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How does cryptocurrency lending work?
Case Study
May 19, 2022

How does cryptocurrency lending work?

Cryptocurrency lending has been around for several years, and has seen exponential growth in the number of users, breadth of assets supported, and the range of lending platforms and approaches. Whilst many crypto enthusiasts may have heard of or even used digital asset lending, fewer are fully aware of how it works underneath the covers. 

Cryptocurrency lending can be thought of in two overarching categories – CeFi (Centralized Finance) and DeFi (Decentralized Finance). In broad terms, with CeFi you are trusting a team with your assets, and with DeFi you are trusting a complex connected code base. If you are curious to learn more about the differences between the CeFi and DeFi lending, you can check out our article here: https://techround.co.uk/cryptocurrency/cefi-vs-defi-difference/

In this post, we will explore what happens under the hood when you decide to use a Centralized Finance lending platform, like Lendingblock.

DYOR!

From the user’s perspective, the maxim of Do Your Own Research holds true, particularly as with lending or borrowing you are establishing a long term relationship unlike simple buying or selling. This in-depth research and due diligence of potential lending platforms for your crypto should include questions about the team, such as “who are they?”, “how long have they been doing this?”, and “do they have relevant experience?”, questions about the company, such as “are they recognised?”, “do they have verifiable partnerships with other trusted firms?”, “how long have they been in business?”, and importantly, questions about what they offer, including “are these rates too good to be true?”, “what do they do with my funds?”, and “how do they generate income to pay the interest they promise me?”. Good CeFi lending platforms have nothing to hide with any of these basic questions, so getting straightforward answers to these questions should be simple. If that’s not the case, it’s cause for concern.

Getting Started

Once you have selected a crypto lending platform and created an account, you should expect that your lender will follow good practices to maintain the integrity of the platform as part of taking care of your assets. This will typically include using blockchain based analytics to check on the provenance of all assets coming into the platform, preventing your investments from being mingled with anything sent from a compromised or suspicious source. Some crypto lending platforms may also ask for information about the source of funds to supplement on-chain analytics. These types of detective and preventive measures are viewed favourably by regulators, even where not strictly mandated, and are a sign that your lending platform takes their fiscal responsibilities seriously.

Having deposited your digital assets with your cryptocurrency lending platform and cleared any checks, you will now have the option to lend them out to start earning interest. The rates you can earn will typically depend on the length of time you wish to lock the assets for, with higher yields for longer periods, and the lowest rates for “open” or “flex” deposits. Note that many so-called flex products have an extended notification for withdrawals, so are actually more like a seven day term for example. When comparing rates, also be sure to double check that the advertised rate applies to the entirety of your deposited amount, as many crypto lending platforms use a splashy headline rate which is only applicable to a small initial investment before reverting to a much lower rate on anything above the low ceiling.

At Lendingblock, we see many customers dipping their toes into the lending pool with short term deposits initially, before taking advantage of higher rates once they are comfortable with the operation of the platform.

Behind the Scenes

So what happens once you’ve entrusted your cryptocurrency to your lending platform and are waiting to receive interest on your Bitcoin and Ethereum?  Exactly how do crypto yield platforms find a way to generate a return on crypto assets to fund the Bitcoin and Etheruem interest rate payments that need to be made? Essentially, this comes down to two strategies: internal lending and external crypto lending. 

Internal lending occurs where Lendingblock has both cryptocurrency borrowers and lenders, and matches funds deposited into our crypto interest Earn product with borrowing demand for our Borrow cryptocurrency loan product. In this case, the borrowed crypto assets are fully collateralised by digital assets provided by borrowers on the Lendingblock platform, and there are no parties involved beyond the crypto borrower, the lender, and Lendingblock.

External lending occurs where there is an excess of deposited crypto funds versus retail crypto borrowing demand on the Lendingblock platform. In this instance, Lendingblock needs to find other ways to earn interest on crypto deposits, by lending Bitcoin and Ethereum to institutional crypto borrowers. As Lendingblock has been active in the institutional crypto lending and borrowing business since 2018, we have developed a comprehensive network of institutional crypto trading relationships, as well as a  comprehensive back office system that manages asset allocation, term durations, interest rates and risk strategy. This system allows our institutional partners to plug their capital requirements into our backend, so we can deploy new Bitcoin and Ethereum assets in a seamless and efficient way. 

Let’s go through a realistic scenario when we, for example, receive a 1 BTC 6 month Earn from a user. 

First, these Earn details are pushed into the backend system that fills out the basic information like amount, cryptocurrency, interest rate, duration, starting/ending dates, expected interest repayment amounts and others. At the same time, this 1 Bitcoin is being swept into our treasury wallet from the deposit address so it can be deployed. 

We then look at potential matches - this involves sorting through all of the offers from our partners and finding the closest one that satisfies our risk requirement, interest requirement and other criteria. Before the match is made, it is reviewed by our team and then the transfer of 1 Bitcoin is initiated from our wallet to the wallet of our provider. 

As a side note, Lendingblock Earns pay out interest on the 1st of every month to all of our crypto Earners, whereas our institutional partners may have a different interest payout schedule to us. For example, they could pay us the interest on a weekly or monthly basis, some even pay the interest at the end of the term, this adds additional cashflow management complexity, which our asset management system needs to handle. 

Maturity and repayment 

Fast forward to the Earn maturity and unlocking, we request the return of the original amount of cryptocurrency and the interest earned on it. When we receive these funds back to our treasury wallet, we double-check that the amounts received are correct.

When the Earn finishes, the Earner’s funds are released along with the remaining interest. This means that the user can now withdraw this crypto or lock it up again in a new Earn. 

All of these entries are logged in our back office system so there is a clear trail of the movement of funds, for accounting, bookkeeping and cashflow purposes. 

Finishing words

As you may have noticed, we have dedicated significant time, resources and thought into ensuring that our systems and processes are able to handle the complexities of crypto lending. 

We hope that you found this post insightful and somewhat interesting. We’ll be producing more similar content on the topic of CeFi, crypto lending and borrowing, as well as general market commentary in the future.