Crypto lending firms have been at the center of the 2022 crypto crash. However, what exactly is a crypto lending firm, and how do they work?
Crypto lending works similarly to a savings bank account. Users deposit crypto and earn interest on the amount. The firms usually pay interests in the same crypto that is deposited. While some firms change their interest rates daily, others offer fixed interest rates with a locking period. Firms that offer such accounts, lend the deposited crypto to other entities at higher rates. It is sometimes difficult to uncover what investments lending firms are involved in due to non-uniform rules.
Although crypto lending is still in its infancy, the industry has been growing at a fast pace.
Types of crypto loans
Collateralized loans: This is the most popular type of crypto loan. They require that the deposited cryptocurrency be used as loan collateral. The majority of platforms mandate over-collateralization, which restricts borrowers’ access to a certain portion of the deposited collateral.
Line of credit: Here users can borrow up to a specific amount of the deposited collateral. However, there are no set repayment terms. Users only pay interest on money they withdraw.
Uncollateralized loans: Uncollateralized loans are similar to personal loans. To be authorized, borrowers must submit a loan application, be identified, and pass a creditworthiness assessment. Because there is no collateral that may be sold off in the case of a loan default, these loans carry a larger risk of loss for the lenders.
Flash loans: Flash loans are usually available on crypto exchanges. They are instant loans that are borrowed and repaid in the same transaction. These are very risky loans that are generally utilized to profit from market arbitrage possibilities, such as buying cryptocurrencies for less money in one market and selling it right away for more money in another, all inside the same transaction.
Why did so many lending firms collapse in 2022
Lending the capital of another’s investment can be risky in the case of a bad bet. In the market crash of 2022, three major lending firms went underwater, blaming market conditions. Celsius, Babel, and Vauld faced liquidity issues which pushed the firms off the edge.
Celsius made a significant investment in a cryptocurrency called stETH, which enabled it to stake on the Ethereum blockchain and profit from DeFi. stETH was trading at a discount after the sudden decline in the value of crypto assets in May, and the token’s liquidity decreased. Due to this, it was more difficult for Celsius to acquire cash for redemptions when customers sought to take their money out. In an apparent effort to prevent the virtual equivalent of a bank run, it stopped withdrawals in June.
Similarly, in June, Babel Finance halted withdrawals due to liquidity pressure. Babel has only 500 clients and limits itself to Bitcoin, Ethereum, and stablecoins.
Likewise, Vauld too suspended its services this month (deposits, withdrawals, and trading).
The market crash began with the Terra episode. But the after-effects had massive impacts on crypto lending firms. When leading lending institutions started moving their money to avoid liquidations on overleveraged holdings in the second week of June, the lending crisis officially began. The intense selling that placed negative pressure on prices resulted in a further decline.
Crypto lending platforms are not regulated and do not offer the same protection as fiat banks. Moreover, they are not regulated. Authorities worry that investors do not understand the risks involved in such lending firms.