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Risks of Crypto Lending

a piggy bank, cash and coins - risks of crypto lending

Crypto lending appeals to many investors, and the reasons are not far-fetched. It presents a unique opportunity to stake crypto holdings and earn returns higher than those offered by traditional institutions.

Some crypto lending platforms offer investors annual percentage returns (APR) as high as 25%. In contrast, the highest annual returns offered by new debt products are around 11% to 18%.

Crypto lending allows borrowers to unlock and borrow cash using their crypto assets as collateral without selling off their stashes.

The ease of lending and borrowing cryptocurrencies is yet another advantage. Bank loans require many verification processes, especially credit scores, which are challenging to build. In crypto lending, things can move quickly because there is no requirement for a credit score to access the loan. Investors too experience little hassle to lend their coins and can do so anonymously, compared to banks where anti-money laundering regulations apply.

Despite the benefits of crypto lending, these are relatively new lending methods compared to established and highly regulated lending systems. They, therefore, carry their fair share of risks and uncertainties. If you participate in crypto lending or intend to do so, you must bear these associated risks in mind to guide your decisions.

Risks Associated With Crypto Lending 

Crypto Price Volatility Risks

a chart showing rise and fall in crypto prices

A primary concern in crypto lending is cryptocurrency’s market fluctuation. Cryptos are highly susceptible to price volatilities.

This unsteady valuation can lead to a lower value on return. For example, assuming you lent 1 Bitcoin (BTC) when the price was $60,000. If the loan is held up to the point where Bitcoin dropped to $42,000, and then the loan is paid back as 1BTC, the value of what you gave out has fallen.

Managing this risk: Be aware of your crypto price volatility and plan your investments in crypto wisely. Follow financial markets to find information that can lead to a fall in crypto prices.

Loan Counterparty Risk

Counterparty risks have to do with external parties that centralized (CeFi) crypto lending providers lend to. Centralized crypto lending platforms usually disclose what they can do with crypto deposits in their contracts. Usually, they lend them to hedge funds, cryptocurrency exchanges, and other institutional investors via over-the-counter (OTC) transactions or online.

However, this exposes lending platforms to the risk of insolvency if the counterparty to these trades fails to return borrowed cryptocurrencies. This, in turn, exposes lenders to default risks. While lending platforms would reduce this risk by over-collateralizing the assets they lend out, these are not entirely transparent transactions and may not always over-collateralize.

DeFi lenders, on the other hand, do not lend assets to third parties and therefore are not exposed to counterparty risks. Collateralization is instead hard-coded in the protocol. As long as the lenders provide enough liquidity and borrowers participate, DeFi protocols are safer.

Managing this risk: With DeFi, you may want to stick with platforms with large liquidy and an equally large, diverse community to prove it. Research the liquidity and insolvency track records of any lender (CeFi or DeFi providers) you choose to invest. 

Risk of Platform Insolvency

In most developed jurisdictions, bank deposits are insured by statutory deposit insurance that guarantees that your deposits will be refunded up to a specific limit if the bank becomes bankrupt. Therefore when a lender deposits money with a bank for loan purposes, the overall risk of losing all the money is very low, and the lender is assured of some compensation even if the bank folds.

In crypto lending, deposits are not insured by any federal deposit insurance, and you might lose all your money if the platform provider goes insolvent. When this happens, the crypto assets of lenders and savers automatically become part of the insolvency estate used by the platform provider, and you would be treated as a creditor in the insolvency proceedings.

Centralized crypto lenders like Binance are easier to hold down in the event of insolvency. It’s harder with DeFi lending platforms like Compound or Aave as they cannot file for bankruptcy technically; there would not be enough liquidity for fresh loan disbursements or interest payouts.

Managing this risk: This risk is entirely out of investors’ control. Risking only a portion of your crypto holdings is always safer than going all in. However, this risk is minimal with DeFi lenders, and investing with them is much safer in this regard.

Custody & Security Concerns

Cyber attacks and security breaches are not new to cryptocurrencies; crypto lending platforms are not different. Although there have been cyber attacks on crypto lending platforms, there hasn’t been a loss of actual cryptos, only private data.

CeFi crypto lending platforms rarely store all invested funds within their platform. A substantial amount is usually lent out to borrowers and third parties. Large lending platforms might work with professional digital assets custody service providers to store cryptocurrencies outside their own platform. However, even digital custody providers are not immune to security breaches.

Therefore, at any given time, the risk of default, counterpart bankruptcy, and theft hangs in the balance for investors. Many CeFi crypto lending providers take out private insurance policies to cover some of these risks, like theft. However, these policies cover only a tiny portion of total assets managed that can be stolen and technical risks. They do not insure the provider’s insolvency risk or counterparty risks.

With DeFi crypto lending platforms, the custody and security risks rest with you and your knowledge of cryptocurrency security protocols. Since these platforms do not hold your assets or offer any insurance, you manage your cryptocurrencies in your own wallet that you connect to the online platform. If you don’t properly handle your assets’ security, they might be stolen or you locked out. However, smart contracts can have technical flaws which might temporarily affect DeFi’s lending protocol.

