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Interest rates offered by crypto lending platforms vary. Generally, investors can expect to earn between 1 and 12% interest. On the other hand, traditional banks can only provide their users with around 2-4% interest.
Also, a crypto platform makes it easy to lend and borrow money, unlike traditional banks, where the process can be complicated.
Despite these benefits, there are still risks attached to the crypto lending industry. This article discusses some of these risks.
What Are the Major Risks Associated With Crypto Lending?
Crypto lending carries several risks. These risks range from security issues to the market's inherent volatility.
Security Issues
The crypto space has experienced many security issues. Since crypto lending platforms are part of this space, they are also susceptible to hacks and thefts.
Flash Loan Attacks
A "flash loan attack" often occurs due to misusing a platform's smart contract security. Large sums of money are often borrowed without collateral by the attacker.
They then manipulate the price of a cryptocurrency asset on one exchange. Next, they quickly sell it on another exchange. These attacks often occur within a short period of time, usually seconds.
The loan transactions occur quickly. Borrowers collect hundreds of thousands of dollars. They have zero risk. They must return the entire amount within the same transaction.
Real-life Example
PancakeBunny, a well-known flash loan attack, used the DeFi protocol. Cybercriminals borrowed BNB in large numbers by using the PancakeSwap lending protocol.
The price of PancakeBunny's token, BUNNY, was then manipulated in off-market lending pools. The value of the BUNNY token crashed on the open market. The result was a drastic drop in the price of the digital asset.
Market Volatility
The crypto industry is prone to constant and volatile fluctuations in price. As a result, an investor's asset can drop immediately without warning.
For instance, if you gave someone a loan of 1 Ethereum (ETH) last May, you lent them an amount equal to $3000. If you were to get it back now (June 25, 2022), even with an interest rate of 10%, you would be getting an amount equal to $1460.
To safeguard themselves in such circumstances, investors must conduct exhaustive personal research. Investors must closely monitor digital assets' market value.
Investors must also have a comprehensive investment strategy to avoid losses. The most sensible strategy for avoiding market volatility is to lend stablecoins.
Stablecoins typically have real-world assets as their backing. These assets may be fiat currencies or commodities. As a result, their values will remain unchanged at all times.
Loan Counterparty Risk
Counterparty risk comes into play when centralized platforms lend to external parties. When it happens, one of the parties engaged in the lending process has breached their contract.
CeFi platforms usually disclose how they use their crypto deposits in their contracts. Their borrowers include cryptocurrency exchanges, hedge funds, and other institutional investors.
The lending platform risks insolvency if the counterparty fails in its obligations. Borrowers who fail to return the loans listed in the trade expose lenders to risk.
This risk is usually rampant with newer, less trustworthy platforms. Lending platforms lessen this risk by over-collateralizing the assets they give out.
Platform Insolvency
The FDIC protects bank deposits in bankruptcy. Thus, customers who have funds stored in a bank can be assured of the safety of their funds.
In contrast, the crypto market is new and not fully regulated. Because of this, a number of lending platforms that are gaining popularity are either not insured at all or are only partially insured.
Volatility and the other risks of loans mentioned above can cause a platform to go bankrupt.
When these platforms are severely exposed to one of these risks, they might not be able to return the funds of their users. In some cases, they eventually file for bankruptcy.
Investors who keep their funds on these platforms must be aware of such risks.
Real-life Example
Celsius is an example of a lending platform that became insolvent. The platform halted customer withdrawals and filed for bankruptcy in July 2022.
Are Some Crypto Lending Platforms Safer Than Others?
Security is one of the most crucial factors when choosing a platform. Some platforms do more to mitigate risks and are safer. Here are two of the safest lending platforms today:
CoinLoan
This loan platform offers institutional borrowers access to digital currency and crypto lending. CoinLoan interest accounts permit investors to earn up to 12.3% APY. This interest rate applies to CoinLoan token (CLT) investors.
Several European regulators, including the Estonian 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. The platform offers attractive investment opportunities to its users. Unlike some other lenders, Nexo offers 12% APY on stablecoins like DAI, USDC, and USDT.
You can find Nexo's certifications on its licenses and registrations page. A $775 million insurance policy also covers Nexo. This policy is possible thanks to its alliance with BitGo and Ledger Vault.
What Are Some Ways in Which You Can Reduce Your Exposure to Crypto Lending Risks?
Even seasoned investors are susceptible to making errors. Some of the risks listed in the previous section can affect investors.
Traders need a plan for their investment activities to avoid those pitfalls. Consider some ways you can protect yourself:
Be Thorough in Your Research
There is intense competition in the crypto lending industry. As a result, platforms try to outbid themselves by promising a higher ROI. Others provide unique services.
When it comes to choosing a lending platform, investors are spoiled for choice. Thus, they must conduct careful research on their choice of lending platform. Proper research will save traders from problems in the long term. Start your research by:
Verifying the Platform's Credibility
Investors should protect their interests by verifying the platform's credibility. They can do this by checking reviews of the platform's services.
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
Reading about the platform's infrastructure can also be beneficial. Checking the infrastructure can help expose any technical flaws associated with the platform.
Verifying the Platform's Smart Contracts
Most smart contracts used by crypto platforms are available and accessible. You can go through them to enhance your technical knowledge. They can also help you make informed decisions.
Rethink Your Crypto-Investing Strategy
Stablecoins vs. Altcoins
The price of Ethereum went from $3000 to $1000 between March and June 2022. In that period, Tether (USDT)—a stablecoin pegged 1:1 with the US dollar—remained at $1. This is an example that shows the stability a stablecoin provides.
Trading altcoins provides the possibility of much higher returns. However, investors who lend out such assets might see their returns diminished.
During a market downturn, stablecoins protect your crypto assets.
Portfolio Management
Some risks are out of the investor's control. These include the possibility of platform insolvency. That situation can result in traders losing their entire deposit.
Investors can protect their assets by spreading their crypto portfolio across different platforms. Investors with diverse portfolios will be better prepared for unforeseen risks.
Conclusion
Cryptocurrency lending comes with its share of risks. Such risks include bad market factors such as exploiting vulnerable protocols. These risks affect the return on investment for traders in the space.
So, you must choose the right crypto lending platform, as each has its pros and cons. By keeping up with the biggest risks in lending, you can figure out how to invest wisely and safely.
Disclosures
The content is only provided for informational purposes. It is not meant to be tax or financial advice, and it does not recommend any particular investment plan. Every investment has risk, including the possibility of a cash loss. Past performance does not guarantee future results.
Bitcompare does not guarantee good investment outcomes. The way a security or financial instrument did in the past does not show how it will do in the future. Before investing in options, clients should carefully assess their financial goals and risk tolerance. Due to how important tax issues are in all lending situations, a customer who is thinking about borrowing money should talk to a tax expert to find out how taxes affect the outcome of any lending strategy.
