Crypto Lending Risks

Major risks that you should consider before involving yourself in crypto lending transactions.

Investors always look to earn passive income on their crypto holdings as they offer better interest rates when compared with traditional financial products, such as savings accounts. Crypto lending allows investors to lend their crypto assets to different borrowers and receive interest payments in return.

Interest rates offered by crypto lending platforms are usually high, sometimes even reaching 27.45%. In contrast, the traditional means can get you up to the 2-4% on money held in a savings account.

You can lend and borrow cryptocurrencies with ease. A typical crypto borrower does not need to worry about the extensive verification process usually required when setting up a savings account. On the other hand, lenders experience little hassle when lending their coins anonymously.

However, even if you know how crypto lending works, the crypto industry is not risk-free.

In this post, we have listed crypto lending risks that you should consider before involving yourself in crypto lending transactions.

What Are the Major Risks Associated With Crypto Lending?

The risks associated with crypto loans are manifold, from security issues to the market's inherent volatility. Let's take a closer look:

Security Issues

Although crypto assets have been around for over a decade, the lending industry is still in its infancy.

With the prevalence of cyberattacks in virtually every industry, the crypto lending platforms are no exception. The threat can even come from the lending platform itself. Such threats are usually of the following two types:

Rug Pulls

Rug pulls usually occur when DeFi developers want to drain a liquidity pool of assets. To accomplish this, the developers must create a novel token and pair it with a market-leading cryptocurrency to set up a liquidity pool. This invites unsuspecting investors to deposit large sums into the pool. DeFi developers use this opportunity to mint millions of new coins using backdoor policies. Developers then look for individual investors to use paired currencies to purchase their new cryptocurrency. Once there are sufficient funds in the lending pool, they withdraw the assets, leaving investors stranded.

Flash Loan Attacks

A "flash loan attack" is a misuse of a platform's smart contract security in which an attacker often borrows large sums of money without putting up any collateral. They then influence the price of a cryptocurrency asset on one exchange before selling it as soon as possible on another. The loan transaction itself happens instantaneously—the borrower may collect hundreds of thousands of dollars in the form of an uncollateralized loan with zero risk. The only drawback is that they must return the entire amount within the same transaction, hence the name "flash" loan.

The most astonishing and rather well-known instance of such an attack is the case of PancakeBunny.

Cybercriminals borrowed BNB in large numbers by using the PancakeSwap lending protocol and covertly manipulated the price of PancakeBunny's token, BUNNY, in off-market lending pools. They then dumped BUNNY on the open market, causing its price to drop almost completely and causing a trust lapse from which they might never recover.

Platform Insolvency

Bank deposits are protected by the FDIC, meaning your money is protected in case of the bank’s bankruptcy.

In contrast, the crypto market is rather new. This has resulted in some lending platforms gaining traction while remaining uninsured. This directly impacts a provider's insolvency risk, which means that should your provider become unable to function, you can lose all of your crypto assets.

Market Volatility

One of the most distinctive features of the crypto industry is the constant and mostly volatile fluctuations in the prices of each digital currency. This can easily cause your asset’s value to drop unexpectedly. For instance, if you gave someone a loan of 1 Ethereum (ETH) last May, you lent them the equivalent of ~$3000. If you were to get it back now (25 June 2022), even with an interest rate of 10%, you would be getting the equivalent of ~$1250.

To safeguard yourself and your assets in such circumstances, you must conduct exhaustive personal research. Keep a strict eye on the market value of your digital assets and devise your investment strategy accordingly.

The most sensible and widely employed workaround of the market volatility caveat is lending stablecoins. Stablecoins are frequently backed by the particular assets they are linked to because their main purpose is to track an asset.

Keeping your investment strategy tethered to the real world affords it a sense of stability and keeps your investment shielded from slight to medium market volatility.

Impermanent Loss

Committing cryptocurrencies to a liquidity pool brings with it the possibility of impermanent loss. An instance of impermanent loss would occur if you deposited your crypto assets in a liquidity pool associated with an automated market maker (AMM) and withdrew them at a later date when the price of the assets had already dropped. An unrealized loss would not have occurred if you had simply held those assets in your crypto wallet.

Liquidity pools

Liquidity pools usually keep cryptocurrencies in a set ratio to each other. This means that to make a transaction, you would have to deposit both the tethered coins in their respective ratios to maintain the value of the liquidity pool. Whenever this value is disturbed, for example, by market fluctuations, the price of the coin in higher supply is increased and vice versa to incentivize arbitrage traders to rebalance the pool.

In such an instance, depending on how the ratios and values changed, you may end up with a "loss." This is because you were entitled to the same percentage of the pool as to when you deposited assets, and the value of that percentage of the pool might have decreased due to rebalancing activities.

