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Centralized vs. Decentralized Bitcoin Lending Works

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Bitcoin Passing from one Hand to Another in a Digital Space
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DeFi lending platforms and decentralized exchanges continue to play an increasingly bigger role in the crypto market. They allow users to access capital and additional use cases for their assets by lending their digital assets. Therefore, bitcoin lending platforms form a key pillar that supports crypto’s mission of driving financial inclusion by using the security of the Bitcoin network as a base for their operations.

Bitcoin lending platforms, which let you lend and borrow bitcoin (BTC), can be broadly divided into two categories: centralized and decentralized lending platforms. In this Learn Center article, we will dive into what centralized and decentralized Bitcoin lending platforms are, how crypto lending works on these platforms, the associated risks and benefits and everything in between. 

How is DeFi Lending Different from Traditional Lending?

Crypto lending platforms perform essential financial functions through digital assets that are comparable to traditional financial services. If you park your fiat in a bank, the bank lends it out and you earn interest. Or, if you’re in urgent need of cash, you can approach a bank for a loan and repay it with interest later. Lending platforms for cryptocurrencies help you do similar functions through digital assets. 

Crypto lending, just like lending platforms in traditional centralized finance, involves three parties: lending platforms (often centralized exchanges), and lenders and borrowers. The lenders loan out their assets and receive interest. The borrowers take out a loan for purposes like trading, arbitrage, or to obtain short-term liquidity without selling their assets. Borrowers need to repay the loan with interest and are often required to put up their own crypto assets as collateral to secure the loan. 

How much collateral you have to put up depends on the loan-to-value (LTV) ratio, which differs from platform to platform. Collateralized crypto loans offer more security to lenders than non-collateralized ones. In case the borrower defaults, they can liquidate the collateral and recover their funds. However, in such loans, borrowers face the risk of margin calls – demands from a broker for a trader to deposit more funds or sell assets to cover potential losses – if the trading value of their collateral drops. Margin calls require the borrowers to either add more collateral or lose their collateral entirely if they cannot repay the loan. 

What is Centralized Bitcoin Lending and How Does it Work?

Centralized bitcoin lending refers to lending or borrowing bitcoin, the largest cryptocurrency by market capitalization, through centralized entities or exchanges. A centralized entity is any that acts as intermediary between the borrowers and the crypto lenders. 

Let’s say you want to lend 2 BTC through a centralized crypto lending platform. All you have to do is set up your KYC with the platform, deposit your bitcoin into the centralized platform crypto wallet, navigate to their “loans” tab, set the loan terms like how much you’re lending, loan duration, expected interest rate, and then confirm your lending offer. 

The centralized lending platform does the rest for you. It finds borrowers, both individual and institutional, for your bitcoin and distributes the interest to you after deducting its cut. Depending on the loan terms, you might receive your interest weekly, daily or even hourly. 

Similarly, if you want to borrow BTC, you have to deposit collateral, enter your loan amount and duration and confirm the borrowing request. Once approved, you will receive the BTC in your platform wallet. Once you repay the loan with interest, you’ll receive your collateral back. 

Types of Centralized Bitcoin Lending

Centralized bitcoin lending can take the following forms:

Margin trading

Some crypto exchanges offer margin trading, allowing traders to borrow BTC for trading. In such cases, the borrowed funds from the exchange’s lending protocol pool. 

Interest-bearing accounts

These are like bank savings accounts, enabling you to simply deposit your bitcoin and earn interest. 

Peer-to-peer lending

Some crypto exchanges connect borrowers with lenders and facilitate peer-to-peer lending. 

Staking & yield farming services

Some lending platforms enable you to stake your BTC to earn interest. Centralized bitcoin lending can also take the form of yield farming, where you lend out tokens to a liquidity pool in exchange for rewards. 

Essentially, centralized bitcoin lending platforms manage the risks of the loans, like locking up collateral and monitoring the LTV ratio. They are also responsible for setting interest rates depending on market conditions, circulating supply and demand. 

