How do cryptocurrency loans work?

Cryptocurrency loans are becoming more and more popular. Thanks to them, you can not only invest, but also entrust the whole thing to automatic smart contracts. Sometimes it is profitable to take out a loan and invest the raised capital with a profit exceeding the interest rate on the loan. How to do it? We explain.

Cryptocurrencies can be borrowed through decentralized applications as well Cryptocurrency exchanges and on projects based on decentralized finance. They are usually secured by cryptocurrencies, but this can of course also be a security in stablecoins. When its level drops below a predetermined value, a deposit must be made up or the loan will be canceled. The loan is easy to pay off at any time, because you know from the beginning to the end how much interest you will pay on each day on which we decide to settle it. 

The risk of loans in cryptocurrencies

But why borrow cryptocurrencies? Above all in order to make money on them. Liquidity pools with an annual interest rate of over 100% per annum are not uncommon on many blockchain projects. There are also much less risky interest rate offers on a constant staking, such as tokens Axie Infinity on the stock exchange Binancewhich can be stacked at the moment at 120,69% per annum. By borrowing cryptocurrencies, you can of course also earn (or lose) on the increase in their value. 

So it comes with a risk that results from the rapid movements of cryptocurrency prices. The least stable coins used to secure the loan can become very cheap quickly, and our position will be liquidated just as quickly when their price drops. So, investing on credit can sometimes lead to large losses, but the prospect of large profits does not deter crypto players. It is worth taking loans based on stablecoins or coins with large capitalization and - thus - small price fluctuations. Then they are not so dangerous financial instruments. Especially since they usually have much better interest rates than traditional loans in fiat currencies. 

How Cryptocurrency Loans Work

We do not have an intermediary financial institution in borrowing cryptocurrencies. This takes place between users, and the fees almost entirely go to the lender. That is why the market of people offering loans is growing faster, because all the risk is taken by those who want to take a loan in cryptocurrencies. The provider only adds money to the pot, and the smart contract takes care of the rest. So everything happens automatically. You do not need to supervise anyone, collect money, etc. and the risk is only theoretical. 

Flash loans in cryptocurrencies 

There are cases where cryptocurrencies can be borrowed unsecured in other tokens. This is called flash loans. However, this is a task only for experienced players, similar to investing on the basis of arbitrage. It is necessary to create not only the main loan transaction, but also sub transactions within one block. If any of the sub-transactions is not made (e.g. because the cryptocurrency exchange rate changes to an unfavorable one), the main transaction will not be triggered. It is canceled and is not added to the blockchain. Of course, everything is supervised by operating zero-one smart contracts.

When are flash loans used? If we know that, for example, the X token is more expensive in a different pool or on a different exchange, and in one transaction we can buy it and sell it immediately for a higher price. For this purpose, you can use a flash loan and after paying the transaction costs, we are left with the price difference. For now, however, flash loans can only be used on one blockchain, because only this meets the conditions for the settlement of the transaction.

Loans secured in cryptocurrencies

Secured loans work differently. You can pledge one cryptocurrency in them to borrow funds in another. The important thing is that the protection of unstable cryptocurrencies is sometimes even 50%. This means that if we have, for example, Only Coin worth 100 thousand. USD, then we will be able to borrow dobo worth up to 50 thousand. zloty. This disproportion is a security for the smart contract, so that in the event of a rapid spread of prices, the position could be closed. As a result, lenders will avoid losses, and only the borrower is at risk. 

The borrower, on the other hand, can invest the obtained funds freely - e.g. in liquidity pools, stack up and even buy a burger with them. However, if prices change unfavorably for him, he will first have to replenish the deposit, and in the extreme case it will be liquidated. If the prices change favorably, he will be able to take out another loan, because his "creditworthiness" will increase, even if he does not add any coins to the pool.

On the one hand, we have readily available capital that can be invested and multiplied, but on the other hand, it is worth remembering that taking out loans "under cork" is almost never the best recipe for achieving financial success, although such cases also happen. In this case, however, everyone has to assess their own possibilities.