One of the benefits of investing in cryptocurrency is the ability to use your crypto holdings as collateral for a loan, even if your holdings are relatively small. In traditional markets, a similar practice is called securities-based lending, but it is typically off-limits to all but high-net worth clients of private banks and large financial institutions.
Crypto loans are much more accessible, and they offer “hodl” investors a way to achieve liquidity from their investment without selling it. In this article, we’ll discuss the advantages, risks, and tax implications of bitcoin and crypto loans, as well as introduce some of the best lenders.
What is a crypto loan?
A crypto loan is a way for traders to receive liquid funds without selling their cryptocurrency. Instead, they use their crypto as collateral for a cash or stablecoin loan.
Individuals may choose to take out a crypto loan instead of selling because they expect their crypto asset’s value to increase or because they want to hold the asset long enough to avoid short-term capital gains tax.
What are the categories of crypto loans?
Custodial crypto (CeFi) loans
Centralized finance (CEFi) loans are custodial; a central entity takes custody of collateral. In this situation, a trader cannot access his or her collateralized assets; the lender controls the assets’ private keys.
The takeaway here is that although custodial crypto loans are still far more accessible and affordable than traditional loans, they still depend on a centralized provider to enforce their terms. Around 80 percent of crypto loans are currently custodial, but this ratio is changing quickly.
Non-custodial (DeFI) crypto loans
Decentralized finance (DeFi) loans are non-custodial. Rather than depending on a central organization to enforce the terms of the loan, they depend on smart contracts. If a trader takes out a DeFi crypto loan, the trader retains control of their assets’ keys—unless they default on the loan.
DeFi platforms cannot directly lend fiat currency; traders receive stablecoins that can then be exchanged for cash. DeFi loans tend to have a higher interest rate than custodial loans.
What do I need to take out a crypto loan?
Compared to the process of applying for a traditional loan, applying for a crypto loan requires relatively little. Credit checks are typically not required; rather, the amount of the loan you will be approved for depends upon the amount of collateral you are able to use. The loan-to-value (LTV) ratio is the ratio between the amount of the loan and the value of the collateral. If you put up $10,000 worth of crypto as collateral and receive a $6,000 loan, your loan’s LTV ratio is 60 percent. Because crypto markets are volatile, LTV ratios on crypto loans are typically low.
What are the risks involved in crypto loans?
Unlike assets held in traditional financial institutions, crypto accounts are not covered by the FDIC. Consequently, there is no federal insurance on any crypto asset in the event an exchange fails. With this in mind, there are three primary types of risk inherent in crypto loans.
As in all cryptocurrency trading, there is a risk that protocols break down because of a technical problem or hacking. This risk is somewhat higher in non-custodial loans, since all DeFi activity is completely algorithmically governed.
The FDIC requires all traditional banks to maintain a certain level of liquidity; crypto loan providers are not subject to this requirement. If the market crashes, an unexpectedly large number of clients default on their loans, or if a platform breaks or is exploited, the platform may find itself without the liquidity to return a borrower’s collateral.
Margin calls and forced liquidations
To prevent illiquidity during market downturns, crypto platforms will issue margin calls or force liquidations. If a cryptocurrency’s value drops to a point where many borrowers’ LTVs are too high for the platform to maintain, the platform will inform borrowers that they must increase the value of their collateral or risk liquidation.
If the call is not met, the platform may liquidize enough of the collateral to bring an account’s LTV back to the maximum allowed ratio. In this case, a trader will have forfeited that portion of their deposit, will have incurred capital gains or losses, and may be charged transaction and broker fees.
How are crypto loans taxed?
If a crypto loan is managed properly and all parties uphold the terms of the loan, the parties should not incur any taxes. The IRS considers cryptocurrency to be property, and, as in traditional trading, using your property as collateral for a loan is not considered a sale and therefore is not a taxable event.
However, there are several potential crypto loan scenarios that could affect your taxes.
Crypto loan fees
Providers charge borrowers interest fees on their loans. These fees can range from around 1% APR to over 12% APR. If you use your loan for investment or business purposes, you may be able to write off these interest fees on your taxes.
Contact a tax professional for more guidance about business deductions.
Failure to pay back the loan
If you don’t pay back your crypto loan, the lender may liquidate all or part of your asset to recoup its losses. This could result in capital gains or losses for you, even though the lender retains the proceeds.
