Crypto borrowing allows those who own cryptocurrencies to use them as collateral to obtain other currencies. This can be done either with a lending platform that matches borrowers and lenders or through peer-to-peer (P2P) lending platforms.
Crypto borrowing can be useful if you want to take out a loan without going through the hassle of dealing with a bank. It’s also attractive because it lets you use your digital currency holdings as collateral rather than selling them to get the money you need. Crypto loans are often faster than traditional bank loans and have fewer hoops to jump through to be approved.
Crypto borrowing has its advantages and risks associated with it. In this article, we will explore the risks of crypto borrowing. If you are looking to lend crypto, view our article on the risks of crypto lending instead.
Reasons for Borrowing
Crypto borrowers borrow for various reasons, but the main reason is to participate in the ongoing Defi hype. People who have stable coins like Dai or USDC can leverage their funds to earn interest on other assets like ETH, BTC, and more.
This allows them to participate in yield farming or earn interest on existing stablecoin holdings. Another common use is arbitrage borrowing on one exchange to buy an asset at a lower price on another and then selling at a gain.
Some crypto borrowers want to hedge their positions in the market. For example, if they think that the price of a particular coin is going down, they may want to “short” it by borrowing that coin and selling it. If the price does fall, they can buy back the coin at the lower price and repay what they borrowed, thereby making a profit.
Some crypto borrowers are looking for working capital for their businesses. They might be online vendors who want to borrow fiat against their BTC balance to pay suppliers to increase inventory.
Some crypto borrowers might be looking for a loan in fiat currency to diversify their portfolios into real estate or stock.
Risks Associated with Crypto Borrowing
Just like any other loan, crypto borrowing comes with risks. The first one is price fluctuation. To ensure that the loaned funds are repaid, the borrower has to put up collateral (usually in the form of another cryptocurrency) that exceeds the loan’s value.
Let’s say someone borrows $1,000 worth of Bitcoin and puts up $1,500 worth of Ether as collateral. If the price of Ether goes down, borrowers need to cough up more collateral or risk a margin call.
A margin call is when the lender asks for more collateral because the value of the crypto has dropped. If you can’t provide more crypto, the lender can sell your crypto collateral to cover their losses.
Despite taking measures to minimize the risks of default, several things can happen to your collateral. Liquidation occurs when the value of your collateral drops below the minimum requirement. The cryptocurrency you deposit into your lending account may fall in value as you borrow against it. If the market price falls, you may not have enough collateral to cover your loan, and the lender will liquidate your position.
Most platforms require your LTV to be 70%. If it goes above that, they may warn you first before liquidating, but they may just go straight to liquidating.
Borrowing crypto also represents an investment risk. Investors are often tempted by newly-listed tokens that they want to get exposure to but don’t want to part with their cash for that purpose. They can borrow and then return them when the asset has risen in price.
Borrowers could find themselves owing more in crypto than their collateral is worth. The Crypto market is generally a volatile asset, which means that there’s no guarantee it will be worth as much tomorrow as it is today.
This risk is compounded by the fact that some lenders require borrowers to pay interest daily rather than monthly or annually (more on this later).
Another risk to consider is platform risk. When you borrow crypto, you’re trusting the lending platform to hold your crypto collateral and pay you the loan amount.
If the lending platform is hacked or goes bankrupt, then you could lose your crypto collateral. There have been a few instances where this has happened, and borrowers have lost all of their cryptos.
To protect yourself from platform risk, it’s important to only use reputable lending platforms that have good security measures in place to protect against hacks.
It’s also a good idea to spread your crypto collateral across different lending platforms so that if one platform fails, you won’t lose everything.
Alternative to Crypto Borrowing that Has Lower Risks
Depending on your need or reason for borrowing crypto, you could use other platforms that have lower risks. One of them is obtaining uncollateralized credit. A few platforms offer this. One of them is ReSource Network.
ReSource Network is a mutual credit platform that enables businesses and registered self-employed individuals to obtain mutual credit without collateral or interest. You may wonder how that is possible; ReSource explained that nicely in this video. To pay back, users will sell their product or services rather than having to upload cash; all in all, it is a win-win.
ReSource works best for those who need a product or service but can’t afford to get it with their own money. Rather than borrow fiat or stablecoins with crypto collateral and all that risks, they can obtain credit on ReSource and get the product or service from a business on the ReSource marketplace. Then, they can list their own products or services and get customers to buy. The revenue from that sale will then pay back the credit they borrowed.
The risk of crypto borrowing is much lower than it used to be, but it is still possible. There are a few ways to mitigate your risks.
It’s important to keep track of the LTV of the loan. As a general rule of thumb, borrow no more than one-fourth of your collateral value but also consider what you may lose if it is liquidated; when in doubt, you should borrow less or not at all. If a lender requires a higher amount, consider moving on to another option. While taking on risks is always involved in the cryptocurrency markets, only invest what you are comfortable losing.