The fact that financial regulators around the world have yet to solidify their stances on crypto lending makes crypto lending risky. Other risks associated with it include volatility, security risks, interest rate fluctuations, and lack of insurance.
We will explain all the challenges of using crypto lending both for the lenders and borrowers.
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Challenges of Crypto Lending
For crypto lending platforms such as Aave, CoinLoan, YouHodler, and Compound DeFi lending protocol, what are the risks associated with their operations for bother the borrowers and the lenders?
We’ve analyzed the advantages of crypto loans in our earlier post (you can read it here) because this post will exclusively focus on the major risks of crypto lending.
Security Risks
Security is a paramount concern in the digital realm, especially in the cryptocurrency sector where assets are often targets for malicious actors.
Here are the several security-related challenges that may arise because of the growth of crypto lending platforms:
Platform Hacks:
Just as cryptocurrency exchanges have been targets, crypto lending platforms can also be vulnerable to cyberattacks.
For instance, a South Korean-based crypto exchange GDAC was hacked on April 9, 2023, and the company lost more than $13 million worth of Bitcoin.
There have been over 50 crypto hacks since 2012, leading to $2.85 billion in losses, according to HedgeWithCrypto (we also have the list of such vulnerabilities here).
If hackers could manage to exploit vulnerabilities in crypto exchange, crypto lending platforms are not exempted either.
Smart Contract Flaws:
Many decentralized crypto lending platforms operate using smart contracts on blockchain networks.
If these smart contracts contain bugs or vulnerabilities, they can be exploited. In some cases, this has led to the loss of millions of dollars worth of assets.
Phishing Attacks:
In 2021, $44.2 million was lost to phishing attacks, according to AAG-IT.COM, anyone can fall victim to phishing unless they take extraordinary security caution, this is one of the challenges of crypto lending platforms.
Borrowers and lenders on crypto lending platforms might be tricked into providing their login credentials on fake websites or via deceptive emails that impersonate legitimate lending platforms.
Lack of Custodianship:
Some platforms might not employ robust custodial solutions, meaning they might not have adequate measures to safeguard users’ funds. This makes them attractive targets for cybercriminals.
Internal Threats:
Cases of insider threat cases are not new and it might not stop soon. For instance, on May 10, 2023, two former employees of Tesla leaked data of more than 75, 000 of current and former employees of the company to a German newspaper, according to gurucul.com
Another case of internal threats was noticed in 2020 when employees of General Electric downloaded thousands of files with trade secrets from the company’s servers just to gain an advantage in a newly proposed company.
That’s to show how desperate some employees of companies could go. They will expose company data and IP for money, revenge or just for envy and with the aim of bringing such companies down.
Malicious actors within a crypto lending platform might exploit their access to misappropriate funds or manipulate platform operations.
Endpoint Vulnerabilities:
The security of a lending platform isn’t solely determined by its own infrastructure. Users accessing platforms from devices with malware or compromised security can also pose a threat.
Volatility
Extreme price fluctuations are associated with the cryptocurrency market. Unlike traditional fiat currencies or stable assets such as gold, the value of cryptocurrencies can see rapid and dramatic changes over short periods.
This volatility impacts crypto lending in the following ways:
Collateral Liquidation:
In a crypto lending scenario, borrowers often provide cryptocurrency as collateral to secure a loan. If the value of this collateral drops significantly in a short span of time (which is not uncommon in the crypto world), it might reach a threshold where the loan becomes under-collateralized.
At this point, lending platforms usually issue a margin call, asking the borrower to add more collateral.
If the borrower fails to do so, their collateral may be liquidated to ensure the lender gets their funds back. This can lead to substantial losses for the borrower.
Uncertain Loan-to-Value (LTV) Ratios:
Due to price swings, the Loan-to-Value (LTV) ratio, which is the ratio of the loan amount to the collateral’s value, can fluctuate. This brings about uncertainty in the borrowing and lending process.
A loan that starts with a 50% LTV could quickly change to 70 per cent or 80 per cent LTV if the collateral’s value drops, prompting aforementioned margin calls or liquidations.
Risk Management Challenges:
The volatility makes risk management more complex for both borrowers and lenders. Both of them have roles to play in risk management.
For instance, borrowers need to constantly monitor the market to avoid getting their collateral liquidated, while lenders have to be wary of market downturns that could lead to a wave of liquidations and potentially reduce the overall return on their investments.
Barriers to Mass Adoption:
For newcomers or traditional investors, the unpredictable nature of the crypto market can be a deterrent. They might perceive crypto lending as unstable compared to traditional lending models, slowing down the mainstream adoption of such platforms
Regulatory Risks
Regulation, or the lack thereof, plays a significant role in the crypto lending landscape. This isn’t the case in traditional bank lending, where there are bodies that regulate the banking system.
