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Cryptocurrencies have opened up more opportunities for investors. Besides the obvious possibility that digital currencies offer wealth by appreciation, there are many ways for crypto players, both active and passive, to get involved. One growing industry is cryptocurrency-backed loans.
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The collateral loan is not a new concept. Auto loans are secured by the value of the vehicle, and mortgages use the value of the home as collateral in the event of default. However, until recently, the securities were not themselves accepted as collateral. Borrowers could rely on their overall portfolio as collateral in the form of reserves, but lenders could not foreclose on those assets if a loan went badly.
However, that is all changing now, as cryptocurrencies become a more important part of our global financial landscape. Some lenders use cryptocurrencies such as Bitcoin (BTC) and Ether (ETH) as collateral for fiat currency loans. So how do these crypto back loans work, and are they worth it?
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Getting a cryptocurrency-backed loan is pretty straightforward
There are several reasons why a lender would want to use cryptocurrencies as collateral. On the one hand, cryptocurrencies are much more liquid than a car or a house. While a vehicle must be repossessed and a house must be foreclosed and resold to recoup losses, digital currencies can be transferred instantly.
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Once a crypto-backed loan is approved, the cryptocurrency used as collateral is then frozen by the lender. The borrower cannot sell the crypto or exchange it for other currencies. During the term of the loan, the borrower and the lender are subject to the volatility of the cryptocurrency.
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The borrower makes equivalent monthly payments for the loan details. When the loan is fully repaid, the lender returns the cryptocurrency to the borrower, who is free to sell or trade it as they see fit.
Crypto loans can also work in reverse. Lenders can issue promissory notes on cryptocurrencies. When the borrower repays the loan, the lender then releases the cryptocurrency which the borrower can sell, trade, or hold.
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Are Cryptocurrency Backed Loans Worth It?
A major downside to cryptocurrency backed loans is that you get stuck with one cryptocurrency and not be able to sell or trade it for another. Crypto’s notorious volatility makes it crucial to be able to change your position at any time.
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However, there are some advantages to crypto-backed loans: using your current cryptocurrency wallet to leverage from purchasing an equal number of crypto tokens at a time can maximize market returns.
For investors who like to keep their crypto assets in a wallet, obtaining crypto loans against their collateral to receive fiat currency is a great way to avoid taxes on earnings. Crypto loans also open the arbitrage negotiation window for lenders and borrowers. Arbitrage trading can be done between decentralized and centralized exchanges. Users can borrow dollars at a lower rate than the decentralized exchange, trade it on a centralized exchange for a cryptocurrency, and then lend it on the decentralized exchange to earn arbitrage fees.
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