Cryptocurrency-based lending has become a mainstay of the decentralized finance (DeFi) universe ever since smart contract-based lending/lending platforms began offering the service to cryptocurrency users. The Ethereum network, the first blockchain to scale smart contract functionality, sees most of the total value locked (TVL) in DeFi protocols dominated by cryptocurrency lending platforms.

According to data from DeFi Pulse, the top 4 of the 10 DeFi protocols are lending protocols that bill for $37.04 billion in TVL, only 49% TVL of the entire DeFi market on the Ethereum blockchain. Ethereum leads in terms of being the most used blockchain for the DeFi and TVL market on the network. Maker and Aave are the biggest players here, with a TVL of $14.52 billion and $11.19 billion, respectively.

Even on other blockchain networks like Terra, Avalanche, Solana, and BNB Chain, the adoption of cryptocurrency-based lending has been one of the major smart contract use cases in the DeFi world. There are about 138 protocols that provide crypto lending-based services to users, amounting to a total TVL of $50.66 billion, according to DefiLlama. Apart from Aave and Maker, the other prominent players in this category of protocol on blockchain networks are Compound, Anchor Protocol, Venus, JustLend, BENQI, and Solend.

Johnny Lyu, the CEO of cryptocurrency exchange KuCoin, spoke to Cointelegraph about choosing blockchain networks for crypto lending. He said:

“I would say that the ideal blockchain for lending and DeFi does not exist as each has its own advantages. At the same time, Ethereum’s leadership is undeniable due to many factors.”

However, he did not deny the possibility of a truly ideal blockchain for DeFi emerging. Kiril Nikolov, DeFi strategist at Nexo, a cryptocurrency lending platform, seconded this opinion. He told Cointelegraph:

“The short answer is no.’ Most blockchains support crypto lending, however, among the main properties to consider are liquidity and reliability, while a secondary determining factor could be network fees.”

Considering that the liquidity and reliability of the Ethereum platform is the highest at the moment due to it being the most widely used blockchain within DeFi, one might consider leveraging the same and making it the blockchain of choice.

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To get started, a borrower must choose from the major lending protocols on the network, such as Maker, Aave, and Compound. While there are a large number of crypto lending platforms, in this article, they are considered the most prominent for the sake of ease of explanation and identification.

Cryptocurrency loans essentially allow users to borrow and lend digital assets in exchange for a fee or interest. Borrowers must post collateral that allows them to instantly obtain a loan and use it for their portfolio goals. You can take out unsecured loans, known as flash loans, on platforms like Aave. These loans must be paid back within the same block transaction and are primarily a feature intended for developers due to the technical expertise required to run them. Also, if the borrowed amount plus interest is not returned, the transaction is canceled even before it is validated.

Since crypto lending is fully automated and simple for the average retail investor and market participants in general, it provides an easy way to earn APRs on the digital assets they hold or even access cheap lines of credit.

An important aspect of secured loans is the loan-to-value (LTV) ratio. The LTV ratio is the measure of the loan balance in relation to the value of the collateral asset. Since cryptocurrencies are considered to be highly volatile assets, the relationship is usually on the lower end of the spectrum. Taking into account Aave’s current LTV for Maker (MKR) is 50%, it essentially means that you can borrow only 50% of the value as a loan relative to the collateral posted.

This concept exists to accommodate the value of your collateral should it decline. This results in a margin call where the user is asked to replenish collateral. If you don’t and the collateral value falls below your loan value or some other predefined value, your funds will be sold or transferred to the lender.

The scope of impact of cryptocurrency-based lending extends beyond the DeFi market as it enables access to capital for individuals or entities without a credit check. This brings in a massive population of people all over the world who have bad credit or no credit at all. Since loans and borrowing are done through smart contracts, there is no real age limit for the younger generation to get involved, which is traditionally not possible through a bank due to lack of credit history.

Related: What are crypto loans and how do they work?

Considerations and risks

Since the adoption of DeFi-based lending has increased to such an extent that even countries like Nigeria is taking advantage of this service and the savior is exploring low interest crypto loansThere are several considerations and risks that are worth noting for investors looking to get into this space.

The main risk related to crypto lending is smart contract risk, as there is a smart contract in play that manages capital and collateral within each DeFi protocol. One way this risk can be mitigated is through robust testing processes put in place by the DeFi protocols that implement these assets.

The next risk you need to consider is liquidity/settlement risk. The liquidity threshold is a key factor here because it is defined as the percentage at which a loan is considered insufficiently collateralized and therefore leads to a margin call. The difference between LTV and liquidity threshold is the security cushion for borrowers on these platforms.

For lenders, there is an additional risk associated with temporary loss. This risk is inherent in the automated market maker (AMM) protocol. This is the loss you incur when you provide liquidity to a pool of loans and the underlying price of the assets on deposit falls below the price at which they were deposited into the pool. However, this only happens when the rates obtained from the group do not compensate for this drop in price.

Nikolov pointed to another risk with DeFi lending platforms. He said that “another is a bad collateral listing that could cause disruption to the entire platform. Therefore, if you are not willing to take these risks, we recommend that you borrow from a platform like ours that guarantees you certain protections, such as insured custody and overcollateralization.”

There have been several instances of hacking since the rising popularity of DeFi, including cream finance, DAO badger, Compound, EasyFi, Agave and Hundred Finance.

Additionally, crypto lending and lending platforms and users are subject to regulatory risks. Lyu mentioned that the regulatory framework on this issue has not been fully formed in any major jurisdiction, and everything is changing before our eyes. It is necessary to separate borrowers from each other: private borrowers and borrower companies.

Essentially, the risks highlighted make it critical that you exercise extreme caution when deploying your capital in cryptocurrency-based loans, either as a borrower or as a lender. Paolo Ardonio, chief technology officer at cryptocurrency exchange Bitfinex, told Cointelegraph:

“It is important that those who engage in crypto lending on DeFi platforms are aware of the risks in what is still a nascent field in the digital token economy. We have seen a number of high-profile security breaches that have put the funds of both borrowers and lenders at risk. Unless funds are secured in cold storage, there will inevitably be vulnerabilities for hackers to exploit.”

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Future of DeFi lending

Despite the risks mentioned, cryptocurrency-based lending is one of the most evolved spaces in the DeFi markets and still witnesses constant innovation and growth in technology. It is evident that the adoption of this DeFi category is the highest among the many others that are growing in the blockchain industry. The use of decentralized identity protocols for user verification could be integrated into these platforms to prevent the entry of scrupulous players.

Ardonio spoke more about expected innovation in DeFi lending this year, stating, “I hope to see more innovation in crypto lending, particularly in terms of the use of digital tokens and assets as collateral in loans. We are even seeing non-fungible tokens being used as collateral on loans. This will be an emerging trend this year.”