In this article, we’re going to dive deep into the world of crypto lending. We’ll discuss the different ways you can put idle assets to work and take out crypto loans. Plus, we’ll explore some of the most prominent crypto lending platforms and the things to consider before using them.
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What is Crypto Lending?
Crypto lending services enable users to borrow or lend digital assets. There are many novel ways to participate in crypto lending. Many of the most prominent crypto lending and decentralized finance (DeFi) protocols mimic aspects of the legacy financial system. However, the two most common types of crypto lending are through a DeFi protocol or a centralized crypto lending platform.
DeFi borrowing and lending platforms enable crypto holders to deposit funds into liquidity pools and earn rewards from protocol fees. Also, users can lock up crypto assets to take out an over-collateralized loan. Furthermore, centralized crypto lending services make it simple to earn a yield on staking. Users can also lock up crypto assets to take out fiat and crypto loans after providing account security information.
Centralized crypto lending platforms take custody of your assets to take the leg work out of crypto staking. However, DeFi protocols enable users to interact with smart contracts to open up debt positions on-chain.
Decentralized Finance (DeFi)
Decentralized finance (DeFi) is a term that describes an ecosystem of peer-to-peer financial products using public blockchain protocols and Web3 technologies. DeFi provides a broad range of financial tools and services that operate outside of the traditional financial system without intermediaries. Furthermore, DeFi is permissionless and censorship-resistant. Accordingly, anyone with an internet connection can use it.
DeFi platforms often replicate elements of the legacy financial system. In particular, DeFi-based borrowing and lending platforms have seen tremendous success by offering significantly more favorable rates than banks.
DeFi protocols use smart contracts to automate trustless financial applications and agreements between parties. Many DeFi platforms can be combined as a sort of “financial Lego”. For example, you could deposit assets in one DeFi lending protocol and take out an over-collateralized stablecoin loan. Then, you could use this loan to earn a yield in another protocol. This is a process known as yield farming. Moreover, several DeFi platforms are built to harness the liquidity of other decentralized exchanges (DEXs) and automated market makers (AMMs).
Automated Market Makers (AMMs)
An automated market maker (AMM) is a protocol used for decentralized exchanges (DEXs). They allow users to swap crypto assets using algorithms rather than order books. Also, AMMs make it possible to exchange crypto assets in a permissionless way without intermediaries.
Traditional markets tend to require at least three parties. However, AMMs use smart contracts, oracles, liquidity pools, and liquidity providers to facilitate decentralized token swaps without middlemen or a single point of failure. Accordingly, the AMM model has become a vital part of the decentralized finance (DeFi) landscape. Furthermore, users interface with one another directly via smart contracts. The rules for trades are set algorithmically, and asset prices rely on a mathematical formula.
Liquidity Providers (LPs)
AMMs need liquidity to function. This comes from liquidity providers (LPs) who deposit funds into a liquidity pool. Generally, LPs will deposit an equal value of two assets into a liquidity pool for others to trade against. In return, LPs receive a portion of trading fees relative to the size of their deposit. Moreover, LPs are an essential component of DeFi borrowing and lending protocols.
DeFi Lending Platforms
Below, we’ll look at some of the most prominent decentralized finance (DeFi) lending protocols available, according to the total value locked (TVL) as recorded by DeFi Pulse. To interact with most DeFi protocols, you’ll need some sort of Web3 wallet such as MetaMask.
MakerDAO is one of the original DeFi protocols and a pioneering project in the crypto lending space. Users can lock up collateral in a “Vault” with the Maker protocol and take out DAI stablecoin loans against it. Also, every DAI debt is subject to constantly accruing interest, known as a stability fee. The stability is paid at the same time as any outstanding DAI debt.
Furthermore, users can take out a DAI loan up to 66% of the value of their collateral with a collateralization ratio of 150%. Any Vault that falls below this incurs a 13% penalty and is subject to liquidation. Plus, liquidated collateral is sold on the open market at a slightly discounted rate.
Holders of the native MKR governance token can vote on proposals to change the parameters of the protocol. Also, the Maker protocol can mint MKR and sell it to counteract a system-wide decline in collateral in the case of a “black swan event” or mass exodus of collateral.
Aave is an open-source, non-custodial liquidity protocol for borrowing and lending. Users can earn a yield on digital assets by depositing them to the Aave protocol. Plus, the Aave protocol automatically adjusts yields depending on the demand for the protocol.
Once users supply sufficient collateral to the protocol, they can take out additional crypto loans. Also, users can take out “flash loans”, whereby a loan is taken out and repaid in a single transaction with the aim of making a profit. Furthermore, the AAVE governance token enables the community to propose changes to the protocol and cast votes on proposals.
