How Crypto Loan Collateral Works

Learn what crypto loans are, how crypto loan platforms provide fast and anonymous loans, and especially how crypto loan collateral works.

You're likely familiar with the concept of loans. Maybe you've taken some personal loans in the past. After all, who doesn't need a few extra bucks once in a while?

This article will focus on an emerging type of loan, the crypto loan. We will discuss what crypto loans are, how crypto loan platforms provide fast and anonymous loans, and especially how crypto loan collateral works.

What is a Crypto Loan?

In simple terms, a crypto loan is a loan you take with cryptocurrencies as collateral. This type of loan is usually managed by a centralized loan platform or smart contract and may or may not require KYC registration before use.

There are two types of crypto loan platforms. The first are the decentralized platforms, which usually do not require KYC. Examples are Aave, Compound, Maker, Fulcrum, Solend, etc. There is generally more need for caution along these lines, though, as most of these protocols are unregulated.

There are also centralized crypto loan platforms. Some examples are BlockFi, and Hodlnaut. Unlike decentralized platforms where smart contracts run the whole process, these platforms require KYC registration and handle the lending and borrowing process themselves.

How Does Crypto Loan Work?

There are three parties to a crypto loan arrangement, and they are:

The Lender

This is an individual or company that deposits crypto assets into a loan platform or a smart contract pool to be used by intending borrowers. The lender receives interest regardless of the market conditions.

The Mediator

The mediator is the crypto loan platform. It handles all the logistics and transactions between the borrower and the lender. The mediators make money by taking their cut of the total interest charged on the loans. The minimum loan amount usually differs from platform to platform. It may be as low as $10 or as high as $10,000.

The Borrower

A borrower is an individual or company that puts down collateral to get a loan. Depending on market conditions, the collateral may be liquidated before the borrower has the chance to pay off their debt. The borrower also has to borrow an amount greater than the minimum loan amount.

Individuals or organizations that borrow from decentralized loan platforms do not have to go through an extensive credit check or KYC system. This is massive when compared with traditional financial institutions.

Therefore, this is how a crypto loan works: the lender deposits some crypto assets with a mediator, which may be an exchange or a smart contract pool. The borrower then borrows them from the mediator and pays interest on the borrowed amount. Part of the interest goes to the lender, while the other part goes to the mediator.

This principle is the same with both centralized and decentralized platforms.

Now, let's talk about the collateral.

A Collateralized Crypto Loan

This is also known as a crypto secured loan, and this is the most common type of crypto loan. This crypto loan method gives the borrower more time to utilize the loan and profit from it before returning the borrowed capital.

In most cases, the borrower faces more risk due to the probability of liquidation amidst market swings. The only risks the lender may face are the risks of smart contract exploitation or dishonest mediators.

How does it work? Let's talk about the collateral itself. There are a few things to note, namely:

  • The collateral is always a different cryptocurrency from what you want to borrow. Therefore, you can't use BTC to borrow BTC, and so on.

  • The LTV ratio of the loan platform determines how much collateral you would put down. LTV means Loan to Value Ratio, and it is a common term in the financial industry used to express the relationship between the expected loan and the collateral value. Generally, the higher the Loan to Value Ratio, the more you'd get. For example, a loan with an LTV of 50% means that if you put down 10,000 USD as collateral, you'll get 5,000 USD as a loan. Meanwhile, the same collateral will yield you a loan of 7,000 USD with an LTV of 70%. Even though a higher LTV ratio translates to a higher loan amount, it also translates to higher interest rates. So, you should keep that in mind.

  • Your collateral is usually kept safe in cold wallets until you're ready to repay. It is not tampered with.

  • You can use your collateral to get other cryptocurrencies. You can also get stablecoins as well as cash. It all depends on the loan platform you choose to transact with.

Why Put Down Collateral?

If you have some cryptocurrencies and need some quick cash, or you need other cryptocurrencies, why not just sell your coins and utilize the money? Why should you put it down as collateral, exposing it to liquidation risks?

Well, if you take personal loans with a bank, wouldn't you put down collateral? To get a secured loan, you might have to put down your house, car, or other personal belongings. Why didn't you sell your house to get the capital you need? It's simply because you don't want to part with your house yet.

The same analogy applies to crypto loans. You put down your digital assets as capital because you want to enjoy other financial benefits while still holding on to your desired crypto.

Unlike personal loans secured through traditional banks, the risk of liquidation is higher with crypto loans, though, because of the volatile nature of cryptocurrencies. Therefore, aspiring borrowers should contemplate the risks well before committing their hard-earned crypto as collateral.

You may be surprised that not all crypto loans attract collateral. How can that be? Let's address it.

Non-collateralised Crypto Loans

These loans are known, in other words, as flash loans. They are so named because they instantly initiate, execute, and recall loans in a single block.

Flash loans are usually managed by smart contracts which hover around the blockchain and ensure that all the conditions are met before finalizing the deal. How does it work?

It usually comes in handy in the decentralized finance world when there is an arbitrage opportunity between two decentralized exchanges (DEX). In that case, if you do not have enough funds to lock in the arbitrage opportunity, you can utilize flash loans to make a quick profit.

Let's break it down. Say a token is trading at 5 dollars on DEX A and at 5.2 dollars on DEX B. This is how the flash loan works:

  • You initiate a transaction to borrow 10,000 dollars from the crypto loan platform.

  • The platform borrows you the amount and immediately uses it to buy tokens on DEX A and sell them on DEX B.

  • The platform then returns the borrowed capital with interest (usually 0.09%) and gives you the profit.

  • That's all! All of that is done in an instant, a flash!

If profit is not made or if the borrower can't return the loan, the transaction is reversed, and the capital is instantly returned to the lender.

Therefore, flash loans are the least risky type of crypto loans because the lender will always get repaid, and the borrower will not lose if there's no profit.

However, there is still the risk of flash loan attacks, where hackers exploit the smart contract vulnerabilities of the crypto loan platform and drain it of its capital.

Final Thoughts

Crypto loans have become more popular in the financial world. Three integral parties come together to make the working of crypto loans. The parties are the crypto lenders, borrowers, and loan platforms.

Crypto loans offer faster processing and sometimes complete anonymity with no credit check. On the other hand, there is an increased risk of liquidation because of the volatile nature of digital assets.

Therefore, if you're going to put down some of your digital assets as collateral with a crypto loan platform, be sure you're only putting down what you can afford to lose.