Cryptocurrency has had mainstream attention for more than two years, yet despite the constant coverage of the industry, crypto lending is still a mystery to many.
For every piece of valid published information, there are multiple pretenders trying to get uneducated investors to “buy in” to their product or service by passing mistruths and omission-riddled, misinformation as fact. This is all the result of the crypto world facilitating the growth of its markets—which should be applauded—but there’s plenty to look out for and avoid.
For the market to continue its growth, it needs to make sure its assets are easily available for investors to lend and borrow. Mainstream interest is high thanks to the market value for the 10 most popular cryptocurrencies being well over $100 billion. Without the ability to easily make these transactions, the crypto markets would be in real trouble.
There are many firms that offer the ability to loan and borrow cryptocurrencies. Some even allow the same abilities as traditional banks, including being able to issue crypto loans on a secured basis—where loans are secured by cash or other cryptocurrencies—or lend cash to a broker while holding crypto as collateral.
The marketplace for these services is similar to those of traditional cash and securities. Those that have high-value volatility, which is a perceived weakness, are more expensive to borrow compared with collateralized loans, which cost less than uncollateralized loans.
Whether you’re lending or borrowing cryptocurrencies, you need to be aware of the below facts.
People borrow crypto to short sell it in the market if they think the price will go down. You can’t sell something you don’t have. To sell something short, you must borrow that asset to deliver when you sell it. The stock portfolios at leading brokerages, prime brokers and custodian banks are regularly lent to other institutions in order to allow others to short those positions. The real question is: Do you want people shorting your crypto?
Lenders need to make sure they have some type of collateral to secure their loans. It’s widely accepted that the high price volatility of cryptocurrency makes it a riskier loan. Whether there’s collateral in a traditional sense or simply the borrower’s reliability, this is paramount for lenders. Loaning cash or crypto to someone without collateral is a risk. Say they declare bankruptcy. If you’re lucky, you will lose some of what you lent, but you’ll likely lose it all.
If borrowers want to borrow cash against their crypto, they will get only a fraction of the value of it in cash. The amount of a loan is dependent on the value of the given cryptocurrency. For this reason, using a stable coin for collateral usually nets a higher cash loan.
Crypto brokers are usually less creditworthy than well-established brokers and banks. It’s for this reason that lenders pay more for loans in U.S. dollars. These are considered loans because institutions like Coinbase are not regulated banks and can’t give the same protections to lenders. These protections include segregated accounts and capital, which guard lenders and borrowers from defaulting.
Just as there are important market realities and facts to consider regardless of whether you are taking out a crypto loan or lending, there are plenty of untruths that have led lenders and borrowers astray.
Crypto lending platform Genesis Trading recently said, “Borrowing and lending using cryptocurrencies and cash are providing new and safe opportunities for our clients to maximize the growth of their retirement accounts."
It’s in Genesis’ best interest to encourage crypto lending, but its use of the word safe is inappropriate. Any loan—be it made to a broker, bank or person—is only as safe as the borrowers’ credit rating. Lending to a crypto broker doesn’t have the same protections that are afforded to other institutions under traditional banking laws.
Crypto lending companies aren’t the only ones that overstate the future of this practice. Stanford University professor Darrell Duffie recently declared that crypto lending will, “up-end,” traditional banking due to the high rates offered on crypto.
This statement overlooks several facts and is misleading when considered in the context of an unsecured crypto loan. Investors need to hold the crypto to capture the yield received from lending it. Crypto has higher rates because it's riskier to hold—remember that the crypto being lent out to the broker is being used to deliver on someone else’s short sell.
As with anything, it’s important to know the facts before trading. The world of crypto banking is different from your traditional bank. As attractive as the yields on lending crypto may sound, they may not produce returns that match the risks.
It’s important to remember that you can lose all your money doing this—there is no banking regulator, like the FDIC.
As an owner of cash or cryptocurrency, there are a handful of answers you should demand before you get involved with a loan.
- What is the credit quality of my counterparty?
- What are the risks of a default?
- What protections do I have in the event of default?
The answers may or may not be straightforward, yet as you continue to ask these questions to your brokers, you will find the omissions in each broker’s answers can be significantly different.
You will find some who offer better terms to some customers than they do others. It behooves you to gather all the information you can regarding crypto lending. Just make sure you read it with a dubious eye.
Murphy McCann is a senior advisor at iTrustCapital