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Get 10%+ on Your Crypto! But is it worth the risk?

Questions to ask before transferring your funds

In November 2020, Cred, a crypto lending company filed for bankruptcy. They had been offering customers 4–10% APY on their crypto deposits, then suddenly, it was gone.

Get Cash without Selling Crypto

In a world of record low interest rates and negative yielding junk bonds, crypto lending platforms have arisen to provide investors with steady, high yields on cash and crypto assets. These yields are incredibly enticing, particularly with rising inflation and interest rates on savings accounts that can’t keep up.

Current crypto rates offered by Celsius

What risks are you taking?

Nothing is risk free. Even the “risk-free asset” par excellence, US government bonds aren’t risk free, even if i̶n̶v̶e̶s̶t̶o̶r̶s̶ academics act like it is. While crypto lending through major platforms like BlockFi and Celsius feel like low risk, easy money, it’s worth examining before you put your money to work on these platforms.

Collateralized Lending

Banks and lenders want to see that their borrowers have some form of backing or collateral on their loans. This helps reduce the risk to the banks in the case that the borrower can’t repay their loan and defaults — they can get something back.

Screenshot of BlockFi loan application.

Margin Call

Crypto is very volatile, which means the value of loans can fluctuate wildly, which can cause the LTV to shift as well. If it moves too far against the borrower, meaning the LTV rises too high, these platforms will issue margin calls, meaning the borrower must put up more collateral to bring the LTV back into line per the contract, otherwise the platform will liquidate their collateral to cover the loan.

Uncollateralized Lending

Many of these platforms also engage in uncollateralized lending. This is giving out a loan simply with a promise to repay. This is the kind of lending that occurs when you use your credit card. Because there is no protection apart from the faith and credit of the borrower, interest rates on these loans tend to be much higher than for the collateralized variety.

Yield Farming

Is your platform extending credit or engaging in its own speculation in the DeFi space? Yield farming has become popular among crypto enthusiasts looking to make an extra return, but this comes with its own set of risks. Moreover, platforms may be taking on high amounts of leverage to engage in this practice. If this isn’t something you’re comfortable with, be sure that the platform you entrust your crypto with isn’t engaging in this type of behavior either.

Security Risks

While Bitcoin hasn’t been hacked, there are countless stories of people losing their keys or accidentally exposing their secrets to malicious actors. The larger the exchange or lending platform, the bigger the target it is for hackers.

Fraud Risks

Not your keys, not your crypto! These centralized lending exchanges require you to put your crypto on their platforms, meaning you have no control over your keys. If your chosen platform is fraudulent, then you’re likely out of luck and will have a very difficult, if not impossible, time recouping your losses.

  • Are the people involved legitimate? Research the founders and find employees on LinkedIn and other sites to see if these are real people.
  • Has the company been backed by VCs or other investors who have done their own due diligence, or is it a fly-by-night start-up? If professionals have backed it, then it’s significantly less likely to be a fraud.
  • Are they being reported on by reputable news outlets? Assuming the news is positive, more corroborating evidence helps reduce your risk of being defrauded.

Jurisdictional and Regulatory Risks

Crypto is gaining adoption and acceptance around the world, however some governments and regulators remain highly skeptical; China seems to ban it every few years and India did the same recently. Your lender makes a prime target for government crackdown and restriction. If this were to happen, you may lose your crypto when they’re put out of business.

Insurance

Cash at your typical bank is insured by the FDIC up to $250,000 (although, with a 1.3% reserve ratio there are legitimate questions about the ability for the FDIC to actually pay out if a major bank fails). This insurance gives depositors comfort in case the bank becomes over extended and cannot meet depositor demands.

Business Model Risk

Even with the safety of over collateralized loans, it very well could be that the market could crash quickly and you’d lose your savings. The “safe” US housing market crashed in 2007–08 and brought many banks and lenders down despite the fact they were sitting on physical homes (e.g. collateral).

Who would borrow at these rates?

Paying 9.75% interest seems astronomically high with 30-year mortgage rates near all time lows, US 10-year bonds under 2%, and over $18 trillion in negative yielding bonds, including junk bonds! So again, why would anyone be willing to pay that crazy rate?

Tax Implications

Taking out a loan is not a taxable event and paying interest on a loan garners a tax deduction. This is crucial for many long-term investors in Bitcoin.

HODLers

Others who are taking out loans may be HODLers who have a need for some cash now. If you believe that Bitcoin is going to $100k, $200k, or over $1 million in the next few years, you don’t want to give up any of your real estate on the blockchain. Borrowing against it, however, can give you some cash now to meet rent when you’re in between jobs, pay for medical expenses, or whatever you might need in the meantime.

Trading Strategies

Crypto trades around the clock and with a lot of volatility, which provides significant opportunities for traders to cash in on its movements. One of the most popular trades of the past year is the Bitcoin contango trade in the futures markets. This trade has been able to return 20, 30, and even 40% annualized to traders with very little risk. If you have a winning strategy with minimal risk, the optimal decision is to trade larger with leverage. Thus many traders and institutions are doing exactly this. They’re happy to pay 10%+ to take out a Bitcoin loan if they know they can get a 30% return on the deal!

Know your Tolerance

Risk tolerance is a very important and personal issue. Far too many people approach these 7, 8, 9% yields as if it’s risk-free money, when in fact it is far from it.

AI/ML researcher writing about technology, economics, and business. Connect with me: https://bit.ly/2scbU1P

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