In popular culture, Bitcoin is known for generally being digital money of some kind. But the reason it came to be known so broadly is because it is much more than just a currency. Bitcoin ushered in a new technological era of enhanced data management and operations: record-keeping, media and communications, and, yes, financial transactions.
Digital currency — by way of their technological underpinning, the blockchain — serve as a revolutionary medium for lending and borrowing. This revolution is already starting to take shape for two reasons:
- Many people now hold digital assets (which can be leveraged for quick cash).
- Blockchain infrastructure makes such leveraging (lending) much more efficient than traditional finance.
- In other words, the theoretical promise of blockchain-based crypto asset lending is now coming to fruition thanks to a population of crypto asset holders now able and willing to put the theory to practice.
But first let’s start by comparing this new kind of finance to the old way of doing things…
Mr. John Fiat goes to his bank for a loan. Maybe he wants to buy a car or needs to do some home improvements or wants to pay off some credit cards. His banker will happily give John some money. After all, this is how banks make their money. But they aren’t just going to risk their money without some kind of assurance. So, the banker tells John he must provide collateral.
collateral (col·lat·er·al) - something pledged as security for repayment of a loan, to be forfeited in the event of a default.
The banker will happily give John $5,000 to pay off credit card debt as long as John puts up something as collateral that is worth at least that much — say, his car. This way, if John defaults on his loan, the bank has something it can take possession of and use to recover the value of the loan. On the other hand, once John pays off his $5,000, the bank no longer has any claim on his car.
Now let’s look at this process in the new world of crypto finance.
- First, when taking out a loan, John doesn’t need to use a home or car as assurance to the lender. Instead, crypto assets are the collateral.
John can borrow $5,000 (or $10,000 or $100,000) as long as he has enough bitcoin (or some other crypto asset) to offer up to the lender. And in crypto finance, the lender can be an institution such as a company, a person, or even just a decentralized pool of assets. (Read more about “CeFi” and “DeFi” below.)
- By being entirely web-based — transacted through a website and processed on a blockchain — collateralization and loan disbursement are more efficient compared to traditional finance. There is no credit check, no need to meet in person, no physical items to offer as collateral. Funds are distributed right away — either to the borrower’s crypto wallet (if receiving crypto assets) or into his/her bank account (if receiving fiat).
With crypto lending, collateral will need to be worth more than the loan itself. And because the value of assets can fluctuate mightily, collateral requirements are often double the loan amount. This is known as a 50% LTV (loan to value), where the loan is half the value of the collateral. If the asset offered as collateral should drop in value significantly, the lender still wants to maintain security on their loan.
- In the world of centralized finance (CeFi) crypto lending, transactions occur between a borrower and the centralized institution (company, website, etc.) So, most will find this realm of crypto finance more familiar. We’re used to the idea of borrowing money from a specific source in control of the money being lent.
In the world of decentralized finance (DeFi) crypto lending, though, there is no entity controlling or managing the loan or loan transactions. There is no “middleman” between a borrower and his/her loan. This is where some people may become confused, but this is also where an additional benefit of crypto finance emerges.
- Rather than a single entity in control (a single point of failure), the lending, collateral, and repayments are all automatically processed on the blockchain through a smart contract, which is simply a set of transactions instructed to be executed on a blockchain network (as of this writing, most often the Ethereum network.)
So, whereas one person sending bitcoin to another person executes a simple A-to-B transaction, a smart contract will execute a dynamic transaction with multiple factors pre-programmed. For a loan smart contract, such instructions may include the loan amount, interest rate, duration, number of payments, collateral, etc.
With such precision of various factors transacted automatically, a smart contract offers considerable convenience and security. Yet whether one chooses this method (DeFi) or the centralized method (CeFi), both branches of crypto lending offer the increased speed, access, flexibility, and security of blockchain and crypto finance, making it a rapidly-growing part of our financial future.