Banking is the lifeblood of the economy — the statement echoes truth, especially since banking enables the actual flow and circulation of monies across national and international economies. One of the most significant branches of banking is the borrowing and lending service.
As per industry data, about 23 million Americans have a collective debt of over $245 billion in personal loans. This stat alone shows just how vast the lending and borrowing space is.
However, the traditional banking system, including lending and borrowing, is hugely centralized, making accessing loans hard. For that reason, lending was introduced in the crypto space, affording investors a super-fast method of accessing loans with no processes.
This guide looks into crypto lending, answering the following questions:
- What are crypto lending protocols?
- What is the importance of lending protocols?
- What are the risks of crypto lending?
- Will crypto lending replace traditional lending?
What are Lending Protocols?
Crypto lending protocols are simply banking for cryptocurrencies.
This decentralized finance (DeFi) cornerstone focuses on enabling the lending and borrowing of crypto assets, much like banks do for fiat, but mainly in a decentralized manner. Their decentralization is courtesy of the blockchain technology that backs them and the automated self-executing codes popularly known as smart contracts.
When writing this report, dozens of popular and well-serving crypto lending platforms existed. For instance, Alchemy listed about 58 decentralized lending platforms in the crypto space, but the number is higher.
At its heart, a crypto lending protocol allows a platform where users can deposit assets in the lending pool. These assets are then lent out to other users with relevant collateral.
An algorithm run through a smart contract determines the interest rates charged in borrowing and lending, making supply and demand dynamics critical.
Types of Crypto Lending Platforms
In cryptocurrency, there are two types of crypto lending platforms: centralized and decentralized protocols. Let’s look at them.
Centralized Crypto Lending Protocols
Centralized platforms operate like traditional financial institutions. In essence, these platforms are hugely centralized and may include centralized exchanges.
Customers must undergo Know Your Customer (KYC) and Anti-Money Laundering checks in centralized crypto lending. You can then deposit the necessary crypto, say Bitcoin, set lending parameters like duration interest, and confirm the lending option.
Platforms like Nexo and BlockFi have been widely mentioned among the largest centralized crypto lending platforms today.
As mentioned, centralized lending platforms, including Nexo and BlockFi, require strict adherence to KCY and AML requirements. The platform must check and keep records concerning the adherence to regulatory standards.
Moreover, centralized platforms offer custodial asset storage, meaning they hold users’ assets in custody, affording more security.
Often, the centralized platforms work with some fixed interest rate system, making things easily predictable for the lenders.
Like in all lending platforms, huge collateral requirements are associated with centralized networks to protect the investors’ monies. Often, a concept known as over-collateralization is applied, where investors stake more funds than the amounts they will borrow. The network holds this collateral till repayment is done.
Here is a summarized working mechanism of centralized crypto lending platforms:
- Users deposit cryptocurrencies.
- This platform lends the assets to borrowers who provide collateral.
- Lenders earn interest on their deposits, paid by the borrowers.
- Borrowers repay the loan with interest. Upon repayment, the network returns the collateral.
Decentralized Crypto Lending Protocols
Unlike their centralized counterparts discussed above, decentralized lending protocols operate peer-to-peer, with no central authority controlling activities. These platforms leverage smart contract automated liquidity pools where users lock assets, which are then made available for borrowing by others.
Decentralized lending enables liquidity in the market while giving the lenders a unique opportunity to earn interest on their deposits. Usually, the interest rates offered in decentralized pools are often higher than general savings accounts, making them highly attractive for crypto holders.
Decentralized lending networks primarily offer a non-custodial type of asset holding where the users retain complete control of their assets. However, since decentralized platforms leverage smart contracts, these autonomous systems enable asset management, not any centralized entities.
The interest rates associated with decentralized lenders are determined with an algorithm that leverages supply and demand principles, leading to a higher return potential for lenders. Interest rates in decentralized lenders sometimes surge to upwards of 20%, depending on the assets.
Decentralized lenders enjoy complete automation courtesy of smart contract working mechanisms.
Here is a summarized working mechanism of decentralized crypto lending platforms:
- Users begin by depositing assets to smart contract-managed liquidity pools.
- Borrowers access the assets by providing collateral, with the terms enforced by smart contracts.
- Networks enjoy fluctuating interest rates based on the conditions of the market.
- The repayment process ensues with borrowers repaying the loan and the smart contract releasing the collateral.
