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Risks and rewards of lending your Crypto

Hats off to the lucky ones, the crypto investors who bought Bitcoin before market prices began to slide in January 2021. Many did nicely, converted some of their holdings to fiat, and retained a sizable pile as a long-term bet.

Now what? How about earning an attractive interest rate on a small portion of those holdings by converting it into fiat and lending it out on a short-term basis to crypto holders who are underwater? Sure, there’d be taxes to pay on what is technically a securities transaction. But what if the interest received is lucrative enough to put that concern aside?

How Crypto lending works
How Crypto lending works

There are a number of crypto lending sites that stand ready to help. Most of those we reviewed charge borrowers interest in the 12-to-22 percent range. The implication is that the borrower is better off with them than a credit card cash advance, which could cost 25 percent or more on an annualized basis. The pitch may also appeal to an individual lender who disdains short-term crypto trading and believes their digital assets will pay off over a long-term investment horizon.

What follows is a discussion of the basic mechanics. But first a few cautions.

Default Risk

The borrower may be a person or small business that can’t get credit elsewhere, for any number of reasons. The borrower may already have maxed out on credit card cash advances, have too much working capital tied up in accounts receivable, or be unable to obtain a term loan from a traditional financial institution. It’s curious, however, that crypto lending sites tend to emphasize easy access to credit. Just one of many examples: “[Y]ou can instantly withdraw a loan. No credit check.” The individual lender has to realize that loan default is relatively common among borrowers with no or low credit scores.

Read also: DeFi vs CeFi lending: Which one is right for you?

The borrower puts up collateral in the form of BTC or another popular digital currency such as Ether or Litecoin. The go-between platform may promise that the lender gets to keep or liquidate 80 percent of the collateral in the event of default. Assuming the lender has done enough homework and has selected a reputable lending/borrowing platform, the arrangement is basically a bet on the future price of the crypto collateral. That may be fine with the lender who is crystal clear on the default risk.

Crypto lending and credit (Source: TheBlockCrypto)
Crypto lending and credit (Source: TheBlockCrypto)

If the borrower defaults or disappears, in the scenario above, the lender is made whole if/when the price of the collateral asset rises to the level at which the sacrificed 20 percent of collateral is offset. The key question here is: How long will that take? Months, years, decades, or whenever? Meanwhile, the platform company keeps that 20 percent to cover operating expenses and book as profit.

That causes one to wonder: Is the platform company aggressively chasing people who own crypto bought at or near market peaks? Are people already strapped for cash? Maybe the idea is to bring in borrowers who have no other choice and agree to pay interest in the 16-25 percent range. Traditional credit-card companies and payday loan outfits do this now.

Security Risks

Individual lenders do have to worry about the risks of theft, fraud, and cyber-attack. So, it’s crucial to understand as much as possible about insurance coverage for stored collateral. Does the platform offer any insurance coverage of this kind? And what amount of the collateral that’s put in storage for the individual lender is covered?

Is it 100 percent for each lender? Or is coverage only extended to the pool of collateral stored on behalf of individual lenders – and if so, is there a maximum coverage limit for the pool? What if a lender with a big loss stakes a claim before others and maxes out the pool’s annual coverage?

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