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Compound (by Compound Labs) is a borrowing and lending platform on Ethereum. Users can deposit crypto assets into a Compound liquidity pool and earn compounding interest. As with other crypto lending protocols, the interest rates adjust according to the demand for the platform and the amount of collateral held within the liquidity pools.
Furthermore, users who supply assets to the protocol receive cTokens in return. These cTokens represent user balances of supplied assets. Users can borrow up to 75% of the total value of their cTokens on certain assets. Plus, collateral can be added or removed at any interval. However, if a loan becomes undercollateralized, other users receive a 5% discount as an incentive for liquidating that debt position.
Moreover, the native COMP governance token gives the Compound community a voice in the decision-making process when voting on proposals to make changes to the parameters of the protocol.
Instadapp is an asset management interface and DeFi wallet that works on top of lending platforms such as Maker, Compound, and Uniswap. The platform enables users to streamline their DeFi portfolios and manage all their positions from a single, convenient location.
Users can perform multiple actions in one transaction to save on fees. Plus, Instadapp offers real-time insights so that users can get the best possible prices on token swaps. Also, the platform features a cross-chain bridge for migrating debts and assets between multiple protocols on different networks with minimal friction. The project is powered by the native INST governance token, which enables holders to vote on upgrades to the platform.
Liquity is a decentralized, governance-free, interest-free borrowing and lending protocol. The platform uses batched liquidations and has a minimum collateralization ratio of 110%. Users can lock up crypto assets as collateral to take out LUSD stablecoin loans with a one-time borrowing fee.
Furthermore, users can deposit LUSD into Liquity’s Stability Pool to absorb debt from liquidations. Doing this enables depositors to earn a share of liquidated collateral. Plus, users can stake the LQTY platform token to earn a share of borrowing and redemption fees.
Crypto Lending Platforms
Despite the popularity of DeFi lending protocols, several centralized crypto lending platforms (CeDeFi) exist. Prominent platforms such as Crypto.com, BlockFi, and Nexo offer crypto staking features with custodial services. These lending platforms allow users to avoid the technical risk of interacting with smart contracts and DeFi protocols. However, these platforms operate more like a traditional financial institution than most DeFi protocols.
Lenders can lock up their crypto as collateral and take out crypto or fiat loans. Some investors prefer to use a reputable centralized crypto lending platform that offers stable rates, high levels of security, and an easy-to-navigate interface.
However, users generally need to provide personal information to access these interest-bearing accounts. Accordingly, DeFi lending protocols provide higher levels of anonymity and enable users to participate in crypto lending without giving their personal data away. Moreover, CeDeFi platforms differ from DeFi platforms in that they are managed by a small group of individuals rather than a decentralized community of token holders.
The lines between CeDeFi and DeFi are blurry. However, by introducing regulatory measures and compliance procedures to DeFi, developers and companies are bridging the gap between the legacy financial ecosystem and the crypto world to offer flexible lending solutions and other financial tools.
Crypto Lending: Things to Consider
The first thing to consider is whether you want to use a custodial or non-custodial service. If you’re happy to give custody of your assets to a centralized lending platform, make sure you select a reputable platform with a track record of security. The security of a lending platform is paramount. If a platform or a protocol is hacked, you could lose all of your funds. That said, some lending platforms cover assets up to a certain amount. Plus, you can purchase DeFi insurance that covers smart contract failures and hacks.
If you want to provide liquidity to a DeFi protocol, you should consider the impact of impermanent loss. Impermanent loss occurs when you provide an asset pair to a liquidity pool. When asset prices drop, you could be left with a different ratio of assets to what you provided. Also, these assets could hold a lower value than when you initially deposited.
Another serious consideration is taxes. Borrowing and lending for variable rates can make for highly complex tax situations. Accordingly, ensure that you are familiar with local tax regulations and always keep track of your portfolio.
Furthermore, watch out for changing interest rates. Many crypto lending platforms begin with attractive rates to help onboard new users. However, these rates may fall over time. As such, it’s worth shopping around for the best options. Moreover, always conduct your own research before interacting with any crypto lending platform. Hacks, scams, and malicious attacks are rife in the crypto space, so remember to stay vigilant.
Crypto Lending Explained – Summary
Crypto lending has become one of the most popular ways to earn a passive income using idle crypto assets. Whether you want to lock up your crypto holdings to take out a fiat loan or provide liquidity to a DeFi protocol and earn fees, crypto lending platforms provide flexible financial tools and services that rival many of the existing borrowing facilities in the legacy finance world.
Moreover, DeFi lending services enable anyone, anywhere, to access financial tools, regardless of their geography. As such, DeFi lending platforms lower the barrier to entry for wealth-generating technologies and provide access to decentralized economies.