Is Bitcoin Lending Safe?

The risks involved with Bitcoin lending and how to reduce or eliminate them.

Crypto lending comes with attractive perks. It allows you to take out personal loans without letting go of your crypto holdings. Apart from that, crypto-backed loans usually come with lower interest rates and quicker funding when compared with their traditional counterparts.

However, it is not all good. As with almost anything that brings benefits, there are some risks attached to cryptocurrency lending. Some of those risks come with the crypto lending platforms involved, while others are associated with the crypto assets.

This article will focus on a specific type of crypto lending — Bitcoin lending. We will discuss how it works, highlight the risks involved, and show you how to reduce or eliminate such risks.

What is Bitcoin Lending?

Bitcoin lending is a type of crypto lending that involves Bitcoin. It could mean using Bitcoin as collateral for the crypto loan you take out or taking out a Bitcoin loan using other crypto assets as collateral.

Because of its relative stability among other cryptocurrencies, most crypto lending platforms offer Bitcoin as one of their main lending products. In fact, some platforms like BTCPOP offer Bitcoin as their only lending product.

Bitcoin Lending Regulations

As with other aspects of the crypto industry, Bitcoin lending is largely unregulated. Many crypto lending platforms argue that their lending products are not securities and do not need to be registered with the government.

However, governmental authorities do not seem to agree with that. For example, BlockFi, a popular crypto lending platform, was recently slapped with a $100 million fine by the SEC for failing to register its lending products with the US government.

This is likely to be a pacesetter for other Bitcoin lending platforms to comply with governmental regulations, much to investors' relief.

Bitcoin Lending Security

How secure is Bitcoin lending? In most cases, this has to do with the lending platform you choose to use.

Centralized crypto lending platforms like BlockFi, Nexo, etc., are generally more secure but come with more restrictions and identity checks. On the other hand, decentralized platforms like Aave and Compound do not require identity checks but are generally less secure than their centralized counterparts.

Risks Associated With Bitcoin Lending

Let us now consider some risks that investors may be exposed to when they engage in Bitcoin lending.

The Risk of Uninsured Deposits

Unlike traditional lending platforms, many Bitcoin lending platforms do not come with deposit insurance. Therefore, there is no guarantee that your capital will be refunded if the platform goes bankrupt.

Centralized crypto lending providers like BlockFi and Nexo offer their users some form of protection because they have an insurance arrangement. For example, BlockFi keeps its crypto assets with Gemini, which has a deposit insurance arrangement of $200 million, while Nexo has total insurance of at least $375 million.

However, this cannot replace the type of security that comes from government-approved insurance corporations like the FDIC and similar institutions with a proven legal framework.

So, if you're looking to start crypto savings accounts with a Bitcoin lending platform, check out what type of insurance policy it has and whether you're comfortable with it.

Bitcoin Lending Scams

This risk is more common with DeFi crypto lending platforms because they rely on smart contracts, which hackers can easily exploit. A typical example is a flash loan attack.

A flash loan is a type of loan that doesn't require collateral. The only condition is that you need to pay it back in a flash, within seconds, before the transaction ends. If you can't pay it back, the transaction reverts as if it never happened.

Because flash loans allow you to borrow large amounts of funds that easily, some hackers exploit them by manipulating the prices of crypto assets to make illegal profits. They then return the loan and disappear into thin air with the profits.

Some other examples of Bitcoin lending scams are rug pulls and impermanent losses.

The Risk with Third-Party Services

Most Bitcoin lending platforms use third-party services to store your Bitcoins. Some even lend them out to other crypto lending platforms or invest in them with some crypto investment platforms. That is how some of them make profits.

It's all good and fine as long as you get paid, right? But what happens when those third-party platforms can not repay the loans? In such cases, your crypto lending platform may go bankrupt, and that will affect you.

Even though most centralized crypto lending platforms try to mitigate this risk by over-collateralizing their lent crypto, your capital is still exposed to risk, especially in times of extreme market swings.

Decentralized crypto lending platforms typically don't lend crypto to third parties, so this risk may not apply to them.

The Risk of Volatility

This is an ever-present danger with Bitcoin and other cryptocurrencies. Even the best crypto lending platforms cannot protect you when the market swings against your prediction, exposing your collateral to liquidation.

That is why you need to watch out for the interest rates and the loan-to-value ratio before signing up on a Bitcoin lending platform. Also, you should have some extra cash on hand in case you get a margin call on your Bitcoin loan.

How to Minimize the Risks of Bitcoin Lending

Use Trustworthy Platforms

This goes without saying. When you put down your collateral with a crypto lending platform, you trust that you'll get it back when you're ready to repay. That is why you should verify how legitimate the platform is before starting with it.

How do you know if a Bitcoin lending platform is trustworthy? Well, is it regulated? Does it have reputable partners? Does it have sound security practices like two-factor authentication and encryption? What about the interest rates it offers? Are they reasonable?

Also, check out whether or not it has insurance coverage and how deep such coverage goes. Lastly, try out multiple platforms to reduce your exposure if something goes wrong with one of them.

An example of a trustworthy Bitcoin lending platform is Nexo. It is licensed in the United States as well as Canada, Switzerland, Lithuania, etc. It also stores its cryptocurrencies in cold wallets and has robust insurance coverage.

Other trustworthy platforms that offer Bitcoin lending are BlockFi and Hodlnaut, among others.

Start with Small Amounts

If you're just starting in Bitcoin lending or just trying out a new Bitcoin lending platform, it may not be wise to lend out your whole portfolio and hope for the best. You should start small and then progress according to your risk tolerance.

That way, you can better assess the security of the platform, its response to customer queries, and what kind of profit potential you stand to gain.

Be Wary of DeFi Lending Platforms

Decentralized Bitcoin lending platforms come with more flexibility than their centralized counterparts. Therefore, it may be tempting to favor DeFi over CeFi regarding crypto lending.

However, keep in mind that Bitcoin lending scams are more common with DeFi platforms. There is no need for regulation, nor is there a need for insurance with these platforms. If they suffer an attack, there is no one to hold; your money is simply gone!

Final Thoughts—Is Bitcoin Lending Safe?

In this article, you have learned that while Bitcoin lending has its advantages, it also presents certain risks. Uninsured deposits, Bitcoin lending scams, volatility, and third-party services may lead to the loss of money for investors.

To mitigate such risks, you should use trustworthy crypto lending platforms, start with small amounts, and steer clear of DeFi lending platforms as much as possible. That way, you will tread as safely as possible in the sometimes tumultuous world of Bitcoin lending.