A Guide To Borrowing Crypto
Taking away the middle man in the financial industry, removing the yellow tape around the lending process, not letting anyone tell you how and how much you can borrow. These ideas have been around in the crypto industry for a while, with the rise of DeFi it has never been a clearer vision.
The crypto borrowing space has ballooned in popularity as the use cases have increased. Being able to defer taxes without liquidating your portfolio, borrow new funds to trade, and even short term lending with the invention of flash loans. There are three key areas of the crypto borrowing space that you need to know about: borrowing fiat currency with crypto as collateral, borrowing crypto in the DeFi space, and the new and little understood flash loan.
The purpose of crypto backed loans are simple, allow crypto holders fast and efficient access to fiat funds without the need to liquidate their portfolio. There are two main advantages to this. You don’t have to liquidate your portfolio to access fiat funds which would incur a capital gains tax. You don’t have to sell crypto assets that you believe in the long term potential of.
How it works?
The idea is simple in theory but actually has a few complexities to it. The simple version would be, you deposit your crypto to use as collateral (typically BTC or ETH) in exchange you can withdraw a percentage of the dollar value of your crypto in cash or stable currency. Every week or month you pay interest on what you borrowed and when you pay off the loan your collateral is unlocked and returned to you.
This sounds like a normal loan, right? Well yes, but there is one key difference between this and a normal bank loan and why the bank won’t accept your crypto as collateral. Volatility. If you go to the bank to get a mortgage they would happily accept your house as collateral, they know there is a slim chance your house will ever be worth less than 80% of what you paid for it and will in reality likely steady increase in value over time.
Bitcoin and Ethereum on the other hand can lose 10+% of their value overnight, what happens if the value of your collateral drops below the amount you borrowed? You’d have little incentive to pay back the loan to get your collateral back.
So how do crypto lenders account for the volatility of your collateral?
The main difference is the level of risk they are comfortable with changes, in this case, the loan to value ratio is lower than the typical financial industry loan.
The loan-to-value ratio is the value of the loan divided by the value of the collateral times 100: (Loan amount/value of collateral) *100 = Loan-to-Value.
Generally, a Loan-to-Value ratio of 50% is an initial starting position, meaning if you deposit 1 BTC as collateral when BTC is worth $10,000 you can borrow up to $5,000. However the value of crypto can change so fast, which means your Loan-to-Value can as well. Most lenders will put strict measures in place as to the maximum LTV you can have before they start making loan payments out of your collateral.
For example, Nexo users will receive 3 notifications when their LTV increases to 71.4%, 74.1%, and 76.9% respectively. When the LTV hits 83.33% they will make an automatic repayment using your collateral.
What are the risks of this type of loan?
There are always risks when you borrow money, there are two main crypto risks you need to be familiar with before you borrow money. How your collateral is being stored impacts how vulnerable your crypto is to being stolen. By depositing your funds to a provider you are giving up control of the asset and giving them the responsibility of protecting your crypto. Look for a company that uses cold storage wallets, has insurance, and has no history of hacks in the past. Missing a margin call is also an issue as your crypto could be liquidated to pay off the loan. If you are borrowing so you don’t have to sell your crypto be sure to borrow an amount that will allow you to provide more collateral if needed, don’t borrow too high a percentage of your entire portfolio.
What are the main advantages?
As mentioned above there are two main reasons to use your crypto as collateral. You need cash but don’t want to trigger a tax event, if you sell part of your portfolio to withdraw into fiat currency this sale will trigger a capital gains event. Borrowing instead of withdrawing can help delay the tax event and could mean reducing your capital gains tax by 50% if you hold longer than 12 months (in some countries). One important thing to note is that some providers will wrap your crypto when depositing, as this is a new coin from the original one you held it is a token to token sale and could be subject to tax, so make sure you check your provider first. The second reason is wanting cash but thinking that crypto will go up in value, borrowing instead of selling when you think the price will increase gives you access to cash without missing out on the potential gains.
How can I get a loan?
There are plenty of loan providers in the space, three of the biggest global providers are Crypto.com, Binance, and Nexo.
Allows deposits in BTC, CRO, XRP, ETH, LTC, EOS, and XLM. The LTV is 50% and the loan can be paid out in your choice of YUSD, PAX, USDC or USDT. The annual interest rate varies between 8 and 12% depending on how much you deposit. Margin calls will be triggered when your LTV exceeds 70% and the loan liquidated when LTV goes beyond 85%.
