What is crypto lending?

Content Producer · 16 November 2021
As an investor looking for a passive income, you might look to dividend-yielding shares to provide you with a regular income. But what about if you’re looking for a passive income while investing in cryptocurrencies? If you’re a long term investor of cryptocurrencies and not looking to sell to return a profit, liquidity could be a major factor you’re considering. That’s where crypto lending comes in.

What is crypto lending?

Crypto lending (also known as staking) is a way to generate a passive income from lending your cryptocurrency. This emerging trend in blockchain operates in a similar way to how P2P lending works, except in this channel, it is a form of Decentralised Finance. Investors lend their cryptocurrencies to people who would like to borrow it, in exchange for interest payments which are referred to as crypto dividends. There are specialised platforms that are built to facilitate crypto lending and there are certain exchanges that also host this functionality. Most platforms accept Bitcoin and other stable coins as lending assets.

There are two ways to consider crypto lending – as a borrower and as an investor.

Cryptocurrency lending for investors

Imagine you own 8 Bitcoins and you’re looking to generate a passive income. You decide to deposit all 8 coins into a wallet owned by a crypto lending platform, and by doing so, you will receive a regular interest repayment (daily, weekly or monthly) from this. Recently, the going interest rate for Bitcoin lending is between 3-7%. Other stable coins can generate a higher interest rate based on their demand – at the time of writing, coins such as the Binance USD token has an interest rate of 17%.  The interest rates shown on the lending platforms are often annualised but they are not fixed which means they can change quickly.

As an investor, it’s important to ensure you’re going to be paid back the money you lend, which is why you want to ensure the person you are lending it to is able to pay the money back. As security and guarantee of loan repayment, the borrower has to stake a percentage of their crypto assets to you as the investor. The idea is that if a borrower doesn’t pay the loan back, the investor can sell the borrower’s cryptocurrency to cover some of the losses.

Cryptocurrency lending for borrowers

So why would a borrower use this form of lending instead of a personal loan, P2P lending or another form of credit? Or why would you not sell your cryptocurrency to receive the funds you require? Well, for borrowers using this method of lending, they’re likely big believers in the future of cryptocurrency and are looking to invest long term without selling. This form of lending also isn’t backed by the security of a bank or financial institution so it doesn’t take into consideration your credit score, income or ability to pay back the loan.

Crypto lending allows you to borrow fiat currency (at the time of writing – USD, EUR, CAD) to avoid having to sell your cryptocurrency. As a form of security, the platform requires you to stake 25-50% of our loan in cryptocurrency which ensures that if you were not able to pay back the loan, some of the loan could be recovered.

How does crypto lending work?

Investors and borrowers are connected through a third-party platform that acts as an intermediary. Each platform operates differently, however the general process is:

  1. The borrower requests a crypto loan from a lending platform.
  2. The lending platform accepts the loan request and requires the borrower to stake the loan with a percentage of their own crypto holdings. The borrower will not be able to access this amount until the entire loan amount is funded back.
  3. Investors automatically fund the loan through the platform. From the investor’s side, this process may seem invisible as it is likely their account balance of crypto will remain the same.
  4. The borrower pays back the loan to the platform, which then reimburses the investor.
  5. Regular interest repayments are made to the investors.
  6. Once the borrower has paid back the loan, they will receive back the amount of cryptocurrency they staked as security.

Pros of crypto lending

As crypto lending does not consider any personal information (i.e. your income, credit score, serviceability) or for you to have a bank account, this form of lending is open to anyone. This has a significant amount of risk associated but is an interesting feature when it comes to the power of decentralised platforms.

As an investor, most platforms are fully automated meaning there is limited effort required to begin seeing the lending dividends appear.

Cons of crypto lending

If you are interested in crypto lending, it’s important to understand the risks involved in using these platforms.

Borrowing from a crypto exchange should not be considered similar to borrowing money from a bank. There is a high level of risk in crypto lending, both as an investor and a borrower. Given the high volatility in the crypto market, there is a chance that the price of the crypto you’ve loaned against can collapse. It’s not unusual for the price of crypto to swing rapidly over the course of a day which may be disconcerting for investors looking for a steady yield.

It is also worth considering the risk associated with the lending platform itself. If the overseas-based platform is hacked or disappears, there is likely to be no options for the investors to regain their assets.

Further to this, to be able to participate in lending or borrowing, you’re required to add your cryptocurrency to an online wallet which is far less secure than storing your own cryptocurrency in a physical wallet.

As a borrower, you are limited by the amount you can borrow as it is usually determined as a percentage of the cryptocurrency you can stake. As an investor, you may be limited by when you can start to receive interest as some platforms require you to stake your crypto for a certain time period (30-90 days) before seeing any yield.

Crypto lending platforms in Australia

At the time of writing, there are no lending platforms based in Australia, and as most are based overseas, this means that Australian consumer laws will likely not apply. There are developments of Australian crypto exchanges investigating products that will allow investors to earn interest on the crypto assets they hold.

Like any investment, there is a relationship between the risk you take on and the level of return you receive. If you’re receiving high-interest returns that are more than what your bank will provide you with, there is a correlation with high risk.

It’s important to consider your investment goals and risk tolerance before determining if this investment vehicle is right for you.

Cover image source: Tika (Shutterstock.com)

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As a content producer in the Commercial team at Canstar, Isabella spends her time preparing engaging content for Investor Hub. Her role involves delivering the latest investment news, strategies and how-to guides on everything investment-related from Exchange Traded Funds to cryptocurrency.

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