In this article, we will explain what crypto lending and borrowing mean and how they work. We will also cover their benefits and risks.
What Are Crypto Lending and Borrowing?
Lending and borrowing are two of the core elements of any financial system. DeFi and the crypto space make no exception.
Through crypto lending, depositors or lenders provide funds to loan takers or borrowers in return for interest on their deposits. You could think of it as a savings account that puts your money to work and allows you to earn interest.
Borrowers, on the other hand, can thus have access to a specific sum of money immediately in return for an interest they pay.
These two processes involve three parties: the lenders, the borrowers, and the lending platform. Interest rates and lending/borrowing conditions vary from one crypto lending platform to another. How much a lender gets in return for their investment depends automatically on the type of platform used.
Centralized and Decentralized Crypto Lending
In the crypto area, these two processes can be accessed through centralized finance (CeFi) companies or decentralized finance (DeFi) protocols.
- CeFi crypto lending
Centralized crypto lending is a subclass of CeFi and takes place on platforms that work similarly to banks. Their regulations and infrastructure follow those of traditional finance.
They integrate KYC (Know Your Customer) and AML (Anti-Money Laundering) verification, assume custody of customer deposits, and even offer cold storage solutions. The overall process falls under human governance. A few examples of such platforms are BlockFi, Nexo, and Binance.
However, these platforms are susceptible to the same problems as centralized crypto exchanges, such as hacks that could result in the loss of customer deposits. Plus, they act as a custodian.
- DeFi crypto lending
By contrast, DeFi lending takes place on decentralized or P2P lending protocols. It allows users to lend and borrow in a completely decentralized way, all without giving up custody of their coins.
Since it is based on smart contracts running on open blockchains, DeFi lending is highly accessible. Generally, it offers favorable loan terms for borrowers and more appealing interest rates for lenders. A few examples of such lending protocols include AAVE, Compound, and dYdX.
How Do Crypto Lending and Borrowing Work?
Simply put, the entire process typically involves the following main steps:
- The loan taker chooses a lending platform and requests a crypto loan.
- Once the loan is accepted, the borrower stakes their crypto collateral, which is higher than the amount they want to borrow.
- Meantime, the investor funds the loan via the platform for which they receive regular interest.
- The borrower can get back their crypto collateral only when they pay off the entire loan.
Some platforms even offer flash loans, and you can find out more about them in our video on this topic.
Benefits and Risks of Crypto Lending and Borrowing
Some of the benefits of crypto lending and borrowing include:
- Low interest rates – borrowers can often get crypto loans at an interest rate below 10 percent.
- Fast funding – once a loan is approved, the borrower can get the funds in just a few hours.
- No credit check – crypto loans can be issued without the platform running a credit check.
- Higher yields for lenders compared to a conventional savings account.
Crypto lending and borrowing also come with risks, though, such as:
- Smart contract risks – hackers can exploit the smart contract’s vulnerabilities to steal funds.
- Interest rate volatility, and
Whether they use a DeFi or CeFi lending platform, lenders can increase the productivity of their crypto-assets and maximize profits. Borrowers can also use their cryptos as collateral to get fast and inexpensive loans. However, before engaging in either side of crypto lending, it is of utmost importance to understand both the risks and benefits involved and acquaint yourself with a lending platform before using it.