As mentioned above, if collateral is liquidized because of an unmet margin call, the borrower will be subject to capital gains tax on any increase in the collateral’s value between the time of its purchase and the time the lender sold the asset.
Leading DeFi loan platforms
Oasis Borrow (MakerDAO)
Oasis Borrow is the hub for crypto loans from the Maker ecosystem, which supports the DAI stablecoin. Maker loans are appealing because they are essentially loans to yourself. Anyone with crypto and a MetaMask wallet can open a Maker Vault and begin minting DAI. With Oasis Borrow, you put up an asset as collateral and agree to either mint a certain amount of DAI or pay back your loan before unlocking your asset. So, essentially you are borrowing crypto that your collateral asset will be used to generate.
Maker offers both a 50% and 75% LTV rate for crypto loans, with the higher rate also receiving higher stability fees (which are variable). The platform’s smart contracts automatically liquidate accounts whose LTVs fall below the agreed upon rate, which also incurs a liquidation penalty of 13% or more.
Currently, Maker is the largest DeFi lending project, with more than $7.3B in locked assets and more than $2.7B in outstanding loans.
Compound is another large DeFi platform. Its users supply cryptocurrency to support the protocol and earn interest on their deposit. The amount they’ve supplied is represented by cTokens, whose value increases with time. However, this cToken supply balance can also be used as collateral for a loan.
Compound’s LTV rates are typically slightly higher than MakerDAO’s. However, Compound not only has no borrowing fees, but it also has a lower liquidation threshold and will only liquidate 50% of an under-collateralized loan, with a liquidation penalty fixed at 8%.
Aave is an innovative protocol with a wider range of loan options than other large protocols. Like Compound, borrowers put up collateral that is used to support the protocol; their contribution is represented in aTokens.
However, beyond regular DeFi loans, AAVE offers flash loans, which it pioneered, and fixed interest rate loans. It boasts a higher LTV rate than other large competitors and very low borrowing rates. Additionally, it accepts 24 coins as collateral, compared to Maker’s 18 and Compound’s 9.
Aave is the highest valued DeFi lending project because of its perceived dynamism and innovation.
Alchemix is a smaller DeFi loan platform that uses a new but intriguing method to provide loans that “pay themselves back over time.” In very simple terms, it works like this: users deposit DAI into a smart contract and in exchange receive a token that represents the deposit’s future yield farming potential. This token is called alUSD and can be transmuted 1-1 for DAI on the Alchemix platform or traded on a DeFi exchange like Sushiswap.
The smart contract then transfers the deposited assets into a Yearn vault that mints DAI. As the yield harvests, Alchemix users’ alUSD debt decreases, meaning that ultimately the deposit’s yield harvest automatically “pays back” the loan.
Alchemix users can mint an alUSD coin worth up to half of the asset they deposit. If we translated this ratio into more typical crypto loan terms, Alchemix offers an LTV of 50%. Although it currently only accepts DAI deposits, it expects to accept more stablecoins soon.
Leading CeFi loan platforms
Celsius Network is a popular loan platform, with over $10B in assets and 485,000 users. This popularity is in part thanks to its extremely low (for now) borrowing rates, which start at just 1% (average CeFi borrowing rates at the time of writing are around 4%). Celsius supports 25 coins and offers flexible LTV rates, although they are capped at 50%.
Another popular CeFi loan platform, Nexo is differentiated because it offers $375 million of insurance on all custodial assets. The platform has $12B in assets and more than 1.5 million users.
Nexo typically has slightly higher LTV rates and slightly lower borrowing rates. It supports 18 currencies.
Among CeFi lenders, Unchained Capital stands out because of its multisig collaborative custody model, which gives borrowers more transparency into their assets and increases security. In this system, accessing collateralized assets requires three private keys. One is controlled by the borrower, one by Unchained Capital, and one by a third-party key agent.
Unchained Capital only offers bitcoin loans and only lends in the United States. Additionally, to use the platform, borrowers must use a hardware wallet from Trezor, Ledger, or Coldcard. Its higher security comes with a somewhat higher barrier to borrowing: it has lower LTV rates and higher interest rates than most CeFi providers.
BlockFi is a huge CeFi player, based and regulated in the U.S. and backed by large financial institutions such as Valar Ventures, Winklevoss Capital, Galaxy Digital, Susquehanna, Akuna Capital, and Fidelity. Motley Fool describes BlockFi as a good fit for beginner and intermediate investors looking to bridge the gap between traditional finance and crypto.
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