As a digital asset, bitcoin has proven itself to be the most secure, decentralized, and trustworthy cryptocurrency in the world. Individuals and businesses alike have adopted buy-and-hold strategies for investing in bitcoin for the long term.
While keeping bitcoin locked away in cold storage is the safest option, some investors may be willing to take on risk to passively earn a yield on their funds.
With bitcoin, there are a number of ways to lend - each with its own terms, degrees of risk, interest rates, and other important factors that investors must consider.
In this article, we will discuss what lending bitcoin is, CeFi vs DeFi lending, and the pros and cons of each method.
What is Bitcoin Lending?
Bitcoin lending is the process of depositing bitcoin (BTC) to a platform for a predetermined duration in return for periodic interest rewards, usually on a daily, weekly, or monthly basis.
The process of bitcoin lending is managed by a platform that connects lenders and borrowers. Lenders supply bitcoin to a “pool” of funds, while borrowers request a loan for these funds and pay off the loan plus interest over a set timeframe. The interest that the borrower is charged for taking out the crypto loan is paid back to lenders as a reward for supplying their bitcoin in the first place.
Through crypto lending, investors can turn their bitcoin into a productive asset that pays them dividends over time. This is a lucrative way to acquire more bitcoin, all while not selling, trading, or buying any funds.
How Does Bitcoin Lending Work?
There are two main types of crypto lending platforms: centralized finance (CeFi) lending and decentralized finance (DeFi) lending.
As we will discuss further, each mechanism has its own advantages and disadvantages.
Bitcoin CeFi Lending
Bitcoin CeFi lending is done through a central institution that helps facilitate the lending and borrowing processes. CeFi platforms act as third-party intermediaries to custody funds and keep capital effectively allocated.
CeFi aims to make cryptocurrency financial services as seamless as it is with traditional financial institutions. With CeFi, users do not have to directly interact with protocols or crypto assets. Instead, the institution will execute transactions and manage funds on the user’s behalf.
CeFi requires processes like KYC (Know Your Customer) verification in order to begin transacting. These measures aim to confirm an individual's identity and prevent unlawful conduct, such as money laundering and tax evasion.
In 2022, several major CeFi crypto firms like BlockFi, Celsius, and Voyager fell into bankruptcy due to the Luna token crash and the overall market collapse. Overall, these events highlighted some of the flaws with CeFi, and the importance of self-custody, and responsible crypto lending strategies.
While the industry was significantly impacted by the fall of many leading players, CeFi crypto lending platforms are still in business today. Some examples of existing CeFi lending platforms include Nexo and Ledn.
Pros of CeFi Lending Platforms
Simpler user experience. The greatest benefit of CeFi lending is its ease of use. With the recent emergence of DeFi, many users can be intimidated by crypto assets, and lack the knowledge to properly interact with digital wallets and lending protocols. Overall, a CeFi crypto lending platform mimics much of the experience traditional lending users are already accustomed to.
Fiat on-ramps. CeFi provides convenient rails for onboarding and offboarding through fiat currency and crypto. CeFi centralized exchanges (CEXs) let users connect various types of payment methods, including bank accounts, debit cards, and wire transfers to buy bitcoin.
Reporting. CeFi platforms that provide crypto lending services help users with taxation and other legal documentation necessary. This is something that is not provided in DeFi, which can be complex and time consuming for users to figure out for themselves.
Cons of CeFi Lending Platforms
Custodial Risk. The most prominent risk CeFi poses is the looming potential for the counterparty to not fulfill its part of its contractual obligations. In using CeFi lending platforms, users must give up custody of their funds, relinquishing them to be managed by the central institution.
Lack of Transparency. Users lack insight into transactions within CeFi and the management of funds behind closed doors. As we have seen first hand, human error and bad judgment can have detrimental effects on how CeFi organizations operate. Some lending platforms may employ policies and strategies that put users’ funds at risk.
Security risks. Cybercriminals are constantly a threat to centralized institutions. Leaked data and hacks to CeFi organizations can lead to a number of crimes, such as stolen funds, fraud, and identity theft.
Bitcoin DeFi Lending
Bitcoin DeFi has rapidly grown in the last couple years, thanks to the amount of developers building on top of Bitcoin. With the emergence of Bitcoin DeFi, many users are starting to bring their BTC out of storage to earn interest payments, all while directly interacting on the blockchain.
