Investors have several options as a result of the rapid adoption and growth of bitcoins and other cryptocurrencies. This includes using digital assets to secure loans directly linked to their value.
Investors can access cash for immediate needs while still retaining the potential upside of their cryptocurrencies. These loans are not without risk, as the crypto investors who lost billions in 2022 by lending assets to crypto-loan platforms have shown.
This article debunks the concept of crypto loans and bitcoin. The reader will be informed about the risks and benefits of crypto loans. They will also learn more about the available options and the answers to commonly asked questions. First, we will discuss some of the common reasons why investors might consider a crypto-loan.
Why Get a Crypto Loan
A cryptocurrency-backed loan is desirable for several reasons. It allows investors to access cash without having to liquidate their cryptocurrency portfolio. Borrowing against crypto can be used to fund major expenses, such as mortgages and car purchases.
Other people may borrow cryptocurrency to increase their leverage and buy more crypto assets. An investor might borrow US dollars using 20% of his crypto portfolio and then spend that amount to buy more cryptocurrency.
Ideal scenario: the investment pays off. The investor uses the realized profits to repay the loan, and keeps the remainder as profit. They may suffer losses, however, if the value or collateral assets drop significantly during the loan period.
Investors can tap into credit lines without having to spend capital. It is not surprising that several centralized or decentralized products offering crypto loans have attracted an important user base.
Crypto loans are available in different types
Different structures and models can be used to generate profits for the lending entity. These crypto loans can be divided into two categories: decentralized and centralized.
CeFi loans are provided by centralized entities. Investors relinquish collateral ownership when they deposit supported assets onto the platform. They receive a credit limit and can borrow against their capital.
CeFi’s loan platform has a major disadvantage: customers are unable to see how the lender is using their assets. Users must have faith that the platform will implement the highest standards of security and risk management to ensure that they can withdraw capital whenever they wish.
Decentralized Finance (DeFi), loans: DeFi differs fundamentally from CeFi because there is no third-party manager of collateral. The funds are instead stored in smart contracts that manage operations like pooling assets of users, yield generation, and liquidation.
DeFi loans have a high level of transparency, and the protocols are built on computer codes which cannot be easily altered if they are correctly constructed. The loans are also heavily overcollateralized to ensure that the risk of default is minimized. The protocol liquidates user positions automatically when they drop below the threshold.
However, DeFi loan platforms present unique risks. Before using a crypto or bitcoin loan platform, users must assess and understand these risks.
Crypto loan risks
Crypto loans come with a variety of risks. The risks associated with crypto loans are diverse.
Token Risk: The main risk associated with a crypto loan comes from the volatility of digital assets. Risk is increased if the tokens have no value at all and continue to fall for a long period of time. Investors who use such tokens could face liquidation in the event of a sudden decline in value due to negative events, such as network outages or security exploits. Bitcoin (BTC), the most secure collateral asset, is ether (ETH). In the event of a crypto market crash, the risk curve increases significantly.
Counterparty Risk: To generate a yield for their customers, many crypto loan platforms, particularly centralized services, assume significant counterparty risks. These companies lend their customers’ assets to hedge fund, quants, high-volume traders and institutional investors. In some cases, they also loan them to everyday investors looking for a cryptocurrency-backed credit line.
The records indicate that the counterparty risk is a real one. Recent collapses of lending platforms like BlockFi, Celsius and Genesis reveal that these platforms could rehypothecate funds from users. The entity that facilitates the loan uses the collateral posted for its own needs. The entire lending system is also connected as a firm can lend assets to investors or other companies without the required collateral.
Bitcoin-backed Loans Examples
Anyone who is interested in taking out a crypto loan must make it a priority to find a platform that has the lowest counterparty risk. Platforms that don’t offer products with interest are the best. The lenders who only accept bitcoins and use multi-signature solutions or cold storage are safer because they adhere to the principles of security and self custody. The lender cannot rehypothecate the funds, and they are not stored on third-party exchanges where the funds can still be rehypothecated. Low-interest lenders are likely to rehypothecate customer funds. Be careful when choosing a lender because it is cheaper.
Crypto lending presents technical risks that are not typically present in traditional banking. The irreversibility in blockchain transactions is the most fundamental form of risk. In a classic case, developers of the Solana-based DeFi Protocol OptiFi accidentally locked $661k in assets when trying to destroy a Smart Contract.
Other risks include private key thefts, smart contracts exploited and price oracle manipulating. These outcomes are closely linked to DeFi loan platforms. Centralized lenders, however, are not immune to this phenomenon as they participate actively in DeFi for revenue generation.
Margin call: Investors may lose their collateral if their loan-to-value ratio (LTV), which is the amount of money they owe compared to their BTC, falls below a certain level. Imagine an investor who deposits $1,000 in BTC and borrows $500 at 80% LTV. The user will receive a margin request if the collateral balance falls below 80% of their borrowed amount. In our example the user’s collateral is sold to cover the borrowed amount if its value falls to $600.
Most platforms clearly state their LTV ratios, and will issue a call to action for users to deposit additional assets if they are at risk of losing their positions. Users must be quick to respond to margin calls due the volatile nature of crypto markets. Otherwise, they risk losing their collateral. Investors can use crypto loan platforms which send out automated price alerts when the LTV ratio may be in danger. It is important to be financially prepared, and to have the ability at any hour of the day or night to deposit collateral.
Risk of repayment failure: Fixed crypto loans have a pre-determined repayment schedule. If you fail to make payments, you may be charged additional fees or have your collateral liquidated.
Flexible loans let users repay their loans whenever they want. Users may still struggle to repay their loans if they suffer substantial losses in their investments or are faced with financial difficulties. These outcomes could lead to permanent financial losses, which can be avoided if you don’t have exposure to crypto-loans.