Crypto Loans Have Significant Risk Attached — Here's Why

The crypto world is evolving at a breathtaking rate, at almost supersonic speed. Many people delved into confusion when Satoshi Nakamoto created the first blockchain, as folks knew little about it. However, today, people are becoming more comfortable with cryptos and are using them in many ways, from sending values to protecting assets.

Different use cases have come up as a result, including crypto loans. Early 2020, when the COVID-19 pandemic hit the globe with severe effects, crypto loans came into the spotlight. People were forced to look for an alternative as loans became harder to get and lending for major items decreased sharply, and crypto loans proved to be that reliable option.

What is a Crypto Loan?

As an auto loan, a crypto loan is a secured loan in which you pledge an asset to secure funding.

Take Bitcoin, for example. It will be the asset provided to a lender in return for cash that you would repay in instalments. If you do not pay back the loan, the lender will liquidate or cash out the Bitcoin.

Crypto lenders such as BlockFi and Unchained Capital provide low annual percentage rates and one to three-year loan durations. However, they have hefty minimum loan amounts.

Risks Associated with Crypto Loans

Generally, cryptocurrencies are quite a risky asset type. Crypto loans are not something you should go into blindly. Several risks present themselves, either security or default risks. Let us dive in:

Volatility

Many cryptocurrencies, such as Bitcoin, see significant price volatility. You may avoid this risk as a crypto saver by investing in stablecoins in your savings accounts. You can even earn more excellent rates on stablecoins on most sites, and you can also get interest payments on stablecoins. Stablecoins are cryptos whose value is pegged to a stable asset, such as the US dollar.

You may believe that stablecoins are a way out, your investment is still at risk because volatile cryptos back the loans of other borrowers on the site.

As a result, what happens if additional borrowers fail, and the platform goes bankrupt? That is, indeed, a genuine worry. However, as a crypto saver, you are not in any danger as long as the platform overcollateralizes those loans, which means that the crypto lending platform always keeps more collateral than it gives out. As a crypto saver, this decreases your risk because the loans made have no loan default risk.

If you are a borrower and opt to secure a loan with volatile crypto, you share the volatility risk of your collateral. It is because the platform may liquidate some of your collateral if its market value falls and you do not respond to a margin call.

Crypto Regulations are Still Uncertain

Cryptocurrencies are a relatively new asset class. Crypto regulations are still underdeveloped compared to mainstream asset classes, resulting in a lack of legal clarity for investors. Legislators may decide to modify how they deal with cryptocurrencies in the future because there is no established legal framework. It might work in your favor but it could also work against you.

Legal issues occur, particularly with DeFi providers, because a licensed firm does not control these platforms. They have no licenses, no CEO, and no formal contracts — and there is little precedence in today’s legal structures for this notion. Who can you sue if your assets are lost because you are not dealing with a legal entity?

In most circumstances, you will be unable to pursue legal action. If, on the other side, a CeFi platform fails to meet its contractual responsibilities, you may be able to sue the platform provider.

Technology Concerns

Smart contracts are used by cryptocurrency lending businesses to automate their lending platforms. Smart contracts govern what happens to your cryptocurrencies, such as interest payments and collateral liquidations.

Smart contracts are essential for DeFi systems since no people oversee the operations in the background, the direct opposite of how CeFi platforms work. Instead, the smart contract handles and oversees all of these responsibilities. That also implies you can’t rely on anyone if the smart contract fails. You are the only bearer of the risk that the smart contract will fail, and you will lose your cryptocurrency in the worst-case scenario.

However, smart contracts on DeFi systems are typically publicly available, which means you may examine them yourself if you have the requisite technical knowledge. Otherwise, you must rely on the platform’s creators and community or invest in a CeFi platform instead.

Crypto Lending Might be Worth the Risk

There are several advantages to converting your cryptocurrency to fiat and lending it out, as well as obtaining a cash loan based on your crypto. While lending organizations may make loans to those with weak credit, they must use their cryptocurrency as security.

Furthermore, while credit history may not be required, most businesses do AML and KYC verification checks on their consumers. It provides some comfort that you will not be dealing with crooks looking to steal your money.

The good news for the borrower is that they retain the full value of their crypto collateral, including gains and losses, since the percentage of the loan varies depending on the platform. Even if the borrower disappears or defaults, the lender at least has cryptocurrency as compensation, hoping it will grow in value over time.

Conclusion

Crypto loans are not risk-free investments. As an investor, in most cases, earning interest doesn’t come without risk. Crypto lending can be a good option if you know what risks you are taking and the expected return justifies them. Investment strategies also affect the degree of risk involved. You can minimize your crypto lending risk by investing only with established providers and in stablecoins or fiat currencies.

It’s also vital to recognize that the traditional banking industry’s risk-return assumptions do not apply to crypto lending in the same manner. For example, even if your risk is reduced, you get paid a greater interest rate on your stablecoins. It may not seem reasonable at first, but the reason is that volatility is inherent in the crypto-financial realm, so stability is valued.

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