Decentralization is a core virtue of cryptocurrency. In the crypto community, decentralized finance (DeFi) describes the growing market of financial products and services being built on the blockchain.

Crypto lending has become one of the most successful and widely used DeFi services, and many crypto exchanges and other crypto platforms offer borrowing and lending services. Investors deposit cryptocurrency, which the platform lends out to borrowers in exchange for interest payments.

What Is Crypto Lending?

Crypto lending is a decentralized finance service that allows investors to lend out their crypto holdings to borrowers. Lenders then receive regular crypto interest, similar to interest payments earned in a traditional savings account.

Crypto lending platforms can be either centralized or decentralized, and lenders may be able to get extremely high-interest rates—up annual percentage yields (APYs) of 15% or more—depending on the platform and other factors.

Borrowers can use cryptocurrency lending platforms to secure cash loans using their crypto holdings as collateral.

Crypto lending can be an attractive opportunity for both lenders and borrowers, but recent turmoil in the crypto lending market underscores the tremendous risks involved in the industry.

How Does Crypto Lending Work?

Cryptocurrency lending platforms are like intermediaries that connect lenders to borrowers. Lenders deposit their crypto into high-interest lending accounts, and borrowers secure loans through the lending platform. These platforms then fund loans using the crypto that lenders have deposited.

The platform sets the interest rates for both lending and borrowing, allowing it to control its net interest margins.

Interest rates vary from platform to platform and from cryptocurrency to cryptocurrency. Platforms may also charge fees for their services or offer higher rates for lenders willing to lock up their crypto for a specified time.

Centralized crypto lending involves trusting a company or other entity to oversee and facilitate the lending and borrowing process. Borrowers and lenders register accounts, and borrowers can apply for loans.

Lenders and borrowers can connect their crypto wallets to a decentralized crypto lending protocol, which automatically facilitates the lending and borrowing processes using smart contracts.

A smart contract is a block of code that runs automatically on blockchain networks when certain conditions are met.

Crypto Lending Platforms

Current rates on popular crypto lending platforms suggest lenders can get paid much higher annual percentage rates (APY) than they can expect in most high-interest savings accounts. For example, Gemini advertises that with Gemini Earn, users can receive up to 8.05% on more than 40 cryptos.

Centralized platforms, such as BlockFi, and Nexo, integrate Know Your Customer (KYC) and anti-money laundering regulatory protocols to limit risk.

But not all crypto exchanges offer crypto lending.

Popular decentralized crypto lending platforms include Aave, Compound, dYdX, and Balancer. These platforms use smart contracts to automate loan payouts and yields, and users can deposit collateral to receive a loan if they meet the appropriate requirements automatically.

Pros and Cons of Crypto Lending

Crypto lending has several advantages over traditional bank loans. First, crypto borrowers can secure a loan without a credit check, making loans available to borrowers who might not be eligible for a bank loan.

Borrowers can often secure a crypto-backed loan at a lower interest rate than a bank loan, another advantage of crypto lending.

Crypto lenders can generate passive income on their crypto holdings at rates that are generally much higher than rates on savings accounts. It can also be a more flexible alternative to crypto staking, which involves locking up crypto and pledging it to a blockchain security protocol.

Unfortunately, Glenn Huybrecht, vice president of operations and chief operating officer at Cake DeFi, says crypto lenders must also understand the risks they are taking on.

Institutional borrowers typically make a deal on individual terms with the crypto lending firms. That’s how things went south for Voyager Digital and BlockFi. These crypto lenders lent hundreds of millions of dollars in cash and Bitcoin (BTC) to hedge fund Three Arrows Capital (3AC), and they became exposed when 3AC defaulted. 3AC filed for Chapter 15 bankruptcy on July 1.

Voyager Digital, BlockFi and Celsius are just three examples of cryptocurrency lenders struggling with severe liquidity crises. Voyager Digital recently filed for Chapter 11 bankruptcy protection. Celsius faces insolvency. Vermont’s Department of Financial Regulation said on July 12 that it believes Celsius is “deeply insolvent” and doesn’t have the liquidity to honor its obligations.

“Some lending providers have been very generous with low collateral requirements, which then puts them in hot water when one of their customers defaults,” Huybrecht says.

Jae Yang, founder of crypto exchange Tacen, says, “Because crypto deposits are not insured by any federal insurance, loan holders risk losing their money if the platform provider goes insolvent.  In recent weeks, we’ve seen this risk play out in real-time, with DeFi lending platforms such as Celsius, Babel and Vauld pausing withdrawals due to ‘extreme market conditions’ and leading to a cascade of downstream issues in the process.”

Dikemba Balogu, a chartered financial analyst and financial advisor for Genius Yield and Genius X, says crypto borrowers must also be prepared for a unique set of risks, including a high liquidation risk.

“Decentralized lending with cryptocurrencies typically requires the borrower to deposit up to twice the value of their requested loan or have a loan-to-value (LTV) ratio of 50%,” Balogu says.

“Liquidation triggers are built into the contract, such as an LTV greater than 75%, [which] would lead to automatic liquidation of the borrower’s collateral to make sure the lender receives the principal back.”

Things can get even messier when sudden price drops and illiquidity in the market prevent the lending platform from selling the borrower’s collateral fast enough and at a high enough to cover the lender’s principal, potentially leading to losses for both the borrower and the lender.

The Bottom Line

If you’re considering lending or borrowing crypto, you should fully understand the vulnerabilities associated with their preferred crypto lending platform.

You should also understand the specifics of your lending account or loan terms and the general risks associated with the volatile and loosely regulated cryptocurrency market.