What is Decentralized Bitcoin Lending? 

Decentralized bitcoin lending takes place through decentralized finance (DeFi) protocols that operate through smart contracts. Now, DeFi lending of bitcoin can take place in two ways: through protocols on Ethereum or other blockchains using wrapped BTC (wBTC), like Aave and Compound, or directly through decentralized applications (dApps) built around the Bitcoin network itself.

Decentralized crypto lending uses smart contracts to automate the entire lending process, eliminating the need for a centralized third party. The smart contracts automatically execute loan transactions when the preset conditions are met. Unlike centralized systems, DeFi lending protocols determine interest rates algorithmically. Eliminating the need for centralized control over the amount of a given rate. 

If you wish to borrow BTC, you have to lock up your collateral assets in a smart contract and once you repay it with interest, it will automatically be unlocked and sent to your wallet. Similarly, if you wish to lend bitcoin, connect your wallet, set your lending market terms like amount and duration, and approve the transaction using your wallet. 

Centralized Versus Decentralized Bitcoin Lending 

Centralized and decentralized bitcoin lending primarily differ in how they handle your assets. In this section, let’s look at the major pros and cons of both centralized and decentralized lending.

Pros of centralized lending

  • Centralized lending is more user-friendly owing to the intuitive interfaces of the platforms and sometimes dedicated customer support teams. This makes it easy even for beginners in the crypto world to participate in the lending and borrowing process.
  • Centralized platforms may have a higher level of liquidity compared to their DeFi platform counterparts. This makes it easy for you to find suitable lending offers or sell collateral.
  • Centralized platforms execute loan transactions internally, often making them faster than decentralized lending platforms, which rely on blockchain confirmation.

Cons of centralized lending

  • Centralized lending platforms control your assets for you, which means if the platform is hacked, becomes insolvent, is rug-pulled, or perpetrates fraud, you could lose your bitcoin. This is a significant risk as demonstrated by the series of bankruptcies of centralized lending platforms in 2022.
  • Centralized lending is less transparent than decentralized lending and requires you to trust the platform to take care of your assets and loan terms. Since the transactions are done internally, there is no record of your crypto lending transaction on the blockchain.

Pros of decentralized lending

  • With crypto lending through DeFi, you retain control of your assets and there is no centralized intermediary.
  • Since all transactions are recorded on the blockchain, decentralized bitcoin lending is more transparent.
  • DeFi lending of bitcoin is trustless since you do not have to trust an opaque organization. Instead, you can depend on open-source codes that can be verified and audited by anyone and the blockchain itself.

Cons of decentralized lending

  • Smart contracts can be vulnerable to attacks. If the smart contract locking up collateral is hacked, you could end up losing your assets.
  • DeFi lending protocols can be complex and appear daunting to newcomers.
  • The comparatively low liquidity on decentralized lending platforms may make it difficult to find borrowers or lenders for certain types of loans.

Decentralized Bitcoin Lending: Early Stages

Bitcoin lending has predominantly been executed via centralized platforms like Kraken and Binance, as well as platforms that have now become defunct like Celsius Network. This is because decentralized bitcoin lending is still in its nascent stage. Developers started focusing on increasing the functionality of bitcoin and building bitcoin-focused applications only two years ago with the help of Stacks.

However, decentralized bitcoin lending has the potential to offer a more secure and transparent alternative to centralized lending. And the recent bankruptcies of lending platforms have only increased the urgent need for decentralized alternatives. 

Crypto Lending Platforms and Bitcoin

Centralized and decentralized lending comes with its own set of risks and benefits. When it comes to bitcoin lending, centralized platforms have been the primary facilitators. However, with increasing interest in expanding Bitcoin’s functionality, decentralized lending of bitcoin is emerging. 

While it's still in its infancy, the need for secure lending options grows stronger for both centralized and decentralized platforms. Ultimately, Trust Machines seeks to empower a lending ecosystem built on the most secure blockchain.