What is The Importance of Lending Protocols
These futuristic lending protocols offer a pivotal component in the DeFi space, offering opportunities to reshape the financial ecosystem. Here are a few key benefits associated with these lending protocols:
High Return Potential
When it comes to lending, traditional lenders often offer the most minimal rates, sometimes below the 1% mark. This is not lucrative at all, especially for investors with small capital.
Digital blockchain-focused lenders have APYs exceeding 10%, sometimes even 20%, depending on the assets in question. As such, crypto lenders sound like the more attractive option for investors looking for maximum gains.
Enhanced Liquidity
Cryptocurrency lending platforms provide enhanced liquidity within the markets. Holders lend their idle assets, ensuring it’s more than just sitting idle in their wallets.
The assets lend circulate in the exchanges after being lent out, increasing the liquidity of markets and thus bringing more stability.
Easy Accessibility to Loans
In traditional setups, getting access to loans takes a lot of work. There are requirements of multiple form fillings, credit checks, giving enough data, guarantors, and also collateral. Obtaining even small loans could take days if not weeks.
Crypto lending platforms have no credit checks, application forms, or guarantor requirements. As such, they are a very reliable tool, especially for individuals with limited credit histories. This is especially good for those living in regions with underdeveloped banking systems.
The Benefit of Automation
Implementing smart contracts, especially in decentralized lending platforms, offers investors an automated, transparent, secure borrowing and lending platform. Smart contracts execute transactions autonomously once some predetermined conditions are met.
Overcollateralization to Protect Buyers
Instead of demanding guarantors for every loan, some blockchain lending platforms use over-collateralization. Here, the borrower has to stake a collateral amount with a higher value than the borrowed amounts.
Let’s say the borrower wants a loan of about $10000 worth of BTC. The investor may need to stake assets worth over $ 10,000.The platforms set a specific ratio for loan to collateral. It could be 1:1.5 or 1:2, depending on the platforms.
By inputting higher value as collateral, the borrower will be forced to repay the loan, making the lender complete.
Risks Associated With Crypto Lending Protocols
Despite the world of opportunities that crypto lending protocols provide, there is a significant risk associated with these projects. Among these risks include:
- The notorious market volatility associated with crypto — Sudden price declines in the collateral asset can cause margin calls, forcing additional collateral or liquidation.
- Smart contract vulnerabilities — decentralized lending protocols operate on smart contracts, which are not immune to bugs and vulnerabilities. As such, some contracts can be exploited, leading to millions in losses for lenders and borrowers.
- Regulatory risks — The regulatory environment associated with crypto assets is still evolving, posing a considerable risk to lending protocols.
- Interest rate fluctuations — decentralized lending protocols do not have fixed interest rates. The fluctuating rates can affect the profitability associated with borrowing and lending.
The Top 5 Lending Protocols
After diving deep into blockchain lending protocols, let’s list the 5 top platforms offering the service. They include:
Aave
A platform launched in 2017, Aave is a DeFI lending network at the pinnacle of the cryptocurrency lending realm. It leverages a liquidity pool model to allow users to deposit and borrow different crypto assets. One of its best features is the ability to offer flash loans, where users borrow without collateral and enjoy quick transactions.
Aqru
Aqru is a crypto-saving platform that supports BTC and ETH with an APY of 2%. Stablecoins in Aqru afford high rates of 10%. This platform affords users the utmost simplicity, where you deposit funds and start earning rates.
YouHodler
There are complaints concerning YouHodler‘s centralization, with many arguing that it’s not a DeFI lending platform. It supports a wide range of crypto loans in fiats like EUR, CHF, GBP, and EUR, with the only crypto loan being USDT.
MakerDAO
MakerDAO is among the most popular, employing a specialized governance system leveraging MKR toker. Based on the Ethereum blockchain, MakerDao allows network participants to create DAI stablecoins by locking collateral.
Nexo
Nexo joins our list of top 5, with great lending options and interest rates ranging between 4% and 12% APY. The platform also hosts unique products like Nexo cards, Nexo Wallet, crypto exchange, and purchase solutions.
Will Crypto Lending Replace Traditional Lending Institutions?
The answer to this question can neither be an outright yes nor no. Even the KOL in the crypto realm share mixed opinions about the potential of crypto lending.
For instance, Andrew Rapsey from Ledn wrote:
“Crypto loans offer speed, lower interest rates, and accessibility, while traditional loans provide stability and predictability.”
The statement indicates that although crypto lending is growing, the improper regulatory framework and security still pose huge risks. Moreover, despite being slow, traditional systems are more stable and predictable.
In conclusion, until such a time that crypto lending solves the challenges and risks associated with it, it will not beat traditional lending systems.