Crypto-Secured Loans: An Explainer on How They Work
Cryptocurrency has come a long way since its early days. The rapid growth of the crypto market and varied use cases keep transforming the way we use money and do business.
This includes access to personal finance, digitized metals, stablecoins, banking the unbanked, and smart contracts, among others.
Today, you can buy a car or house, hire a lawyer, or pay for your travels with digital assets, as more than 15,000 businesses globally accept Bitcoin. 2,300 of those companies are in the United States. Businesses are adjusting to cryptocurrency’s popularity, and so are consumers. People spend over $1 million on goods and services in Bitcoin every day, in the US.
46 million Americans have invested in Bitcoin and more than 300 million people use crypto around the world. With that, the ever-growing community of crypto businesses and holders are seeking new ways to benefit from their digital assets, without the necessity to convert them into fiat money.
Crypto-secured lending is one of those innovations that let’s borrowers use their digital assets in a new way, effectively connecting lenders and borrowers.
Crypto-secured loans: What are they?
Each day, people spend millions of dollars worth of crypto on goods and services. But there are also those who would like to benefit from their digital assets when making significant purchases without selling them.
Those who are long-term building their crypto portfolio can use a portion of their digital assets to secure a loan in fiat currency. This is similar to how people use their cars or houses as collateral for an auto loan or a mortgage.
You could be a crypto-native business developing a new digital ecosystem aimed at boosting customer loyalty. Or, a car dealer who wants to increase an average receipt amount. On both cases, crypto-secured loans can provide you with a strategic edge against your competitors.
Crypto-secured loans: Types
Similar to regular bank loans, crypto loans come in various shapes and sizes. Depending on their needs, businesses can use ready-made solutions to offer customers the following types of loans involving digital assets.
Collateralized loans require that borrowers deposit their crypto before the loan is funded. Most crypto lending platforms typically request their clients overcollateralize their loans. A low loan-to-value ratio means lower risk of margin calls and more favorable interest rates for borrowers.
This is another type of collateralized loan, with no predetermined term length. Credit lines offered by crypto lending platforms allow users to borrow up to an equivalent of a certain percentage of the deposited digital assets, with no fixed repayment terms. The interest is charged only upon funds withdrawal.
These loans presume borrowing and instant repayment within a single transaction. Flash loans are typically used by crypto traders who want to increase their daily profits using leveraged trading or practice arbitrage trading, which includes buying assets on one platform and instantly selling them on another at a higher price.
Flash loans are mostly offered by crypto exchanges and are considered high-risk. This is because using them may lead to near-instant liquidation of the client’s entire deposit, should the price swing in the wrong direction.
Functionally similar to personal loans, uncollateralized loans are not that popular among crypto users. Since there is no collateral available for liquidation, lenders have to deal with potentially higher risks of losing funds in the event of default.
Applying for such a loan will most definitely include ID verification and a credit check. Not mentioning an increased exposure to the market’s volatility on top of significantly higher interest rates compared to collateralized loans.
Crypto-secured loans: Advantages
Apart from the fact that after repaying the loan borrowers get their digital assets back, crypto-secured loans offer a number of lucrative advantages, such as:
This may be a huge advantage for underbanked borrowers or those who do not have an established credit history. For example, millennials, who are considered the most underbanked generation, are more likely to invest in digital currencies than any other generation.
In the eyes of banks, this consumer type – even if they have more than enough in their crypto savings – may still be considered unreliable borrowers simply because of their age and the fact that more of their assets are held outside of traditional banking institutions. Still, millennials and Gen Z have a strong appetite for credit.
This comes directly from the previous statement. No credit check means less time spent on bureaucracy. Some crypto lending marketplaces can provide a cash loan right after the borrower transfers the required amount of collateral. Have you ever seen incumbent banks acting that fast?
If you believe digital assets’ value will increase as time passes, crypto-backed loans may be an excellent opportunity for borrowers to benefit.
Since crypto-backed loans are secured loans, borrowers receive far better rates compared to standard loans. Combined with the accessibility of these financial products for unbanked or underbanked borrowers, this may become critical when it comes to making big-ticket purchases.
Crypto-secured loans: Disadvantages
Similar to any financial product, crypto loans have a number of drawbacks that every borrower has to consider before applying.
Those who bought Bitcoin at $3,000 and are currently aiming at long-term gains may be less concerned about how another market dip would affect their portfolio. But using those funds as collateral will require more attention to the charts.
In case the crypto assets provided for a crypto-backed loan take a serious plunge, the lender may initiate a margin call requiring borrowers to pledge more crypto to stabilize their loan-to-value ratio. Otherwise, a lender may sell part of their collateral to reduce the market volatility exposure.
The risk of liquidation during a price drop is only one side of the coin. Not being able to access their collateral before a borrower repays their loan reduces their ability to capitalize on their portfolio during market spikes.
This may seem a minor inconvenience, however, it can be quite distressing when the unrealized return exceeds the entire sum of the loan by multiple times.
Compared to more than 18,000 cryptocurrencies existing on the market, the number of digital assets available for use as collateral for crypto-backed loans is limited by a slew of the most popular ones.
Even when it comes to the top ten cryptocurrencies, some of them may not be eligible for loans on certain platforms, so borrowers may have to exchange their digital assets before using them as collateral. This may interfere with their investment strategy and incur additional expenses.
Loans using cryptocurrencies as collateral are not subjected to federal insurance. All lenders and borrowers participating in the process should be aware that in the event of a security breach or a deep market plunge there will be no guaranteed compensation.
Crypto-backed loans are fully digital products and heavily depend on hardware and software integrity.
Crypto-secured loans: Types of lending marketplaces
Before incorporating crypto loans into your business model, you have to decide whether you are going to stick with centralized finance (CeFi) or decentralized finance (DeFi.) Or, find a Marketplace that offers both. While the former operates in a legacy manner giving a “crypto edge” to traditional financial practices, the latter offers a disruptive intermediary-free peer-to-peer ecosystem.
While both may offer lucrative deals, they also have their own strong and weak points. Knowing them is vital for understanding what risks and benefits you may face.
Centralized finance is our past, our present, and, most certainly, our nearest future. This is the system where monetary policy is determined by the state, while banks and financial institutions are overwatched by regulators and act as intermediaries and custodians who facilitate transactions with consumer funds on their behalf.
Regulatory compliance is one of the most obvious positive aspects of CeFi. This typically means that there are centralized entities responsible for all operations with user assets. KYC checks combined with an ability to assess potential borrowers’ financial solvency allow CeFi lenders to offer tailored financial products and better interest rates.
Even with the introduction of DeFi, centralized crypto exchanges like Binance and Coinbase continue dominating the digital assets trading landscape. When it comes to crypto lending, centralized entities still hold a significant market share. This is thanks to attractive interest rates, registered and legitimate operations, and the potential ability to restore access to user funds in case private keys are lost.
Security and privacy concerns may undermine user trust. While companies invest a significant amount of money and effort in user data storage and analysis, their security protocols may leave this information exposed to hacks, blackmailing and identity theft.
Before doing business with any financial service providers, companies and individuals should conduct thorough research into the platforms that will act as their intermediaries and make sure they are trustworthy.
Decentralized finance has become the first major alternative to the legacy financial system. The DeFi market is intermediary-free, which means users deposit liquidity on a non-custodial basis by connecting their crypto wallets to smart contracts.
Unlike CeFi, where users put trust in the intermediary that can conceal the funds’ allocation from users, all lending and borrowing operations in DeFi are governed by open-source codes that provide full transparency.
Finally, DeFi protocols do not require any credit checks or KYC procedure approvals. As long as users have crypto wallets and enough funds to provide collateral, they are welcome to enrol in the market.
Unfortunately, the elimination of intermediaries does not eliminate the trust issue in DeFi. It simply shifts towards the necessity of trusting the underlying blockchain technology and the integrity of smart contracts running on top of it.
DeFi has no institute of reputation – there are no credit scores and no credit-based lending, which means lower capital efficiency compared to CeFi lending markets.
Last but not least, risks of losing or compromising private keys still bear high operational risks. This may lead to a loss of control over user funds or make them fall prey to scammers.
Here, it would be appropriate to say that the line between CeFi and DeFi is becoming quite blurry these days. If a lending marketplace uses blockchain as the underlying technology but is still governed by a third-party centralized entity, it can not be considered 100% decentralized.
Crypto-secured loans: How they taxed in the US?
The IRS Notice 2014-21 classifies cryptocurrencies as “property.” It states that all operations with crypto are to follow common tax rules for property transactions, including paying capital gains taxes whenever you make profit from selling your digital assets.
It is worth noting that borrowing and lending in fiat currencies typically is not considered a taxable event.
Aside from cashing out crypto savings, earning interest by lending or staking crypto, receiving airdrops, mining income, as well as crypto-to-crypto exchange deals are also considered taxable events.
While the lender receives the borrower’s digital assets as collateral and provides a personal loan in fiat money, everything is clear for both parties. In certain scenarios, however, receiving a loan in crypto may incur a taxable event.
Some DeFi protocols use crypto-to-crypto swaps offerings: for instance, CETH in exchange for ETH to facilitate loans. Despite the fact such transactions are still in the gray zone of tax legislation, investors who prefer to stick with a more conservative approach may report such swaps as taxable events.
Another episode in crypto lending that can trigger unexpected tax consequences is liquidation. In the case of a margin call when a borrower was unable to reduce the loan-to-value ratio for their loan, the lender has a right to sell part of the collateral to reduce the risk exposure.
If the liquidation price of the collateral asset was higher than the price the borrower paid when acquiring that asset, the borrower may be subjected to capital gains tax. On top of that, the borrower would be required to pay the tax liability.
Crypto-secured loans: Lending rates as a competitive advantage
The fast advancement of the digital asset market creates challenging conditions for industry players. Lenders and crypto-native businesses are intent on offering unique or more favorable conditions to borrowers to maximize competitive advantage and gain trust with crypto users around the world.
This healthy competition pushes crypto businesses to invent better ways of generating passive income and increasing the value of crypto holdings and investment portfolios, which would result in a greater number of new users. One of them is offering crypto-secured loans or more attractive loan terms through a marketplace letting consumers earn more on their idle digital assets or providing higher returns.
As a rule, CeFi lenders offer higher rates than their DeFi rivals. That is because CeFi platforms’ business model enables for ensuring more stable rates. It makes the whole process more predictable for both lenders and borrowers. Moreover, CeFi crypto lenders can offer more insurance options and even help you avoid additional fees, as you only have to transfer your assets once, unlike when using a DeFi platform.
When exploring the rates and options a crypto-secured loan platform offers, you can determine whether it is suitable for you or not. As usual, apart from attractive rates, it’s worth paying attention to the security and transparency of the company, as well as the way they treat their clients and follow regulations.
About the author
Snehal Fulzele is the founder and CEO Cion Digital. He is on a mission to help non-crypto businesses embed crypto in their existing financial systems. Cion Digital’s Blockchain Orchestration Platform allows institutions to build innovative finance solutions by connecting their existing systems with the complex and ever-changing world of decentralized finance (DeFi). This allows access new revenue opportunities in the evolving digital asset economy.
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