Crypto Borrowing: Everything to Know
By Beluga Research September 6, 2023
- Cryptocurrency borrowing involves a user obtaining a loan by pledging their crypto as collateral
- This type of borrowing provides a user with liquidity and makes it possible for them to invest further without selling their initial holdings
- Crypto borrowing gained popularity during the rise of decentralized finance (DeFi) platforms
- Disadvantages include volatility risk, collateral requirements, counterparty risk, high interest rates and regulatory uncertainty
Cryptocurrency borrowing involves a user obtaining a loan by pledging their crypto as collateral. The practice of crypto borrowing goes hand in hand with the range of crypto loans. Crypto loans typically incur interest. There are fees for users who default on their loans. Further, the users may be branded as failing to meet their obligations. This can make it harder for a user to get a crypto loan in the future.
A Brief History
Cryptocurrency borrowing gained popularity with the rise of DeFi platforms. These platforms allow users to lend, borrow and trade digital assets in a decentralized manner. MakerDAO, one of the earliest DeFi projects, introduced decentralized stablecoins backed by collateralized cryptocurrencies. This innovation paved the way for lending and borrowing protocols in the crypto space.
Since then, several lending platforms have emerged, including Compound and AAVE. The platforms often operate on blockchain networks like Ethereum. They use smart contracts to automate the borrowing process. Cryptocurrency borrowing has evolved to include features like adjustable interest rates, different collateral options and sophisticated lending algorithms.
Borrowing: Everything to Know
A user should start by choosing a reputable lending platform that supports borrowing and lending. Next, they should create an account and complete the necessary Know Your Customer (KYC) procedures. The lending platform specifies acceptable collateral types and loan-to-value (LTV) ratios. LTV ratios determine the percentage of collateral value that can be borrowed.
After depositing collateral, a borrower requests a loan by specifying the desired amount and duration. The platform calculates the interest rate based on market conditions and the borrower's creditworthiness. It is important to review the terms and conditions. These include the interest rate, repayment schedule and associated fees.
Upon approval, borrowers receive the funds in their designated wallet or trading account. They can use the funds for various purposes. Examples include investing in other cryptocurrencies, covering expenses and funding business operations. A borrower must repay the loan with interest within a specified timeframe. A failure to repay can result in the lending platform engaging in collateral liquidation.
- Become familiar with the platforms and protocols that facilitate these transactions. Most cryptocurrency borrowing occurs through DeFi platforms that use smart contracts for trustless lending and borrowing. These platforms operate on blockchain networks like Binance Smart Chain.
- Connect the user's digital wallet to a compatible DeFi platform. A wallet acts as a user's gateway to the borrowing process. It allows them to interact with smart contracts and manage borrowed funds. After a user has connected to the DeFi platform, they can explore the available lending options. Then they can choose the cryptocurrency they want to borrow.
- Provide collateral, which can be other cryptocurrencies like bitcoin or ether. The collateral's value determines the user's borrowing limit. If a user does not repay the loan, the lender can liquidate the collateral to recover their funds.
- Absence of intermediaries. Traditional lending involves banks and financial institutions that oversee the process and charge fees. Cryptocurrency borrowing is decentralized. It eliminates intermediaries and reduces the cost of borrowing.
- Speed and efficiency. Traditional lending is time-consuming. It involves paperwork and waiting for approvals. Cryptocurrency borrowing operates on blockchains. This enables speedy transactions and approvals. Smart contracts automate the process. They eliminate the need for manual verification.
- Globally accessible. Cryptocurrency borrowing has fewer borders than traditional lending. Its global reach offers access to more participants. Cryptocurrency borrowing levels the financial playing field. It also expands financial opportunities for new groups of customers.
- Benefits unbanked and underbanked entities. Cryptocurrency borrowing platforms provide an alternative financial infrastructure for entities with few banking options. This empowers users from individuals to businesses to borrow and lend without relying on traditional banks.
- Access to Liquidity . Cryptocurrency borrowing allows individuals to access liquidity without selling their digital assets. This is useful for investors who believe in the long-term value of their holdings and choose not to sell them.
- Diversification . Borrowing cryptocurrencies enables users to diversify their investment portfolio without investing additional funds. The users can employ the borrowed assets to explore different projects. These may include participating in DeFi protocols and engaging in trading activities. The latter action expands a user's exposure to the crypto market.
- Leveraged Trading . Cryptocurrency borrowing allows users to engage in leveraged trading. Users can amplify their trading positions through practices such as staking coins. They can increase their profits if the market moves in their favor. Leveraged trading also carries the risk of greater losses.
- Earn Interest . Cryptocurrency borrowing provides an opportunity for users to earn interest on their holdings by lending their digital assets. They can generate a passive income stream by using assets that would otherwise sit idle.
- No Credit Checks . Cryptocurrency borrowing typically does not require credit checks or extensive paperwork. It is more accessible to users with limited access to traditional financial services. Such users typically face challenges when trying to obtain conventional loans.
- Volatility Risk . Cryptocurrency borrowing exposes borrowers to the risk of market fluctuations. Cryptocurrencies are extremely volatile. If the value of the borrowed assets declines significantly, a user may struggle to repay the loan or provide additional collateral. Any failure on their part could lead to the liquidation of their holdings.
- Collateral Requirements . Cryptocurrency borrowing requires providing collateral, usually in the form of other digital assets. The value of the collateral must often exceed the borrowed amount. There is a risk of losing the collateral if the borrower fails to meet the loan terms. The collateral requirement can limit borrowing capacity for users with limited crypto holdings.
- Learning Curve. A user with zero to little experience in dealing with sophisticated loans may struggle to understand the terms of their loan. A platform or exchange can assist with this concern by giving the user information about loans and how the loans will affect the user's credit. The platform or exchange can also provide tools to practice. Then the user can see what pros and cons the loan may offer.
- Counterparty Risk . Engaging in cryptocurrency borrowing involves trusting a lending platform or individual lender with one's digital assets. While reputable platforms employ security measures, there is always a risk of fraud. Thorough research and choosing trusted platforms or lenders help lessen the risk.
- Interest Rates . The interest rates associated with cryptocurrency borrowing can be significantly higher compared to traditional loans. The decentralized nature of crypto lending and the absence of intermediaries can lead to higher borrowing costs. Users should carefully consider interest rates and associated fees before taking out a loan.
- Regulatory Uncertainty. The regulatory landscape surrounding cryptocurrencies and crypto lending is still evolving. This creates uncertainty and potential risks for borrowers and lenders. Regulatory changes or restrictions have the potential to impact the availability and terms of cryptocurrency borrowing services.