So, some of the regulatory risks can emerge in the following ways:
Uncertain Legal Status:
Many jurisdictions are still grappling with how to categorize and regulate crypto assets. Without clear regulatory guidelines, crypto lending platforms and users operate in a gray area, which poses challenges in terms of compliance and potential legal repercussions.
Policy Shifts:
As regulatory authorities catch up with the rapidly evolving crypto landscape, they might introduce new policies or reinterpret existing ones.
Such shifts can have abrupt and profound impacts on crypto lending platforms and their users.
For instance, a jurisdiction might suddenly ban crypto lending or introduce restrictive licensing requirements, disrupting operations. In countries such as China and Nigeria, there has been policy shifts about crypto trading in the past, this could also affect crypto lending.
Operational Constraints:
In response to regulations, lending platforms might need to implement strict Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures.
While these processes enhance security and compliance, they can also reduce user privacy and make the lending process more cumbersome.
Increased Costs:
Complying with regulations often comes with associated costs. Platforms may need to invest in legal consultations, compliance infrastructure, and ongoing reporting mechanisms. These costs can trickle down to users in the form of higher fees or reduced profitability.
Jurisdictional Disparities:
Regulatory approaches to crypto lending vary significantly across countries. While some countries may be welcoming such as crypto-friendly countries like Switzerland, Malta, Canada, and Portugal others might be restrictive such Bank of Thailand, Nepal, Indonesia, and Qatar.
This inconsistency can challenge platforms operating in multiple jurisdictions or users who transact across borders.
Potential for Clampdowns:
In some cases, regulators might take a hard stance against crypto lending, leading to platform shutdowns or freezing of assets. Such actions can result in significant losses for both lenders and borrowers.
Reputation Risk:
Regulatory controversies can tarnish the reputation of crypto lending platforms, diminishing user trust and deterring potential new users.
For instance, a crypto lending platform that plans to start operation in Qatar will have to consider the environment and its stance on cryptocurrency in the past. In 2018, the oil-producing country banned crypto trading because of its volatility.
Lack of Insurance
Traditional banking and financial systems often come with certain safety nets, one of the most significant being deposit insurance.
But in the crypto lending world, the absence or limitation of such insurance mechanisms presents its own set of risks in the following ways:
No Guaranteed Protection:
Traditional banks in many countries provide deposit insurance, which means that even if the bank fails, depositors can recover a certain amount of their funds. In contrast, many crypto lending platforms don’t offer similar insurance, leaving users exposed to potential total loss.
Platform Failures:
If a crypto lending platform becomes insolvent, users might not have any recourse to recover their deposited funds or assets due to the lack of insurance, this is one of the disadvantages of crypto lending platforms.
Limited Scope of Existing Insurance:
While some crypto lending platforms do claim to have insurance, it’s essential to scrutinize the details.
The insurance might cover only specific assets, certain types of risks (like external hacks but not internal fraud), or may be capped at amounts that don’t fully compensate all users.
Reliability of Insurance Providers:
The emerging nature of the crypto space means that even if a platform has insurance, the reliability and solvency of the insurance provider itself can be a concern.
If both the platform and its insurance provider face issues simultaneously, users might still end up at a loss.
False Sense of Security:
A platform advertising insurance could give users a false sense of security, leading them to not take other necessary precautions. It’s crucial for users to understand the extent and limitations of any insurance provided.
Higher Costs:
To procure insurance, platforms might incur significant costs, which can be passed on to users in the form of higher fees or reduced interest rates.
Counterparty Risk
Platform Solvency:
If you’re lending through a centralized platform, there’s a risk that the platform itself might become insolvent or face financial difficulties, making it unable to meet its obligations to users.
Borrower Default:
On the other side of the lending equation, borrowers might fail to repay their loans. Even if there’s collateral in place, rapid market fluctuations can lead to scenarios where the collateral doesn’t cover the borrowed amount, especially if it has to be liquidated at a lower market value.
Decentralized Protocols:
In decentralized lending, where there isn’t a centralized entity overseeing transactions, the risk gets shifted.
Here, the counterparty risk might revolve around the reliability of the smart contract and the underlying protocol, as well as the behavior of individual borrowers and lenders.
Lack of Legal Recourse:
Given the pseudonymous nature of many crypto transactions and the potential cross-border nature of many deals, pursuing a defaulting counterparty through legal avenues can be complex, expensive, and sometimes, practically impossible.
