Crypto loans: What they are and how they work

• Crypto loan is a term that can refer to a range of centralized and decentralized borrowing/lending activities involving cryptocurrency.

• Crypto loans serve a variety of use cases for consumers, traders and institutions alike, unlocking arbitrage opportunities, providing yields, and freeing up liquidity.

• However, crypto loans are not without risk. Users should perform due diligence and be aware of the risks when using or providing crypto loans.

Crypto loans involve one party lending cryptocurrency to another. 

Similar to a credit card or traditional loan, the borrower receives funds from the lender under the agreement that they will repay the amount over time in full, plus interest.

In the context of cryptocurrency, this simple concept can be applied across a range of venues: a crypto loan could be a simple agreement between friends, it could use a centralized intermediary to manage the transaction, or a decentralized, smart contract-based entity that programmatically enforces the contractual agreement.

Though the end result is ultimately the same, each of these options comes with its own benefits and drawbacks. 

Crypto loans can be attractive for both sides of the transaction. Let’s consider a few scenarios.

Maintain crypto holdings

Alice holds large amounts of Bitcoin (BTC) and believes that the price will increase over time, but needs access to a short-term loan to cover unexpected bills. 

She doesn’t want to sell her BTC and miss out on any potential price appreciation, so she decides to lend her BTC via a centralized platform instead and generate interest from her idle assets. 

In this case, Alice still owns her crypto — she’ll continue to benefit from future price increases while earning fiat-denominated interest. Additionally, depending on her geographic location, she may additionally enjoy more favorable tax treatment as she hasn’t sold her BTC to realize gains.

Leverage a better position

Bob has conducted rigorous technical analysis and is confident that Ether (ETH) will increase in value over the coming year.

He has an ETH position already, but wants to increase his trade size. He deposits his ETH into a smart contract as collateral in exchange for an amount of newly-minted stablecoins.

Using the newly acquired stablecoins, Bob proceeds to buy more ETH — which he deposits once again into the smart contract, and withdraws more stablecoins. He continues “looping” his funds in this way until he has a much bigger ETH position, allowing him to benefit even more from any future price increase.

Note: this strategy is only effective if ETH’s price increases. If it decreases, Bob will amplify his losses as the stablecoin loan(s) must be repaid in full to unlock his original deposit(s).

Earn tokens or potential airdrops

A true DeFi power user, Priya stays on top of all of the latest developments in decentralized finance and interacts with protocols that offer good incentives.

She stumbles across a new Solana lending platform and, upon doing some research, decides to lend some SOL to take advantage of the high APY on offer. 

What’s more, there have been rumors of an upcoming airdrop, and she feels this is the best way for her to increase her chances of receiving it.

We’ve explored, conceptually, how crypto loans work. Let’s now take a closer look at the different kinds of loans that exist.

Collateralized loans

Mortgages, car loans, and pawnbroking are examples of collateralized loans, which require the borrower to provide collateral to access funds.

Collateralized loans may offer lenders greater security: if the borrower defaults, the lender can sell the collateral to recover their losses.

In the crypto space, these types of loans are popular on both centralized and decentralized platforms. If the borrower fails to repay their loan with interest, they forfeit their assets. Alternatively, the borrower might choose not to repay, allowing the lender to liquidate or retain the collateral.

Crypto lending protocols typically mandate overcollateralization, meaning borrowers must pledge more collateral than the loan amount. This can provide an extra layer of security for lenders. For example, on the MakerDAO platform, users can mint DAI by depositing assets whose value exceeds the amount of DAI they wish to borrow.

For instance, to borrow DAI, a user may need to deposit assets worth 150% of the DAI amount. This ensures that the lender has some protection if the value of the deposited assets drops below the borrowed amount.

Uncollateralized loans

Student loans, credit cards and overdrafts are regarded as uncollateralized (or unsecured) loans. They do not require the borrower to put up any collateral to secure the loan. In case of non-repayment, lenders must pursue the borrowers via legal means.

Given the high degree of privacy that can be achieved in the crypto space, these kinds of loans are virtually non-existent on blockchain-based platforms. However, a handful of centralized lenders (e.g., Goldfinch, Ondo Finance and Centrifuge) operate uncollateralized crypto loan platforms, mandating rigorous KYC verification before approving loans.

