Lending and borrowing are probably the most common practices amongst financial market participants - they are basically fundamental drivers of growth in almost every marketplace. Today, counterparties interact by lending or borrowing assets, commodities or other financial market instruments to create additional value. This practice has been passed down across civilizations and seems to be a perfect fit even for emerging markets like crypto.
So, how do financial market participants lend or borrow assets? There are a couple of avenues that counterparties use to lend and borrow, although banks are the most popular go-to institutions in traditional finance. In the case of banks, market participants who want to lend their money can choose to save and earn interest from their capital. As for those looking to borrow, banks lend them capital at a specific interest rate - this is normally determined by both macro and micro factors.
While banks act as intermediaries, there are other factors which define the underpinnings of lending and borrowing. You've probably come across the word 'collateral' - this is the security that a borrower places in order to advance a loan. In some cases, the security can be physical property such as a vehicle, house or piece of land. Collateral acts as a guarantee that the lender 'bank' will recover their proceeds in case the borrower defaults on repayment.
With most economies being bank-based, lending and borrowing are a fundamental pillar of global markets. In fact, the products tied to this niche have evolved over the years to increase financial inclusion and variety for different types of market participants. Notably, the interest rates vary across markets - depending on systematic and unsystematic factors.
Cryptocurrencies have skyrocketed in recent years and are now expanding to feature a whole range of products - most of which exist in traditional finance. One of the areas that is gaining significant traction is crypto lending and borrowing. This emerging market niche now offers its users avenues to borrow or lend against their crypto assets.
The underlying concept is pretty simple and follows traditional models for lending and borrowing - only this time collateral is either a crypto asset or stablecoin. Let's put it into perspective, you can borrow or lend within the crypto market by placing your Bitcoin as collateral to receive a stablecoin loan. Similarly, one can obtain a Bitcoin loan by placing their stablecoins as collateral.
Being an ecosystem on the rise, crypto provides multiple options for lending and borrowing - both on centralized exchanges like Binance and Decentralized Finance (DeFi) protocols such as Aave, Maker and Compound. The latter is especially lucrative with the rates going as high as 8% annually; in comparison, U.S bank savings accounts offer roughly 1%.
Centralized crypto lending is structured in a similar manner to traditional Fintech - exchanges provide lending style products where users can earn some yield. This type of crypto lending has become a popular way to lend crypto assets like Bitcoin and Ethereum amongst others. The platforms that feature these products normally determine the interest rates - this could vary depending on the lock up period or withdrawal flexibility.
Some of the centralized crypto lending products can yield as much as 6% annually - still higher than the rates offered in traditional finance. It is quite noteworthy that service providers in this niche are required to be KYC compliant which means that users have to provide their proof of identification or residence. This is not the case for DeFi lending protocols as we will see in the next section.
DeFi is the backbone of decentralized crypto lending - this crypto niche went mainstream in summer 2020, although there had been work in progress since 2018. Ideally, the innovations in this space are meant to decentralize traditional finance by creating a permissionless marketplace where participants can interact in a trustworthy and secure manner.
So far, a number of financial products have already been replicated in this upcoming ecosystem - some of which include lending products, decentralized exchanges and derivatives. For the purpose of this article, our focus is on the DeFi lending protocols. These platforms are on the rise and could soon define the future of finance.
As of press time, the leading DeFi protocol is Maker with a total value locked (TVL) of $6.92 billion. This protocol was the pioneer to offer lending style products in DeFi alongside other platforms like Compound and Aave. Unlike centralized crypto lending platforms, DeFi protocols do not require KYC - hence their decentralized nature.
When it comes to the yield opportunity, the rates here could go as high as 8% annually depending on which stablecoin or crypto asset one uses to lend and borrow. Let's take a look at some of the rates on Aave to get a better picture;
As we have highlighted, credit markets play an important role in the creation of wealth by facilitating an ecosystem where lenders and borrowers can interact. In crypto, lending and borrowing opportunities are now providing a platform to further leverage the underlying potential. Here are some of the ways that crypto lending is changing the game:
The rise of lending and borrowing within the crypto market has created more investment opportunities than there were before. Prior to the debut of these products, HODLing or trading crypto assets was the order of the day- crypto market participants had limited options to grow their wealth. With lending opportunities now in the picture, investors and traders can participate in the crypto credit market to earn a passive yield on their digital assets. In fact, some of the options that are available provide less riskier alternatives of participating in the crypto market.
Crypto lending and borrowing can now be compared to traditional credit products in terms of the fundamental value - in fact, some DeFi diehards are of the opinion that the former will eventually phase out traditional financial products. Today, this nascent market provides alternative credit avenues that yield much more compared to the rates offered by some of the largest banks globally. Yield farming opportunities can yield as much as 400% - usually in tokens that might not necessarily have as high worth as it might seem, but in many cases that is still way above the 4-5% offered on U.S junk bonds. It is not surprising that even institutional investors are slowly joining the crypto bandwagon.
The issue of taxes in crypto is a major challenge to most people including the veterans - crypto lending seems to have provided a solution to this headache. While you should note that this is not tax advice, it is probably worth knowing that a dollar denominated liquidity attracts less taxable events. In that case, one can use crypto lending to obtain a dollar denominated loan to help them cover their daily expenses instead of selling their crypto assets. This is because the latter action would trigger a taxable event based on the realized gains, while the former does not.
Crypto lending and borrowing has also created a means to access leverage for the market makers in this industry. By taking out a loan, a crypto trader can increase their position and pay back later when they have realized the profits. Initially, this was only available through margin trading on centralized exchanges - DeFi has now changed the game by featuring a decentralized credit market.
Just like any young innovation, the crypto lending and borrowing ecosystem is still facing some fundamental and technical challenges. Some of these are a result of regulatory uncertainties amongst other macro risks associated with the current global monetary structure:
Most crypto loans are highly over-collateralized because of the volatile nature of this market. Assuming you wanted to take out a USDT stablecoin loan of $100 worth against BTC, the required collateral could be up to $150 worth of BTC. In addition, the loan borrowers have an obligation to keep a close eye on the liquidation ratio to make sure that it is within a safe range at any time. While this may be effective, large volatility wicks could wipe out your capital in minutes.
Crypto lending faces huge technological risks, especially in an experimental space like DeFi. The smart contracts that are used to build DeFi protocols could be compromised at any time - in some cases, millions worth of crypto funds have been drained in hours. Given the technological issues on Ethereum blockchain (where most DeFi apps recide), it may take a while before such risks are completely eliminated.
DeFi lending protocols are largely exposed to liquidity risks - the rates on these products can suddenly shift if a large amount of capital is brought into or taken out of the system. As it stands, whales who dominate this space sometimes take advantage to manipulate such scenarios. It is only prudent to account for significant liquidity risks when using the DeFi lending protocols.
Crypto in general faces serious regulatory risks given that most jurisdictions are yet to set any guidance on digital asset operations. In some countries like the U.S, this has partly hindered both investor and innovator participation in the crypto market. Most people are stuck on the tax implications and other issues like the fact that DeFi is still unregulated - no KYC is required.
The credit market is clearly a growth driver for any financial ecosystem - it follows that crypto lending is likely to grow bigger in the coming years. Going forward, more stakeholders will be joining the crypto market to participate in one way or another. Lending and borrowing opportunities are a perfect on-ramp for both newbies and veterans. However, a lot still needs to be done before these products are adopted mainstream.
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