Crypto Basics series: Centralized crypto lending
“Bitcoin”, “blockchain” and “cryptocurrency” are words that most people have at least heard of since the industry exploded in the ordinary public consciousness over the past year and a half.
During this series of articles, we will delve into the basics of the industry, and give an introduction to crypto that will give you a solid foundation in technology and its lexicon (Cryptographers should never be allowed to mention anything the public will eventually need to know.).
In short, it will be enough to understand what people are talking about and decide if you want to learn more.
Read more from PYMNTS ‘Crypto Basics series:
What is a blockchain and how does it work?
What is a crypto wallet and how can you avoid losing a quarter of a billion dollars?
How to lose crypto without being hacked
Is Bitcoin really anonymous and how can law enforcement track it?
What is a consensus mechanism and why does it destroy the planet?
What is mining and why does the Bitcoin business not work?
Tokenomics of Crypto
What is a permitted blockchain and how does centralized decentralization work?
What is a Satoshi? Bitcoins Million-Dollar ‘Penny’
What is a Native Token, Non-Native Token and White-Label Crypto?
So what are cryptocurrencies?
In short, it is a two-part system that works much like basic banking services, at least at random: People lend money to an interest-rate platform, and others lend, usually using their own crypto as collateral. Not so different from using savings deposits to finance equity loans.
But the reality is much more complicated. First, there are two types of lending platforms: centralized, ie private companies, and decentralized financial platforms (DeFi) that use smart contracts to connect lenders and borrowers without a reliable third party such as a bank in the middle. These are issued by independent companies and by many crypto exchanges.
In this first of two articles, we will look at centralized crypto borrowers, which have been in the news a lot in recent weeks.
This is because several of the largest became insolvent after a large borrower defaulted on more than $ 1 billion in loans, causing them to stop withdrawing. One, Voyager Digital, went bankrupt this week, and two more, BlockFi and Vauld, were bought up at good basement prices.
Read more: Reckless crypto lending, opaque operations paved the way for Voyager Digital to go bankrupt
Another, Celsius, is struggling to avoid bankruptcy after investing heavily in the lender’s funds in a lucrative but very risky DeFi project.
See also: Collapse of Crypto Lending Platform Celsius points to major problems
One question is why take out a loan with crypto collateral when you can only sell it?
There are several reasons, starting with the psychology of crypto investors. Even with the recent crash that has left about half of all bitcoin buyers under water, many investors have made a lot of money – on paper – by holding on to their digital assets through thick and thin. They expect that it will not only return to the November highs – bitcoin was close to 70,000 dollars – but that it will continue to rise much higher. Both bitcoin $ 100,000 and even bitcoin $ 1 million were common choruses last year. “Hodl”, which means hold on for dear life, is a popular crypto theme.
Second, in the last six months, everyone who sells would sell low.
Third, taxes. Crypto sales trigger capital gains; loans do not. Even with interest, it’s a bargain.
How lending works
Crypto lending is quite simple. You deposit crypto with the lender, you get back interest, usually referred to as return, paid daily or even every hour. Even if interest rates were always significantly better than the banks offer – even 2% is 10 times what you get from a savings account – lending rates can be outrageous. Celsius, for example, offered 17%.
Different cryptocurrencies and stack coins offer different interest rates. Some lenders, such as the Kraken Stock Exchange, only take institutional buyers, while others offer direct loans to individuals, which can be very small.
It is worth noting that these are not “earn” programs run by some centralized exchanges and DeFi programs where the lender’s capital is invested with a blockchain validator to earn block rewards.
See here: PYMNTS DeFi Series: What is Staking?
How loans work
Borrowing can be very easy for individuals. You deposit cryptocurrency and get a loan – either in stack coins or, from some lenders, in fiat currency.
Individual borrowers take out loans with collateral, which usually requires 125% to 150% of the loan amount, to take into account the extreme volatility of crypto. This is automatically liquidated if the security falls to a point where it is close to the borrowed amount, so margin calls must be processed quickly.
The terms range from a week to a year, and interest rates are generally lower than credit cards. Nexo, for example, offers terms of 0% to 13.9%
Larger institutional borrowers cut individual terms with the crypto loan companies. This is where Voyager Digital and BlockFi went wrong, as they lent hundreds of millions of dollars in cash and bitcoins to a hedge fund, Three Arrows Capital, which lost heavily on a DeFi investment and defaulted.
There are a number of dangers of lending and borrowing.
For borrowers, it is mainly the risk of being liquidated, which means selling when the price falls and gets a capital gain.
For lenders, you trust the lender to lend your capital carefully. If too many loans default, they can become insolvent and stop making payments – as Voyager and BlockFi did.
Apart from that, lenders often lock their crypto so that it cannot be withdrawn during a certain period of time, making it very illiquid.
Some lenders have private insurance and others do not. But no one has FDIC coverage like banks, and legal protection is small.
Then there are the hacks. While DeFi lending protocols are more receptive, you trust that the lending lending company keeps the funds safely stored.
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