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What are Crypto Loans and How They Work

Crypto loans are, in fact, not too different from other types of loans. They are about people getting cryptocurrency for a certain fee and in exchange for some collateral – fiat currencies or other assets. So, a borrower gets crypto for trading and other goals, while a loaner makes a profit from the fee they receive for lending their digital funds. Crypto loans are provided by crypto exchanges and various DeFi platforms.

Generally, loans are considered a useful instrument in the economy that stimulates the market. What about crypto loans though? At first, the list of things one could do with crypto was not quite diverse: paying for mysterious goods and services, reselling it to get a speculative income (Trading) or keeping it as a long-term investment tool (Hodl). With loans, the opportunities to make money with crypto broadened both for the loaners and the borrowers, thus making the overall usability of crypto assets higher.

Types of Crypto Loans

  • Loans with Collateral
    In this case, to get a loan and use crypto, the borrower needs to provide certain collateral for the loaner. And with the high volatility of almost all the cryptocurrencies, usually, that collateral would be twice the size of the loaned amount in crypto. If the value of that collateral falls below the loan amount or some other level, it will be liquidated, and the collateral will go to the loaner or will be sold. To avoid that, the borrower needs to keep track of the current collateral value and replenish it if necessary. After the loan is returned and all the fees are paid, the collateral is returned to the borrower. The loan is managed by a smart contract.
  • Flash Loans
    This type of loan does not include collaterals. These are quick loans that are taken and returned within one specific transaction. If the borrower fails to return the funds within one transaction, it is simply not verified and therefore not performed. A smart contract just does not verify this block and does not add it to the chain.

    This is how it works:
    A borrower gets a loan that s/he uses to purchase the crypto s/he is missing in order to resell it in a different pool for more. If all of these actions result in a success, the borrower receives the profit and now can give the loan back, pay the fees for using the funds, and that’s all! The flash loan is performed and is a part of blockchain now. If at least one of the subtransactions in this scheme doesn’t work out, the loan is cancelled and its block is simply not created.

As with other loans, crypto loans can be used for making different types of income:

  1. Lending Arbitrage
    This is a way of reselling a loan: a borrower takes crypto in one place with a lower interest rate and lends it to someone else on another platform for a higher fee. The main risks are changing interest rates. Also, the rate is often floating depending on the asset price which, as we know, can be very volatile with crypto.
  2. Margin Trading or Leverage Trading
    In this case, there is no physical exchange – there is just no need for it. In this case, a loan is used for speculative operations with crypto, and the loaner’s funds are secured with a collateral, like margin in margin trading with other assets like Forex, stocks, or commodities.
  3. Profiting from Loan Liquidation
    Technically speaking, this is not the easiest way to make a profit. To do so, liquidators create special bots and set them to look for loans with low enough collateral to liquidate them. The collateral goes to the loaner while the liquidator receives a reward for their work.

Crypto Loans Risks

  • A smart contract that manages loans can be hacked, there have been numerous examples of that. As a result, the funds can be successfully stolen from a platform.
  • The main risk for a borrower is the high volatility and unpredictability of crypto. The borrower may always lose the collateral that may be liquidated due to its currency rate fall.

The events of the past couple of months when cryptocurrencies went record low, while the Terra crash and almost instant devaluation of its Luna token have undermined investors’ faith in DeFi… All this shows just how changeable and unpredictable the crypto market is.

You can find our thorough research of the reasons behind the crash of this seemingly promising project and its consequences in the article What Happened to Terra LUNA by the RESERVEUM Analytical group.

Unfortunately, many projects that offered crypto loans didn’t survive the recent market fall and couldn’t maintain their liquidity. For instance, one of them was Celsius Network – a quite popular platform specialising in crypto loans, among other things. It is not operating anymore, the funds are locked inside the platform. The founders are doing their best to meet their obligations to the clients by using all of their liquid assets, but so far, the Celsius Network site is not responding and the prospects aren’t clear.

Unfortunately, it’s another time when cryptocurrencies showed their vulnerabilities; now, most of the dreams that Bitcoin is going to be the currency of the future are shattered. Meanwhile, we will continue our work on an algorithm of a truly effective currency that would never fall in price.

According to the analysis group findings: reserveum.org

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