Crypto-backed loans are rising globally, and they’re rising very fast. Market figures from last year point to an outstanding debt volume of USD 8.5 billion, and they can cross the USD 45 billion mark by 2030. It’s easy to understand why: interest rates are typically lower, borrowers get to keep their positions in the crypto market, and there’s no need for credit checks. Naturally, crypto-backed loans aren’t free from risks on both sides, as they involve highly volatile assets. However, some cryptocurrencies are more volatile (and less reliable) than others, meaning that not all are accepted as collateral. Learn more about it here.
A Vast Market
There are about 10,000 cryptocurrencies in the world today, but only about a hundred of them can be used as collateral, with Ethereum and Bitcoin loans leading the way. Stablecoins can also be used for the same purpose, including Tether (USDT), USD Coin (USDC), TrueUSD (TUSD), and DAI.
In fact, market volatility is the main reason only a handful of cryptos are accepted as collateral. Above all, options like Bitcoin and Ethereum have proven that they won’t vanish into thin air, even if market prices head south. Since the value of such stablecoins is pegged to the US dollar, they can store value much more reliably than regular cryptos, especially during market swings.
Typically, lenders place margin calls when the collateralized assets fall below a pre-agreed value. In this case, borrowers must make additional deposits, having their cryptos liquidated otherwise. The result is a situation that leaves no winners, as liquidating devalued assets doesn’t always make up for outstanding debts. Security breaches and cyberattacks are constant threats to which not even giants like Bybit are immune.
NFTs As Collateral
While crypto-backed loans, like the ones offered by Figure, dominate the headlines, another trend is rising: NFT-backed loans. Similar to cryptos, non-fungible tokens can also be collateralized for quick access to cash. DeFi lending platforms on the Ethereum blockchain lend stablecoins like USD Coin and Tether for collateralized NFTs. The benefits are pretty much the same, but more risks are involved.
For instance, there’s the risk of illiquidity if an NFT loses value so drastically that no one wants to buy it. Worse still, since NFTs are unique, it’s much trickier to calculate their market value, leading to mispricing. Both sides must also worry about smart contract vulnerabilities. The risk is even higher for those lending peer-to-peer, as the other party can fail to hold their end of the deal.
How the Business Works
Crypto-backed loans are also risky for lenders, but the potential profits are quite enticing. In this context, lenders can skip the credit checking process because the repayment is guaranteed and has a comfortable margin. While collateralized vehicles or real estate can raise to 80% of their value in cash, collateralized cryptos typically can raise about 30% of their current market value, increasing lenders’ profit margin if prices go up.
Crypto-lending platforms can be CeFi (centralized) or DeFi (decentralized). CeFi platforms are financial institutions that work similarly to traditional banks. They typically have KYC and AML protocols to prevent fraud, advanced security systems, and cold storage solutions. CeFi lending happens on-chain and involves intermediary custodians. All transactions are ultimately subject to human governance.
DeFi lending operations are peer-to-peer, and KYC/AML protocols aren’t necessary. They also have more attractive interest rates and margin lending, but return and borrowing rates tend to be more erratic. Smart contracts govern all operations, and borrowers can have nearly instant access to permissionless credit. Risk assessment of smart contracts requires considerable technical knowledge, which is a barrier for beginners.
Shielding Up
Crypto-backed loans can be extremely vulnerable to market volatility, but there are ways to mitigate the risks. Borrowers can buy insurance coverage for their assets. Insurance deals can vary greatly, but they usually cover losses up to specific limits and for specific reasons. For instance, it’s possible to buy coverage against cyberattacks, which are becoming alarmingly common.
Relying on a single crypto as collateral can also be tricky; if that crypto falls, everything falls with it. That’s why specialists advise using a pool of cryptos as collateral, cutting losses if one of them collapses while increasing market exposure. Borrowers must also pay attention to each lender’s loan-to-value ratio (LVR).
The LVR tells how much of the collateralized asset will be offered as a loan. High LVRs may look more appealing as they offer more funds for the value. However, such loans are also more likely to suffer from margin calls, as the margin between the loan and collateral is slimmer. Conversely, a low LVR means a smaller loan with more predictable conditions.
Final Thoughts
The crypto-lending market is expanding fast, including dozens of cryptocurrencies, stablecoins, memecoins, and even NFTs. Crypto-backed investments are inherently risky, requiring skill and quite a bit of luck. Nevertheless, there are tested strategies for mitigating the worst risks, like insurance coverage for collateralized assets and portfolio diversification.
Borrowers can increase their safety significantly by running reputation checks on potential lenders. Previous cases of security breaches and hacks are usually red flags. It’s a very competitive market, which means borrowers can shop for the best features, fees, and conditions on CeFi and DeFi platforms.