Are Crypto-Backed Loans Safe During Market Volatility?

Most traditional loans are backed by real-life assets, which are used as collateral; it could be a vehicle or real estate, for instance. Should the borrower fail to repay the lender, the latter has the right to seize the property used to gain access to the funds. Crypto-backed loans work similarly, but there’s a catch.

This kind of loan allows companies and investors to raise funds in fiat currency or other cryptocurrencies based on their expected market value. There’s another advantage here: investors get to keep the ownership of their cryptos if they repay their debts on the due date, which means they can also reap some profit if their assets rise above the value agreed for the crypto or Bitcoin loans. However, investors should pay attention to a key aspect of the crypto market: volatility.

Risks and Prizes

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Indeed, every asset can lose value. Real estate prices can crash due to external causes, like problems in urban infrastructure or rising crime, for instance. However, cryptocurrencies are famous for sudden spikes and collapses, which means it’s a risky business for both ends of the deal.

If changes are too abrupt, brokers offering crypto loans can request additional deposits (margin calls) and even liquidation. Additionally, cyberattacks on crypto brokers and wallets have become common, and even giants like Bybit have suffered billion-dollar losses in Ethereum.

Such security breaches can cause severe damage to lenders and borrowers.

Besides, crypto regulation is constantly changing across the world, which means that compliance is also a significant challenge. Still, crypto-backed loans, like the ones offered by Figure, allow investors to raise funds quickly.

Meanwhile, bypassing the lengthy credit checking process required by traditional loans is possible. Indeed, such loans don’t require credit checks at all, as the crypto value is enough to secure the loan. So, it’s the perfect method for individuals or companies with low credit scores. Better still, like most collateralized loans, interest rates tend to be lower, and the repayment terms are more flexible.

How It Can Be Used

Some crypto-backed loans don’t involve fiat currencies but other cryptos and stablecoins. For instance, it’s possible to back a USDC loan with Bitcoins. In this context, a common tactic involves reinvesting the loan amount into Bitcoin and paying it back with unrealized profits if prices increase.

Bitcoins are also used for securing mortgages, offering owners quick access to the real estate market without selling their assets. Likewise, crypto-backed loans allow investors to raise cash for real estate purchases and keep their positions in the crypto market.

Entrepreneurs have also been using this kind of loan to expand their business operations. Companies that suffer from low credit scores or don’t have other assets to collateralize have access to credit using their portfolios and still have the chance to profit from market appreciation. Since interest rates are usually lower than in traditional loans, investors and companies can also use this option to restructure their debts on better terms.

Navigating Market Volatility

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Nothing crypto-related is safe when lines start going up and down in the market. Lenders and financial institutions shield themselves by making margin calls when the collateralized asset falls below a certain threshold. Lenders can simply liquidate the assets if borrowers fail to cover that margin.

Meanwhile, borrowers can protect their funds by buying insurance coverage for their assets, some offering protection even against cyberattacks. So, crypto-backed loans aren’t safe unless borrowers pay for their safety. Still, they will only be safe to the extent of their coverage, if there’s any.

Security is a key aspect that both sides of the deal should worry about. Features like two-factor authentication (2FA), multi-signature wallets, and cold storage for collateralized assets significantly reduce theft and fraud risks and are desirable on any crypto-lending platform. In fact, choosing the right platform is the first and most important step of the process.

Investors must do some legwork and compare platform reputation, interest rates, and LVR  (loan-to-value ratio). This ratio indicates the percentage of the collateral that can be borrowed. Loans with high LVRs offer access to more funds but are also more vulnerable to margin calls, which means they’re also riskier.

The Lenders’ Perspective

Last August’s statistics show that the Bitcoin-backed lending market’s outstanding debt was valued at USD 8.5 billion. More importantly, this market is set to reach USD 45 billion in 2030, indicating a steep upward trend. Despite volatility risks, depending on local regulations, it can be a very attractive investment option.

In countries like the United States, cryptocurrencies are seen as property, meaning any profit made from them is taxable. However, the money raised with collateralized cryptocurrencies isn’t taxable since it isn’t considered capital gain. Unlike traditional assets, cryptos are traded around the clock, allowing real-time valuation. In more traditional markets, valuation can vary considerably during off-hours.

The fact that crypto-backed loans don’t require credit checks is also an advantage for lenders instead of a liability. Since collateralized cryptos guarantee the repayment, lenders can apply margin calls or liquidate them should their valuation vary too much. So, it’s possible to offer loans to those who wouldn’t be eligible in traditional markets, thus expanding lenders’ opportunities.

Lending platforms can be centralized (CeFi) or decentralized (DeFi). CeFi platforms are controlled by companies and governed by contracts, providing much more predictability. DeFi platforms grant permissionless lending based only on smart contracts, making risk assessment more challenging for beginners.