The growth of the cryptocurrency industry created demand for new financial products to support crypto asset classes. The current bear market has spurred this demand, as many speculators who refuse to offload their crypto-assets (in hopes of riding out the down trend until the next market turnaround) require immediate access to capital. At the same time, numerous institutional investors are seeking to access cryptocurrencies in order to hedge current positions or implement new trading algorithms. In response to the demand from these such customers, a new cryptocurrency lending market has emerged.
Two Types of Lending
The first type of crypto lending enables borrowers to secure cryptocurrency using fiat currency as collateral. To date, the major borrowers of this nature have been institutions and hedge funds seeking to speculate on the market or gain additional liquidity for high-frequency trading strategies.
The other type of crypto lending, and the one which has garnered more attention from retail investors, allows borrowers to secure fiat capital in exchange for putting up cryptocurrency as collateral. This is predominantly used by retail investors who have suffered major losses (in some cases, as much as 90% of crypto-assets value) over the past year. These investors may need to access capital in order to pay down debts or expenses, but are reluctant to divest themselves of their crypto-assets. Lenders are able to provide capital resources for investors, while allows them to maintain their cryptocurrency holdings.
Lenders in both situations are providing capital to a market which has, up until recently, been viewed as extremely illiquid.
How Does Crypto-Backed Lending Work?
Rather than utilizing credit scores like traditional banks, lenders in this business require cryptocurrency as collateral for cash loans. Borrowers post cryptocurrency as collateral and pay back loans in monthly installments. If a loan is paid back successfully, the collateral is released back to the borrower. If the loan defaults, the lender has the right to seize the cryptocurrency held as collateral.
While this is very similar to traditional collateralized loans, there are a few differences. First, crypto loans must be over-collateralized; this means someone looking to borrow $10,000 may need to post $15,000 in cryptocurrency value as collateral in order to secure their loan. While this may seem excessive, most lenders require such over-collateralization because of the extreme volatility of cryptocurrency prices. Because prices fluctuate so frequently, lenders fear cryptocurrency put up as collateral may devalue significantly over time, and therefore not suffice in the case of loan default.
Additionally, many crypto lenders have stipulations which allow them to liquidate the cryptocurrency held in collateral if the price falls below a minimum valuation threshold. This is a failsafe to protect the lender against the possible scenario in which the collateral devalues to the point of worthlessness.
Cryptocurrency investors who have experienced financial gains from trading face significant exposure to capital gains taxes. One way to mitigate this exposure is by securing cryptocurrency-backed loans. This works because, while the purchase and sale of cryptocurrency are subject to capital gains taxes, borrowing capital against cryptocurrencies is not considered a sale of cryptocurrency, and is therefore not subject to capital gains tax.|
This is of major benefit to cryptocurrency investors who seek to sell large amounts of crypto-assets outright. It should be noted that the IRS has yet to provide guidelines on these loans (including, for example, whether interest payments are tax deductible), therefore investors should always consult a tax professional before considering cryptocurrency loans for this purpose.
Anyone Can Become a Lender
Crypto lending does not just provide to access capital for borrowers; it enables cryptocurrency holders to earn interest from depositing their cryptocurrency with a lender or becoming direct lenders themselves.
Some companies that provide interest on cryptocurrency deposits, such as Celsius, do not require any specific lock-up period, and pay-out interest every week. Deposited coins are held in secure, cold storage wallets, waiting to be reclaimed in the event of a withdrawal. Other platforms, such as Nitrogen, are a decentralized marketplace for lending, making it easy for anyone to lend cryptocurrency based upon a set of loan terms verified on the blockchain. Borrowers and lenders set their lending terms on the platform and find a party with which to trade. All loans are secured in smart contracts. This peer-to-peer lending model mimics that of fiat lending services such as Lending Club and Prosper.
Earning interest on deposits and direct, peer-to-peer lending bring the cryptocurrencies one step closer to a full-service financial industry.
The Major Players
Cryptocurrency prices faltered in 2018, but this proved to be a catalyst for growth for the crypto lending market; the number of cryptocurrency startups grew exponentially over the year, as more and more investors sought to obtain capital.
The biggest lender in the market to date appears to be Genesis Capital, which originated $1.1 billion in loans in 2018 alone, and is on track to do even more business in 2019.
Galaxy Digital, led by former Wall Street executive Michael Novogratz, raised $250 million for a crypto lending fund. Novogratz sees this fund as a primary way to bring institutional investment into the industry.
Meanwhile, Celsius Network provided $630 million worth of crypto-loans since the launch of its app in July 2018. Celsius has focused on providing these loans not just to retail investors, but to exchanges and hedge funds as well.
Supplying to a Demand
Crypto lending meets a demand for accessible financing in the cryptocurrency market. The practice enables institutional investors to borrow in order to conduct their high-frequency trading and hedge their current positions, and grants retail investors access to capital while still maintaining the potential upside of the future cryptocurrency market and an advantage to avoid capital gains taxes. At the same time, depositors earn interest which allows them to grow their crypto-assets for doing nothing more than making a deposit. Such lending is providing a win-win for everyone involved, and poised for further growth as the entire cryptocurrency industry matures.