Flash loans

Unique to the crypto space, flash loans are technically uncollateralized loans with a unique condition — the borrowed funds must be repaid within the same transaction they are borrowed, usually within seconds.

You might wonder, how can anyone do anything with a loan in just a few seconds?

This is made possible by leveraging smart contracts, which can execute transactions using the flash loan instantaneously.

Given their complexity, flash loans are typically utilized by experienced developers who have the technical expertise to construct a smart contract that:

1. Requests the loan.

2. Utilizes the loan across DeFi protocols.

3. Repays it (plus interest) within a single transaction.

If the loan is not repaid within the same transaction block, the transaction is rolled back as if it never happened. This means the funds are automatically returned to the lender, protecting them from the uncollateralized borrower.

So, how might someone use a flash loan?

Let’s imagine someone notices a discrepancy in the prices of Chainlink (LINK) across two different decentralized exchanges (DEXs).

They decide to take advantage of this arbitrage opportunity using a large flash loan, which they prepare by creating a series of smart contracts that programmatically execute the trade.

Within a few seconds, the borrower receives the flash loan, executes their strategy, and returns the funds plus interest.

In this scenario, they successfully executed the trade and netted a profit without risking any of their own funds.

We’ve mentioned the two types of crypto lending platforms in this article: centralized and decentralized. Let’s explore these categories in more detail, along with their benefits.

Centralized lending platforms

Centralized crypto lending protocols can either be dedicated platforms or part of a crypto exchange's product suite.

With this type of platform, the centralized company acts as a middleman — they aggregate deposited funds from users, make them available to borrowers, and set interest rates and fees.

Benefits:

• Better customer support: Centralized platforms often provide more comprehensive customer support.

• User interface/user experience (UI/UX): They typically offer more polished and user-friendly interfaces.

• Transaction reversals: They may be able to revert accidental on-platform transactions.

Decentralized lending platforms

Decentralized lending platforms operate similarly to centralized ones but without a middleman. The administrative functions are handled by smart contracts on blockchain networks like Ethereum or Solana.

Funds are deposited into a liquidity pool, and interest rates are set algorithmically, typically based on supply and demand. The protocol enforces the loan terms.

Benefits:

• No intermediaries: Anyone can access these platforms without KYC or identity verification.

• Transparency: Smart contracts are publicly auditable, making the platforms more transparent.

• On-chain operations: All transactions and operations occur on the blockchain.

To mitigate default risk, decentralized platforms require borrowers to over collateralize, meaning they must lock in more crypto than they can borrow. This provides an additional layer of security for the platform.

Crypto lending, whether on centralized or decentralized platforms, carries many of the same risks associated with other blockchain applications and platforms:

• Centralized platforms: Centralized platforms present a single point of failure. They can be hacked or go bankrupt, preventing users from reclaiming their funds. Unlike traditional financial institutions, which often have regulatory safeguards to compensate users, crypto venues typically do not.

• Decentralized platforms: Decentralized platforms also face risks of exploits or hacks. Due to their distributed nature, users may have even less recourse in case of protocol failure. While the code is often publicly available for auditing, it’s often beyond the comprehension of the average user.

As with any decision, strong due diligence is recommended. Be sure to investigate the team, the interest rates and, in the case of decentralized platforms, their tokenomics, architecture and audit status. 

Remember also that high crypto volatility could result in sudden margin calls should the value of your collateral fall too low — so keep an eye on crypto prices.

Only invest what you can afford to lose. Even the most robust-looking projects can fall prey to sophisticated hacks, or turn out to be misappropriating customer funds. It’s often recommended that traders should never allocate more funds to a particular protocol than they are prepared to lose.

Want to put your crypto to work? Your key consideration will likely be the interest rate. The higher this percentage is, the greater your return over the specified time period.

Get to know the top providers and protocols in this growing space — there are many, and each will differ in its terms, rates and requirements.

A recent article from Koinly identified CoinRabbit, Nexo and Unchained Capital, among others, as popular options.

Remember to read the small print to identify any particular conditions: some platforms may offer higher rates, with the caveat that funds must be locked for a fixed term. Others, while lower, may allow you to withdraw any time.

Once you’ve found a platform that suits your needs, sign up via the required flow. The platform you select may ask for proof of address and identity, and other contact details.

Kraken makes it easy to buy and trade many popular cryptocurrencies, which you can lend or use as collateral across various DeFi protocols.

Start your crypto journey today!