You can rebalance the loan my depositing additional collateral or making a repayment. You have 12 months from the initial loan date to repay the loan but interest accrues daily at a rate of APR/ 365.
Allows deposits in BTC, BCH, BNB, XRP, ETH, EOS, and LTC. The initial LTV varies depending on the currency you deposit but can range from 50% to 65% paid to you in USDT or BUSD. The loan term varies from 7 to 90 days. Similar to crypto.com there will be a margin call when LTV reaches 75% and a liquidation of your collateral when it reaches 83%.
The advantage of Binance is that you can use the loan for margin and futures trading on the platform if you qualify for that service, however the annualised interest rate is much higher than the competition ranging from 18.25% to 18.98% depending on the currency you choose to borrow and the length of the loan (this rate is subject to change daily, this is the rate as of writing the article).
Unlike Binance and Crypto.com who offer lending as an additional service, lending is the main function of Nexo. You can provide collateral in up to 17 crypto currencies. As stated before the initial LTV is 50% and portfolio liquidation occurs at 83.33%. The funds can be paid to you in cash or stablecoins and interest rates start at 5.9%, depending on the currency you provide collateral in.
The idea behind crypto backed loans is using your crypto portfolio as collateral while you access fiat currency that you can actually use. There are two unique ideas behind DeFi loans, there is no central entity responsible for holding and distributing loans (hence the decentralised part of decentralised finance) and they don’t pay cash but rather they pay the loan in crypto.
There are many advantages to this model over the centralised approach above. You can be paid out in a variety of crypto tokens not just stable coins or cash, because it is DeFi there are no KYC requirements and you can remain anonymous, you don’t have a central entity controlling your funds and there is no middle man so the rate can be lower.
Three of the core ideas behind DeFi are security, privacy and control and the case is no different for borrowing in the space. You can still liquidate the funds to fiat if you need the cash but you can also leverage your positions and use the loan as a margin position and access protocols in the space that require a specific currency without liquidating your portfolio.
The key difference between DeFi and a centralized loan is that the market determines everything, the rates you can borrow and lend at are determined by the amount of funds supplied and demanded, the amount you can borrow of a certain currency based on your collateral is also determined by market forces. These change just like they would on the open market, in seconds.
This means interest owed is continually owed and paid on a per-day or even per-second basis. As the time since the loan lengthens so does the interest payable, it is continuously added to the balance owed. You can pay it off at any time you want but if the amount owed ever exceeds the collateral ratio and the amount of collateral you have the funds are automatically liquidated.
The biggest players in the market are Aave, Maker and Compound. They offer similar services in terms of the market based approach to rates but are all slightly different depending on what you want. Aave offers stable and variable rates on a variety of assets, Maker is based around Dai and Compound offers purely variable rates changing daily depending on the market.
Flash loans are without question the most complicated borrowing protocol in the DeFi market and resemble traditional loans the least. There are two elements that make flash loans so unique - they are very quick and you don’t need collateral.
You can borrow massive amounts of liquidity, use it with other protocols but you have to repay the funds (with a small fee) in a single transaction or the initial lending part of the transaction is canceled. This is a unique idea and the potential uses have not fully been explored, released by Aave the flash loan is still a young idea.
If you are interested in borrowing money to use medium or long term flash loans aren’t for you but they still have some very interesting use cases.
At this stage the primary use of flash loans has been to take advantage of arbitrage opportunities that appear on different DEXs, some smart people have figured out how to exploit DeFi contracts and use flash loans to make close to a million dollars.
A more interesting use case to the discussion of long term borrowing is the use of flash loans to refinance your debt. Let’s say you borrow ETH on Compound at 8% interest but Aave is offering only 4% interest for borrowing ETH. In this case you can use a flash loan to move your loan across to Aave without having the funds to pay back the loan.
Here is how that would work:
- Borrow a flash loan from Aave
- Use the proceeds to pay your debt on Compound
- Borrow on Aave at 4% interest
- Use the proceeds from the new borrowing to pay back your flash loan.
Hopefully you’ve gained a better understanding of how the crypto borrowing space operates and the various options available. From a tax perspective, proceeds from borrowing are not taxable but if you use those proceeds to trade or generate a profit these gains likely are. It is also worth noting that depositing your funds to various centralised or decentralized platforms may trigger a tax event if you lose control or have your token transferred to a new coin.