The development of blockchain and digital currencies has revolutionized how people transact. Traditional financial institutions must be able to adjust to the rising popularity of cryptocurrencies and embrace blockchain technology. As more people adopt cryptocurrencies, financial institutions expand their services. They challenge the more conventional lending models, and crypto-backed loans emerged.
Understanding Crypto-Backed Loans
Crypto-backed loan (Bitcoin loans) is a type of collateralized loan. In this case, cryptocurrencies are the collateral that users can exchange for stablecoins or fiat currencies. Typically, borrowers can leverage their crypto values, such as Ethereum or Bitcoin. In return, they get a loan without selling their assets. Thus, they gain access to liquidity while still owning the crypto they have.
Bitcoin loans, like the one Figure Lending offers, or othercrypto-backed loans are similar to traditional loans. Borrowers leverage their assets (car, home, etc), which are treated as collateral. On the other hand, crypto-backed loans allow borrowers to use digital assets as security for their loans. When aiming to get a crypto-backed loan, the amount someone can borrow is usually a percentage of the collateral crypto’s value (LTV/Loan to Value ratio).
How They Work
Obtaining a crypto-backed loan isn’t too complex. Yet, several key elements should be understood before borrowers request one.
Centralization of Crypto Assets
Cryptocurrencies tend to nestle on decentralized networks. No specific body controls the flow of transactions. When borrowing a crypto-backed loan, borrowers must move their crypto assets to a centralized, secure platform. This platform can be a financial institution or another secure platform offering a crypto-backed loan.
The value of the crypto assets that the borrowers have will determine the available loan amount that the borrower can access. The more valuable the crypto they have, the higher the loan can be.
LTV (Loan to Value) Ratio
After the centralized platform holds the collateralized assets, the loan limit that the borrower can access is determined. Financial institutions impose an LTV ratio, representing the percentage of the collateral’s value for the loan limit. For example, if the LTV ratio is 60% and the borrower deposits Bitcoin worth $100,000, they may be able to borrow $60,000.
Interest Rates and Loan Terms
Like other types of loans, crypto-backed loans have interest rates and terms. As cryptocurrencies are relatively less risky as collateral, a crypto-backed loan usually has lower interest rates than traditional loans. Still, as cryptocurrency prices can wildly swing, there’s a chance the interest rates can be higher.
The loan terms vary greatly depending on the platform or institution. Generally speaking, the platform expects borrowers to repay the loan within a specific period. Failing to repay before the terms are over will result in the liquidation of the collateral.
Liquidation of Collateral
Cryptocurrency prices can rise and fall dramatically. When they fall below a certain threshold due to various factors, the lender can liquidate the collateral asset to recover the loan amount.
This is one of the most significant differences between traditional and crypto-backed loans. In conventional loans, borrowers typically don’t risk losing their collateral unless they fail to meet the repayment terms.
