Uncollateralized Loans And Market Volatility Turned Early Crypto Lending Into A Disaster

The early days of the crypto lending industry were for the most part disastrous. Borrowers and lenders interacted on peer to peer platforms like BTCJam and BitLendingClub. Borrowers would apply for a loan by explaining what they needed the loan for and by linking to their identity and various data that proved their reputation. If a borrower consistently repaid loans they would gain reputation and gain the ability to take out bigger loans. 

Unfortunately, numerous scammers plagued these peer to peer lending sites. A common scam was to payback consistently and build credit, and then default when taking out the biggest loan possible. Lenders tried to track down the loan scammers and bring them to justice, but usually to no avail. Further, the laws in most of the world do not allow loan defaults to be treated as a criminal case. Instead, it is a civil case, meaning the lender would have to hire a lawyer and go to court, and even if the lender wins they could still get nothing if the borrower has no money or assets. 

BTCJam and BitLendingClub ultimately shut down due to regulatory pressure, since their model was creating a dangerous environment for lenders and leading to big losses. 

The most obvious reason that these early crypto lending platforms failed is due to offering uncollateralized loans. Loans were given out based on trust and credit, making it too easy for scammers to take loans and not payback. Further, the volatility of cryptocurrency made these loans risky. If the price of Bitcoin (BTC) fluctuated wildly, like it often does, then either the borrower or the lender could lose big. For example, if a borrower took out a 1 Bitcoin (BTC) loan, cashed it out, and then the price of Bitcoin (BTC) rises 100%, the borrower may have no choice but to default on the loan. 

The Crypto Lending Industry Has Learned From Past Mistakes And Has Adopted Collateralized Loans

The crypto lending industry has learned from these mistakes however and is rising like a phoenix from the ashes. Graychain released a 26-page report on the state of the crypto lending industry and found that nearly 100% of crypto loans are now collateralized. This has led to explosive growth, with more growth expected. Indeed, the modern crypto lending industry is apparently only 24 months old as of Q2 2019, but there have been 244,000 loans totaling $4.7 billion, with $86 million of interest annually. 

Astonishingly, the crypto lending industry has gone from being a disaster where tiny loans often defaulted, to a multi-billion dollar industry, and this is all thanks to collateralized loans.

BlockFi is a good example of how a modern crypto lending platform works; most popular and successful lending platforms operate in a similar way to BlockFi. Fiat loans are only given out to people who can offer cryptocurrency collateral, and more collateral must be given than the amount loaned to protect the platform from market volatility. 

The industry standard is 150% collateral, meaning if someone deposits $15,000 of Bitcoin (BTC) they can receive a $10,000 fiat loan. However, the collateral percentage ranges from 110% to 200%. 

If the market value of a cryptocurrency begins to drop significantly than BlockFi sells off collateral in order to ensure that 100% of the US Dollars that were lent out are recovered. 

Additionally, there is an interest rate of 4.5% annually on loan, and this interest can either be paid or deducted from the collateral. 

The question arises, why would someone decide to receive less than the full value of their cryptocurrency via a collateralized loan, on top of interest rates, if someone could just sell their cryptocurrency for 100% of its value?

Crypto Collateralized Loans Are A Tax Loophole, And A Way To Access Cash While Still HODLING

First off, when someone sells cryptocurrency they must pay a capital gains tax of 15% to 25% on any profits. Putting that cryptocurrency up as collateral for a fiat loan does not count as selling it, however, and no capital gains tax has to be paid

This gives people the ability to cash out crypto in a tax-free way, although mathematically it would usually net more money to sell the crypto and pay the capital gains tax. 

This leads to perhaps one of the main reasons that people choose to participate in these loans. Many cryptocurrency users desire to hold long term but may run into a situation where they need to cash out their crypto. Instead of cashing out, users can access half of that money immediately while still technically holding the crypto. If the price of their crypto collateral rises, they can simply pay back the loan and get the crypto back, versus the case where they sold the crypto and there is no way to get it back. 

Crypto Lending Platforms Now Offer Interest On Deposits Like A Bank

Additionally, crypto lending platforms now offer interest on deposits, which is a good way for people to grow their crypto stash if they were planning on holding long term anyway Interest rates apparently range from 1% to 10%, depending on which platform is used and which cryptocurrency is deposited. This is far greater than interest rates at a bank, which are usually in the 0% to 2% range, although the crypto market has volatility so the value of the deposit in terms of US Dollars could decrease even with the added interest. 

CoinMarketCap now has an “earn crypto from crypto” page, where the interest rates offered across various platforms and for various cryptocurrencies are updated live.  Currently, CoinMarketCap shows data from BlockFi, Crypto.com, Celsius Network, Binance, Bitfinex, Nuo, dy/dx, Compound Finance, Fulcrum, Coinbase, and Nexo, which is essentially a list of most crypto lending platforms. 

Although the ability to earn significant interest just by holding cryptocurrency is enticing, users must be careful to research the platform they are depositing on. In order to earn the interest, these lending platforms need to make money with the deposited crypto, much like a bank which uses their customer’s money for investments in order to pay interest. 

Unfortunately, crypto lending platforms are not FDIC insured, and generally not insured in any way, so in the eventuality that the platform lost money from bad investments or was hacked, users would lose their funds. 

Therefore, crypto users who are considering earning from a deposit on one of these platforms should do thorough research and read the terms and conditions carefully before investing. Perhaps the best rule of all is to not deposit any crypto that you cannot afford to lose. 

Thus, the crypto lending industry has learned from the mistakes of the past. Instead of peer to peer markets with uncollateralized loans, which ended in disaster, nearly 100% of crypto loans are now collateralized. The safety that collateralized loans provide has facilitated the growth of crypto lending into a multi-billion dollar industry, and it seems the growth has only just begun.