Cryptocurrency lending is the next big thing in the industry, rivaling the 2017 ICO boom in popularity. However, promises of over 10 percent interest rates don’t come without its own sets of risk—despite its bid to replace the traditional financial system, crypto lending is still very much an experimental market.
We break down the benefits and the dangers of crypto lending in 2020 so you can make an informed decision on how to enter the market.
Crypto lending is the latest phase in the evolution of DeFi
In its decade-long evolution, the crypto industry has gone through many phases and iterations, but it’s this last one that has the potential to disrupt. Decentralized finance, an ecosystem of platforms and services built mostly on the Ethereum network, has seen incredible growth—the total USD value locked in DeFi increased 216 percent this year, jumping from $691 million on Jan. 1 to $2.2 billion on Jul. 10.
However, jumping headfirst into DeFi and pouring your holdings into crypto lending platforms is far riskier than it might sound. Despite their superficial similarity to banks and other financial institutions, these platforms are very complex and require at least a basic understanding of how smart contracts work in order to fully utilize their potential. The platforms also require users to protect their keys,
Understanding risk is understanding how crypto lending works
The cryptocurrency lending market is not a homogenous one, as there are hundreds of different platforms that offer dozens of different services. However, there are two major groups these platforms can be sorted in, and they’re based on how they manage users’ money.
Custodial lenders act as traditional banks do, and require users to trust that they, as an entity, will protect their funds. Custodial platforms such as Celsius, Nexo, and BlockFi use their name and their brand to build a reputation that will entice people to believe that their funds, whether they’re borrowing or lending, will be safe.
Non-custodial lenders, on the other hand, rely on code to protect the funds of their users. Everything that’s done on the platform is done through programmable smart contracts that are created and executed independently from the company that has created them.
Both of these categories bring about their own types of risk.
Focusing first on custodial lenders, we see that they suffer from the same problems traditional banks do. Firstly, custodial lenders, as their name suggests, hold custody of the funds you put into the platform.
Technically, this means that you transfer all control over the funds to the company—someone else has the private keys to your cryptocurrencies and can use them at will. If the company was to fail or experience any issues with withdrawals, your funds are as good as lost.
Due to strict security measures in place, there have been no notable issues with any of the leading custodial providers, such as Crypto.com, Cred, and Celsius. DeFi lending platforms are still on the path to maturity and the whole lending landscape is currently like a giant stress test.
While most platforms have contracts with liability insurance providers, these contracts are usually capped at a certain amount that’s most likely lower than the platform’s actual holdings. This is done in traditional finance as a way for insurance providers to protect themselves.
Gemini, a cryptocurrency exchange founded by the Winklevoss brothers, handles the custody for BlockFi and has its deposits covered by Aon. Cred had its funds insured with Lockton.
Crypto.com has multiple insurance policies to the tune of $360 million and stores all customer funds in cold-wallets. USD balances on Crypto.com of US citizens up to $250k are covered by FDIC insurance.
Therefore, if you choose to lend or borrow through custodial platforms with insurance, bear in mind that their contract might not cover all of its funds. It’s also worth noting that even if the contract might cover all of the company’s funds, it might not cover specific events such as ransomware.
On the other hand, non-custodial lending platforms have a much more straightforward role than their custodial competitors. As the company itself doesn’t have access to its clients’ funds, the risk of losing your yield-earning holdings at the hands of the company is as close to zero as it can get.
However, they do present a new type of danger—technical failure. While using platforms such as Compound and Uniswap removes the risk of human error, it introduces technical failure that could render the smart contracts they’re based on useless. Despite every decentralized lending protocol subjecting its code to extensive testing and auditing, the code’s open-source nature means that malicious actors are always actively searching for vulnerabilities.
The fact that “code is law” in decentralized finance both gives it leverage over traditional markets and brings about new risk. As most cryptocurrency lending platforms rely on economic incentives to encourage its users to participate in the network, a change in market sentiment could cause them to essentially stop working. While the risk of economic incentive failure is by far the lowest one when it comes to decentralized crypto lenders, it’s still worth considering.
Weigh your options
When users are aware of all of the risks cryptocurrency lending in any of its forms brings, the burgeoning industry becomes much less dangerous. These platforms can be utilized by both speculative traders and hodlers—those that want to maximize their exposure to the market can benefit from interest rates ranging from 6 to 10 percent, while those that steer clear from trading could put their idle holdings to work.
Users should research the platforms, centralized or not, they want to deposit their funds to and then weigh their options carefully. Diversification is always a good strategy to minimize risk when choosing lending platforms.