Traditional Lending vs. Crypto Lending

What Is Traditional Global Lending?

Since the introduction of modern banking, the lending process has been a crucial driver of economic development. In general, a lender provides money, property, or other assets to a borrower under the premise that the borrower will return the assets or repay the lender in the future. More specifically, lenders extend credit to borrowers, which means borrowers must repay the debt. In most cases, lenders provide borrowers with loans in cash, also known as fiat money. However, because lenders require an incentive to lend their money, interest is usually charged in addition to the loan amount, and the interest serves as a lender’s fee for the loan. For example, let’s say a borrower receives a $5,000 USD loan at an annual percentage rate (APR) of 3% over a 24-month repayment term. The resulting loan payments, inclusive of principal and interest, would be $214.91 per month, equating to a total of $5,157.75 — which means the borrower would pay $157.75 in interest.

Traditionally, an intermediary — a bank, for example — facilitates the entire process and acts as the primary authority in the transaction. These financial institutions bring borrowers and lenders together. Specifically, most global banks rely on what’s known as a fractional reserve banking system. Within this framework, a set percentage of bank deposits serves as credit for borrowing customers. In other words, a mere fraction of the amount of money deposited by customers and loaned out to borrowers is actually held in reserve by such banks at any given point in time. One weakness of this system is that if the majority of customers withdraw their money at the same time — in what is known as a bank run — the bank might not have enough money in reserve to reimburse the majority of its customers all at once. This can prove highly problematic, not just to borrowers and lenders, but to entire macro-scale economies.

Financial Technology (FinTech) and Peer-to-Peer (P2P) Lending

Although historically central banks have usually dictated benchmark interest rates, private lenders often compete with one another to win business. For example, the benchmark rate might be 1%, while personal loan rates fall between 1.5% to 3% at financial institutions. Banks and credit unions have historically been the primary source of consumer credit. However, this dynamic has been shifting as crowdfunding and peer-to-peer (P2P) lending platforms like Kickstarter and LendingClub experience widespread adoption. Financial technology (FinTech) and open finance platforms like these can help make financial services more accessible and convenient to the general public. At the same time, these solutions are generally still integrated with the traditional banking system and utilize its centralized infrastructure.

How Does Crypto Lending Work?

In contrast to fiat-denominated lending, which tends to occur on conventional Web 2.0 networks, crypto lending involves the use of cryptocurrency. These digital assets are built on decentralized blockchain technology, which can help make them more transparent, tamper-resistant, and pseudonymous. Moreover, unlike fiat, most cryptocurrency isn’t directly controlled by a sovereign nation and can be sent worldwide via a cryptocurrency protocol’s underlying network. As crypto adoption accelerates, countless crypto lending platforms have emerged to facilitate financial activity across the decentralized economy.

The earliest crypto lending initiatives solved inadequate cash flow by emulating traditional lending products. Crypto lending platforms can unlock the utility of digital assets by securing crypto as collateral against loans. As a result, crypto holders can obtain loans denominated in fiat or other cryptocurrencies without losing control of their assets.

Here’s an example of how it can work:

Let’s say an investor holds 5 ether (ETH), and the market price is on the rise. Since they want to profit on the upward price movement, they’re reluctant to sell any of their ETH. However, they also need cash to fund an unexpected expense and have no other source of capital.

Crypto lending is beneficial in this scenario because investors can receive a crypto-backed loan by utilizing their ETH as collateral, while holding on to an asset that may appreciate in value. However, this process currently operates with a standard requirement of over-collateralization. Most crypto lending protocols require excess collateral to help protect the lenders against crypto price volatility. Although traditional financial institutions also issue loans as a fraction of collateral value, this ratio is often near 0.80 (80%), whereas most crypto loans require 2 (200%) to 3 (300%) as collateral. In other words, if you wanted to borrow $1,000 via a crypto loan, you would need to deposit $2,000 to $3,000 worth of ETH in order to receive the $1,000 in cash. However, in the fast-developing landscape of DeFi, more and more financial products are approaching collateralization in increasingly novel ways.

Centralized Crypto Lending

While essentially all crypto lending involves exchanging digital assets in one form or another, the underlying infrastructure of a crypto lending platform dictates whether the process is centralized or decentralized.

