A benefit of investing in cryptocurrency is the opportunity to use your crypto holdings as collateral for a loan, regardless of the fact that your holdings are relatively small. A similar practice is called securities-based lending in traditional markets, but it is typically only available to high-net-worth clients of private banks and large financial institutions.
Crypto loans offer “hodl” investors a way to liquidate their investments without selling them. This article discusses the advantages, risks, and tax implications of bitcoin and crypto loans, as well as some of the best crypto lending platforms.
What is a crypto loan?
Crypto loans allow traders to receive liquid funds without selling their cryptocurrencies. Rather, they use their crypto as collateral for a cash or stablecoin loan.
Some people choose to take out a crypto loan instead of selling because they expect the value of their crypto asset to increase or because they want to avoid short-term capital gains taxes.
What are the different types of crypto loans?
Custodial crypto (CeFi) loans
Centralized finance (CEFi) loans are custodial: a centralized entity handles collateral. The lender controls the private keys to the collateralized assets, which the trader cannot access.
Despite the fact that custodial crypto loans are far more accessible and affordable than traditional loans, they still rely on a centralized lender to enforce it terms. Around 80 percent of crypto loans are now custodial, but this ratio is rapidly changing.
Non-custodial (DeFI) crypto loans
Decentralized finance (DeFi) loans do not require custody. Instead of relying on a central organization to enforce loan terms, they use smart contracts. Traders who take out a DeFi crypto loan retain control of their assets unless they default on the loan.
DeFi platforms do not lend fiat currency directly; traders receive stablecoins that can then be converted into cash. DeFi loans usually have a more expensive interest rate compared to custodial loans.
What do I require to take out a crypto loan?
In comparison to the process of applying for a traditional loan, applying for a crypto loan is relatively straightforward. In most instances, credit checks are not required; instead, the amount of the loan you are approved for will depend on the amount of collateral you can provide. A loan-to-value (LTV) ratio represents the relationship between the amount of the loan and the value of the collateral. The LTV ratio of your loan is 60 percent if you put up $10,000 worth of cryptocurriencies as collateral and receive a $6,000 loan. Since crypto markets are unpredictable, LTV ratios on crypto loans are typically low.
What are the risks associated with crypto loans?
Cryptocurrency accounts are not insured by the FDIC, unlike assets held at traditional financial institutions. Therefore, there is no federal insurance covering crypto assets in the event of an exchange failure. There are three primary types of risk associated with crypto loans.
Technical risk
There is a risk that the protocol will fail in all cryptocurrency trading due to a technical problem or hack. The risk is higher in non-custodial loans since all DeFi activity is algorithmically governed.
Counterparty risk
The FDIC requires traditional banks to maintain a certain level of liquidity; crypto loan providers are not required to do so. A crypto lending platform may not have the liquidity to return a borrower’s collateral if the market crashes, a large number of clients default on their loans, or if a platform breaks or is exploited.
Margin calls and forced liquidations
During market meltdown/turndown, lending platforms will issue margin calls or force liquidations to prevent illiquidity. When the value of a cryptocurrency drops to a point where most borrowers’ LTVs are too heavy for the platform to maintain, the platform will notify borrowers to increase their collateral value or face being liquidated.
If the call is not fulfilled, the platform may liquidate enough collateral to return an account’s LTV to the maximum allowed ratio. As a result, a trader will have forfeited that portion of their deposit, incurred capital gains or losses, and may be assessed transaction and broker fees.
How are crypto loans taxed?
If a crypto loan is managed correctly and all parties adhere to the terms of the loan, there should be no taxes to pay. As with traditional trading, the IRS recognizes cryptocurrency to be property, and, as in conventional trading, using your cryptocurrency as collateral for a loan is not taxable.
However, there are several possible scenarios in which a crypto loan could affect your taxes.
Crypto loan fees
Borrowers pay interest fees to lenders. Fees can differ from around 1% APR to over 12% APR. You may be able to deduct interest fees from your taxes if you use your loan for investment or business purposes.
For more information about business deductions, consult a tax professional.
Failure to pay back the loan
In the instance that you fail to repay your crypto loan, the lender may liquidate all or part of your asset to recover its losses. Although the lender retains the proceeds, this could result in capital gains or losses for you.
Forced liquidation
When collateral is liquidated because of an unsettled margin call, the borrower will be liable to capital gains tax on any appreciation in the collateral’s value between the time of its purchase and the time the lender sells it.
