Is Crypto Lending a Good Idea and How Safe Is It?
Crypto lending is among the most popular activities within the crypto space. According to DefiLlama, lending protocols currently account for $42 billion in the $111.5 billion decentralised finance (DeFi) market, with a nearly 38% market share.
But regardless of its popularity, is crypto lending a good idea, and how safe is it really for digital asset investors? In this article, we will take a deep dive into cryptocurrency lending to provide an answer to these questions.
What Is Crypto Lending?
Crypto lending refers to the practice of depositing crypto assets to a platform or a pool that lends them out to borrowers. In exchange for providing capital, you earn interest based primarily on the current supply and demand for that specific cryptocurrency among lenders and borrowers in the market.
Depending on their type, crypto lending platforms can either act as centralised, trusted intermediaries between lenders and borrowers or facilitate peer-to-peer (P2P) lending as a non-custodial and trustless service. Each has its own advantages and disadvantages for users, which we will explore in more detail later.
Lending crypto provides you with regular passive income and the opportunity to (further) diversify your digital asset portfolio. Moreover, if you reinvest the interest you earn, you can compound returns and boost your yield over time.
On most platforms, crypto lending is overcollateralised, meaning that borrowers must deposit more collateral than they can borrow. This significantly decreases the risks for lenders, yet it is still critical to be aware of factors that could make this activity more risky. These include risks related to volatility, counterparties, and smart contracts.
How Does Crypto Lending Work?
Now, let's take a more detailed look at how crypto lending works with an overview of the process and platform types.
The Crypto Lending Process: An Overview
In general, three market participants engage in crypto lending: a lender, a borrower, and a platform, which can be a centralised exchange like VALR or a DeFi protocol like Aave. Based on their interactions, the cryptocurrency lending process goes as follows:
The lender supplies assets to the platform and receives interest payments in exchange.
The borrower deposits collateral to the service and uses it to borrow cryptocurrencies. Since most loans are overcollateralised on lending platforms, borrowers can't borrow more than the value of their collateral.
The platform locks up the borrower's collateral and distributes the lender's assets to his wallet, which he can use as he wishes.
To redeem his collateral, the borrower must repay both the loan's principal and interest. Suppose he fails to do that in time or his collateral's value falls below the pre-determined loan-to-value (LTV) ratio—the ratio of the loan to the value of the borrower's collateral—. In that case, the platform will liquidate the borrower's collateral to recover the lender's funds.
Regardless of whether the borrower has repaid his debt to the platform, lenders can typically withdraw their assets from the lending platform at any time. One exception is fixed-term loans, where they must wait until the end of the lock-up period to unlock their coins.
In the crypto market, lenders' annual percentage rate (APR) is influenced by multiple factors, such as the supply and demand for a specific asset among borrowers and lenders, the volatility of the cryptocurrency (more volatile coins tend to have higher APYs), and market liquidity. Undercollateralised loans like flash loans can provide higher APRs but have significantly greater risks.
Types of Crypto Lending Platforms
Crypto lending platforms have two primary types: centralised exchanges and DeFi lending protocols.
Centralised Exchanges
In addition to trading, centralised exchanges like VALR offer crypto lending services to their users. On these platforms, they act as a trusted intermediary that connects lenders with borrowers.
Centralised exchanges set their own rates for lending and borrowing and tend to offer flexible terms. While they come with increased counterparty risks due to their custodial services, these platforms provide a convenient, user-friendly experience tailored for beginners and veteran crypto users.
DeFi Lending Protocols
In contrast with centralised exchanges, DeFi lending protocols like Aave, JustLend, and Compound Finance provide users a decentralised, trustless, and non-custodial experience.
Instead of serving as a trusted intermediary, these platforms leverage smart contracts to connect lenders with borrowers in a peer-to-peer (P2P) way and without any third parties. In some cases, this allows them to offer better APYs for lenders, but at the cost of user experience and potential smart contract-related risks.
What Are the Benefits of Crypto Lending?
Lending cryptocurrencies to borrowers can provide you with multiple benefits, including:
Earning Passive Income: With crypto lending, you can put your idle coins to work in exchange for earning interest. Once you deposit your assets to a lending platform, you start generating passive income on your cryptocurrencies. Crypto lending works similarly to a traditional savings account, but with offering higher APRs for lenders (in most cases). For instance, while you can earn an up to 15% annual percentage rate (APR) by lending cryptocurrencies on VALR, the average APY for a US savings account is only 0.57%.
Diversifying Your Portfolio: Having a diversified crypto portfolio spreads your risks across multiple assets (and even asset classes) and is an excellent way to maximise your returns. Lending cryptocurrencies can come in handy for diversifying your portfolio, and it can prove to be an efficient strategy for long-term HODLers seeking to put their coins to work while holding onto them.
Compounding Returns: By compounding interest, you can reinvest the returns you earn as a lender to maximise your yield. Purchasing more coins and lending them to borrowers each time you receive an interest payment enables you to boost your lending APY in the long run. While some platforms have auto-compounding features, you have to reinvest your earnings manually on others to benefit from the compounding effect.
Is Crypto Lending Safe?
You can realise multiple benefits by lending your cryptocurrencies to borrowers. But is crypto lending safe as a lender?
In general, you can face the following risks on crypto lending platforms:
Market Volatility: Market volatility can have a negative impact on your funds as a lender. First, if you supply volatile assets like Bitcoin (BTC), Ethereum (ETH), Dogecoin (DOGE), or nearly any of the available cryptocurrencies out there, extreme price swings could decrease the value of your deposit and your earnings or even cause you losses. Volatility also affects borrowers' collateral, potentially making the loan undercollateralised in case of a significant drop in the collateral assets' value.
