How do Crypto-Backed Loans Work?

How do Crypto-Backed Loans Work

Over the past decade, ownership of crypto assets has continued to grow significantly. A recent survey commissioned by Coinbase estimates that over 50 million U.S. adults own at least one type of cryptocurrency. While speculation has been a dominant use case for many crypto owners, other use cases have grown in prominence creating new value for crypto assets and their owners. One such use case has been the ability to get liquidity from crypto assets without having to sell. Traditionally, a crypto owner would need to sell their crypto, either on an exchange or through a purchase, if they wished to use its value for another purpose. However, this can be a cumbersome and costly process that results in loss of future gains as well as potential taxes. As a solution, some companies are allowing crypto owners to borrow against the value of their crypto assets, using those crypto assets as collateral for the loan. 

Loans collateralized by crypto have enabled a new source of liquidity for crypto owners. While relatively novel for the crypto industry, collateralized loans have been an integral part of traditional finance for many years. Before taking out a crypto-backed loan, it’s important to understand the basics of collateralized loans and how they work in crypto. 

Why do people take out collateralized loans? 

Taking out a collateralized loan on assets such as a house or stock portfolio is a common practice. For example, a loan on a stock portfolio (including stock, bonds, and ETFs), commonly known as a securities-based line of credit (SBLOC), has been a popular option for individuals with large stock portfolios for many years. Traditional brokers act as lenders, holding the borrower’s stock portfolio as collateral and offering a line of credit in return. Generally, there are four main reasons individuals take out a margin loan rather than sell their stock.

  1. Future Price Appreciation
    By using the assets as collateral instead of selling, individuals can benefit from future price appreciation. Even though the lender holds the stocks as collateral, the individual retains ownership of the assets. So if the price of the assets increases during the period they are used as collateral, the individual will receive the assets back at a higher value once they repay their loan. This works both ways, however, so if the price of the assets decreases during the period they are used as collateral, the individual will receive the assets back at a lower value.
  2. Asset Income

Many stocks and bonds pay income to the owner through dividends. Individuals with a securities-based line of credit will continue to receive any dividend income even while their portfolio is being used as collateral for a loan. The dividend income can even be used to help pay the interest on the loan.

  1. Avoiding a Realized Gain

In the U.S. (and many other countries), selling stock creates a taxable event. If there are any gains realized by the sale, the individual will need to pay capital gains taxes on them. However, borrowing against a stock portfolio does not trigger a taxable event (assuming no stocks are sold), and therefore does not incur capital gains tax liabilities for the individual. This allows individuals to get liquidity of their assets without having to pay large amounts of taxes.

  1. Deducting the Interest Expense
    The interest on some loans is deductible which can reduce the overall cost of the loan. Borrowers should check with a tax advisor first to understand if this is applicable for their loan.

How do Crypto-Backed Loans Work?

Crypto-backed loans work similar to securities-backed lines of credit although there are some key differences — one of which are the lenders. Crypto-backed loans are generally offered by centralized finance (CeFi) lenders or decentralized finance (DeFi) lenders. CeFi lenders are centralized platforms and operate similar to traditional lenders. Examples would be Ledn, Nexo, and SALT Lending which are tech startups. They provide a familiar user experience where borrowers transfer their collateral assets, agree to an interest rate and loan term, and then receive the funds — typically in fiat. One drawback to CeFi lenders is that their loan books tend to be opaque, so it’s difficult to assess the counterparty risk borrowers take on. 

DeFi lenders, usually referred to as DeFi lending protocols, are a novel concept for finance as no centralized entity controls them. Instead, they rely on smart contracts which contain self-executing code that enforces the logic of the protocol. For example, by supplying one type of crypto as collateral to a specific smart contract address, the same individual would be allowed to borrow a different type of crypto from the same protocol. This innovative system allows individuals to interact with DeFi protocols in a permissionless fashion and without having to trust third-party intermediaries. Additionally, this can allow borrowers to avoid many traditional fees on loans. 

Unlike CeFi lenders, DeFi lending protocols are entirely transparent, as their code, and any transactions are publicly accessible on public blockchains. This means that anyone can view and audit the funds going into and out of the relevant smart contract addresses. Unlike CeFi lenders, many DeFi lending protocols have floating interest rates that fluctuate each second based on the market supply and demand for a specific asset. This can benefit borrowers when demand for an asset decreases as the interest rate will also decrease. However, the inverse is true as well, and borrowers could end up paying a higher interest rate if demand for an asset increases.

Compound, Aave, and Maker are well-known DeFi protocols that exist on Ethereum. DeFi lending protocols tend to be more difficult to use than CeFi lenders as they require an Ethereum wallet and familiarity with novel terms and concepts. At Rocko, we are working to solve this and enable individuals to easily borrow from DeFi protocols using their accounts at centralized exchanges (in addition to Ethereum wallets) while retaining full control. Users can set up their loan in minutes — without needing any DeFi expertise or a prior Ethereum wallet. 

Only some of the benefits and risks of crypto-backed loans are discussed here and it’s important to research all of the risks before getting started. Rocko.co/learn offers a catalog of articles covering the in’s and out’s of DeFi borrowing.  

What Can Crypto-Backed Loans be Used For?

Pay Down Higher-Rate Debt

Borrowers with high-rate debt, such as credit card debt, personal loans, or student loans, may be able to borrow at a lower cost using a crypto-backed loan. If so, they could take the funds from the crypto-backed loan and use them to pay down their higher-cost debt, allowing the borrower to reduce their monthly interest expense.

Large Purchases

A crypto-backed loan can be a strong source of liquidity for large purchases such as a car, boat, or family vacation. Additionally, since many DeFi protocols allow borrowers to borrow more without additional origination fees, borrowers could use crypto-backed loans to finance their everyday purchases. 

Investment Capital 

Many borrowers wish to use their loans to invest in hopes of making returns. A crypto-backed loan can provide liquidity for a host of other investments such as stocks, real estate, or other crypto. 

Starting or Expanding a Business 

For aspiring entrepreneurs, a crypto-backed loan may provide the first capital to start a new business. Whether it’s product development, hiring staff, or purchasing inventory, leveraging crypto holdings for liquidity could allow business owners to access quick capital without a lengthy application process. 

Summary

Cryptocurrency and blockchains offer an opportunity to rebuild the global financial system in a more efficient, transparent, and inclusive manner. While the potential is yet to be fully realized, crypto-backed loans are already empowering individuals globally by providing a new source of liquidity to better their financial lives.

Crypto-backed loans offer a new liquidity source by allowing crypto owners to borrow against their assets without selling. These loans are available through both centralized and decentralized finance lenders.

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