The thing is though that most all of these crypto lending platforms only offer over collateralized loans, so the risk of them being screwed over by lack of payment from the person taking the loan is negligible. Meaning If I want to lend $100 worth of USDC I must give $200 as collateral worth of BTC to get the loan. Where if that $200 worth of BTC drops to a worth of $100, it's liquidated, paying off your loan, leaving the lender with no outstanding loan and the loan taker with the $100 worth of USDC still, but no longer their BTC. (this would trigger a Capital gains event too, as the BTC was effectively sold.)
These types of loans of course aren't useful for most people in the traditional sense where somebody needs access to money they don't have. These are mostly for 2 cases:
1) Exposure to other crypto when you think both your collatoral and the crpyto you want to be lent will both be worth more. SO you borrow $100 worth of USDC, give $200 BTC as collatoral, use the $100 USDC to buy $100 worth of ETH. SO if after a month ETH and BTC have gone up, you can sell enough to pay the $100 USDC loan and keep the profit.
2) Access to illiquid capital. If you have $1 million of BTC but don't want to sell it and trigger a capital gains event, you use that as temporary collateral to get access to something else, thus never selling your current crpyto holdings (unless they fall below the liquidate threshold of the loan)
I should say too, using these methods still has counter party risk regardless.
One extra detail. The liquidation price isn't equal to the loan principal, it's higher. So in your example $100 USDC loan with $200 BTC collateral will have the BTC sold once the value drops to $150 and the remaining BTC if any is returned. This is to reduce the chances of the price dropping below the principal before liquidation is complete.
The reason they require so much collateral is because the value of the collateral is highly correlated with the value of the investment, since both the investment and the collateral are in the form of crypto-assets, and crypto-asset prices tend to move together. This means, in the event of a crash in the crypto market, the probability of incurring losses from such a loan would not be negligible.
Then there's also foreign exchange risk. The return on these loans is quoted in terms of the currency the debt is denominated in, whereas what the investor cares about is the return of the investment in terms of their local currency. This is the same situation that an investor would face if they decided to buy Argentine bonds, which pay over 20% annually in pesos. The return that they would get in their local currency would likely be much smaller. It could even be negative.
Thank you! I've been trying for years to get someone to explain to me how DeFi loans make any sense whatsoever when they are all so over-collateralized. Your explanation helped put the pieces together a little bit. I still don't understand how the unit economics make much sense, but yeah.
These types of loans of course aren't useful for most people in the traditional sense where somebody needs access to money they don't have. These are mostly for 2 cases: 1) Exposure to other crypto when you think both your collatoral and the crpyto you want to be lent will both be worth more. SO you borrow $100 worth of USDC, give $200 BTC as collatoral, use the $100 USDC to buy $100 worth of ETH. SO if after a month ETH and BTC have gone up, you can sell enough to pay the $100 USDC loan and keep the profit.
2) Access to illiquid capital. If you have $1 million of BTC but don't want to sell it and trigger a capital gains event, you use that as temporary collateral to get access to something else, thus never selling your current crpyto holdings (unless they fall below the liquidate threshold of the loan)
I should say too, using these methods still has counter party risk regardless.