How Do Crypto Lending Pools Work

Understand how decentralized finance and crypto platforms work.

To many people, the word "loan" carries a scary connotation. Yet loans are one of the fundamentals that underpin our economic system. In the crypto space, several companies offer loans to clients. These loans are much easier to get than those from traditional financial organizations. Because of this ease of acquisition, loans provide a level of economic freedom to individuals that has never existed before. For the investor, loans are a way to leverage one’s crypto assets to generate passive income. To understand how these crypto lending platforms work, we must first look at decentralized finance.

Decentralized Finance and Loans

By now, most people know what decentralized finance, or DeFi, is. For those not yet aware, DeFi is a cutting-edge financial technology based on blockchain interaction, allowing access to financial instruments independent of banking systems. One of the financial instruments that DeFi offers is loans. These systems are far more attractive than traditional lending because investors can make more on their initial deposits. Many crypto loans use stablecoins as their medium of transfer. Since these coins don't slip in value, there's less risk to the lender and borrower.

A crypto loan typically involves three parties: the lender, the borrower, and the organization or smart contracts that set the interest rates. A user usually deposits crypto assets into their account before getting access to a loan on a platform. However, this isn't always the case. In typical crypto lending platforms, there are a few different types of loans:

  • Flash Loans: These are the only loans that don't require an initial deposit to take out. These are typically used to take advantage of trade opportunities where everything can be done in the same transaction. They are usually completed before a single block on the chain has been added. If the borrowed funds cannot be repaid before the block ends, the transaction isn't validated, meaning no funds are sent to the borrower.

  • Collateralized Loans: These types of loans are more common in crypto lending. A depositor can take out a crypto loan only after they have a deposit of crypto assets as collateral. They can then get access to a loan up to their loan-to-value (LTV) ratio. Digital assets can fluctuate in value, and the LTV is designed to ensure that the organization doesn't disburse more in loans than the depositor has to cover the payments.

  • Margin Trading/Leverage: Theoretically, a borrower can deposit some value in crypto assets and access crypto loans based on their deposit value. However, nothing is stopping the depositor from then depositing this loan amount into a separate account and using it to gain further leverage for loans. As such, an investor can extend the value of their crypto loans. They have access to crypto loans based on the amount of collateral value they have on the platform. Some DeFi lending platforms even allow trading with leverage, enabling depositors to risk their deposits on the open market.

How Does DeFi Lending Work?

DeFi lending is pretty different from traditional lending in several ways. In traditional lending, one person with money lends to another person without money. This lending and borrowing can be done through a direct agreement, but it's more commonly done using an intermediary, such as a bank. The depositor gets interest payments based on when the bank lends their money to the borrower. Typically, the bank charges much higher interest rates than it pays out to the depositor. The reason they can do so is due to their assuming the risk of the loan. The depositor doesn't have to worry about whether their loaned money comes back or not. They don't even know who the bank is lending their money to. The bank has checks and balances to ensure that the borrower repays the loan.

The goal of DeFi lending is to remove the bank from the equation. To do this takes a bit of overhead since you're trying to replace a whole slew of checks and balances with an automated system or a lending platform. The benefit of doing so is that the lender now gets the total interest rate that the borrower pays without worrying about the intermediary taking such a large cut. Protocols will still see a cut of the fees, but it’s far less than what traditional financial institutions take from loan payments. This approach results in far higher interest rates for depositors, while borrowers are likely to see no significant difference in the amount they pay back through their loans.

A lending protocol serves to replace the bank in many automated systems. The lending protocol comprises smart contracts that incentivize people to deposit certain types of crypto assets as collateral. So, for example, lending platforms might offer higher interest payments on ETH, encouraging people to deposit their ETH into the platform. The depositor can then leverage that ETH's collateral value to borrow other types of digital assets, depending on their needs. The interest rate on both sides of the equation is constantly changing, depending on the lending platforms' supply and demand for loans. Some DeFi lending platforms do provide static interest rates, however, meaning a more stable payout over time.

