Decentralized finance has grown rapidly in the past few years. Even with the market crash in 2022, DeFi reached a record-breaking number of 43 million users, according to Dune Analytics.
While decentralized crypto exchanges control a chunk of the DeFi market, crypto lending protocols are slowly gaining market share. Bitcoin, specifically, is playing a crucial role in the cryptocurrency lending sector — around $30 billion of BTC was used as collateral for crypto loans in 2021.
In this Learn Center article, we will delve into crypto-backed lending for digital assets, with a specific focus on Bitcoin lending. We'll also dive into the different types of crypto collaterals, loan terms and some crypto lending platforms.
But first, let's define what crypto lending is.
What is Crypto Lending?
Cryptocurrency lending is the practice of lending and borrowing cryptocurrencies. Three parties are involved in typical crypto-backed loans — the crypto lender, borrower, and the lending platform, whether on a centralized or decentralized protocol. If you are lending your assets, all you need to do is deposit your crypto, and the platform will pay you interest when they lend out the funds. If you are a borrower looking to get a crypto loan, you have to put up other crypto as collateral in most cases.
Collateral is funds that you lock up for the loan period when borrowing assets. It ensures security for the lender — if you fail to repay your loan, the lender liquidates the deposited collateral to recover their funds.
How Crypto Lending Works
Based on the collateral requirements, there are three primary types of crypto-lending arrangements. However, arrangements do vary from platform to platform and can influence how users choose a crypto lending platform:
In these crypto lending arrangements, the lender is required to put up collateral whose value exceeds the loan amount. The excess collateralized crypto you put up acts as a buffer in case of price volatility, thereby offering more security to lenders. These types of crypto loans are used by both centralized and decentralized crypto lending services to minimize risk.
These loans involve borrowing an amount that is higher than the value of your collateral. These types of loans pose more risk for lenders and are, therefore, less common.
These loans do not require borrowers to put up crypto assets as collateral, but there’s a catch: you have to repay the loan with interest within a single block. This means you have a few seconds or a few minutes to repay the loan. If you can't repay the loan within this brief timeframe, the transaction is automatically canceled, and you won't actually borrow any funds.
Centralized and Decentralized Crypto Lending: How Crypto Lending Platforms Work
Crypto loans are typically also categorized into two broader categories: centralized and decentralized lending.
In centralized crypto lending, a centralized entity, like an exchange or an institution, controls the assets of the lenders and the terms of the lending arrangement. Basically, the centralized entity acts as an intermediary, just like traditional lending institutions such as a bank.
You deposit your crypto in the platform’s wallet, and the platform lends it out to borrowers, which could include individuals and institutions. The platform decides the crypto interest rate, crypto collateral requirements, and other aspects of the Bitcoin loan agreement. The borrowers pay the platform interest, which is then distributed among the lenders by the platform.
With decentralized lending, there is no centralized intermediary. Instead, the entire lending process is handled by smart contracts and decentralized apps (dApps) and protocols. This means that you can directly interact with the protocol through smart contracts that automatically lock and unlock collateral based on pre-defined loan terms.
Interest rates are often determined algorithmically based on the demand and supply of specific cryptocurrencies. Aave, Compound, and MakerDAO are some popular decentralized cryptocurrency lending platforms that have cemented their place in the crypto market over the years.
What is Bitcoin Lending and How Does it Work?
Two years ago, Stacks, a Bitcoin layer 2 blockchain, brought smart contract functionality and DeFi to Bitcoin. Since then, there has been significant growth in DeFi projects built in the Bitcoin DeFi and Bitcoin lending is one of them.
Bitcoin lending basically refers to the lending and borrowing of bitcoin. Most Bitcoin DeFi lending takes place through Wrapped Bitcoin (WBTC) on platforms built on Ethereum and other blockchains. WBTC is simply an ERC20 token that is compatible with the Ethereum blockchain. You lock up your BTC in a smart contract and mint an equivalent amount of WBTC, which means WBTC is always backed 1:1 by BTC. Once you mint WBTC, you can then use it on any Ethereum dApp, even lending platforms like Aave and Compound.
It is important to note that using WBTC comes with some risks. For instance, if the smart contract gets hacked, you could lose your locked Bitcoin. Besides, WBTC may have less liquidity than BTC, so you might face challenges selling it.
Pros of Crypto Lending
Lending allows you to diversify your crypto portfolio beyond simply holding and trading. It's another way to put your crypto assets to work and diversify your risk while creating a source of passive income.
Lending platforms offer the flexibility to access liquidity without selling your crypto assets. If you are in urgent need of funds but don’t want to sell your bitcoin because you believe its price will appreciate in the future, borrowing might be the way for you.
Borrowing against your crypto assets rather than selling them can help you defer capital gains taxes. Selling assets can trigger tax liabilities, while borrowing does not have the same tax consequences.
Risks of Crypto Lending
Third party risk
Since last year, many crypto lending platforms have filed for bankruptcy, including Celsius, which used to be one of the largest centralized lending platforms. Since most of these platforms are unregulated, users of these centralized platforms have to wait for the bankruptcy process to recover their assets. In fact, there is no guarantee that they will be able to recoup 100 percent of their assets.
Therefore, you should carefully review the financial health of a centralized lending platform before you lend them your crypto. If your crypto lending platform is unreliable, you risk losing access to your funds.
In DeFi, smart contracts that lock up your crypto assets are a significant risk. Since DeFi is an emerging technology, these third party smart contracts can contain hidden vulnerabilities that hackers can exploit to access your funds.
If the value of the collateral you provided at the time of borrowing drops significantly, it can trigger a margin call. In a margin call, the borrower either has to put up more collateral or risk liquidation.
Some lending platforms have lock-in periods during which you cannot withdraw your assets. This limits liquidity and access to your funds.
Bitcoin Lending: Merging DeFi and Security
Crypto lending enables you to put your assets to work and earn interest. Borrowing crypto also helps you access liquidity quickly without selling your assets and take advantage of trading and arbitrage opportunities.
However, crypto lending also comes with risks. That is why it is important that lending platforms, and DeFi at large, should prioritize security. Chains with robust security like Bitcoin should be the foundation for DeFi transactions, simply because its security has been battle-tested for decades.
Our mission at Trust Machines is to make BTC lending a reality, so that DeFi inherits the high level of security of the Bitcoin network. Our announced upcoming lending app will be built on this ethos, and will be designed to unlock the true potential of the Bitcoin financial ecosystem.
Ultimately, the crypto lending market has opened up new possibilities for the crypto community. Many of the crypto products, DeFi lending platforms and and lending sites that you see are giving users another way to utilize their crypto. That's why DeFi loans and the top crypto lending platforms available continue to explore new ways for crypto enthusiasts to use their assets, whether it's by lending or borrowing digital assets, or additional loan services that may be of interest.