Centralized crypto lending, a subset of centralized finance (CeFi), occurs on platforms that emulate traditional banking regulations and infrastructure. Platforms like BlockFi, Nexo, and Binance integrate Know Your Customer (KYC) and Anti Money laundering (AML) amongst other regulatory protocols. These platforms usually assume custody of customer deposits and implement processes to help ensure collateral is stored securely, often integrating cold storage solutions. Some CeFi platforms also offer deposit insurance. Although setting up access to a CeFi solution can be time-consuming, there are inherent benefits to using a regulated crypto lending platform with structures and policies that are familiar to traditional investors.

Also important to note is that centralized crypto lending occurs on-chain. However, an intermediary facilitates the process and acts as a custodian. Deposits and withdrawals still register to the underlying blockchain, but the overall process falls under human governance.

Decentralized P2P Crypto Lending Platforms

Unlike CeFi solutions, decentralized or P2P lending protocols fall within the realm of decentralized finance (DeFi). In general, DeFi platforms are non-custodial and many don’t adhere to regulatory protocols like KYC or AML. In addition, DeFi lending returns and borrowing rates reflect underlying liquidity pool (LP) supply and demand, which in many cases can make their rates less predictable. Decentralized crypto lending platforms often compete with centralized solutions by offering features like margin lending, favorable interest rates to lenders, and more appealing loan terms for borrowers.

Unlike CeFi lending, DeFi lending is highly decentralized and utilizes automated code to administer most or all processes. Platforms like Aave, Compound, dYdX, and Balancer use smart contracts to automate crypto loan payouts and generate lender yields. This dynamic helps ensure that DeFi platforms remain highly accessible and require only collateral to issue a loan. Users can deposit collateral and receive loans in various denominations such as BTC, ETH, USDC, GUSD, or even fiat. Decentralized crypto lending also generates a public, transparent record of all transactions, making DeFi systems highly censorship resistant.

Despite the benefits of such arrangements, decentralized crypto lending platforms might not adhere to the same regulatory protocols and consumer protection regulations that CeFi platforms do, which may leave users vulnerable if something goes awry. Further, DeFi lending protocol yields are typically lower than those found on CeFi alternatives.

Risks of Crypto Lending

Crypto lending generates several potential benefits for consumers, but comes with unique potential risks. As a result, users should acquaint themselves with these platforms before using them. The major risk vectors of which you should be aware of before engaging with decentralized lending platforms are as follows:

Liquidity Risk (Centralized Crypto Lending): Borrowers may be exposed to liquidity risk when utilizing centralized crypto lending platforms. For example, if their collateral falls below the value that keeps lenders whole, they’ll need to supply more liquidity to the protocol, or lenders risk losing their original investment via liquidation.

Liquidity Risk (P2P Crypto Lending): On DeFi platforms, the use of liquidity pools can result in interest rate volatility if a large amount of capital moves in or out of the system.

Technical Risk (P2P Crypto Lending): Since DeFi crypto lending protocols utilize smart contracts, there’s a risk that the code might be corrupt. As a result, hackers can exploit contract vulnerabilities to steal funds or crash the platform.

Taxation and Regulatory Risk (Centralized and P2P Crypto Lending): Whether consumers utilize a centralized or decentralized crypto lending platform, there can be taxation and regulatory risks. Because many decentralized platforms don’t adhere to KYC, AML, or other regulatory protocols, an element of uncertainty remains evident in emergent decentralized lending practices.

Crypto Lending Pros and Cons

Although crypto lending introduces many remarkable benefits to the process of lending, traditional lending still maintains distinct advantages. For example, almost all crypto loans require over-collateralization, which isn’t an optimal credit mechanism from a lender’s perspective. More specifically, you need to hold cryptocurrency before receiving a loan; there are no unsecured financial products. Of course, this dynamic prevails due to crypto price fluctuations — a variable many fiat currencies are less subject to. However, excess collateral can also serve as an ideal stabilization mechanism that helps prevent liquidation.

In the event liquidation is required, crypto performs well as a collateral source due to its relative ease of liquidity. In contrast, liquidations in traditional credit markets can involve lengthy proceedings. For example, in the event of a bank moving to repossess a house after a lender’s mortgage is in foreclosure. Another benefit of crypto lending is the higher yields it has been known to generate for lenders compared to a conventional savings account. Whether utilizing a centralized or decentralized platform, lenders and borrowers alike can leverage cryptocurrency to help maximize profits and increase the productivity of their assets.