Loan Counterparty Risk

Counterparty risk comes into play when centralized platforms lend to external parties. Counterparty risk means that one of the parties (e.g., borrowers) involved in the loan transaction might default on their obligation.

The CeFi platform usually discloses how they utilize their crypto deposits in their contracts, and their borrowers include cryptocurrency exchanges, hedge funds, and other institutional investors. Therefore, the lending platform risks insolvency if the counterparty fails to return the cryptocurrencies listed in the trade. This exposes the lenders to default risks.

This risk is usually rampant with newer, lesser trustworthy platforms. Although lending platforms would lessen this risk by over-collateralizing the assets they give out, these transactions are not always completely transparent, therefore, they might not always do so.

Are Some Crypto Lending Platforms Safer Than Others?

Retail traders turn to cryptocurrency to earn passive income as their faith in established banking institutions erodes. Digital assets, which are user-driven and transparent, can provide customers more confidence, financial freedom, and control over their money than a traditional bank account. This explains why crypto lending has grown in popularity.

Users can lend and borrow cryptocurrency effortlessly on crypto lending platforms. Through crypto-based wallets that are functionally comparable to typical bank savings accounts but may provide much greater yields, CeFi introduces the possibility of earning interest.

However, one of the most crucial factors to consider when choosing a platform is its security. Users must trust crypto platforms with their funds, and hacking and privacy breaches are legitimate concerns. Some platforms do more to mitigate risks and are safer. We have listed three of the safest lending platforms today:

CoinLoan

It is a loan platform that offers institutional borrowers access to order currency and crypto lend. CoinLoan interest accounts permit investors to earn up to 12.3% Annual Percentage Yield (APY) for staking the CoinLoan token (CLT).

Several European regulators, including Estonia Financial Authority, regulate this platform. CoinLoan has a $100 million insurance fund thanks to its association with BitGo.

Nexo

Nexo is another crypto lending platform that offers crypto-backed loans. If considered in terms of investment opportunities, it is one of the best platforms which offers up to 12% APY on stablecoins like DAI, USDT, and USDC.

You can find Nexo's certifications on its licenses and registrations page. Nexo is also covered by a $775 million insurance policy thanks to its alliance with BitGo and Ledger Vault.

What Are Some Ways in Which You Can Minimize Crypto Lending Risks?

Even the most seasoned crypto lending investor would be vulnerable to making mistakes or falling victim to one or more of the risks we discussed. The question then becomes of securing yourself and your interests the best you can against these risks. Below are some of the best ways to do so:

Be Thorough in Your Research

Almost every crypto lending platform will try to outbid its competitors by promising a higher ROI or claiming they have more secure protocols. However, doing your research on your chosen lending platform will save you much remorse later on. You can start your research by:

Verifying the Platform’s Credibility

You can attempt to protect your interests in this endeavor by vetting the platform's credibility on some of their other projects. Read about their team as well. This could give you a better idea of the probability of them pulling a fast one on you.

Verifying the Platform Infrastructure's Stability

Additionally, reading more about the platform's infrastructure will give you insight into any technical flaws it might be incorporating, some of which could become an opportunity for an exit scam.

Verifying the Platform's Smart Contracts

Most smart contracts used by crypto platforms are publicly available and easily accessible. You can go through them to enhance your technical knowledge and make a more informed decision by checking their security.

Rethink Your Crypto-Investing Strategy

Stablecoins vs. Altcoins

The price of Ethereum fluctuated between $3000 and $1000 between March 2022 and June 2022. On the other hand, the price of Tether (USDT)—a stablecoin pegged 1:1 with the US Dollar—remained, as expected, at $1. This is a prime example of the difference in stability that a stablecoin provides over its altcoin counterparts.

While trading in altcoins provides the possibility of much higher returns, giving out crypto loans in such currencies might see your returns diminished. In such a landscape, stablecoins will come to your aid and help you protect your crypto assets. Investing in stablecoins also helps protect you against impermanent loss.

Portfolio Management

Some risks are out of the investor's control. These include the possibility of platform insolvency, which brings with it the risk of losing your entire deposit, as crypto deposits are not insured by any form of statutory deposit insurance.

In such cases, the only sure-shot way of protecting yourself and your assets is to not invest a large chunk of your digital currency portfolio with a single platform. Having your crypto deposits in more than one platform will provide your portfolio with an adequate level of diversity that will dilute unforeseen risks.

Conclusion

Crypto lending comes with its share of risks. Such risks range from bad market factors exploiting vulnerable protocols to market volatilities affecting the return on investment that you might be getting.

So, you must choose the right crypto lending platform as each has its pros and cons. Moreover, staying updated on the major lending risks enables you to figure out how to invest wisely and safely.