Lending secured by cryptocurrency. What is it and why is it needed Skip to content

Lending secured by cryptocurrency. How it works and what is the benefit from it

Table of content

With the advent of DeFi, a new way of making money has appeared in the blockchain industry — lending secured by cryptocurrency. In this article we will tell you about this type of lending and the way it works. We will give you examples of earning money on cryptocurrency secured loans.

What is lending secured by cryptocurrency

This is a type of lending that is used in the decentralized finance ecosystem. DeFi is made up of many applications that work autonomously and provide tools similar to traditional financial instruments. One such tool is lending, which is available in the MakerDAO app on the Ethereum blockchain and Just Lend app on the TRON blockchain.

How lending secured by cryptocurrency works

The peculiarity of lending in DeFi comes from the autonomy of such applications. Unlike a bank, the application cannot check a potential borrower for solvency. Everything works automatically via smart contracts. Therefore, in order to obtain a loan, the user must secure it with a collateral. The collateral must exceed the loan amount by a certain percentage, which depends on the specific app. Upon reaching this condition, the smart contract will automatically issue a loan.

Take the MakerDAO project as an example. In MakerDAO, you can take out a loan in DAI stablecoins pegged to the US dollar in a 1:1 ratio. You need to leave a deposit, which is at least 150% of the loan amount, in order to receive a loan. For example, you want to take out a loan for 1,000 DAI secured by Ethereum cryptocurrency (ETH). This means that you must leave a deposit of at least $1,500 in ETH. If the ETH rate is $10,000, then you must leave at least 0.15 ETH as collateral. You also need to pay interest for a loan secured by collateral in cryptocurrency. In the case of MakerDAO, it’s 8.5% of the loan amount.

Keep in mind that 150% is only the minimum collateral percentage. If the rate falls and the collateral percentage is less than 150%, then your collateral will be sold, and you will have to pay not only an 8.5% stability fee, but also a 10% liquidation fee. Therefore, it is recommended to leave the collateral above 150% to protect your loan from the collateralized cryptocurrency’s volatility.

What are the benefits of such loans

There are two reasons for using loans secured by cryptocurrency. The first reason: such a loan allows you to fix a part of the investment portfolio. Let’s say you are not sure that the ETH rate will rise and you want to protect a part of your assets from a fall. You take out a loan in DAI stablecoins against the collateral in ETH cryptocurrency. If the ETH rate rises, then the value of your collateral will rise too and you will make a profit. It will be less than without using a loan, since you need to pay an 8.5% stability fee. But if the rate falls and your collateral is sold, then you will still have DAI stablecoins you have borrowed. Their value will not change as they are stablecoins pegged to the US dollar.

The second reason: get leverage. Let’s say you expect the ETH rate to rise. You borrow 1,000 DAI against a collateral of 0.15 ETH at a rate of $10,000. For a 1,000 DAI loan, you immediately buy another 0.1 ETH. If the rate rises to $15,000, then the price of your 0.25 ETH will increase to $3,750. If we subtract from this amount a loan of $1,000 and an 8.5% stability fee, then you get $1,165 profit. If you didn’t use MakerDAO to get leverage and just kept your cryptocurrency in your wallet, then your 0.15 ETH would only increase in value by $750.

It should be borne in mind that leverage increases not only profits, but also risks. If the rate falls, then you will lose more money than without a loan. Let’s continue the example with a loan of 1,000 DAI and a collateral of 0.15 ETH at a rate of $10,000. Let’s say the rate fell to $5,000. The liquidation occurs when the collateral percentage falls below 150%, that is, at a rate of $9,999.99. At this point, you are charged a 10% liquidation fee and an 8.5% stability fee. The remainder of your collateral is auctioned off. Only 0.02 ETH of your 0.15 ETH collateral is returned to you. Along with the leverage purchased for 1,000 DAI, you still have 0.12 ETH. Let’s compare the losses in case of a fall in the rate from $10,000 to $5,000 under the following scenarios:

  • if you used leverage, then at a rate of $5,000, your 0.12 ETH will cost $600. Your losses on the fall of the exchange rate will be $900;
  • if you left the entire loan amount in DAI stablecoins, then your losses will be $400;
  • if you did not take out a loan, but simply kept the cryptocurrency in your wallet, then your losses will be $750.

In the examples given, the rate increased and decreased by 50%. Therefore, it is necessary to take into account that with small fluctuations in the exchange rate, the profit from leverage may be less than without it due to the need to pay an 8.5% stability fee.

Summary

Lending secured by cryptocurrency is one of the areas of the decentralized finance ecosystem. It works on the basis of stand-alone apps that automatically issue a loan if the user leaves a collateral that exceeds the loan amount by a certain percentage. This percentage depends on the specific loan app.

If the percentage of cryptocurrency collateral becomes less than necessary due to fluctuations in the collateral cryptocurrency’s rate, 2 types of fees are immediately charged from the user — stability and liquidation fee. If the user returns the loan before this moment, then he only pays the stability fee —  an analogue of interest on the loan.

There are 2 benefits from such loans:

  1. Fixing a part of the investment portfolio. If you take out a loan in stablecoins, then you will lose less money if the rate falls.
  2. Getting leverage. If you are confident that the collateralized cryptocurrency’s rate will increase, then you can buy even more cryptocurrency with stablecoins. If the cryptocurrency’s rate increases, your profit will be greater than without a loan.
Related Articles