Managing this risk: Before investing with a CeFi, you must understand the extent of their assets security insurances and never overestimate them. For all you know, their claims could be marketing stunts. So do your own research and invest with only credible lenders with large markets or liquidity. If you’re a DeFi user, get educated on how best to protect your invested crypto assets before diving in. 

Smart Contract Technology Failures 

Smart contracts are not legally binding contracts, as the name implies. They are programs stored on a blockchain that governs the execution of actions when preset conditions are met. 

Smart contracts are also used to automate crypto lending processes. They regulate what happens with your cryptocurrencies when certain actions—like interest payments or collateral liquidations—are taken. Since developers design these software codes, they may contain security or functionality flaws that seriously cost investors.

DeFi crypto lending protocols are better faced with smart contract risk. Unlike CeFi lending platforms where human customer support might aid program errors, there is no such human control in DeFi lending platforms. You risk investing with a DeFi and cannot rely on anyone if a smart contract failure causes financial harm. 

Managing this risk: Most smart contracts on DeFi platforms are publicly available, and you can check to study the protocols if you have the technical knowledge. Otherwise, do your research and evaluate the platform’s community’s trust in their smart contracts before investing.

Unclear Cryptocurrency Lending Regulations 

Cryptocurrency regulations are nowhere as advanced as the technology itself, resulting in a lack of investors’ confidence in any crypto lending product. If your assets disappear, you cannot take legal action.

Regulators in many jurisdictions have started taxing cryptos, and there’s no telling how that would affect cryptocurrency lending overall. When governments start paying direct attention to this new market, it’s impossible to predict how positively or negatively laws would affect investors’ funds.

Managing this risk: Crypto taxes impact your rewards as a crypto lending investor, depending on your jurisdiction. In the United States, crypto earnings are taxed either at regular income task rates or capital gains tax rates. Understand crypto taxes and smart contracts before investing. 

Defi Cyber Attacks and Crypto Lending

Without any form of traditional regulation in the DeFi space, crypto lending activities are exposed to two major kinds of cyber risks:

  1. Rug Pulls
  2. Flash Loan attacks

Let’s look at these quickly.

Rug Pulls

Rug pulls are a type of exit scam used by DeFi developers to drain a liquidity pool of assets. To do this, DeFi developers create a new token, pair it to a leading cryptocurrency such as Ether (ETH) or Tether (USDT) and set up a liquidity pool.

They entice people to deposit into the pool through marketing, often on promises of extremely high yields. Once the pool has amassed a substantial amount of the leading cryptocurrencies, the DeFi developers then use back doors purposefully coded into the token’s smart contract to mint millions of new coins. They trade these for the popular cryptocurrencies, leaving the pool with millions of worthless coins. The founders then disappear without a trace.

The biggest rug pull occurred in 2020 when SushiSwap developer Chef Nomi suddenly liquidated his SUSHI tokens after raising over a billion dollars in collateral. The price of the coin dropped to near zero after that. During the second half of 2020, DeFi related rug pulls and exit scams accounted for 99% of all blockchain-based fraud.

Flash Loan attacks

Flash loans are unique loan products within the DeFi space. Flash loans are a type of unsecured loan where a borrower can receive a loan without putting up any collateral. Instead, they have a shorter period (usually a few seconds) to pay back the total amount within the same transaction the loan was disbursed.

There are no limits to how much a person can borrow since there is zero risk in issuing these loans. Also, there are no credit score checks or other screenings to access flash loans.

Given the ease of access, flash loans are targets for attackers. These attackers borrow large sums of money using these flash loans and then use them to manipulate the market or exploit vulnerable DeFi protocols for their gain.

An example of this is the popular PancakeBunny headline story. Here attackers borrowed large amounts of Binance coin (BNB) through the PancakeSwap lending protocol, manipulated the price of BUNNY in off-market lending pools, and then dumped that BUNNY on the open market; netting about $3 million. This caused the value of BUNNY to crash by 95%!

Conclusion

“Trust” is the watchword in crypto lending. “Trust” in your chosen CeFi lending platforms or DeFi smart contracts. This is a ball game for people with risk tolerance who understand that they may end up with crypto returns rather than fiat in the case of a default. 

Crypto lending isn’t something you dabble into blindly, as risks are involved. While some of these are hard-wired into the crypto space and cannot be entirely avoided at the moment, others are more manageable. Both borrowers and investors must conduct exhaustive personal research and test and try out multiple lending platforms to diversify the risks or conclude on selected trusted platforms to work with. 

Anyone can successfully mitigate these risks and reap the tremendous rewards associated with crypto lending with the right knowledge.

For assistance with your crypto investment strategy, book an appointment with a cryptocurrency consultant. Also, subscribe to our blog using the form below, so you get updates on strategies such as this one.

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