By Nathan Ferguson
Ever since the advent of Bitcoin in 2008, cryptocurrencies have seen a rise in systems in which they are very well adapted to the everyday life of millions of people all around the world. As integrated as it has become, many advancements have come about in cryptocurrency technology, allowing it to achieve the credibility of something upon which legitimate financial systems can be founded.
In this article, we will be discussing advancements in cryptocurrency technology which is an emerging trend in the cryptocurrency sphere, Crypto Lending.
In order to ensure proper readability and understanding of key core concepts, the entire article is going to be divided into parts and will approach the topic in the following manner:
- What is Crypto Lending?
- Overcollaterization
- Why is Crypto Lending gaining popularity?
Before jumping on to the main bullet points to be discussed, it is necessary to offer some context. Cryptocurrency Lending has risen in popularity in the last few years as innovation in the crypto sphere multiplies exponentially every given year. As this article explores the idea of cryptocurrency lending for purely the purposes of information, it is imperative to know how the idea took root and grew.
Traditionally, cryptocurrency owners are all encouraged to ‘Hold On for Dear Life’ or HODL their cryptocurrency assets in their digital wallets in hopes that the value of their particular cryptocurrency will shoot up and they would be able to go home with more and more profit than they otherwise would make.
However, huge increases in price only take place in highly volatile cryptocurrencies, and they often take time. This may make not just any person but most uneasy and impatient as the value of their cryptocurrency may or may not increase, and those increments may only be very small.
This can be attributed to the high volatility cryptocurrency experiences even as we write this very article. Many cryptocurrencies, with volatilities so high, could mean hundreds of thousands of dollars of profit in just a matter of months, enticing many to keep their cryptocurrencies in their wallets.
Take the most infamous cryptocurrency, Bitcoin, for example. Bitcoin’s price touched $24,000 in December of 2020, which meant an increase of 224% in a year. Right next month, in January of 2021, it touched the $40,000 mark and is now currently being traded at $35,000 as of January of 2022.
With the incentive to exploit such price swings and gain large profits, investors are told to HODL. While many investors do so, there came a time the tug of a problem raised everybody’s heads. While they have held their cryptocurrency in their wallets, they have locked in a sizable amount of their wealth. This is a problem in the eyes of many cryptocurrency investors. In their minds, not being able to use money is a disadvantage to storing cryptocurrency in wallets.
What comes as an answer to solve this is cryptocurrency lending. While there may be many types and forms, this article is being written to provide a good idea as to how lending is carried out in the crypto sphere, with the intention of not encouragement but rather education.
What is Crypto Lending?
At its core, Crypto Lending allows investors a solution to the problem discussed earlier. Whereas one investor may want to profit from the volatility of a particular cryptocurrency asset, they may be forced to take their cash and keep it in the form of that very cryptocurrency in their digital wallet. This traditional method of profiting off the volatility of cryptocurrency assets is indeed still something that is very widely adopted. However, innovation has indeed driven us to another chapter of cryptocurrency adoption.
Crypto Lending allows investors to lock in their investment in terms of an equivalent amount in their chosen cryptocurrency or cryptocurrencies in their wallet while also allowing them to have money they can spend simultaneously. This is the one key feature that led Crypto Lending to have gained so much momentum in the crypto sphere. Let’s dive deeper into this concept in order to ensure a better grasp is achieved.
Crypto Lending is a method allowing investors to both simultaneously keep their money invested in their preferred cryptocurrency assets and have cash at hand that they can very well spend. This is achieved by the investor holding the amount stored in cryptocurrency held up as collateral. The investor can then receive a loan against that collateral, which they will have to return as per the particular lender-borrower agreement. The investor will be known as the borrower in this case.
The process involves the investor using their own money and assets to first acquire a certain amount of a particular cryptocurrency which the lender accepts and then handing that over to the lender as collateral. An agreement is usually set between the lender and the borrower now, according to which an amount is lent to the investor is usually stablecoins, but could be fiat cash too. This depends heavily on the agreement between the borrower and the lender.
However, when such a procedure purely involves fiat currencies such as paper money, it usually involves the person holding up a particular asset and handing it over to the lender as collateral and the person receiving the asset held as collateral upon returning the borrowed amount plus the interest, if there was any.
The collateral the person held is now returned back to the person, and the person now owns 100% of that asset. Any depreciation or appreciation in the value of that asset is now upon the person who owns it. In most of such scenarios, the very asset held as collateral would probably be pieces of real estate, gold or other common but valuable items which are nowhere near as volatile as cryptocurrencies. This introduces us to one key difference in how crypto Lending acts differently than your Normal Everyday Lending most would be familiar with.
Overcollaterization
The asset held as collateral in your normal everyday lending example may appreciate or depreciate in value while you have handed it over as collateral. However, because most assets which are held as collateral are not as volatile as cryptocurrencies, it is generally considered okay to lend money that is close to the value of the item held as collateral as the lender can sell the collateral in order to recover the amount in case the borrower cannot pay it back. In traditional lending practices, the chances of recovering those losses are higher than the chances of recovering losses if the asset held as collateral is a cryptocurrency.
It is due to this that cryptocurrency lenders deploy special practices to ensure they do not incur a loss in this entire process, as the chances of a borrower not being able to return his borrowed amount back always exists. Hence in crypto lending, there is a practice of ‘over-collateralization’. This means that it is often the case that the borrower has to hold and lock as collateral, an amount of cryptocurrency that in value is often much more than the amount he/she is being lent.
This is to ensure that if any said cryptocurrency held as collateral falls in value over time, the lender can get it exchanged with an amount that helps them recover their loss. However, if the tide goes the other way around and the said cryptocurrency increases in value, the lender may as well turn out with a profit in case the collateral is passed off to him as his complete property.
