What is a crypto loan?

The crypto market serves as an endless ocean of investment opportunities. However, when trying to seize them, we often face a dilemma – whether to sell our current assets and focus on others or retain our strategy and cope with the FOMO effect^[1].

So-called crypto loans can address these issues and allow investors to borrow valuable assets without losing the current ones. In the following article, we’ll examine exactly how they work.

How do crypto loans work?

The primary mechanism behind crypto loans is very similar to the traditional ones. We can borrow a particular asset (e.g., to use it elsewhere) and repay the debt we owe with additional interest included. Obviously, we can also become lenders and earn passive income thanks to interest paid by our debtors.

Crypto loans vs. bank loans

There is, however, one substantial difference between non-crypto and crypto loans. The latter are usually backed by collateral, while traditional loans (e.g., run through para-banks) require no backing at all.

If we consider borrowing money from the institution, the lack of collateral doesn’t seem to be an issue. Such entities insure themselves against non-repayable loans – for example, by applying astonishingly high interest rates to all their financial instruments. They’re also very effective when it comes to debt collection.

But the web3 world was not intended to be a space of broken trust, vindication, and unfavorable financial conditions. And, as most crypto loans are processed in a P2P^[2] manner – without any institutions involved – they require a different mechanism.

Crypto loans with collateral

To remove the element of trust from the equation and, at the same time, make both parties sure about the safety of the transaction, such crypto loans require collateral. In other words, if you want to borrow one type of asset, you need to use another one (that you have on your web3 wallet or the centralized exchange) as a “backing” for the payment.

How high the crypto loan collateral usually is? It very much depends on the loan-to-value (LTV) ratio. We can calculate it using this simple formula:

LTV = Market Value of Loan Amount / Market Value of Collateral

Various lending platforms (Aave, Compound) and centralized exchanges (Binance, Kraken, Crypto.com, etc.) offer different LTV values. They also obviously vary for different cryptocurrencies we use (as collateral or a loan itself).

However, usually, the lower the LTV, the lower the interest rate as well. So, it’s in the borrower’s interest to back up the loan with as much collateral as possible. Higher collateral will also reduce the risk of liquidating the loan – which could happen in times of very high market volatility.

Crypto loans without collateral

You can also find crypto loans without collateral in the market. They function in a similar way to traditional, non-crypto loans and require going through the application process, identity verification, and creditworthiness check. As they are not aligned with web3 primitives and serve as a pretty complex solution (compared to quick and accessible crypto loans with collateral), such instruments are not popular among crypto users.

Flash loans – instant crypto lending and borrowing

There is one more type of crypto loan you should be aware of – a flash loan. It’s a very risky and advanced financial instrument that enables you to loan and repay or borrow and get repaid immediately – during one single transaction.

Flash loans are as flashy as they can get – they last only a few seconds. During this time, a borrower can, for example, exploit arbitrage opportunities^[3] and sell a borrowed asset on an exchange where it’s priced higher than by the lender (or the platform) – and earn a profit on the price difference. As you can imagine, it’s a difficult task. That is why flash loans are not recommended to non-advanced crypto traders.

Crypto loans in the UK

Crypto loans are available all over the world, and the UK market is no exception. There are various platforms offering web3 loan services available in the UK – both in the area of centralized (Crypto.com, Hodlnaut, Nexo) and decentralized finance (Aave, Compound, MakerDAO). Thanks to such services, you can borrow crypto or become a crypto lender and gain an additional source of passive income.

Are crypto loans taxable in the UK?

However, it is essential to bear in mind that crypto loans are taxed in the UK – the same as other DeFi instruments. They could be subject to Income Tax and Capital Gains Tax, no matter if you are a borrower or a lender.

If you want to learn more about crypto loan UK taxes, please check our taxation guide for decentralized finance.

Are crypto loans a good idea?

We are not here to give you any financial advice. However, it’s hard to argue that crypto loans are one of the most interesting and effective instruments of the DeFi space. They serve as the “epitomes” of trustless and permissionless web3 – due to their accessibility to anyone who wants to use them and has the required collateral. Without any additional conditions needed to be met.

But please remember that crypto loans’ nature can be very risky – especially in times of market volatility and significant price fluctuations (that will affect the LTV and interest rates). Such instruments still serve as tools for advanced traders and people who really need them to execute their complex investment strategies. If you don’t want to, for example, exploit arbitrage opportunities, crypto loans may not be the perfect solution for you at the moment.

^[1] FOMO – Fear Of Missing Out. It refers to the feeling of lost opportunity, experience, relationship, etc., due to not being involved in a particular event.

^[2] P2P – Peer-to-Peer; from one user to another.

^[3] Arbitrage – a trading strategy based on capitalizing on price differences between various exchanges. It is usually executed by buying an asset at a lower price on one exchange and selling it immediately on another one (with a higher price of this asset).