Guide to crypto lending and how interest rates are determined

In this article, we deep dive into the mechanics of how crypto lending works and how interest in generated and passed down to depositors.

Guide to crypto lending and how  interest rates are determined

Many centralized finance financial services platforms like BlockFi, Nexo and Hodlnaut offer a interest-earning product promising high yields on cryptocurrencies.

How do they work and can they afford to sustain these yields? In this article, we deep dive into the mechanics of how crypto lending works and how interest in generated and passed down to depositors.

Traditional lending

To understand crypto lending, it might be useful to start by understanding how traditional lending - a service that financial institutions and global banks broker - works.

In a traditional lending process, a lender provides money, property or assets to the borrower in hope that the borrower will return the assets in full in the future. As an economic incentive to lend money (extend credit), borrowers often need to pay interest on their borrowed money in addition to the borrowed amount (repay debt).

Banks and financial institutions have traditionally been the broker of the transaction between lenders (depositors) and borrowers. Within the current economic framework, banks operate on a fractional reserve banking system where the bank merely needs to set a percentage of deposits as reserves to service withdrawals, while the rest can be loaned out to borrowers.

In recent times, the industry has been disrupted by modern financial technology firms and peer-to-peer firms where digital platforms have sought to further democratize the market for lending and making it more accessible on both sides of the demand and supply spectrum - to less credit-worthy borrowers (e.g. startups, SME financing) and to retail users who are willing to take up more risks for higher returns.

Crypto lending

Crypto lending is similar, but it operates in the blockchain space with cryptocurrencies. It carries significant benefits over traditional lending platforms such as greater transparency, faster speed and access to loans and best of all, a global market for credit.

Crypto lending is a bedrock of financial activity in the crypto ecosystem, as lending and borrowing unlocks the utility of cryptocurrencies, making them available for use as collateral for loans, or taking loans in stablecoins for making leveraged bets.

Demand and supply for crypto lending

The interest rate that you see advertised on the website and subsequently paid to depositors if often a variable rate based on both demand and supply.

On the supply side, depositors like retail investors, mom-and-pop investors or other institutional lenders can deposit their idle cryptocurrencies into these platforms for yield. The entire supply in the market consists of all players who hold cryptocurrencies and are able to deposit them into these interest accounts. These includes cryptocurrencies held in exchanges that could be used for lending and borrowing.

On the demand side, there are a couple of drivers to borrow cryptocurrencies. Asset managers and financial institutions can borrow to hedge and take short positions. Market makers can borrow to provide liquidity on exchanges and make OTC trades.

Crypto companies can borrow for working capital and make operational payments. Mining companies can borrow to purchase mining equipment and use the staking rewards to pay them off.

Retail users can borrow against their deposited assets to buy physical assets or make leveraged trades.

Out of the 3, it can be assumed that most of the demand for borrowing comes from the financial institutions given the size of their opportunities. Assuming if they can earn a return that is higher than their borrowing cost, it is likely that they would borrow to secure that profit.

Since borrowers pay an interest to borrow cryptocurrencies, they are the main source of yield that CeFi platforms pay out to depositors. These platforms may take a cut of the revenue to further reinvest into the product or company. The net yield is then passed on to depositors.

How supply affects interest rates

The supply of cryptocurrencies flowing into these platforms will impact the available liquidity for borrowing in the market and drive competitive behaviors across firms to reduce rates and increase borrowing.

As new users and firms enter the lending market for yield, the supply of cryptocurrencies available for borrowing generally increases. This drives long-term interest rates down over time.

How demand affects interest rates

At the same time, new institutions are also entering the crypto borrowing market each day given that traditional financial institutions are still risk adverse when it comes to making loans to crypto companies.

They may borrow due to the wide array of opportunities in the space, from yield farming to staking. Furthermore, many of these financial institutions borrow to make delta-neutral trades or basis trades at low risk.

The demand for stablecoins tend to be the highest across all cryptocurrencies as USD or stable assets are often used as the base currency for the above trades. This is why lending platforms often offer the highest yields on stablecoins.

Wrapping up

The dynamics of demand and supply in the crypto market is constantly changing as a result of yield opportunities emerging in this space. That's why rates you see on CeFi platforms are constantly adjusting to keep up.

At the same time, the emergence of DeFi lending platforms are shaking the market dynamics even further. Not only do they attract new liquidity and supply into the market with their token incentives, many of these platforms offer borrowing at much lower cost, further putting pressures on the yield that CeFi institutions offer.