What is crypto lending?

Crypto lending is a process where users loan out their cryptocurrency to borrowers or protocols in exchange for earning interest or yield. Crypto aims to iterate upon traditional financial tools by providing unique ways of generating yield for users who hold them. Since the creation of Bitcoin in 2009, crypto has taken on functions that have historically belonged to traditional finance. One of those important functions is earning yield on assets, which is simply the amount of earned value on funds. In traditional finance, yield can be generated in many ways, for instance, through deposits in a bank account or through dividends on equity holdings, and it is expressed as a percentage of the original value. One of the main ways to earn yield in crypto is by lending owned crypto assets, which is a familiar practice from traditional finance. Yield is typically measured in annual percentage rate (APR) or annual percentage yield (APY).

When you keep your money at a financial institution, the institution can lend those funds to other customers through mortgages, credit cards or personal loans. By depositing your money into a bank account, you are lending it to the bank, which then lends it to someone else at a higher rate. You receive a percentage through a typically low rate on your deposit account.

Removing the intermediary institution means that the lending market can operate differently, potentially allowing interest from lending to flow more directly to the end user. This is the basis for decentralized lending through protocols, where smart contracts automate the process of lending between users. Decentralized finance (DeFi) protocols use pools of users' funds to provide liquidity to borrowers and distribute lending yield among lenders. Some centralized finance (CeFi) systems also allow for crypto lending, operating an in-between model closer to traditional finance institutions.

Earning yield in crypto comes with its share of risks. Typically, higher potential yield is accompanied by higher risk. Two types of risk are universal to currencies: volatility and inflation. Crypto has historically been more volatile than other asset classes, meaning that holding any one asset carries the risk of it devaluing while in your possession. Similarly, every cryptocurrency's specific tokenomics determines its rate of inflation, or the amount of new crypto tokens released, which might affect the value of the cryptocurrency.

When lending assets through a traditional finance institution, a customer’s bank deposits are no longer their property and become the property of the bank. Under fractional reserve banking rules, the bank can loan out money without keeping customers' deposits in cash, risking illiquidity in the case of a bank run. While DeFi protocols ensure that assets remain non-custodial, lending cryptocurrency in DeFi relies on smart contracts, meaning all processes are automated through code. Although the code used in these protocols is often audited by third-party organizations, there can be flaws that allow bad actors to exploit it. This might result in the siphoning of funds out of lending pools or flash loan attacks.

Crypto has shifted how people think about banking by adapting traditional practices into new forms and introducing alternative ways to generate yield. Blockchain technology continues to offer a different take on finance. Crypto yield is available through several methods, including lending. These methods carry risks, including the potential loss of principal.

Disclosures:

Content provided for educational purposes only. Not investment advice or a recommendation. Trading and owning digital assets involves significant risk, including the risk of substantial loss. Cryptocurrency services are offered through an account with Robinhood Crypto, LLC (NMLS ID 1702840). Robinhood Crypto is licensed to engage in virtual currency business activity by the New York State Department of Financial Services. Cryptocurrency held through Robinhood Crypto is not FDIC insured or SIPC protected.