However, all advantages come at a cost. Here the price is paid by the borrower as it can negatively impact them due to the lender requiring ‘over-collateralization’. The borrower must put up at stake far more than what they receive, and coupling that with the interest they have to pay at the end of the agreement, crypto lending may bite into their wallet.
Moreover, some platforms which specialize in handing out crypto loans may require the borrower to maintain what is called a ‘loan to value ratio, or LTV for short. What this essentially means is the borrower must take into account the volatility of the market with respect to their asset, which is held as collateral and must increase the collateral to match the ratio amount agreed at the beginning of the agreement, should the value of the pre-existing collateral fall.
Illustrating this with an example would lead us to produce the following image. Say John has put up $100 worth of BTC as collateral in order to get $10 worth of cash. Now say during the time the borrower has the money borrowed, the $100 worth of BTC falls down in value to $90. At the beginning of the agreement, it was decided that the loan/value ratio must be $10/$100, and hence the borrower must give in $10 worth of BTC more as collateral in order to keep the agreement intact.
These can indeed create problems for the borrower, and hence crypto lending is indeed a practice gaining momentum but only due to the unusual chance of profit for the borrower. This is what we will be focusing on next in this article. If there are such high chances of being struck in a position of problems by market volatility, how is crypto lending still gaining momentum? Why would a person still consider crypto lending?
Why is Crypto Lending gaining popularity?
Incentives are the root motivation for all people to do anything. When it comes to crypto lending, the risk is quite high but so is the potential reward. Let’s go back to reiterating the situation in which one could find themselves due to crypto lending.
The person can use their current cryptocurrency assets and deploy them as ‘collateral’ to a particular lender in order to receive a loan against it. This loan could be in stablecoins, a form of cryptocurrency that tends to stay stable in value.
The reason why many would prefer this is because of the potential profit to the borrower. In this case, if the borrower returns the borrowed amount plus the interest charged, then they receive the entire collateral back. If all the borrower needed was some liquid cash to operate while also making sure his cryptocurrency assets remained intact in order to earn profits due to market volatility, this is all they needed. Now, after they are done with the liquid cash and are in a position to return it back according to the contract, they receive the entire collateral back.
The potential for profit here lies in the value of the particular collateral. If the value of the collateral assets rises in value, the borrower walks home with potentially more money than he borrowed and has paid interest with.
Let’s illustrate this with an example in order to really ensure the point remains reinforced. Take Bart, for example. Bart needs some cash but does not want to liquidate his 5 BTC because he is quite confident that the value of his assets is going to rise. Because he still needs cash and wants to keep his cryptocurrency assets intact, he puts the 5 BTC up as collateral in order to receive a certain amount of money as a loan he may have to pay interest on as well.
Now a week later, Bart is in a position to repay the loan and the interest and can then, according to the agreement between Bart and the lender, repay the loan in order to receive his 5 BTC back. If the price of 5 BTC rises as Bart predicted, he may have walked home with a net profit rather than a net loss.
However, it is important to note that this benefit largely depends on the ‘IF’ the value of the collateral rises.
There are other reasons we can explore as well, which explain why cryptocurrency lending may be popular amongst many, given the good amount of statistics indicating that a sizable chunk of individuals who own cryptocurrency are Millennials and below, the other reasons why cryptocurrency lending may have to do with the preferences of this population.
One trend we are seeing in what this target population likes is the ease of accessibility, and that is seen a lot when it comes to cryptocurrency lending in its current form. As of this year, there are numerous platforms that offer cryptocurrency lending services which are, in a way, giving them an edge over the traditional way people used to access lending services.
In the traditional method of how people used to get loans, they would be subjected to many rigorous checks, which can be a hassle to get through. Credit scores are just one of a large number of other factors by which an individual may be assessed in order to establish their eligibility for a particular amount.
Not only does this make the entire process of getting the very loan a rather less-smooth one, but it also takes time. This means that individuals may have to wait before they can be handed over the loan, as they are subjected to being evaluated on their past banking history.
This is something that cryptocurrency lending platforms have realized and have now strategically placed themselves to give their users a cunning edge over those who access loans via banks in the traditional sense. As a result, in many cases, cryptocurrency loans can be practically instant. As most processes regarding cryptocurrencies take place online, this could also save interested borrowers long hours at the bank and give them increased accessibility over the internet.
Moreover, another reason may have to do with the fact that cryptocurrencies, because of existing on the internet, are accessible all across the globe. However, it is the state of life that varies from place to place. For example, people living in the United States may not feel as big of a hassle getting a bank account as people would in Nigeria. There are many places in the world where easy access to banking services is a facility that individuals can only wish for.
As getting a loan in many places would require access to large financial institutions such as banks, lending services in the traditional sense may not be as accessible to many individuals as they may be to individuals who are looking into cryptocurrency lending. Not only are cryptocurrency lending services instant, but they are highly accessible as they are practically available anywhere there is the internet.
Other than this, there are numerous more reasons which may as well arise from the situations we have discussed before. As stated, traditional banking services check your credit score before offering you a loan. In cryptocurrency lending, it may not be the case necessarily. Hence cryptocurrency lending may be gaining the momentum it is gaining due to another point which gives its users far greater accessibility to its services.
Conclusion
This article explored the core concept of cryptocurrency lending and why it has seen a rise in its popularity, such as the one it is experiencing as of right now. Given it is a fairly new form of lending, responses have been mixed indeed. A good mix of pros and cons and conceptual knowledge has been embedded into the article in order to give readers a good idea of what Cryptocurrency Lending is.