For those new to DeFi, DeFi lending is conducted through a decentralized application (dApp) and governed by automated smart contracts rather than a centralized entity. These smart contracts are often open-source, allowing anyone to view and audit the lending protocol’s coding for themselves.
Through a decentralized lending platform, users have significantly more transparency and control over their funds. All transactions are publicly visible through a distributed ledger, meaning anyone can verify activities on the blockchain.
DeFi is a fundamental pillar of cryptocurrency, blockchain, and Web3 entirely. With these technologies, the world is trending towards systems that empower the end user and remove the reliance on central entities. This way, users can carry out peer-to-peer transactions that optimize the efficiency of crypto lending and borrowing.
The most well known form of Bitcoin DeFi lending is done with Wrapped Bitcoin (WBTC) on Ethereum. With Wrapped Bitcoin, users can interact with the vast Ethereum ecosystem, including top crypto lending platforms like Aave and Compound. Obviously, this presents an inconvenience for users who wish to stay on the Bitcoin network.
Native Bitcoin DeFi lending has grown in popularity with the growth of Bitcoin layers like Stacks, RSK (Rootstock), and Liquid Network. Layers utilize smart contracts to carry out decentralized lending transactions. Transactions occur within each layer, but are later bundled and sent to Bitcoin’s base for final settlement.
Pros of DeFi Lending Platforms
Self-custody. Only the user can control their crypto assets with a pair of private/public keys. DeFi lending eliminates the need to trust that an institution will uphold its commitments and responsibly manage their funds. This aspect has become extremely valuable with the collapse of large CeFi crypto lending platforms in 2022.
Bankless. DeFi lending platforms are accessible without traditional banks. Now, millions of unbanked people across the world have the opportunity to participate in crypto lending activities.
Permissionless. With just a crypto wallet and a WiFi connection, anyone can access DeFi lending. Decentralization means there are no intermediaries deciding who gets approved or denied services.
Cons of DeFi Lending Platforms
Full responsibility. As previously alluded to, interacting with blockchain-based lending applications can be a daunting experience, especially for novice users. If any mistakes or errors are made, there is very limited customer support in DeFi. Similarly, it is almost impossible to undo transactions because of the immutability of blockchain. By self-custodying funds, users must undertake full accountability for how they fund their digital wallet and what lending protocols they use.
Smart contract risk. Counterparty risk still exists in DeFi, but in the form of smart contracts. Users must trust that a crypto lending protocol’s smart contracts are free of coding errors. These bugs usually only become evident once they are already exploited, making them so difficult to mitigate. In the worst case scenario, smart contract risk can cause the collapse of a lending protocol and subsequent loss of users’ funds. Therefore, they have yet to be truly battle-tested to perform as anticipated for a long period of time.
Network Complexity. Decentralized bitcoin lending platforms are more complicated than with other leading blockchains, like Ethereum. This is due to the fact that most bitcoin lending transactions require the use of layers to execute complex smart contracts and achieve practical speeds and costs.
Bitcoin Lending Interest Rates
Interest rates on bitcoin lending platforms can range anywhere between 0.5-8% APY (Annual Percentage Yield), depending on the protocol, loan amount deposited, and term of the loan. These rates are not constant, and are constantly adjusted alongside external market conditions.
High interest rates make crypto lending far more attractive than traditional bank lending. However, it’s important to factor price volatility of the underlying crypto asset (in this case, bitcoin,) into a lending strategy.
Why Lend Bitcoin?
Utilizing lending platforms yields opportunities to effortlessly earn passive income on their BTC.
With both CeFi and DeFi, bitcoin investors can choose which method best fits their investment goals.
CeFi may be better for crypto novices who want support with storing and lending funds. Alternatively, decentralized lending platforms may work better for users who want to interact directly with lending dApps and value self-custody.
All in all, lending is a fundamental part of bitcoin capital markets. Before lending, it is critical to acknowledge the risks of lending, and assess your risk tolerance, and carefully examine each individual bitcoin lending platform.
This article is not financial advice, and therefore should not be used to make an investment solely based on the information included in this article. Lending bitcoin introduces an element of risk that you may not need to incur.