An Example of DeFi Lending

An investor currently has 10 ETH, and the market is on the rise. They want to benefit from their ETH but don't want to sell it just yet. What options do they have? The investor can leverage a crypto loan that uses their ETH as collateral. When they deposit the 10 ETH into the platform, they get back buying power equal to a percentage of the deposit. This buying power might be as much as 50% of the deposit, so 5 ETH. Using this 5 ETH of value, the investor can borrow another currency from the platform. The amount they borrow can not be more than the equivalent value of 5 ETH at the time. They can use this new capital to do whatever they want and pay it back to free up their deposited ETH. This allows for the flexible management of cryptocurrencies and increases the buying power of held digital assets without having to liquidate those assets.

Volatility and Collateral

If a crypto holder deposits funds into a liquidity pool, the value of that deposit is likely to change over time. This situation occurs because of the volatility of the asset. As a result, crypto lending platforms provide loans based on a percentage of that value to account for changes due to volatility. Decentralized lending platforms do this to ensure that even if the collateral falls, the organization still has enough of it to cover the loan, should the borrower not be able to pay back the loan amount. If the value of the deposited assets ever drops below a particular value, the crypto lending platforms may liquidate the position to make up for the lost value. This process is similar to being margin-called when doing stock trading.

How do the crypto lending platforms know when the value gets too low? Smart contracts constantly monitor the market price of assets through oracles. These smart contracts are coded so that if the market price hits a trigger level, they execute a liquidation on the collateral to recover the loan amount. Once the collateral falls below that strike point, the borrower needs to pay back their loan and lose access to their collateral. While the lending and borrowing processes are similar to those of a bank in some ways, the major difference is that there is no centralized organization involved in the crypto lending process.

Depositor Tokenization

So, what does the depositor get for putting their assets into the crypto lending pools? Typically, a depositor gets a particular token that can go up or down in value depending on the interest generated. Tokenization is unique to the DeFi lending space. In essence, a token holds the interest generated on a particular deposit. By sending that token to a third party, a depositor can share their interest with whoever they choose. The closest analogy in the traditional banking system is the government bond. These bonds accrue value over time and can be cashed in at a specific date for the value of the bond. DeFi lending doesn't have any particular strike time for cashing in on the interest token. As a result, the holder could hold onto those interest tokens for as long or as little as they like.

Composable Lending Protocols

One of the most potent parts of lending pools is how composable these protocols can be. There may be several different crypto lending platforms, each offering a different interest rate. With composable lending protocols, smart contracts can determine which crypto lending platform provides the best value for money. It can then take money deposited into one lending platform's liquidity pools and put it into a different platform's liquidity pool where the interest rate is more lucrative for the client.

The Risks of Crypto Lending

Crypto lending isn't a foolproof system. While there is the potential to earn passive income from depositing your digital assets into a pool, there are also significant concerns that a depositor should be aware of. Crypto lending platforms are not regulated, although there is a push by the SEC to change that. This lack of current regulation also means that deposit insurance doesn't cover these deposits into the liquidity pool. If the organization decided to stop operation tomorrow, you'd be unable to withdraw your funds.

Impermanent loss is another risk that plagues DeFi lending. When a depositor puts their money into liquidity pools, there's no guarantee that those assets' collateral value will remain constant. Cryptocurrencies fluctuate in value often, and the value of those deposited assets may rise or drop depending on market forces. Lending pools tend to maintain a constant ratio of a particular token compared to another one on the lending platform. Arbitrage traders help to equalize the difference in value between deposited assets and the current market price. Impermanent loss happens when the crypto lending platform tries to balance out this discrepancy and ends up with less value in the liquidity pool than it originally had.

What This Means for You

Crypto lending pools are simply decentralized methods of lending/borrowing that allow you to leverage your assets in a new and exciting way. Instead of a savings account where your assets are paid based on the interest rate, your potential for earning is nearly endless with lending pools. For example, a depositor could use a flash loan to take advantage of a trade or arbitrage opportunity and repay the loan before the end of the block. There are significant risks in taking advantage of these opportunities, so doing your own research is preferable. There is the potential for a substantial gain, but it needs to be tempered with knowledge.