What Is Crypto Lending and How Does It Work?
Table of Contents
Introduction
What is crypto lending?
How does crypto lending or crypto loan work?
Types of crypto loan
Advantages and disadvantages of crypto loans
Things to consider before getting a crypto loan
Famous crypto lending projects
How to borrow using a crypto loan on Binance?
Closing thoughts
What Is Crypto Lending and How Does It Work?
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What Is Crypto Lending and How Does It Work?

What Is Crypto Lending and How Does It Work?

Intermediate
Published Feb 4, 2022Updated Jul 19, 2022
9m

TL;DR

Crypto lending lets users borrow and lend cryptocurrencies for a fee or interest. You can instantly get a loan and start investing just by providing some collateral. This could be through a DeFi lending DApp or a cryptocurrency exchange. When your collateral falls below a certain value, you will need to top it up to the required level to avoid liquidation. When you return your loan plus a fee, your capital is unlocked. 

You can also get collateral-free loans known as flash loans, which you must pay back within the same transaction. If you cannot do this, the lending transaction is reversed before it has the chance to be finalized. Crypto loans make borrowing and lending simple, and the process is completely automated by smart contracts. For many, it's an easy way to earn APY on crypto assets they HODL or access cheap credit.

However, just like any project, smart contract, or investment on the blockchain, crypto lending also involves financial risk. For example, if you use a volatile coin as collateral, you can be liquidated overnight. Smart contracts can also be hacked, attacked, or exploited, which often leads to big losses.

Before borrowing or lending, understand that you will lose custody of your coins. This removes them from your control and reduces your liquidity. Take note of all the terms and conditions of the loan to understand when you can access your funds and any fees involved. You can start taking loans out with your Binance account today by heading to the Crypto Loans page.


Introduction

When you think of gains and losses in crypto, volatile prices and hectic markets can come to mind. But that's not the only way to make money on the blockchain. Crypto lending is an easily-accessible service where you can lend out your funds with relatively low risk. On the other hand, you can also quickly gain access to borrowed digital assets at low-interest rates. Taking out and giving loans is often more straightforward, efficient, and cheap with crypto, making it an option worth exploring for both parties in a loan.



What is crypto lending?

Crypto lending works by taking crypto from one user and providing it to another for a fee. The exact method of managing the loan changes from platform to platform. You can find crypto lending services on both centralized and decentralized platforms, but the core principles remain the same.

You don't just have to be a borrower, either. You can passively earn an income and gain interest by locking up your crypto in a pool that manages your funds. Depending on the reliability of the smart contract you use, there is usually little risk of losing your funds. This could be because the borrower put up collateral, or a CeFi (centralized finance) platform like Binance manages the loan.


How does crypto lending or crypto loan work?

Crypto lending typically involves three parties: the lender, the borrower, and a DeFi (Decentralized Finance) platform or crypto exchange. In most cases, the loan taker must put up some collateral before borrowing any crypto. You can also use flash loans without collateral (more on this below). On the other side of the loan, you may have a smart contract that mints stablecoins or a platform lending out funds from another user. Lenders add their crypto to a pool that then manages the whole process and forwards them a cut of the interest.


Types of crypto loan

Flash loans

Flash loans allow you to borrow funds without the need for collateral. Their name is due to the loan being given and repaid within a single block. If the loan amount cannot be returned plus interest, the transaction is canceled before it can be validated in a block. This essentially means that the loan never happened, as it was never confirmed and added to the chain. A smart contract controls the whole process, so no human interaction is needed.

To use a flash loan, you need to act fast. This requirement is where smart contracts come into play again. With smart contract logic, you can create a top-level transaction containing sub-transactions. If any sub-transactions fail, the top-level transaction will not go through.

Let's look at an example. Imagine a token trading for $1.00 (USD) in liquidity pool A and $1.10 in liquidity pool B. However, you have no funds to purchase tokens from the first pool to sell in the second. So, you could try to use a flash loan to complete this arbitrage opportunity within one block. For example. Imagine that our primary transaction will take out a 1,000 BUSD flash loan from a DeFi platform and repay it. We can then break this down into smaller sub-transactions:

1. The borrowed funds are transferred to your wallet.

2. You purchase $1,000 of crypto from liquidity pool A (1,000 tokens).

3. You sell the 1,000 tokens for $1.10, giving you $1,100.

4. You transfer the loan plus borrowing fee into the flash loan smart contract.

If any of these sub-transactions cannot execute, the lender will cancel the loan before it takes place. Using this method, you can make profits with flash loans without any risk to yourself or collateral. Classic opportunities for flash loans include collateral swaps and price arbitrage. However, you can only use your flash loan on-chain, as moving funds to a different chain would break the one transaction rule.

Collateralized loans

A collateralized loan gives a borrower more time to use their funds in return for providing collateral. MakerDAO is one example, as users can provide a variety of crypto to back up their loans. With crypto being volatile, you will likely have a low loan-to-value ratio (LTV), such as 50%, for example. This figure means that your loan will only be half the value of your collateral. This difference provides moving room for collateral’s value if it decreases. Once your collateral falls below the loan's value or some other given value, the funds are sold or transferred to the lender.

