Innovations within the decentralised finance (DeFi) space have already shown how utilising blockchain technology for financial services can offer an alternative to conventional finance products. From insurance to savings accounts and securities trading, DeFi technology has opened up a variety of services that fintech startups can offer.
One of the fastest growing areas of DeFi is cryptocurrency-backed loans. Just as traditional financial institutions offer secured fiat currency loans against a car or house, a crypto loan is secured using cryptocurrency as collateral.
Unlike conventional loan products, cryptocurrency-backed loans use smart blockchain contracts to govern the loan and cannot be altered by a third party.
“Crypto investors are often praised for taking the HODL (hold on for dear life) approach to investing. But the manner in which one HODLs can vary greatly,” explains Nicole DeCicco, founder of cryptocurrency consulting firm CryptoConsultz.
“‘Hodlers’ often consider and participate in crypto lending and staking platforms in order to earn interest on their investments. While not without risk, the benefits of such platforms are unarguably impressive to say the least.”
It’s not difficult to see why borrowers are increasingly interested in crypto loans, thanks to the ability to gain access to relatively low interest rates, practically instant funding and no credit check. Data from CoinMarketCap shows that the global market capitalisation of all crypto assets, including bitcoin and ethereum, is close to $1.8tn, illustrating the major market potential for crypto loans.
For crypto whales (people who have millions upon millions of crypto in their digital wallets), lending their crypto through online platforms can provide them with fiat currency from interest, without facing the same level of taxes that selling their crypto could result in.
However, like many financial products, taking out a crypto loan is not without its risks. Bitcoin and other cryptocurrencies are well known for their high volatility, and within days can increase substantially or collapse. Due to this inherent instability, crypto loans typically have an extremely low loan-to-value (LTV) ratio and require borrowers to provide additional capital if the crypto price falls below a preset value.
“It’s imperative that those interested in using crypto loans understand the rules of the smart contract and scrutinise the fine print just as one would a traditional loan,” adds DeCicco.
Crypto loans face regulatory hurdles
Although many regulators around the world are beginning to set out cryptocurrency regulations, a lack of clear and comprehensive guidelines has created a difficult operating environment for many crypto loan platforms. In February of this year, a subsidiary of major crypto platform BlockFi called BlockFi Lending LLC was alleged by the US Securities and Exchange Commission (SEC) to be offering a lending product that was illegal.
According to the SEC, BlockFi Lending LLC did not register the BlockFi Interest Account lending product as a security and also failed to accurately represent the product’s risks. Although the crypto platform did not agree with the allegations presented by the SEC, they did approve payment of a $100m settlement charge, which is the largest penalty ever for a crypto enforcement action.
“One main reason for scrutiny focused on lending rather than trading in general is that lending is multifaceted. Without clear regulation, crypto lending companies are not held to the same standards of reporting. There is very little disclosure about what is going on behind the scenes,” adds DeCicco.
From a regulatory perspective, more is needed for these platforms to thrive. At the moment, crypto lending platforms are not required to meet certain banking regulations and are also not covered by any form of deposit protection or Financial Services Compensation Scheme. This leads to customers having little recourse if the platform were to fail or face liquidity challenges.
Is it a disruptive platform?
A number of firms have sprung up in recent years to offer crypto loans through a central company. Firms like BlockFi, Celsius, YouHodler and CoinLoan provide loans in the centralised finance (CeFi) space and offer customers similar benefits to DeFi but with the customer experience and strong security of conventional financial companies.
In a short amount of time, many platforms have reported extremely high growth when it comes to crypto loans. For example, CoinLoan saw crypto-backed loans increase by 2000% in 2021, mirroring the strong year for crypto in general. As these platforms continue to grow, are large financial institutions at risk of losing customers to innovative crypto loans?
For Ilya Volkov, CEO and co-founder of cryptocurrency exchange and lender, YouHodler, the rise of crypto-based lending does not present any risks for traditional lending markets.
“Technically speaking, crypto-based lending is a form of traditional pawnshop loans, where crypto is used as a form of collateral [pledge]. That means that we speak not about disruption or competition with legacy businesses, but about some kind of an extension to them,” he says.
Compared to traditional finance organisations that date back often hundreds of years, there’s no question that crypto lending is still a new industry. But as crypto adoption grows, with a survey by research firm Piplsay finding that 49% of millennials own cryptocurrency, it may not be long before customers and high-street banks consider crypto loans.
“At this moment it’s a hustle to borrow money from a bank,” says Alex Faliushin, CEO and founder at crypto lending platform, CoinLoan. “Crypto loans allow anyone with funds to loan money instantly and to be a lender as well, giving healthy returns in comparison to holding money in the bank.”
The account opening process at an exchange or crypto lending platform is also usually simpler and more innovative when compared to bank accounts.
It may be some time before crypto loans reach their full potential and people feel comfortable embracing a relatively new financial product. However, the benefits for crypto owners in securing a loan against their holding could be too attractive to turn down.
“In time we will see more and more ways to use crypto lending platforms to have the best utility for your money and the use cases will develop in time with the industry,” concludes Faliushin.