Crypto lending is marketed as a safe, rewarding, and fool-proof alternative to investing and trading. You’re told that lending has almost no risks, that your assets are kept away in cold storage, and that your 15% interest rate is backed by real and tangible growth. But is crypto lending actually safe?
The market experienced many disastrous events in 2022. A leading cause behind those disasters were lending platforms. Influential companies such as Genesis, Voyager, and Celsius have gone under. Everyone was promised smoothless lending. But what we got in the end was far from that.
Today’s article discusses crypto lending platforms – specifically, how safe they are. You’ll learn more about how crypto lending works and where lending platforms get their yield from. I will also explain the differences between CeFi and DeFi lending.
What Is Crypto Lending?
Crypto lending is a process in which you deposit cryptocurrency to a platform or smart contract in return for yields. The yield is represented by an annual interest rate that is either stable or variable. Lending yields range anywhere from 2% to 20%. Lending is marketed as a safe and stable alternative to trading with linear growth.
There are many benefits to lending cryptocurrency rather than dabbling with banks and their laughable savings accounts:
- APY rates are far higher
- Lent assets are volatile
- Cryptocurrencies grow in value over time
- No lending requirements
- Sometimes self-custodial
What’s even more important is that lending is wholeheartedly decentralized. Everyone can lend assets, no matter what their background is. All they need is an internet connection and a device. Even the bankless can lend crypto!
But let’s be honest. The reason why investors are attracted to crypto lending in the first place is the incredibly high APY rate. APY rates for certain cryptocurrencies can go as high as 25%. Think about that for a second. You’re guaranteed a 25% annual growth on top of the potential speculative rise in your cryptocurrency’s value. What’s not to love about that?
Learn 5 Ways to Earn Passive Income With Crypto
Lending is a way to make money on top of already making money by exposing your portfolio to digital assets. An alternative is to trade, but more than 90% of traders lose money doing so. Therefore, crypto lending presents itself as a healthy, stable, and profitable method for making more money with your crypto investments.
How does Crypto Lending Work?
Crypto lending is rather simple from a user’s perspective. You have cryptocurrencies on a blockchain wallet and you deposit those assets to a lending platform. The entity you’re dealing with safeguards your crypto, and after a year (or a shorter period) you can withdraw your crypto along with the newly gained yield.
You can deposit funds to a lending platform for however long you want. However, they are typically time-locked for a specific period. Lock periods can last as low as 7 days or as long as a year. In some cases there might not even be a time-lock, and you can withdraw assets whenever you want.
On the other side is a friendly borrower – someone who takes your assets for other investing purposes. The borrower gains access to funds loaned to the platform and has to pay an interest rate for the duration of the loan. This interest rate paid by the borrower is basically the APY rate that you earn for lending.
For the borrower to take out a loan he must provide some form of collateral. The collateral ratio depends on the lending platform. It starts at 100% but can go as high as 150%. Collateral types can include anything from crypto assets to non-fungible tokens, and other forms of digital assets.
The situation is much more complex behind the scenes. The platform you chose has to secure your assets after receiving them. This usually involves moving cryptocurrency from a hot wallet to a cold wallet. The company should probably also have some form of proof of reserves that helps them confirm their reserves.
Is Crypto Lending Safe?
Crypto lending is super safe, at least in theory. Whatever you deposit to the lending platform is taken by a borrower – who must provide at least 100% collateral for the loan. And as I mentioned earlier, there are even cases where the platform requires a 150% collateral ratio.
So from the above, you can pretty much tell that the supply has a fixed 1:1 ratio in contrast to lending. Each loaned asset is backed by collateral provided by another borrower. And the interest rate you receive from the platform is majorly paid for by the borrower paying his own fees for taking out the loan.
But is crypto lending really safe? 2022, much like many other previous years, have shown us that this isn’t the case. Several big lending platforms have gone under over the years, including prominent players such as Genesis, Voyager, and many others. Even some exchanges, like FTX, have gone under without any previous warning.
