Crypto Lending Protocols: Risks and Benefits

Cryptocurrency lending platforms allow users to stake their assets to earn an annual percentage yield or to borrow a specific amount of another cryptocurrency using their staked assets as collateral. This becomes an intriguing option for users intending to hold certain coins for the long term while seeking liquidity in the DeFi sector.

Use Cases of Lending Protocols

For instance, you can stake BTC and borrow a stablecoin. The Loan-to-Value (LTV) ratio in such cases can reach up to 80%. This means by staking cryptocurrency like ETH worth $10,000, a trader could take a loan in stablecoins such as USDC or USDT up to $8,000. The cryptocurrency will remain frozen until the user repays the borrowed funds along with interest, typically ranging from 5–15% annually. 

Users can also earn from lending protocols. For example, by staking their cryptocurrency in lending, traders receive income from other traders using these funds. Thus, the platform shares profits with the user for providing their liquidity. 

Another way to earn from lending emerged relatively recently and involves retroactive airdrops. For instance, the Solana-based crypto platform Jito distributed tokens worth tens of thousands of dollars at the end of 2023 to those who staked at least $100. Following this, other protocols (including Kamino, Margin Finance, ZeroLend) also announced upcoming airdrops for their users and introduced a points system.

Therefore, the use cases of lending protocols can be divided into several categories:

• Earning profits by supplying liquidity;
• Farming stablecoins with an annual yield of 5–15%;
• Holding cryptocurrency while leveraging stablecoins within the DeFi ecosystem;
• Receiving airdrops from the lending platform or the underlying cryptocurrency network.

Risks and Drawbacks of Lending Protocols

Like any DeFi protocol, cryptocurrency lending comes with its own set of drawbacks. The main risks associated with participating in crypto lending platforms include:

• The potential for platform scams;
• The risk of protocol breaches by hackers leading to user fund loss;
• Exorbitant network fees that could render potential profits lesser than transaction costs, predominantly in Ethereum-based applications;
• Trader position liquidation due to high volatility.

While the first three points are straightforward, the liquidation mechanism in lending protocols is quite specific. This process only threatens those traders who have deposited assets into the platform and borrowed another cryptocurrency. 

Liquidation may occur for two reasons: if the collateral cryptocurrency falls too sharply (failing to cover the provided loan) or if the borrowed tokens rise too much (exceeding the collateral value).

For instance, a trader who borrows 1 ETH ($3,000) against a collateral of 4,000 USDT will face liquidation if the market price of Ethereum rises above $4,000.

The reverse situation (where the value of collateral assets falls sharply) will also trigger liquidation because it becomes economically unfeasible for the platform to continue providing credit to such a trader.

The percentage change in coin price required for liquidation depends on several factors: the chosen cryptocurrency, the type of borrowed tokens, the LTV, and the overall use of LTV by the trader (i.e., how much of their collateral the user is leveraging on the platform). If a trader borrows the maximum possible amount of assets, then liquidation of the balance will occur with a 20–30% change in the price of the collateral assets.

Details on using ETH and potential liquidation on Aave. Source: app.aave.com

Remember, even stablecoins carry a risk of liquidation. For example, some users deposit USDT and borrow USDC (perhaps to receive a potential airdrop). However, if exchanges experience a sharp deviation in stablecoin rates (even for a few seconds), the user's balance could be liquidated.

How to Safeguard Funds in Lending Protocols?

Here are a few tips to help protect your money when using lending protocols:

• Avoid using the maximum LTV. This way, the liquidation price will be far off, significantly reducing the risk of losing your collateral;
• Deposit funds only in verified credit protocols with high liquidity, good reputation, and appropriate audits;
• Keep a reserve of funds on your balance for possible collateral increase, thereby reducing the risk of liquidation. For instance, if staked BTC might soon be liquidated, deposit an additional amount of coins into the protocol to push the liquidation price further away;
• If using only stablecoins, spread your funds across several platforms.

The Largest Crypto Lending Platforms

DeFiLlama features a ranked list of lending protocols, sortable by daily activity, total value locked (TVL), daily percentage change, trading volume, etc. Formally, TVL is the most critical indicator of any lending protocol, as it reflects user interest in the protocol.

According to this criterion, the top ten crypto lending protocols include:

• Aave;
• Just Lend;
• Spark;
• Compound Finance;
• Venus;
• Morpho;
• LayerBank;
• MarginFi;
• Kamino;
• Radiant.

Lending Platform Rankings according to DeFiLlama. Source: defillama.com