What is a Crypto Loan and How to Get One in 2024

What is a Crypto Loan and How to Get One in 2024
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Crypto lending platforms are a cornerstone of the DeFi industry, enabling users to quickly access liquid capital without selling their digital assets. Crypto-backed loans, like their fiat counterparts, are disbursed on the basis that they will be paid back in full including interest. The difference is that the collateral is denominated in cryptocurrency. Typically, so is the capital granted as a loan – although it can also be cash.

Lending protocols have proliferated since the first DeFi bull run in 2021, with competition between them putting users who do their research at a major advantage. Of course, the protocol you decide to use will depend on many different factors, not just who has the most favorable terms (interest rate, borrowing cap, etc). Other considerations will be the reputation of the platform and its security measures, the number of supported cryptocurrencies, and the level of customer support on offer.

How to Get a Crypto Loan

So, the big question for those who've never jumped into this space is: how do you actually obtain a crypto loan? 

Well, the process differs depending on the protocol you use but generally speaking you'll have to create an account on a lending protocol, then deposit crypto funds into a lending pool which depends on smart contracts to automate the lending/borrowing process. In return, you'll generally receive tokens native to the protocol which represent the principal and interest of the loan in question.

The amount that you are able to borrow will, of course, vary according to how much you deposit in the pool as collateral and the stipulated loan-to-value (LTV) ratio. It's important to familiarize yourself with the protocol in question to understand how it works before you lock up your capital.

While many lending protocols are very similar, we have started to see different types of platform and model appear. Cross-chain lease protocol Nolus, for example, employs a partial liquidation engine to shield against market volatility and full collateral loss while maintaining a healthy LTV ratio.

The Pros and Cons of Crypto Loans

So, why would you want to obtain a crypto loan in the first place? Well, there are many advantages, from low interest rates (often below 10%) to the transparency granted by blockchain, to the ability to access capital quickly and with minimal fuss. In fact, most crypto lending protocols don't even require a credit check, so even if your rating isn't great, you can still acquire funds. 

Moreover, borrowers don't have to hand over personal information (as you would with a bank) or even money directly to a platform, since the aforementioned smart contracts require only a deposit into an automated lending protocol. Loan terms are often more flexible than those offered by a bank, too.

On the lender's side, the benefit is obvious: it's an opportunity to earn passive income (interest) from making funds available to borrowers, without selling.

There are cons too, though: there is a high risk of liquidation with the majority of lending protocols, not to mention overcollateralization demands – meaning the value of the collateral is greater than your loan’s value. If your collateral is $5,000, say, you may only be able to access a loan of $2,500 or $3,750.

Types of Crypto Loan

As mentioned, protocols offer different processes, terms and even loan types. Here are some of the main options.

Flash loans: These types of loans, offered by liquidity protocols like Aave, allow users to borrow without putting up any collateral whatsoever – providing the liquidity is returned within one block transaction. To execute a flash loan, you need to create a contract that requests a flash loan, which then must execute and pay back the loan plus interest and fees within the same transaction. Naturally, this option is beyond the capability of novices.

Leases: DeFi leases are a relatively recent innovation and differ from loans in a few key ways. To take the aforementioned Cosmos-based Nolus protocol as an example, it grants users up to 150% financing on their initial deposit, bucking the industry trend of over-collateralization. Interest rates are also locked up the moment the lease contract is created, another departure from lending protocols' variable rates.

Overcollateralized loans: We covered this one earlier but to reiterate, overcollateralized means you have to deposit collateral greater in value to the loan. Lenders like Compound put this measure in place to protect themselves against the risk of counterparty default.

The Risks of Crypto Lending

As we mentioned in the cons section, crypto lending entails some notable risks. Chief among them is the risk of auto-liquidation, wherein a protocol force-closes a loan position by selling collateral to pay off the debt. This can happen if, for example, the value of the crypto used for collateral drops, taking the LTV ratio into dark waters. This is also known as a margin call.

It is not uncommon to read stories about users of DeFi lending protocols falling victim to cascading liquidations due to market turbulence. Of course, there are steps that can be taken to mitigate liquidation risk: you can set up position health alerts (the Open DeFi Notification Protocol is one option), self-liquidate by allocating some existing collateral to clear a percentage of the debt, use a protocol with a higher LTV, etc.

Alternatively, you can reduce the margin call risk by as much as 40% compared to other DeFi lenders using the Nolus lease protocol.

Liquidations aren’t the only risk. Users of DeFi lending protocols also run the risk of the protocol itself being exploited by hackers. Last year, Euler Finance was the victim of a sophisticated flash loan exploit that drained $197 million worth of user funds. Although Euler was able to negotiate the return of most of the stolen funds to reimburse users, these events understandably rock the confidence of many.

Conclusion

DeFi lending is a major pillar of the DeFi industry, and for good reason. The ability to access fast capital from a permissionless protocol means banks (and loan sharks!) are no longer the only show in town. That said, those considering loaning or borrowing should think hard about which protocols suit their needs best, before jumping in with both feet.

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