What is crypto lending?
Crypto assets aim to improve upon traditional financial tools by providing unique ways of generating yield for users who hold them.
Since the creation of Bitcoin aimed to reimagine the financial system in 2009, crypto assets have come a long way by steadily taking on other functions that have historically belonged to traditional finance (TradFi).
One of those important functions is earning yield on assets, which is simply the amount of earned value on funds. In traditional finance, yield can be generated in many ways—for instance, through deposits in a bank account or through dividends on equity holdings—and it is expressed as a percentage of the original value.
In general, higher yield is offered by crypto asset tools as compared with TradFi instruments like savings accounts, money market accounts, certificates of deposit, and even bonds. Part of this is due to the incentive mechanisms associated with the growing adoption of this new technology. Another reason is because peer-to-peer systems avoid the overhead costs associated with big banking practices.
One of the main ways to earn yield in crypto is by lending owned crypto assets, and is a familiar practice borrowed from traditional finance. Yield is typically measured in annual percentage rate (APR) or annual percentage yield (APY).
What is lending?
When you keep your money at a financial institution, the institution can lend those funds to other customers through mortgages, credit cards or personal loans. In other words, by depositing your money into a bank account, you are really lending it to the bank who then lends it to someone else at a higher rate. You get a cut of the share through a typically low rate on your depositor account (like your savings or checking accounts).
But what if there wasn’t an intermediary institution in that lending process? Some argue that removing the middle-man (i.e., the bank) means that the lending market is more efficient, allowing profits from lending to flow more directly to you—the end user—and increasing your yield.
This is the basis for decentralized lending through protocols like Aave, where smart contracts automate the process of lending between users. Generally, decentralized finance (DeFi) protocols use pools of users’ funds to increase liquidity to borrowers and spread lending yield evenly among lenders.
Some centralized finance (CeFi) systems also allow for crypto lending, either through exchanges like Bitstamp or independently run companies. These operate an in-between model that is closer to TradFi institutions, though they usually offer higher yields on crypto holdings than banks would with fiat currencies.
Earning yield risks
As with all financial dealings—in TradFi or otherwise—earning yield in crypto comes with its fair share of risks. Typically, higher yield is accompanied by higher risk, and this holds true in both staking and lending.
Two types of risk are universal to currencies: volatility and inflation. Crypto has historically been more volatile than other asset markets, meaning that holding any one asset carries the risk of it devaluing while in your possession. Similarly, every cryptocurrency’s specific tokenomics determines its rate of inflation (or the amount of new crypto tokens released) which might affect the value of the cryptocurrency.
When lending crypto assets through a traditional finance institution, customer bank deposits are no longer their property and become the property of the bank. Under fractional reserve banking rules, the bank can loan out money without keeping customers’ deposits in cash, risking illiquidity in the case of a bank run.
While DeFi protocols ensure that your assets are always your assets because they are non-custodial, lending cryptocurrency in DeFi relies on smart contracts, meaning that all processes are automated through code. Although the code used in these protocols is often audited by third party organizations, there can be flaws that allow hackers to exploit it. This might result in the siphoning of funds out of lending pools or flash loan attacks.
Why it matters to you
Crypto has revolutionized how we think about banking. By adapting TradFi practices into new forms and introducing innovative ways to generate yield, blockchain technology continues to offer a fresh take on finance.
Users who are interested can—with an appreciation of the risks involved—dip their toes into the world of crypto yield. Lending is one of the ways this can be accomplished.
Importantly, at Bitstamp, we never lend customer assets without their instructions, and we never convert crypto before lending it out. All loans are provided on open terms, so our customers can withdraw their assets at any time without lock-in periods.
Bitstamp offers a platform that allows you to lend your assets and earn crypto yield for doing so.
Note: Bitstamp Lending is not available in the US, Singapore, and the UK.
Crypto lending essentials
- Lending is a way to share assets to reputable institutions to participate in the crypto market.
- Crypto lending is a TradFi practice that has been adapted into unique forms using crypto assets.
- Participating in yield-generating crypto practices comes with risks including asset volatility, inflation, opportunity loss, and hacks.