on stable currency loans is mainly related to the principles of supply and demand. Stablecoins are still a nascent industry, accounting for only 2-3% of the total cryptocurrency market cap.

On lending platforms, a significant amount of loan supply comes from stablecoins. Many people buy these cryptocurrencies just to lend them out on these platforms, but the supply is surprisingly low compared to the supply of the top cryptocurrencies. Taking Compound Finance as an example, the total supply of ETH is 50% more than that of DAI and USDC combined.

But in terms of demand, the numbers are startling. On Compound Finance, the demand for DAI is nearly 40 times that of ETH. Large institutional traders and cryptocurrency payment processing companies are behind the huge demand for DAI. Institutional traders include hedge funds and market makers who use cryptocurrency loans to speculate.

How does cryptocurrency lending work?

Like securities-based loans, cryptocurrency-backed loans are backed by digital currencies. Basically, it's similar to a mortgage. You will hold your crypto assets for loans and pay them back within a predetermined period. These types of loans can be obtained through cryptocurrency lending platforms or cryptocurrency exchanges. While you still retain ownership of the collateralized cryptocurrency, you give up the right to transact with the digital currency.

Cryptocurrency lending is a viable option because of several advantages: low interest rates, choice of loan currencies, no credit checks, fast funding, and the ability to earn passive income from idle cryptocurrency. In addition, you can lend your own digital currency on some encrypted platforms and get a higher APY (over 10%).

All cryptocurrency lending transactions have two distinct parties: a borrower and a lender. Borrowers are required to deposit crypto assets as collateral to secure loans from lenders. This arrangement benefits both parties as the borrower receives an instant loan against their crypto assets, while the lender earns interest on the loan issued. If the borrower defaults, they will dispose of the underlying crypto assets to realize their funds.

Detailed steps of cryptocurrency lending

Whether you're looking for a cryptocurrency loan on Binance, Coinbase, or any other platform, the basics are the same. The borrower must go through the following steps.

The lender's steps are:

Things to Know Before Getting Into Cryptocurrency Lending

Cryptocurrency loans are a form of borrowing similar to fiat-backed loans. When trading cryptocurrencies, there are several factors to be aware of.

Can I lend cryptocurrency?

You might be wondering if cryptocurrency lending is safe. Before you become active on a crypto platform as a lender, make sure you are up to date on the details. When you transfer your cryptocurrency to any lending platform, they hold the keys to the cryptocurrency, not you. You only own bonds issued by smart contracts. Checking the auditing standards of smart contracts, the history of the project and its team can help you make an informed decision.

If you are blindly lending your crypto assets, then don’t be surprised if your crypto disappears. For example, QuadrigaCX is nothing short of a horror story. A Netflix documentary discusses the suspicious death of Canadian cryptocurrency exchange QuadrigaCX founder Gerald Cotton and how he misappropriated client funds. About $190 million worth of digital assets were lost on exchanges.

All in all, you need to do your due diligence before deciding to use a lending platform. No matter which lending platform you use, it is crucial to understand the rules and limitations. One mistake can be costly, so please do your best to do your due diligence before making a decision.

Cointelegraph Chinese is a blockchain news information platform, and the information provided only represents the author's personal opinion, has nothing to do with the position of the Cointelegraph Chinese platform, and does not constitute any investment and financial advice. Readers are requested to establish correct currency concepts and investment concepts, and earnestly raise risk awareness.