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Crypto Lending

Crypto Loans: How Do They Work?

Crypto lending is revolutionizing the lending industry and creating access to capital to a class of borrowers that has historically been shut out. Crypto-lending platforms allow customers to use their cryptoassets as collateral to borrow cash and other assets. In many instances, crypto borrowers are able to take out a loan without a credit check. In addition, these platforms allow customers to lend their cryptoassets by depositing them into an interest-bearing account to generate passive returns.

A crypto loan is like a mortgage or car loan, in that a borrower pledges their cryptoassets to obtain a loan in fiat money (cash) or stablecoins, and the lender earns interest on the loan.

Crypto lenders typically allow their customers to swap or trade cryptoassets, which, depending on their business model, may be subject to laws and regulations of the jurisdictions in which they operate.

Cryptoassets are digital representations of value, secured through cryptography. The most well-known form of cryptoasset is bitcoin, but there are thousands of other cryptoassets. The global market capitalization of cryptoassets is now more than $2.6 trillion — or nearly the 2020 GDP of Great Britain.

Unlike a mortgage or car loan, crypto lenders typically require no installment payments or fixed loan terms. Borrowers are required to maintain a loan-to-value (“LTV”) ratio based on the amount and type of cryptoasset collateral posted. The LTV can be substantially lower than the market value of the cryptoasset. If the LTV goes above the required threshold, it will trigger a margin call, which requires the borrower to increase their deposited crypto collateral or pay down the loan. If the borrower does not increase their deposit or pay down the loan, a portion (or sometimes all) of their collateral will be sold to reduce the LTV.

Many cryptocurrencies experience significant price volatility and lending platforms may not always function well or provide sufficient notice of changes in LTV. This results in the chance of liquidation being relatively high. In fact, there are many customers who have been entirely liquidated of their collateral.

Can I Earn Interest on My Crypto?

In addition to taking out loans, crypto lenders also allow their customers to deposit their cryptoassets into interest-bearing accounts. These accounts generate passive profits derived solely from the lending and investment activities of the platforms. Customers can earn interest well beyond that of traditional savings accounts — while the FDIC’s average interest rate on savings accounts is .06%, major crypto lenders routinely offer customers between 9.5% and up to 17% yield on their crypto deposits.

Through their interest-bearing depository accounts, crypto lenders function like a bank or investment fund. But unlike those institutions, crypto lenders operate in a regulatory gray zone and lack other significant customer protections such as FDIC insurance.

The crypto-lending industry has exploded in recent years. Nexo claims over $12 billion assets under management (“AUM”) and BlockFi saw a 1,711 percent increase in AUM just last year.

When examining crypto lending platforms, you should check to see if they are regulated to do business within your state. Crypto lending can be done in a legal, safe, and regulated environment.

It is important that crypto lending platforms offer safe products to their customers. Part of this safety is derived by ensuring that companies use rigorous risk controls and require sufficient collateral requirements on their products.

Many platforms have robust disclosures that educate their consumers on the specifics of the terms of their offerings. However, some user agreements may contain predatory provisions, such as terms that transfer ownership of your cryptoassets to the crypto lending platform. Make sure you check the user agreements associated with any crypto lending platform you are interested in using.

Are there Predatory Players in the Crypto-Lending Industry?

The rapid rate of growth coupled with the lack of regulations creates a perfect storm for bad actors in the industry to prey on unsuspecting customers by misrepresenting their services and through contracts that unconsciously harm their customers.

Bulgaria-based is one of the clearest examples of a predatory actor in the crypto lending industry. For instance, Nexo customers may believe (based on Nexo’s advertising) that when entering a contract, they are not transferring ownership of their cryptoassets to Nexo. Yet in the fine print of its terms and conditions, customers are not only required to sell their cryptoassets to Nexo, but for far below the market price. And their terms and conditions provide that Nexo can dispose of its customers’ collateral “in any manner at its sole and absolute discretion.”

Another example — Nexo customers may believe that Nexo owes them fiduciary duties based on Nexo’s public statement that it has “a fiduciary duty to everyone involved with Nexo.” Again the fine print of Nexo’s terms and conditions states the exact opposite of its public representations to consumers — providing that “no fiduciary relationship exists between” Nexo and its users and there is “no trust or other obligations in respect of your Nexo Account” apart from those terms.

On its website, Nexo also promises its customers that it will provide them with notifications of their LTV ratios to protect customers “even under extreme market conditions” when in fact customers may not receive notifications in a timely manner, causing them to be liquidated.

Fortunately, lawmakers, regulators and customers are starting to take notice.

Some states have taken actions against Nexo and other crypto-lending platform providers and a class action complaint was recently filed in federal court in California alleging that Nexo breached its contracts and violated California consumer protection laws in connection with its suspension of loan repayments in the cryptocurrency XRP.

Where Does Yield Come From?

Crypto lending yields can be quite attractive for those wishing to earn passive income off of their crypto-assets. For example, on some centralized crypto-lending platforms, individuals can earn up to 6% APY on their bitcoin holdings, 4% APY on their ether holdings, and up to 10% APY on their stablecoin holdings (e.g. USDC).

Where does this yield come from? Just like with a traditional loan, yield comes from the fact that there exists some natural demand for borrowing. Some of this demand comes from the fact that businesses need to borrow assets to purchase capital goods, and those who cannot get a traditional bank loan may find crypto lending as a useful alternative for getting access to capital.

However, another reason there is significant demand for borrowing assets in crypto markets comes from the desire for leverage. Investors who believe that certain prices may go up may want to borrow cash to buy more of that asset, especially if they expect that the asset growth will be greater than the interest rate they are paying to borrow.

Borrowing for purposes of leverage can be risky and such strategies should be considered with extreme caution.

Centralized Finance (CeFi) vs. Decentralized Finance (DeFi)

Recent innovation in the crypto economy has resulted in the advent of decentralized finance or “DeFi.” Unlike centralized finance (“CeFi”), where the method of exchange is regulated through a centralized entity (like Coinbase), DeFi allows individuals to engage in certain types of transactions through the use of peer-to-peer smart contracts that are recorded on a particular blockchain.

In CeFi, users rely on the use of exchanges to execute transactions (such as swapping, lending, or borrowing). The use of DeFi allows for the removal these intermediaries, which enables people to engage in transactions by relying on an underlying smart contract rather than a third party.

While DeFi may be attractive to some, it is not without risks. Because smart contracts are written and deployed by humans, there can be errors in the code that expose these contracts to attack. Knowing which DeFi platforms are safe and which ones are more risky can be challenging.

Before choosing to deploy funds into DeFi, you should research the platform that you plan to use. If a DeFi platform has a history of not exposing funds to attacks, that is typically a good sign.

What Are Customers Saying About Their Crypto Loan Experiences?

Customers across the country are sharing their experiences with predatory crypto lenders to help protect other unsuspecting people from falling prey to high-risk crypto-lending schemes. Click to read a selection of consumer reviews.