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Do you want to take out a crypto loan? Here’s what you need to know

Cryptocurrency-based lending has become a mainstay of the decentralized finance (DeFi) universe since smart contract-based lending/borrowing platforms started offering the service to crypto users. The Ethereum network, the first blockchain to scale smart contract functionality, sees most of the Total Value Locked (TVL) on DeFi protocols dominated by cryptocurrency lending platforms.

According to data from DeFi Pulse, the top 4 out of 10 DeFi protocols are lending protocols that account for $37.04 billion in TVL, just 49% of the TVL of the entire DeFi market on the Ethereum blockchain. Ethereum is the leader in terms of the most widely used blockchain for the DeFi market and TVL on the network. Maker and Aave are the biggest players here, with TVL of $14.52 billion and $11.19 billion, respectively.

Even on other blockchain networks like Terra, Avalanche, Solana, and BNB Chain, the adoption of cryptocurrency-based loans has been one of the main use cases of smart contracts in the world of DeFi. According to DefiLlama, there are about 138 protocols offering crypto loan-based services to users, totaling a TVL of $50.66 billion. Besides Aave and Maker, the other prominent players in this protocol category on blockchain networks are Compound, Anchor Protocol, Venus, JustLend, BENQI and Solend.

Johnny Lyu, the CEO of crypto exchange KuCoin, spoke to Cointelegraph about choosing blockchain networks for crypto lending. He said:

“I would say the ideal blockchain for lending and DeFi does not exist as each has its own advantages. At the same time, Ethereum’s leadership is undeniable due to many factors.”

However, he did not negate the possibility of the emergence of a truly ideal blockchain for DeFi. Kiril Nikolov, DeFi strategist at Nexo – a cryptocurrency lending platform – shared this view. He told Cointelegraph:

“The short answer is ‘no’. Most blockchains are crypto borrowing friendly. However, key characteristics to look for include liquidity and reliability, while a secondary determining factor could be network fees.”

Considering that the liquidity and reliability of the Ethereum platform is currently at its highest as it is the most widely used blockchain within DeFi, one might consider leveraging these advantages and making it the blockchain of choice.

Celebrity Players

First, a borrower must choose between the major lending protocols on the network such as Maker, Aave, and Compound. Although there is a plethora of crypto lending platforms out there, this article will consider the most prominent ones for ease of explanation and attribution.

Cryptocurrency lending essentially allows users to borrow and lend digital assets for a fee or interest. Borrowers are required to post collateral that will enable them to borrow immediately and use it for their portfolio goals. Platforms like Aave allow you to take out unsecured loans called flash loans. These credits must be repaid within the same block transaction and are primarily a feature for developers due to the technical expertise required to run them. In addition, if the borrowed amount plus the interest is not repaid, the transaction will be canceled even before it is validated.

Because crypto-based lending is fully automated and easy for the average retail investor and market participant, they generally offer an easy way to earn annual percentage returns on the digital assets they hold, or even access cheap lines of credit.

An important aspect of secured loans is the loan-to-value ratio (LTV). The LTV ratio is the measurement of the loan balance relative to the value of the collateral. Since cryptocurrencies are considered highly volatile assets, the ratio tends to be on the lower end of the spectrum. Considering that Aave’s current LTV for Makers (MKR) is 50%, this essentially means you can only borrow 50% of the value as a loan relative to the collateral posted.

This concept is designed to give the value of your collateral room to maneuver should it fall. This will result in a margin call where the user will be asked to replenish the collateral. If you don’t do this and the value of the security falls below the value of your loan or some other pre-determined value, your funds will be sold or transferred to the lender.

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The magnitude of the impact of cryptocurrency-based lending extends beyond the DeFi market as it allows access to capital for individuals or businesses without a credit check. This brings with it a mass population of people around the world who have bad credit histories or no credit histories at all. Since lending and borrowing are all controlled by smart contracts, there is no real age limit for participation by the younger generation, which is traditionally not possible with a bank due to the lack of credit history.

Related: What is crypto lending and how does it work?

Considerations and Risks

With the adoption of DeFi-based lending now growing so much that even countries like Nigeria are taking up the service and El Salvador is exploring low-interest crypto lending, there are several considerations and risks worth noting for investors delving into this space a.

The main risk in crypto lending is smart contract risk as there is a smart contract that manages the principal and collateral in every DeFi protocol. One way to mitigate this risk is through robust testing processes implemented by the DeFi protocols that deploy these assets.

The next risk you need to consider is liquidity/liquidity risk. The liquidity threshold is a key factor here, as it is defined as the percentage above which a loan is considered undercollateralized and thus leads to a margin call. The difference between LTV and liquidity threshold is the safety cushion for borrowers on these platforms.

Another additional risk for lenders is related to temporary losses. This risk is inherent in the Automated Market Maker Protocol (AMM). This is the loss you incur when you are providing liquidity to a pool of loans and the underlying price of the pledged assets falls below the price at which they were paid into the pool. However, this only happens if the fees generated from the pool do not offset this drop in price.

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Nikolov pointed to another risk with DeFi lending platforms. He said: “Another reason is poor collateral listing, which could cause disruption to the entire platform. So if you’re not willing to take those risks, we recommend borrowing from a platform like ours, which guarantees you certain protections like insured custody and over-collateralization.”

Since the rise in popularity of DeFi, there have been several instances of hacks including Cream Finance, Badger DAO, Compound, EasyFi, Agave, and Hundred Finance.

Additionally, both cryptocurrency lending and borrowing platforms and users are subject to regulatory risks. Lyu mentioned that the regulatory framework on this topic has not been fully created in any major jurisdiction and everything is changing right before our eyes. It is necessary to separate borrowers from each other – private borrowers and companies from borrowers.

In essence, the risks outlined make it crucial for you to exercise extreme caution when committing your capital to crypto-based lending, either as a borrower or as a lender. Paolo Ardonio, chief technology officer at crypto exchange Bitfinex, told Cointelegraph:

“It is important that those participating in crypto lending on DeFi platforms are aware of the risks in a fledgling area of ​​the digital token economy. We’ve seen a number of high-profile security breaches that have put borrowers’ and lenders’ funds at risk. If funds are not secured in cold storage, there will inevitably be vulnerabilities for hackers to exploit.”

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Future of DeFi lending

Despite the risks mentioned, cryptocurrency-based lending is one of the most developed areas in the DeFi markets and it still experiences constant innovation and technological growth. It is evident that the adoption of this DeFi category is the highest among the numerous others growing in the blockchain industry. The use of decentralized identity protocols could be integrated into these platforms to verify users to avoid entry by unscrupulous players.

Ardonio continued to talk about the innovation expected in DeFi lending this year, stating, “I expect to see more innovation in crypto lending, particularly in terms of using digital tokens and assets as collateral for loans. We are even seeing non-fungible tokens being used as collateral for loans. This will be an emerging trend this year.”