Loans have existed for almost as long as humankind itself: lending was already practiced in Mesopotamia 4,000 years ago, and laws regarding loans and debts are described in detail in the Code of Hammurabi. Simply put, a loan is a temporary transition of goods from a party that has an abundance of it to another party to use as they see fit.
Crypto loans are not so different in their general rules from traditional bank loans. There is still an interest rate because lenders need to get their profit from loans, collateral to secure the loan, and an agreement. However, there are also some crucial differences. Let’s look at them in detail.
What are secured and unsecured loans?
As mentioned above, lenders are usually protected by collateral in case borrowers fail to return the loan. Collateral is a way to build a trusting financial relationship between two parties. For bank loans, real estate often serves as collateral, but what if a loan is taken on a fully digital platform that doesn’t accept physical assets as collateral? In this case, lending platforms require users to deposit a sum in either fiat or crypto, and then use it as collateral for their loans. As an additional layer of protection against cryptocurrencies’ volatility, platforms overcollaterise loans, meaning that they require more funds as collateral than a client is planning to borrow. Based on the loan-to-value (LTV) ratio, clients can calculate how much they need to deposit in order to borrow the sum they need. For example, if one wishes to borrow 0.5 BTC, and the LTV for a loan in BTC is 50%, they would need to deposit 1 BTC as collateral. This method is used on both centralized and decentralized finance platforms. Unchained Capital, Celsius, SALT, and others use collateral as a loan security method.
However, paying to get a loan only makes sense for those who want to build on their capital. Most people borrow funds because they need to, not because they want to add to their existing savings. Unsecured lending platforms allow other forms of reliability assessment: potential clients are rated based on the purpose of the loan, their previous experience borrowing funds, or other forms of verification. However, if you find a platform offering loans without any sort of verification or collateral, it is important to check if you can trust this service and keep in mind the risks it may pose.
What is a flash loan and is it worth the hype?
You might have heard of a relatively new type of unsecured loan that stirred the cryptocurrency community — a flash loan. It was initially only available to developers through Solidity based smart contracts, but in 2020 the DeFi platform Aave made them available to the general public. Later other DeFi platforms picked up and developed the idea.
A flash loan is provided with some help of a smart contract stating that the loan should be repaid in the same block of transactions, hence the name “flash”. If the sum isn’t returned to the lender in time, the smart contract reverses the transaction.
The instant nature of flash loans is both their pros and disadvantage: it’s perfect for the arbitrage market (when one buys a large amount of an asset on one platform and sells it on another where it’s more expensive) or to close other loans without going through a costly loan cancellation process. At the same time, it can also be used as a weapon to exploit weaknesses in DeFi platforms: bZX, Harvest Finance, Cream Finance, Binance Smart Chain, and Pancake Bunny lending protocols fell prey to hackers using flash loans with malicious intent.
Flash loans can give anyone an opportunity to wield a tremendous sum (even if just for a moment) and exist on decentralized finance platforms only.
What is the difference between centralized and decentralized platforms?
Centralized finance platforms, or CeFi, have a more traditional approach to their structure, being vertical structures with a single individual or company at their helm, executing a single vision and will. This traditional approach also applies to loans: they require identity checks and KYC verifications, but in return, CeFi platforms offer more secure operations, customer support, and more stable interest rates set by the company and not by the market. A downside of this controlled system is the fact that transactions and user accounts are monitored by the CeFi platform, too. Therefore transactions can be censored, accounts can be closed, and assets aren’t stored in clients’ custody.
DeFi platforms, on the other hand, are created by horizontally governed companies, execute payouts without human intervention, and use smart contracts. They are more transparent both in their structure and operation: any DeFi client can check on the transaction state and verify its execution, and fully control their assets without the intervention of middlemen or financial regulators. In addition, DeFi platforms are characteristically more innovative, presenting new features, solutions, and instruments. Furthermore, some lenders prefer DeFi over CeFi because of higher interest rates.
Pros and cons of a crypto loan
Bearing in mind everything we mentioned above, what makes crypto loans especially attractive for borrowers? Let’s sum up:
- You don’t necessarily need a good credit score. Instead, you might need to present a sum for collateral if you have funds, a viable plan for what you want to use the loan for if you have a strategy in mind, or a set of verification documents (depending on a platform).
- It is significantly quicker to get a crypto loan compared to banks.
- Crypto loans have noticeably lower interest rates than bank loans.
Of course, there are no pros without cons. Let us see what might stop crypto loans from becoming an ultimate loan solution:
- Overcollateralisation makes it difficult for those short on funds to get a crypto loan.
- Cryptocurrencies’ high volatility might make repaying the loan more costly and more complicated: if the price of the crypto you borrowed is higher at the time of repayment than it was when you borrowed the sum, you will end up paying back more than you borrowed. The same goes for collateral: if the currency of the collateral depreciates, the collateral itself decreases, endangering your loan.
Platforms offering crypto loans
So where does one take a crypto loan? Multiple CeFi and DeFi platforms offer them on different terms. Here are just a few examples:
Salt — the first crypto loan provider that presented this product in 2016. This CeFi accepts Bitcoin, Litecoin, Ether, Doge, or SALT to be used as collateral. Customers can get loans in fiat or cryptocurrency.
Aave — a DeFi platform that pioneered flash loans based on the Ethereum network in 2020 (In April 2021, the Aave protocol was deployed on the Polygon network). Aave offers loans to borrowers, high interest rates for lenders, and taking flash loans using a side party user interface, for example, furucombo.
Compound — an Ethereum network based DeFi app launched in 2018.
Compound’s clients can deposit or contribute their crypto to a liquidity pool and earn interest, as well as borrow and lend. The borrower and lender matchmaking process is automated, and loans are overcollaterised.
Celsius Network — a CeFi project established in 2017 offering lending services with crypto as collateral, its own wallet, and high interest savings accounts.
As you can see, there are a lot of factors to take into account if you consider taking a crypto loan, but offers from crypto lending platforms make traditional bank loans pale in comparison. We hope you found this article useful and wish you good luck in the world of cryptocurrency!