The main danger with lending platforms is trust. By depostig crypto funds to a lender you’re trusting the company that they will use your assets as intended – they provide it to borrowers. But if the platform acts maliciously, it may decide to use user funds in other ways.
For example, a company might use your funds for speculative investing. Or it may utilize them within more risky investing strategies in order to get a higher return. Imagine a company placing your hard-earned money within a volatile liquidity pool. The pool’s impermanent loss eats up your funds and the company ends up losing your money.
Or maybe they employ even crazier investing strategies. The company might use your funds to invest into an altcoin, to leverage trade cryptocurrencies, to bet on options or futures markets. The list is endless, and there is no end in sight with what the company might do.
That’s why whether a lending platform is safe ultimately depends on their team’s reputation. An experienced team with a name in the game is less likely to misuse your funds than a newly arrived lending platform. Big players have made mistakes too, but the fact is that the chance for something like that to happen is less likely with reputable actors.
CeFi vs. DeFi Crypto Lending: Differences Explained
There’s a big difference between decentralized and centralized lending platforms. The main difference is that DeFi platforms will use smart contracts to facilitate the transactions between borrowers and lenders. This means that borrowers and lenders directly interact with each other, rather than a centralized entity.
Lending dApps store all funds on a public and decentralized ledger. Moreover, there is singular entity handling or impacting the lending process in any notable way. Smart contracts completely automate the lending process, leaving no room for mistakes or malicious activity.
Interacting with decentralized lending platforms also takes place with non-custodial wallets. This means that the custody over your assets is handled by yourself. A smart contract ensures that the assets you deposit will be returned to your wallet once the loan period ends.
Decentralization severely limits the risks of losing your assets to malicious actors. However, there’s still risk present. Instead of the lending operator, the danger here is a malicious actor that can exploit smart contracts and drain funds from the platform’s smart contracts. The danger here is much more real as a hacker can steal far more funds – often with limited repercussions.
The DeFi sector has lost over two billion dollars in funds over smart contract exploits over the last two years. Most victims were bridge platforms and yield farming protocols. However, lending platforms still account for a huge amount of lost funds and make an important statistic.
Lending protocol Cream Finance lost $130 million in a flash loan hack last year. Another lending dApp called Beanstalk lost $181 million this year in April through a similar flash loan hack. There are simply far too many examples for decentralized lending protocols to be deemed safe. Even if the protocol reprimands investors, a huge loss of funds still took place.
Should You Lend Cryptocurrency?
Crypto lending platforms offer great and stable returns for little to no risk. You can earn up to 15% per year just by lending your assets to someone else. Some platforms offer flexible interest rates, and some even allow you to withdraw anytime you want. But are the risks worth the rewards, and if so, should you still lend cryptocurrency?
2022 saw a huge breach of trust. Several companies, platforms, hedge funds, and investing firms have evaporated within the span of a year. Famous lending platforms such as Genesis, Voyager, and Celsius also took part in this disaster. Many investors are now afraid from giving custody over their crypto to someone else in fear of losing their money forever.
Crypto lending is safe as long as you’re dealing with the right company. A reputable team won’t ever risk jail time for embezzling user funds, freezing assets, or using customer assets to fund yields through other means. But as you have seen, knowing who to trust is becoming ever more difficult.
Decentralized lending platforms present a healthy alternative. Their nature prevents anyone from misusing user funds because all power is completely delegated to smart contracts. However, smart contracts are not immune to hacks, and many exploits have happened over the past two years. This means that not even DeFi lending is 100% safe.
I’m not telling you not to lend at all. But the message you should receive from this article is that you should lend safely. I advise you to take the old crypto adage of “you should not invest more than you can afford to lose” and replicate it in the lending world as well. So be careful who you trust, lend a small amount of your portfolio, and monitor your funds.
If you want to learn more about crypto lending, I recommend reading the following articles: