Last week, we discussed different ways that crypto lending works under the hood of CeFi platforms like Lendingblock. Now it’s time to look at the other side of the coin - how do cryptocurrency loans work? What happens once a borrower decides to borrow cryptocurrency?
Crypto loans are more complicated products when compared to cryptocurrency lending, however need not worry, we will start from zero and go over the inner workings of how cryptocurrency borrowing works from all the different angles.
Firstly, what are crypto loans? Put simply, they are loans backed (collateralised) by cryptocurrency. A borrower would use one cryptocurrency to borrow another cryptocurrency (typically a stablecoin) against it. The crypto borrower would then receive the borrowed crypto and do whatever they want with it, similar to how you can get a secured personal loan or even a mortgage in the traditional sense. At the end of the loan, the borrower repays the borrowed crypto plus interest and receives their original cryptocurrency collateral back.
One of the reasons why crypto borrowing is more complicated than crypto lending is down to the financial jargon involved. Let's take a look at the most common terms used when it comes to cryptocurrency loans.
Collateral - this is what the crypto borrower would use to secure the loan, in other words, it gives the lender something to hold and prevents the borrower from running away with the borrowed digital assets. In the event of non-payment of the crypto loan, then the collateral would be forfeit and ultimately go to the lender or crypto borrowing platform.
Principal - this is what the crypto borrower receives when the loan is successful i.e. the borrowed crypto. When the borrower receives the principal, they are in full control of that asset for the duration of the crypto loan, meaning they can sell it, exchange it, lend it out, borrow against it and so on. However, the cryptocurrency principal has to be returned in full at the end of the loan in order to avoid the collateral being forfeited.
Loan-to-value (LTV) ratio - represents the value of the borrowed crypto as a percentage of the value of the collateral. The formula is (value of cryptocurrency principal / value of cryptocurrency collateral) * 100. For example, if a borrower takes out a $10,000 USDT crypto loan against their 1 Bitcoin (exchange rate being $30,000), then the LTV would be 33.33%, because $10,000 USDT is worth a ⅓ of 1 Bitcoin. Each crypto borrowing platform has their own LTV requirements for their crypto loans and there isn’t a standard % for the crypto borrowing market. However, typically, lower LTV loans are seen as lower risk and thus have lower interest rates.
Margin call - this occurs when there is a decrease in the value of the collateral when compared to the value of the principal i.e. the value of the collateral has dropped below a certain level and/or the value of the principal has risen above a certain level. Using the above example of borrowing $10,000 USDT with 1 BTC (valued at $30,000), if the value of Bitcoin drops to $20,000, then the borrower will be required to deposit additional Bitcoin to bring up the total value of the collateral back to $30,000, meaning that the total collateral amount of Bitcoin will need to be topped up to 1.5 BTC to reestablish the 33% LTV.
Liquidation - this can happen for three reasons: 1) a significant amount of time has passed when no additional collateral has been added during a margin call; 2) at loan maturity, the borrower decides not to repay the crypto loan in full; 3) in severe market movements, the loan LTV can rise rapidly, leading to the collateral being liquidated and closing out of the loan. Then the crypto lender will sell some or all of the collateral and return any excess back to the crypto borrower after the lender’s principal has been returned in full.
Collateralised vs uncollateralised loans - some crypto loans can be backed by Bitcoin, Ethereum and other digital assets; these are what’s known as collateralised loans. While other loans can be backed by nothing and formed purely based on trust and reputation, these are what’s known as uncollateralised loans.
So what are the use cases for crypto loans?
There are a number of purposes that cryptocurrency loans fulfill in the blockchain ecosystem.
Access to liquidity - crypto loans allow borrowers to gain access to one cryptocurrency without the need of selling their primary crypto holdings. This means that they can still HODL and take advantage of market opportunities in the meantime.
Shorting - by borrowing one cryptocurrency against another, it is possible to bet on the direction of the market. For example, let’s say you are betting on the price of Ethereum going down, then you can borrow 1 Ethereum (valued at $2000) against your $4000 USDT (200% LTV), as soon as you receive 1 Ethereum, you can immediately sell it for $2000. If the price of 1 Ethereum goes to $1000, now you can buy 2 Ethereum for that $2000. You can then return 1 Ethereum back to the lender and keep 1 Ethereum as profit.
Tax efficiency - in some jurisdictions, getting access to liquidity without selling your cryptocurrency would be a non-taxable event, meaning that the crypto borrower would be able to acquire stablecoin/fiat for short term needs without being liable for capital gains taxes.
How do crypto loans work on crypto borrowing platforms?
There are many platforms and protocols that allow cryptocurrency enthusiasts to borrow one form of crypto against another, though in this piece, we will focus on CeFi platforms like Lendingblock.
Firstly, the crypto borrower would need to create an account and go through all the necessary checks, if required. Unlike traditional finance, most CeFi crypto borrowing platforms do not implement credit checks. At Lendingblock, we also don’t enforce identity verification for withdrawals that are under a certain threshold.
Next, the crypto borrower would be able to create their instant crypto loan. This would involve selecting the currency they wish to borrow, using Bitcoin, Ethereum or some other crypto as collateral, duration and LTV ratio. The crypto borrowing platform will display the amount of cryptocurrency the borrower needs to deposit in order to finalize the loan, the total interest due and payment schedule.
When the crypto borrowing platform receives the user’s collateral, the crypto loan is instantly released and the borrower can do whatever they want with the principal! They have full ownership of the principal and they can sell it, lend it out, borrow against it and so on.
In the backend, the crypto borrowing platform might then put the borrower’s collateral to use - they could lend it out to other parties to earn interest on it for the duration of the crypto loan. Understandably, this process carries a certain amount of risk and that is why it is important to be mindful of the crypto loan platform’s risk management framework before conducting business.
Also, in the background, the backend systems would constantly be checking the price of the collateral and the principal. This is to ensure that if the market moves significantly, events like margin calls and release of excess collateral are processed in a timely manner.
During the term of the cryptocurrency loan, the loan platform may require the borrower to pay interest on a weekly/monthly basis. There isn’t an industry standard when it comes to frequency of crypto loan payments and largely depends on the terms of the platform. Regular crypto interest payments reduce the final payment amount but can be seen as a hindrance to the borrower’s ability to take market opportunities. Some platforms, like Lendingblock, allow all of the interest to be rolled up and paid at the end at no extra cost.
Crypto Loan Repayment
When the cryptocurrency loan matures, the borrower deposits the principal crypto and pays any outstanding interest remaining on the loan. After a successful repayment, the crypto collateral is released and transferred back to the borrower.
In cases where the borrower does not repay the principal or the crypto loan interest in full, the lender has the right to liquidate part of their collateral in order to cover the cost.
We hope that you found our article useful and that it provides some insight into how CeFi crypto borrowing platforms work.
Till next time!