crypto lending and borrowing

In short

A friend of mine once asked whether she could put her coins to work the way a bank puts a deposit to work. If you are holding crypto and wondering the same thing, you have probably seen platforms that promise a yearly rate for lending it out. Lending crypto means handing your coins to a platform or a pool that lends them on to borrowers, who pay for the use. Borrowing means putting up coins as collateral, which is a pledge the lender can keep if the loan goes bad, and taking out cash or other coins against it. Read the rate, the collateral rules, and the fee schedule before you move a single coin. Find out who holds your coins while they are lent, because that one fact shapes your risk. Check whether the platform has a written plan for what happens if its price feed fails or its borrowers cannot repay. Keep this in mind. A rate is never free money.

The whole of it

What it is

I once watched a neighbor borrow against his truck so he would not have to sell it. He kept the truck, got his cash, and paid interest for the privilege. Crypto borrowing works on much the same idea, only the truck is a pile of digital coins. A borrower locks up coins as collateral and receives a loan, often in a coin pegged to the dollar. The lender is the person or pool that supplies the money, and it earns interest for waiting.

There are two broad kinds of platform. A centralized one is a company. It takes your coins, keeps them in its own accounts, and runs the lending behind closed doors. A decentralized one runs on software called smart contracts, which are programs that carry out the lending rules on a blockchain without a company in the middle. Each has its own risks, and neither one is insured the way a bank deposit is. The Federal Deposit Insurance Corporation says on its own website that its coverage applies to deposits at insured banks and does not cover crypto assets. That is worth a slow read.

How it works

A friend of mine likes to say that the fine print is where the story lives. So here is the story of a loan. The borrower deposits collateral worth more than the loan. This extra cushion is called overcollateralization, and it exists because coin prices can swing hard in a single day. The platform sets a loan to value ratio, which is the loan amount divided by the collateral value. If that ratio climbs past a set line, the platform sells some of the collateral to repay the lender. That sale is called a liquidation, and it can happen fast and without a phone call.

Lenders earn interest because borrowers pay it. On a pool, the rate often moves with demand. When many people want to borrow, the rate rises. When few do, it falls. A platform may also take a cut for itself, so the rate a lender sees can be lower than what a borrower pays.

If you are lending, you may be handing over control of your coins. On a centralized platform, the company often has the right to use them, and your claim becomes a claim against the company. The platform must honor withdrawals, but that depends on the platform staying solvent. In a bankruptcy, a customer may stand in line with other creditors. Several lending firms went through exactly that in 2022, and the court filings are public record.

The numbers, and where to find yours

You have probably noticed that a big rate on a screen tells you very little by itself. Look for the annual percentage yield, which is the yearly return after compounding. Then find the borrowing rate, the loan to value ratio, the liquidation line, and every fee. Each platform lists these in its terms and on its rate pages. Read them from the platform itself, not from a post about it.

Taxes matter too. The Internal Revenue Service treats virtual currency as property. Its page on digital assets and the question on Form 1040 ask taxpayers about digital asset activity. Interest earned is generally income, and a liquidation may count as a sale. The rule for reporting these amounts is set each year, so check the current IRS guidance at the time you file. For reference, the dollar threshold that triggers certain reporting is the current figure, which the official source publishes each year, and the long term holding period for capital gains is the current figure, which the official source publishes each year.

The Consumer Financial Protection Bureau and the Securities and Exchange Commission both publish investor alerts on crypto lending products. The SEC has also brought actions against some lending programs, and those orders are on its site. Read what the agencies actually say. Don't lean on hearsay.

A worked example

Let me tell you about a woman named Maria. She holds coins worth $20,000 and does not want to sell them. She finds a platform that lets her borrow up to 50 percent of her collateral value. So she borrows $8,000, which is 40 percent of $20,000, and stays well under the cap.

The platform charges her 9 percent a year on the loan. Over twelve months, 9 percent of $8,000 is $720 in interest. Say she also pays a one time fee of 1 percent. One percent of $8,000 is $80. Her cost for the year is $720 plus $80, which is $800.

Now the scary part. The platform liquidates when the loan reaches 80 percent of the collateral value. Her loan is $8,000. To find the collateral value at which that line is hit, divide $8,000 by 0.80. That gives $10,000. So if her coins fall from $20,000 to $10,000, the platform may begin selling. That is a drop of $10,000, or 50 percent.

Suppose the coins fall to $9,000 before she can add more. The loan is now $8,000 against $9,000 of collateral, a ratio of about 89 percent. That is past the line. The platform sells enough coins to bring the loan back in range, and Maria loses the chance to ride out a recovery. She might also owe a liquidation penalty. If the penalty is 5 percent of the $8,000 sold, that is $400 gone.

Now picture her as a lender instead. She supplies $5,000 to a pool paying 4 percent a year. Four percent of $5,000 is $200 over the year. That is a modest reward. Against it sits the chance that the platform fails, in which case the $5,000 itself is at risk. Weigh $200 against $5,000. It is a real question.

Where it goes wrong

A neighbor of mine lost sleep over a loan he thought was safe. It was safe, right up until the market moved. The first trouble is price swings. Collateral can lose value faster than a borrower can respond, and a liquidation can lock in the loss. Gaps and outages make it worse, since a platform's price feed can lag or fail.

The second trouble is the platform itself. A company may mismanage funds, lend them out unwisely, or collapse. Lenders then become creditors with no deposit insurance. A smart contract can carry a coding flaw that an attacker uses to drain a pool. Audits help, but they are not guarantees.

The third trouble is plain confusion. Terms can change. A rate shown today may drop tomorrow. Withdrawals may be paused. Rules may also shift by country and by state, and a product open in one place may be barred in another. Taxes add another layer, since a liquidation can create a taxable event the borrower did not plan for.

Take heart, though. Most of these problems can be seen coming if a person reads closely and asks plain questions. That is no small thing.

Questions to answer before you leave this page

Do you know who holds your coins while they are lent, and what claim you have on them if the platform fails? Have you found the loan to value ratio, the liquidation line, and the penalty, and worked out how far prices could fall before they apply? Can you name every fee, from the borrowing rate to any one time charge, and add them up for a full year? Have you read the platform's own terms on withdrawals, pauses, and rate changes? Do you understand how interest and a liquidation would be taxed under the current IRS guidance? Have you checked what the SEC and the CFPB have said about the kind of product you are considering? And if the worst happened tomorrow, would you still be able to sleep?