For example, a 50% LTV loan of $10,000 BUSD will require you to deposit $20,000 (USD) of ether (ETH) as collateral. If the value drops below $20,000, you will need to add more funds. If it falls below $12,000, you will be liquidated, and the lender will receive their funds back.

When you take out a loan, you'll mostly receive newly minted stablecoins (such as DAI) or crypto someone has lent. Lenders will deposit their assets in a smart contract that may also lock up their funds for a specific time. Once you have the funds, you're free to do with them as you wish. However, you will need to top up your collateral with its price change to ensure it's not liquidated. 

If your LTV ratio becomes too high, you might also have to pay fines. A smart contract will manage the process, making it transparent and efficient. At the repayment of your loan plus any interest you owe, you'll regain your collateral.


Advantages and disadvantages of crypto loans

Crypto loans have been commonly used tools in the DeFi space for years. But despite their popularity, there are some disadvantages. Make sure to take a balanced look before you decide to experiment with lending or borrowing:

Advantages

1. Easily accessible capital. Crypto loans are given to anyone who can provide collateral or return the funds in a flash loan. This quality makes them easier to acquire than a loan from a traditional financial institution, and there's no credit check needed.

2. Smart contracts manage loans. A smart contract automates the whole process, making lending and borrowing more efficient and scalable.

3. Simple to earn passive income with little work. HODLers can drop their crypto in a vault and begin earning APY without having to manage the loan themselves.

Disadvantages

1. High risk of liquidation depending on your collateral. Even with highly over-collateralized loans, crypto prices can drop suddenly and lead to liquidation.

2. Smart contracts can be vulnerable to attack. Badly written code and back-door exploits can lead to the loss of your loaned funds or collateral.

3. Borrowing and lending can increase the risk of your portfolio. While diversifying your portfolio is a good idea, doing so through loans will add extra risks.


Things to consider before getting a crypto loan

By using a trusted lending platform and stable assets as collateral, you'll have the best chance of crypto loan success. But before you rush into lending or borrowing, consider the following tips too:

1. Understand the risks of handing over custody of your crypto coins. As soon as the coins leave your wallet, you'll have to trust someone else (or a smart contract) to handle them. Projects can be the targets of hacks and scams, and, in some cases, your coins may not be immediately accessible to withdraw.

2. Think about market conditions before lending your crypto. Your coins may be locked up for a certain period, making it impossible to react to crypto market downturns. Lending or borrowing with a new platform can also be risky, and you may be better off waiting until it builds up more trust.

3. Read the loan terms and conditions. There's a vast amount of choice available of where to take out loans. You should look for better interest rates and favorable terms and conditions.


Famous crypto lending projects

Aave

Aave is an Ethereum-based DeFi protocol that offers various crypto loans. You can both lend and borrow, as well as enter liquidity pools and access other DeFi services. Aave is perhaps most famous for its work in popularizing flash loans. To lend funds, you deposit your tokens into Aave and receive aTokens. These act as your receipt, and the interest you earn depends on the crypto you are lending.

Abracadabra

Abracadabra is a multi-chain, DeFi project that allows users to stake their interest-bearing tokens as collateral. Users gain interest-bearing tokens when they deposit their funds in a lending pool or yield optimizer. Holding the token gives you access to your original deposit plus the interest earned.

You can further unlock the value of your interest-bearing tokens by using them as collateral for a Magic Internet Money (MIM) stablecoin loan. One strategy would be to deposit stablecoins in a yield-farming smart contract and then use the interest-bearing tokens to generate MIM. As long as your stablecoins don’t experience volatility, the chances of liquidation will remain low.

Binance

Apart from its exchange services, Binance offers a range of other crypto financial products for users to lend, borrow, and earn passive income. If you don't want to access DApps and manage a DeFi wallet yourself, using a CeFi (centralized finance) option can be much easier. Binance gives access to simple crypto-collateral loans across many tokens and coins, including Bitcoin (BTC), ETH, and BNB. Funds for these loans come from Binance users who want to earn interest on their HODLed crypto.


How to borrow using a crypto loan on Binance?

You can easily borrow crypto directly from your Binance account. First, log in and then head to the Crypto Loans page.


1. Input the amount and crypto you want to borrow.

2. Choose the asset you want to provide as collateral. The amount you need to provide will show in this field based on the Initial LTV seen on the right-side panel.

3. Select the length of time you want to borrow the asset for.

4. Click [Start Borrowing Now] once you're happy with the details of your loan.

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Closing thoughts

When done responsibly, crypto lending platforms provide value to both the borrower and lender. HODLers now have another option to earn passive income, and investors can unlock the potential of their funds by using them as collateral. Whether you choose a DeFi or CeFi project to manage your loans, understand the conditions involved and make sure to prioritize using a trusted platform. Blockchain technology has made it easier than ever to access and provide credit, making crypto loans a powerful tool for those who are interested.