According to the FDIC, the national average interest rate on savings accounts currently stands at a pitiful 0.04% APY -- a pittance compared to the money your bank's earning by lending out your deposits. As a crypto lender, you get to enjoy interest rates of up to 15% APR. But before you ditch your savings account, you'll need to learn four fundamental rules to help minimize your risk and maximize your odds of a successful investment.
How does bitcoin lending work?
Crypto lending works similarly to a hard money loan: A borrower must first put up some at-risk collateral -- in this case, a portion of their crypto -- that you as the lender can seize if the borrower defaults on their payments. Usually, the collateral has to be over 100% of the amount they are borrowing. In turn, you know that if things get hairy, you can quickly recover your money by claiming the collateral.
Why would a borrower want to borrow funds, rather than spend the equivalent amount in what they already own? Well, suppose you hold a bunch of Bitcoin (BTC 0.36%), but the Bitcoin market is on the rise. You may not necessarily want to sell it, because you would miss out on potential gains. Instead, you can use your Bitcoin as collateral, borrow a stablecoin such as Tether (USDT 0.01%) -- with its value pegged to the U.S. dollar -- and still get liquidity. Once you pay off your loan, you get your Bitcoins back -- and if their value's risen in the interim, all the better.
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Crypto lending is just one of the several paradigm shifts of decentralized finance (DeFi). Lenders can benefit from their crypto wealth without selling off large portions of their crypto holdings -- which could trigger capital gains tax and cost them long-term gains should the crypto market enter another bull run.
With that in mind, pay close attention to the following five rules for a successful crypto lending venture, so that both you and your assets are ahead of the game.
1. Monitor ever-changing local crypto regulations
Recently, especially in the United States, crypto regulation has sparked many heated debates among politicians. One popular lending platform in particular, BlockFi, was recently served cease and desist letters from multiple states' attorneys general -- just in time for its proposed IPO.
State regulators have since been cracking down on all of the DeFi lending platforms, concerned that DeFi lending constitutes an "offering of unlicensed securities." Adding fuel to the fire, earlier this month another platform, Poly Network, disclosed a security breach that cost users $600 million.
Coinbase (COIN 2.88%), one of the largest decentralized exchange platforms in the world, just announced that it has plans to approach the Securities and Exchange Commission with its own regulatory framework pitch. It should be noted that this happened merely weeks after Coinbase was forced to shut down its own crypto lending operations because of SEC securities law violations. As crypto's increasing popularity attracts greater scrutiny from regulators of all stripes, expect more big crypto players to embrace this kind of regulation on their own terms -- or risk having governments force it upon them.
2. Only use well-established lending platforms
Legitimate lending platforms will most often work with specialized providers to make sure your crypto is stored safely, similar to a traditional bank. To find legitimate platforms, search for centralized platforms and margin lending funds, as opposed to DeFi platforms (more on this in rule 4).
Check the fine print to see whether and how an exchange will protect your investment from theft or other catastrophes. Celsius insures all its users' assets against loss through Fireblocks and Primetrust, both of which provide insurance for any assets that are kept on the Celsius platform and wallet. Bear in mind that this insurance doesn't cover any loss you experience from funds that you have borrowed, for instance, in the case of a hacker getting into your wallet.
Additionally, Crypto.com has an impressive crypto insurance policy via a division of Lloyd's of London. It'll cover up to $750 million in total losses across the entire exchange, including third-party theft; note that we don't know whether this will cover every holding on Crypto.com, since the company doesn't disclose its amount of assets under management. Still, that kind of protection vastly expands the security of your funds.
3. Borrow, lend, and get your interest paid in stablecoins or fiat currency
Altcoins like Ethereum (ETH 2.28%) and Cardano (ADA 2.40%) are volatile. If they drop while you're lending them out, you won't have the freedom to sell them and limit your losses, since they're all tied up with the borrower. On the other hand, an altcoin you are currently lending could see significant gains -- great for borrowers, but not so great for you. Same goes for interest; if you get rewarded for your lending in altcoins, who's to say the value of those coins won't hit rock bottom the very next day?
But stablecoins are backed either by the U.S. dollar or gold. No matter what happens with the crypto industry, they're always better positioned to withstand volatility. Tether (USDT 0.01%), USD Coin (USDC +0.01%), and Binance USD are the most well-known stablecoins, each pegged 1:1 to the U.S. Dollar.
If you insist on lending out altcoins, you don't have to lose out on the gains when a particular coin you're lending out sees a sudden jump in value. Look for reputable platforms that offer automatic adjustments during price fluctuations; if the value of the crypto you're lending rises while you lend it, the amount the borrower has to pay back increases to match it. That not only keeps borrowers from collecting profits that are not written into their loans, but also gives you, the lender, gains that you can pocket or apply as credit toward your next investment. As for interest, getting paid in stablecoins preserves your rewards for lending out your coins in the first place -- but still gives you the freedom to trade those stablecoins for a rising altcoin the next time you see it headed upward.
4. Unless you're a seasoned crypto trader, steer clear of DeFi platforms
If your bank fails, the government will restore what you've lost -- up to $100,000 per account. But on DeFi platforms, if you lose all your assets in some unexpected way, you don't have any third party to hold accountable.
Users can lend or borrow digital currency either through DeFi platforms, like Compound or Aave, or through centralized finance (CeFi) networks like Celsius. All DeFi lending services track their transactions with a blockchain; there is no traditional bank or other central authority involved. While it's nice not having to trust a third party with your assets, DeFi protocols are subject to technical errors and hackers.
However, on every CeFi network, the people running the company act as the central authority. Therefore, as a lender, you really need to trust that whoever controls the platform will always act in good faith. Make sure any CeFi platform you research has a recovery system in place, like a custody firm that safeguards your money, just in case your assets become compromised or lost.
There is another more mainstream and reliable method to becoming a crypto lending investor: Join a margin lending fund such as Invictus Capital. Invictus offers a seamless service that lets lenders profit from crypto that they are holding in their portfolio. In a custody account, your money is under the management of a large financial institution, such as Citigroup, which has to abide by the stringent custody rules set forth by the SEC, and provide you with monthly statements tracking your accounts. These funds won't reimburse you if your holdings lose value in the market, but they will protect you if the creators of a currency pull a scam and skip town with your money.
The road ahead
Despite the many risks involved with crypto lending, I'd feel cheated by missing out on its great ROI potential. On the other hand, you might want to hold off on trying it until the industry sorts out all its ongoing regulatory wrangling. What if you lend out a generous portion of your holdings just before the SEC decides to ban all crypto lending? That kind of uncertainty won't help you or anyone sleep well at night.
Once the dust settles and the SEC formally issues a clear set of rules and regulations for crypto borrowers and lenders, and you are well prepared with a wealth of research and knowledge, crypto lending could be worth your whole in the long run. Just remember to work with a trusted, established lending platform that tells you exactly how and where your money is being stored and safeguarded while you're not using it.
