There is no free lunch, also not in crypto lending. If you want to earn a return on your capital, you always have to accept a certain amount of risk – and the higher the potential return, the higher is usually the risk. Cryptocurrencies are a prime example of this market mechanism. The asset class can deliver exorbitant returns, but investors have to live with high volatility.
Crypto lending offers investors a way to profit from the innovative power of the crypto asset class without excessive risk-taking. In this article, you will learn what risks you are taking with crypto lending and why it's not as risky as you might think.
Insolvency risk: Deposits are not insured
You can't compare crypto savings accounts to bank deposits. While bank deposits are usually subject to statutory deposit insurance in most developed jurisdictions, crypto savings accounts are not. In the U.S., this insurance is provided by the Federal Deposit Insurance Corporation (FDIC). In other developed nations there are similar institutions. They guarantee that your deposits will be refunded up to a specific limit if the bank becomes insolvent. Your risk of losing your money is very low for sums that fall within the statutory insurance limits. But keep in mind that you pay for this security with a negative real return.
In contrast, with crypto savings accounts, you can earn double-digital interest rates. However, since crypto savings accounts are not insured by any state deposit insurance, you might lose all your money if the platform provider goes bankrupt. The assets would then become part of the insolvency estate and you would be treated as a creditor in the insolvency proceedings. To reduce this risk, you should be aware of your crypto lending platform provider's economic health and be extra careful with less-established platforms.
Unlike with CeFi providers, you do not bear any insolvency risk with DeFi providers such as Aave. As there is no private company behind a DeFi platform, they cannot file for bankruptcy. Instead, the risks of these platforms are primarily technical.
Counterparty risk: What does the lending provider do with your cryptocurrencies?
Crypto lending platforms receive cryptocurrencies from savers and borrowers. CeFi providers regulate in their contracts what they are allowed to do with the provided capital. You can find a clause like this in the terms and conditions of pretty much every CeFi platform:
That essentially means CeFi platforms use your cryptocurrencies - whether you're a saver or a borrower - to make money with it. They primarily lend them to crypto exchanges, hedge funds, and other institutional investors through their online platforms and over-the-counter (OTC) transactions. This creates a counterparty risk because if the counterparty to these trades fails to return the cryptocurrencies, your lending platform provider may become insolvent. While the platform will reduce this risk as much as possible by over-collateralizing the assets it lends out, it is not always transparent to most crypto lending users what risks the platform provider actually takes in OTC transactions. They may not always over-collateralizing their transactions, exposing your capital to default risks. This risk does not exist with most DeFi providers, as they do not lend the assets to third parties, but only to other users on the platform. In that case, the collateralization is hard-coded in the protocol, and as long as the smart contract works, you're on the safe side.
Custody Risks: How and where are your cryptocurrencies stored?
Compared to the early days of the crypto industry, platform providers now have a much greater understanding of security flaws and have significantly improved their IT-infrastructure. Still, cyber-attacks on digital exchanges have happened. That said, the same can happen in the traditional banking industry, where you are not entirely safe from fraud and hacks either. Also, to put things in perspective: While there have been cyber-attacks on crypto lending platforms, none of them has yet led to any loss of cryptocurrencies; but private data has already been stolen.
When it comes to IT-security, the most crucial aspect is how and where your cryptocurrencies are stored. Large crypto lending platforms cooperate with professional custody service providers such as Bitgo. Even these service providers cannot guarantee the security of your cryptocurrencies, but their security concepts are considered relatively safe and reliable in the crypto industry.
Some CeFi providers are covering the risk of theft with private insurance policies. Unlike deposit insurance at banks, these policies do not insure the provider's insolvency risk, but only technical risks or theft of assets. However, they usually cover only a small portion of the total assets that providers manage. Therefore, even these insurance policies would not fully cover the loss in the event of a severe security failure. Besides, the platform providers lend a large part of the invested cryptocurrencies to third parties, so they are usually not even in the custody of the lending platform. That's why you should not overestimate the importance of these insurances; in many instances, they are more of a marketing stunt.
DeFi platforms handle custody differently. DeFi providers don't have any insurance, and they usually don't work with custody providers. Instead, you manage your cryptocurrencies in your own wallet that you connect to the online platform. As a DeFi user, you are responsible for your own security - depending on how knowledgeable you are, this can be either an advantage or a disadvantage.
So the crypto lending risk with DeFi providers is not necessarily the crypto custody, but rather that you don't manage your own custody solution well. Also, a DeFi platform's smart contract can have technical flaws. Remember: If you give your money to a DeFi platform, you trust the platform protocol, not a company.
Smart contract risk: What if the technology fails?
The term "smart contract" can lead to misunderstandings. It's not a legally binding contract but a piece of software code that governs a particular course of action like an if-then function. It is therefore only as "smart" as its developers. As people make mistakes, the smart contract may also contain errors, for example, functional or security gaps.