Operational Risks:
The counterparty, especially if it’s a platform, might face operational issues such as software bugs, server downtimes, or other technical problems that prevent users from accessing or managing their funds.
Lack of Transparency:
Some platforms or decentralized protocols might lack transparency about their operations, financial health, and risk management practices.
This opacity can make it challenging for users to assess the true counterparty risk they’re taking on. Some of crypto platforms that have shut down in the past.
For instance, as of October 2020, cointelegraph reports that 75 crypto exchanges shut down due to hacks, scams, and financial-related issues.
Some of them include Altsbit, Nerae, Bithoven, COSS, kkex, and cryptex among others. In all 63 crypto exchanges have shut down in 2023 at the time of publication.
Interest Rate Fluctuations
Here’s a comprehensive look at the challenges posed by interest rate fluctuations in crypto lending:
Dynamic Nature:
Unlike traditional financial systems where central banks often set benchmark interest rates and changes are typically gradual, crypto lending rates can be highly dynamic. They may change rapidly based on supply and demand, platform algorithms, or broader market conditions.
Impacts on Borrowers:
Borrowers might take a loan at a particular interest rate, but if that rate increases significantly during the loan term, it can increase the cost of borrowing, potentially leading to financial strain or default.
Impacts on Lenders:
While lenders might be attracted to high interest rates, fluctuating rates can mean that the returns on lent assets can change frequently. A lender expecting a steady return might find their actual yield varies considerably.
Liquidity Concerns:
Rapid changes in interest rates can affect liquidity on lending platforms. Extremely high rates might indicate a liquidity shortage, while very low rates could suggest an oversupply of funds. Both scenarios come with their own sets of challenges and risks.
Dependence on Platform Algorithms:
Many decentralized lending platforms use algorithms to determine interest rates based on factors like asset supply and demand. If these algorithms have flaws, are not transparent, or can be gamed, it could lead to unfavorable or unpredictable interest rate shifts.
Lack of Understanding
Making Informed Decisions:
Without a solid grasp of how crypto lending works, you might struggle to make decisions that align with your financial goals or risk tolerance.
Understanding interest rates, collateral requirements, and platform fees is crucial for your success.
Navigating Platform Differences:
Different platforms have their own terms, features, and risk profiles. Without a clear understanding, you might choose a platform that doesn’t suit your needs or exposes you to unexpected risks.
Recognizing Scams:
The crypto space, unfortunately, has its fair share of scams and fraudulent schemes. Your lack of knowledge might make you more susceptible to falling for such traps, leading to potential financial losses.
Overleveraging:
If you’re borrowing, you might be tempted to take on more debt than you can comfortably manage, especially if you’re not fully aware of the implications of volatile collateral or fluctuating interest rates.
Managing Technical Aspects:
Crypto lending involves various technical components, from managing digital wallets to interacting with smart contracts. Without understanding these elements, you might make errors, potentially risking your assets.
Liquidity Issues
Difficulty Accessing Funds:
If a platform has low liquidity, you might find it challenging to withdraw your assets quickly. When you need funds urgently, this can be particularly problematic.
Unfavorable Rates:
Low liquidity can lead to less favorable lending or borrowing rates for you. As a lender, you might earn less interest, and as a borrower, you might pay more.
Platform Stability:
If many users are trying to withdraw funds simultaneously from a platform with liquidity issues, it might lead to delays or even temporary shutdowns, affecting your ability to manage your assets.
Collateral Liquidation:
As a borrower, if you face a margin call due to collateral value dropping and the platform lacks the liquidity to handle rapid sales, you might incur slippage or unfavorable sale prices when your collateral is liquidated.
Potential for Irreversible Loss
Collateral Devaluation:
If you’ve borrowed funds and provided crypto as collateral, a significant market downturn can devalue your collateral.
If liquidated, you might not only lose your collateral but also still owe the platform if the collateral doesn’t cover the full debt due to rapid depreciation.
Operational Errors:
Operational errors are one of the risks of crypto lending. For instance, mistakes, like sending funds to the wrong address or interacting with a faulty smart contract, can lead to permanent losses. Once done, these actions typically can’t be undone.
Reputation Systems
Building Trust:
As a newcomer, you might find it challenging initially to establish trust. Without a strong reputation score, you could face limitations or less favorable terms when borrowing or lending.
Privacy Concerns:
To build a reputation, you might need to share more personal information or transaction history than you’re comfortable with, potentially compromising your privacy.
Conclusion
The risks associated with crypto lending as highlighted in this article are not to deter you from exploring the new emerging blockchain-backed lending system, but for you to know the challenges of crypto lending.