Top Leading DeFi lending platforms
Oasis Borrow (MakerDAO)
Oasis Borrow is the Market hub for crypto loans from the Maker ecosystem, which uses the DAI stablecoin. Loans from Maker are appealing because they are loans to themselves. Maker Vault can be opened by anyone with crypto and a MetaMask wallet. In Oasis Borrow, you put up an asset as collateral and agree either to mint a certain amount of DAI or to repay your loan before you can unlock your asset. So, essentially you are borrowing crypto that your collateral asset will be used to generate.
Maker offers both a 50% and 75% LTV rate for crypto loans, with the higher rate also receiving higher stability fees (which are variable). The platform’s smart contracts automatically liquidate accounts whose LTVs fall below the agreed upon rate, which also incurs a liquidation penalty of 13% or more.
Currently, Maker is the largest DeFi lending project, with more than $7.3B in locked assets and more than $2.7B in outstanding loans.
Compound Finance
Another large platform for DeFi is Compound . Users deposit cryptocurrency to support the protocol and earn interest. They are represented by cTokens, whose value increases over time. This cToken supply balance may also be used as collateral for a loan.
Compound’s LTV rates are typically higher than MakerDAO’s. Although Compound does not charge borrowing fees, it has a lower liquidation threshold and will only liquidate 50% of an under-collateralized loan, with an 8% liquidation penalty.
Aave
Aave is an innovative protocol with more loan options than other large protocols. Borrowers put up collateral to support Compound; aTokens represent their contributions.
AAVE also offers flash loans, which it pioneered, and fixed interest rate loans in addition to regular DeFi loans. It offers a higher LTV rate than other large competitors and very low interest rates. Moreover, it accepts 24 coins as collateral, compared to Maker’s 18 and Compound’s 9.
Ave is the most valued DeFi lending project based on its perceived dynamism and innovation.
Alchemix
Alchemix is a DeFi loan platform using a new but intriguing method to provide loans that “pay themselves back over time.” In very simple terms, users deposit DAI into a smart contract in exchange for a token that represents the deposit’s future yield. The token is called alUSD and can be transmuted 1-1 for DAI on the Alchemix platform or traded on a DeFi exchange like Sushiswap.
A smart contract then transfers the deposited assets into a vault that mints DAI. Due to the yield harvest, Alchemix users’ alUSD debt decreases, which means that finally the deposit’s yield harvest “pays back” the loan.
Alchemix users can mint an alUSD coin worth up to half of what they deposit. Alchemix offers an LTV of 50% if we translate this ratio into more typical crypto loan terms. Though it currently only accepts DAI deposits, it expects to accept more stablecoins soon.
Leading CeFi lending platforms
Celsius Network
Celsius Network has over $10B in assets and 485,000 users. CeFi’s popularity is partially due to its low (for now) borrowing rates, which start at just 1% (average CeFi borrowing rates at the time of writing are around 4%). Celsius supports 25 coins and offers flexible LTV rates, but they are capped at 50%.
Nexo
Nexo is another CeFi loan platform that offers $375 million of insurance on all custodial assets. The platform has greater than 1.5 million users and $12 billion in assets.
Nexo typically has slightly higher loan-to-value ratios and slightly lower borrowing rates. The company supports 18 currencies.
Unchained Capital
As one of the top CeFi lenders, Unchained Capital stands out because of its multisig collaborative custody model, which gives borrowers greater visibility into their assets and increases security. This system requires three private keys to access collateralized assets. Unchained Capital controls one, the borrower controls one, and a third-party key agent controls the third.
Only Unchained Capital lends in the United States and only offers bitcoin loans. Because of its higher security has a higher borrowing barrier: it has lower LTV rates and higher interest rates than most CeFi providers. Furthermore, borrowers must use a hardware wallet from Trezor, Ledger, or Coldcard. to use the platform.
BlockFi
Founded and regulated in the U.S., BlockFi is backed by large financial institutions such as Valar Ventures, Winklevoss Capital, Galaxy Digital, Susquehanna, Akuna Capital, and Fidelity. According to The Motley Fool, BlockFi is a good option for beginner and intermediate investors looking to bridge the traditional finance and crypto divide.
Margin trading involves borrowing assets from a broker (third party). The trader has access to a larger amount of capital, allowing them to leverage their positions. However, margin trading cryptocurrency is also risky, as an unlucky trade can lead to a complete loss.
Margin trading cryptocurrency boosts trading results so that traders can make more money from successful trades. Since price movements are easy to predict, it is prevalent in low-volatility markets, particularly the international Forex market. Stock, commodity, and cryptocurrency markets also have margin trading options in India.