Crypto lending providers use smart contracts to automate their lending platforms. The smart contracts regulate what happens with your cryptocurrencies, for example, interest payments or collateral liquidations. Smart contracts are particularly relevant for DeFi platforms, where unlike on CeFi platforms, no humans control the operations in the background. Instead, the smart contract performs and governs all of these tasks. That also means that you can't rely on anyone in case the smart contract doesn't work. You alone bear the risk that the smart contract might fail and that you might lose your cryptocurrencies in the worst case.
That said, the smart contracts on DeFi platforms are usually publicly available, meaning you can check it yourself, given you have the necessary technical understanding. Otherwise, you have to trust the developers and the community behind the platform – or invest with a CeFi platform instead.
RT @alvinfoo: What is a smart contract?— David Doughty (@daviddoughty) August 10, 2020
Via https://t.co/6q7f878Bnz #fintech #blockchain #finserv #bitcoin #cryptocurrency #smartcontract @101Blockchains pic.twitter.com/xiBIfuDLeA
Infographic: What is a smart contract?
Tweet: Wie funktioniert ein Smart Contract
Lack of legal certainty: Crypto regulations are still in their infancy
Cryptocurrencies are a new asset class. Compared to mainstream asset classes, crypto regulations are still poorly developed, resulting in a lack of legal certainty for investors, for example, regarding the tax treatment of cryptocurrencies. As there is no proven legal framework yet, legislators could decide to change how they deal with cryptocurrencies in the future. This could also be to your advantage, but it might not.
Legal challenges arise especially with DeFi providers, as there is no regulated company running these platforms. They have no licenses, no CEO, and no legal contracts – and there is little precedent for this concept in today's legal frameworks. As you are not dealing with a legal entity, who can you sue if your assets are lost? In most cases, you won't be able to take any legal actions. On the other hand, if a CeFi platform fails to fulfill its contractual obligations, you could sue the platform provider.
Volatility: primarily a concern for borrowers
Many cryptocurrencies are subject to wide price fluctuations – for example, Bitcoin. As a crypto saver, you can easily avoid this risk by investing stablecoins in your savings accounts. On most platforms, you can even get higher rates on stablecoins, and you can also receive your interest payments in stablecoins. Stablecoins are cryptocurrencies whose value is tied to an underlying asset with stable value, such as the U.S. dollar. This way, the value of the stablecoin fluctuates only as much as the underlying asset. So you no longer have the same volatility risk as with free-floating cryptocurrencies. With Bitcoin lending, for example, you always run the risk that the price of the asset might suddenly drop
With some lending providers, the interest rates are higher if you optionally invest or save a portion of your assets in the platform's native cryptocurrency (or "lending token"). If you want to invest at these higher rates, you need to be aware of these lending tokens' volatility. You can also get a higher interest rate on some platforms if you opt to receive your interest in the platform's Lending Token, as many platforms offer loyalty programs if you buy their tokens. Be aware that most of these tokens have a low market capitalization and low liquidity. As a result, their volatility is much higher than with Bitcoin. To avoid this, you can also invest without owning any platform tokens. You then don't get the higher rates of the loyalty program, but only the platform's base rate. On the other hand, you avoid the volatility of the lending token as you only save in your cryptocurrency of choice – use a stablecoin, and you won't have any volatility risk at all.
You might think that even if you don't invest in lending tokens and invest only with Sablecoins to avoid volatility, your capital could still be at risk because the loans of other borrowers on the platform are backed by volatile cryptocurrencies. Hence, what happens if other borrowers default and the platform becomes insolvent? And that's indeed a valid concern. However, it is not a risk for you as a crypto saver as long as the platform overcollateralizes those loans, meaning the crypto lending platform always holds more collateral than it lends out. As soon as the value of the cryptocurrencies deposited as collateral approaches the value of the loan, the platform automatically liquidates a portion of the collateral to restore its Loan-to-Value ratio (LTV). This reduces your risk as a crypto saver because the loans made have no loan default risk.
On the other hand, if you are a borrower and choose to secure a loan with a volatile cryptocurrency like Bitcoin, you bear the volatility risk of your collateral because the platform may liquidate some of your collateral if its market value decreases and you don't react to a margin call. If you consider that the prices of Bitcoin, for example, can drop very quickly, then sometimes there is not enough time to service a margin call. In this case, the platform would liquidate your collateral immediately without you being able to react anymore. As a borrower, you should also check the exact conditions of the platforms. Some platforms may have a clause that allows them to sell your entire collateral once the LTV exceeds a certain threshold. That's not standard industry practice though; usually, the platform would only liquidate enough collateral to restore a pre-agreed LTV.