How to Manage Risk When Lending and Borrowing Bitcoin
Lending and Borrowing Bitcoin is all the rage in 2020. But what risks must users consider before enjoying 8% interest on their BTC?
- New businesses have emerged to help Bitcoin users do more with their money.
- Lending Bitcoin is the next step in a maturing crypto market.
- Many of these platforms aren't without inherent risks, however.
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Borrowing and lending Bitcoin is the next step in the premier cryptocurrency’s evolution. Instead of merely “hodling” or trading volatility, users can now use their capital in new and interesting ways. And just as there was a risk in purchasing BTC early in the cryptocurrency’s life, there is also a substantial risk in entering the nascent borrowing and lending market.
The following guide digs into the nature of these risks, compares various platforms, and offers a handful of ways to minimize danger. Readers should come away with a much richer understanding of how they can earn 8% on their Bitcoin holdings.
Remember, there is no such thing as a free lunch.
From “Hodling” to Lending Bitcoin
The health of markets, crypto or otherwise, hinges on the efficient use of idle capital.
This is why markets reward participants for resolving any inefficiencies. These resolutions could be in making educated bets on incoming trends, filling arbitrage opportunities, or offering liquidity to certain illiquid financial pools.
We can think of these three examples as phases in the crypto life cycle.
In the beginning, there was only Bitcoin. Buying BTC at that time was essentially making a bet that traditional finance needed competition to keep it honest. The original Internet money also offered censorship-resistance, immutability, and a host of other unique characteristics. It was a political bet more than a financial one.
Still, if you had bought $100 worth of BTC on Jan. 1, 2015, for instance, you would be up ~186% on Jun. 23, 2020.
On the way to those profits, however, you would have experienced a rollercoaster of volatility.
A similar phenomenon occurred during the ICO boom. The market exploded with various blockchain-based solutions to real-world problems. The more convincing the copy and effective the marketing scheme, the steeper the returns on the associated tokens. People were desperate to find the “next Bitcoin.”
Both of these strategies are still in play, of course. People continue to invest in Bitcoin and altcoins with expectations of future appreciation. Likewise, traders continue to inspect daily charts and predict when prices will shift.
With few exceptions, though, the crypto space was limited to these two activities. And soon, it became clear that many of these inflated altcoins popped, taking Bitcoin down with it.
Prices have yet to recover since they dropped at the beginning of 2018. Many smaller, more poorly managed crypto projects were wiped out entirely.
But for the projects that survived, they would go on to offer real utility and help usher in a new era for the crypto sector. Among this group of survivors were viable borrowing and lending platforms. These days, such platforms are all the rage.
But before you rush into a high-yielding crypto scheme, it’s crucial to understand how these platforms work. Like any investment, you need to know why your funds are earning interest and where they are being held while they turn over yield.
One way to think about this is by making a distinction between technical risk and custodial risk.
Understanding the differences between custodial and non-custodial lending will help you better mitigate risk.
Another consideration is that of centralization. And finally, understanding how volatility can affect your holdings, whether lent or borrowed, is crucial for ensuring you don’t take on more risk than anticipated.
Custodial Risk and Lending Bitcoin
Custodial lending platforms require users to keep their Bitcoin on the platform. Examples of lenders like this include Celsius, Crypto.com, Cred, BlockFi, and Nexo. For certain crypto enthusiasts, this is less than ideal.
This arrangement means that you do not have perfect control of your funds. In a very technical sense, the company is holding your Bitcoin. Now, there has yet to be a significant issue with users not being able to retrieve funds from the platforms mentioned above. But this is still a tenable risk.
The majority of companies in the crypto space are startups. And the harsh reality is that startups, no matter the industry, have an extremely high rate of failure. It’s fair to say that this rate is slightly higher within the crypto space.
So, what happens to your funds when your preferred lending platform goes bust?
In the case of BlockFi, they have offloaded custody to the American exchange, Gemini. The exchange insures these funds in two ways.
All USD deposits are covered by the Federal Deposit Insurance Corporation (FDIC). Second, Gemini announced in 2018 coverage by Aon, a UK-based insurance company. Though this arrangement isn’t without its imperfections, the extent of coverage approaches the standards of traditional financial institutions.
Cred enjoys a similar arrangement, though they are not FDIC-insured. The firm has partnered with Lockton to help insure their custodied funds. The coverage extends to a wide range of crypto-centric events, including data breaches, cyber extortion, system failure, ransomware, and many others.
Though your Bitcoin may be fully insured on any of these platforms, you must consider how your personal data is protected. This aspect is often overlooked in the borrowing and lending industry.
This became a major issue for BlockFi in May 2020. Though all user funds were safe, the company confirmed that the breach exposed users’ names, home addresses, account activity, email addresses, and dates of birth.
The above outline reveals two key considerations when lending and borrowing Bitcoin.
The first is understanding which entity is holding your BTC. Then you need to understand how these funds are protected as well as your rights in case the company goes bankrupt or is hacked.
The second consideration is that of user data. Though there were no financial damages incurred, the BlockFi incident highlights the need for diligence when handing over personal information.
The final consideration is the variable interest rates. Unlike many decentralized exchanges, custodial platforms determine their rates internally. This means that they can change at the whims of the company.
Of all the risks outlined in this article, these changes are perhaps the least dangerous.
To help mitigate this and to lock in expected rates, Cred advises its users to “to pledge [their] assets by the 1st or 15th of that month.”
Lending and Borrowing platforms are exciting primitives for the world of crypto. Not only do they signal a maturing market, but they also offer users new ways to earn on their Bitcoin. This incentive will likely attract a new wave of investors escaping a zero-interest-rate policy world.
Still, this incoming demographic must be aware of the risks associated with using third-party services. As outlined above, the two primary risks revolve around custody or how the company is keeping your Bitcoin secure and personal data.
There are very few financial institutions that can guarantee perfect security. But understanding how custodians insure their funds, examining the team behind the business, and using best OpSec practices can minimize your risk.
Disclosure: Cred is a sponsor of Crypto Briefing.