Counterparty Risks: Lending crypto on a centralised exchange involves increased counterparty risks, which could lead to a loss of funds in the case of incidents like security breaches, platform insolvency, or exit scams.
Smart Contract Risks: As DeFi lending protocols rely on smart contracts to facilitate transactions between borrowers and lenders, a vulnerability in the contract could expose users' funds to a potential exploit.
The good news is that there are multiple best practices to minimise your risks in crypto lending. The first is choosing a reputable platform with robust security measures and regular audits by prominent third-party firms. Suppose you are seeking to lend assets on a centralised service. In that case, it is also a good idea to choose a provider that offers insurance or a guarantee for compensating victims in the case of a security incident.
Moreover, while lending stablecoins can minimise your volatility, diversifying your lending portfolio across different assets and platforms is a great way to spread risks.
Is Crypto Lending a Good Idea? 3 Key Factors to Consider
You should consider three key factors to determine whether crypto lending is a good idea for you as an investor:
1. Interest Rates and Terms
As a lender, your goal is to maximise your earnings without taking risks higher than your risk appetite. To achieve that, you should evaluate interest rates, loan terms, and fees across different platforms to find the best opportunities.
While some providers offer lenders variable APRs that regularly change with market conditions, others provide predictability with fixed interest rates. By understanding the terms and conditions of lending agreements, you can also gain valuable insights into platforms' charges (e.g., origination, withdrawal, liquidation, and transaction fees) and loan terms (e.g. collateral requirements, LTV ratios, and the duration of loans).
2. Lock-Up Periods
While some services offer lenders the ability to withdraw their funds at any time, others feature lock-up periods. In the case of the latter platforms, you have to wait until the end of a specific period (e.g., six months) for your asset to become transferable again.
On the one hand, flexible lock-up terms offer you the ability to adapt to changing market conditions more efficiently and take advantage of new opportunities in time. In contrast, platforms with fixed lock-up terms tend to offer higher APRs for lenders.
3. Tax Implications
Crypto lending generates interest on your crypto assets, which makes such activities subject to income taxes in most jurisdictions. However, it is crucial to consult with a tax professional to calculate your potential taxes and ensure compliance with the applicable laws and regulations.
Top Tips for Safe and Effective Crypto Lending
In addition to what we have already explored in this article, here are a few additional tips and tricks to stay safe and enhance your crypto lending strategies:
Choose a Reputable Platform: Whether you seek to lend crypto on a centralised exchange or a DeFi protocol, choosing a reputable platform with transparent security practices is a must to ensure your funds' safety. To do that, you should evaluate providers' reputation and regulatory compliance through extensive research. In addition to carefully reading the information displayed on the lending service's website, look for user feedback on social media and forums, read reviews from reputable third-party sources, and monitor the news related to the platform.
Use Stablecoins to Minimise Your Risks: Stablecoins like Tether USD (USDT) and USD Coin (USDC) are pegged to fiat currencies and other less volatile assets to minimise volatility for holders. This makes them attractive coins for lending, especially if you are looking to generate steady returns without getting exposed to extreme price fluctuations.
Stay Informed on Market Conditions: Keeping yourself up-to-date with the current news of the crypto market, lending platform developments, and regulations and monitoring market trends can help you make informed decisions and adapt to changing market conditions more efficiently.
How to Start Lending Crypto on VALR
As a popular activity in the cryptocurrency market, crypto lending enables you to generate a passive income, diversify your digital asset portfolio, and compound your returns without necessarily engaging with high risks. However, to realise these benefits, you must choose a reputable service provider to lend your coins to borrowers.
Lending on VALR enables you to earn interest by offering your cryptocurrency assets to other VALR customers, particularly those who need funds for margin trading. Instead of keeping your crypto idle, you can lend it out through VALR's easy-to-use lending feature, earn passive income, and grow your holdings over time.
Follow the steps below to get started with crypto lending on VALR:
Open a new or log into an existing VALR account. If you haven't already, you should make sure to pass Know Your Customer (KYC) checks (it only takes a few minutes).
Fund your account with crypto or fiat in the "Wallets" menu.
Once your assets are credited to your account, choose "Lending" from the "Earn" menu.
Select your preferred cryptocurrency and click the "Lend" button next to its name. Currently, you can lend South African rans (ZAR), Bitcoin (BTC), Ethereum (ETH), Tether USD (USDT), and USD Coin (USDC) with up to 15% APR on VALR.
Set the amount to lend and choose whether to specify your own interest rate or use the prevailing rate, which depends on borrowers' demand and current market conditions. Before proceeding, read VALR's Terms and Conditions and tick the appropriate box to indicate that you accept the risks related to the platform's lending product. Finalise the transaction by clicking "Submit Offer."
After submitting your lending offer, it will soon become locked in an auction, and you will start earning interest on your deposited assets on an hourly basis.
You can unlock your deposit at any time by clicking "Manage" and then "Unlock."
Curious whether crypto lending is a good idea? Start your lending journey now with VALR!
Frequently Asked Questions
-
Risks of crypto lending include market volatility, counterparty risks (such as exchange insolvency or security breaches on centralized platforms), and smart contract vulnerabilities (in DeFi protocols).
-
Crypto lending regulation varies by jurisdiction. While some platforms may adhere to regulatory frameworks, others operate in unregulated environments. It's important to research a platform's compliance and transparency before participating in crypto lending.
-
Benefits of lending crypto include earning passive income through interest on idle crypto assets, diversifying your digital asset portfolio, and compounding returns by reinvesting earned interest.
Risk Disclosure
Trading or investing in crypto assets is risky and may result in the loss of capital as the value may fluctuate. VALR (Pty) Ltd is a licensed financial services provider (FSP #53308).
Disclaimer: Views expressed in this article are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.
