The total market cap for cryptocurrency has increased from approximately US$150 billion to US$2.5 trillion, over the course of the pandemic alone. The market is expected to grow at a compounded annual growth rate of 60.8% between 2021-2026. The exponential growth of the crypto marketplace, whether you believe in the widespread adoption of cryptocurrency as a form of money or not, is proof that crypto is going to be a financial asset that’s going to continue to drive interest in the years to come.
However, in spite of the bullish behavior of the crypto markets, crypto-asset holders’ spending power is still relatively limited.
This limitation exists because :
- There are only few ways of spending crypto on real world goods and services
- Crypto-asset holders would rather hold on to their crypto-assets in the hopes that they continue to appreciate in value.
As a result, value of crypto is not leveraged like other financial assets and remains locked in the wallets of the crypto holders.
What is CeFi vs. DeFi Crypto lending?
Crypto lending entails a lender loaning fiat money to a crypto-owning borrower and securing said loan by taking a security interest over the borrower’s crypto assets. Lenders in this situation often control crypto assets as collateral, holding them until the loan is repaid or the crypto assets are liquidated.
In a centralized crypto lending arrangement, between a traditional financial institution and borrower, the loan is often repaid in cash installments over the term set out in the loan agreement. Upon defaulting on the loan, the lender may liquidate the crypto assets under its control in an attempt to recoup the loan amount.
The centralized crypto lending relationship, otherwise known as the Ce-Fi model, differs from decentralized or peer to peer lending solutions that fall within the realm of decentralized finance (De-Fi).
In De-Fi lending arrangements, money is typically pooled by participant lenders in an application governed by code (i.e., smart contracts), which is used to generate crypto loans, automate payouts and create lender yields for certain participants.
Either arrangement enables the borrower to monetize and leverage its crypto assets, providing them with liquidity without requiring them to sell off their underlying crypto assets. At the same time, the lender is able to generate additional secured loans with attractive returns, using a loan structure that can minimize its risk should the borrower default.
Legal Aspects of Cryptocurrency Loans
Before offering a crypto loan, it is essential for the prospective lender to gain an understanding of the contractual mechanisms and remedies required both to take security over a particular crypto asset, and enforce their security interest in an event of default.
For example, a lender should take into account some (or all) of the following legal considerations:
- Regulatory compliance: Ensure compliance with any regulatory regime that governs if and how it is able to make crypto loans.
- Taking security: Determine how to take a first-ranking security interest over the crypto asset.
- Market volatility: Consider how to safeguard its position from material volatility of the underlying crypto assets, and the devise the appropriate mechanism and process to demand further collateral from the borrower, if necessary.
- Crypto asset use: Understand rights the borrower will have with respect to the crypto assets serving as collateral during the term of the crypto loan. In some crypto lending arrangements, the lender may make money not only from charging loan fees and collecting interest on payments, but also from managing crypto deposits to earn yield revenues.
- Collateral security: Develop methods to safeguard the security of the crypto asset during the term of the loan to prevent cyber theft, ensure appropriate key administration, and respond to certain blockchain related changes that may affect the collateral while in custody. Examples of blockchain related changes may include token swaps, roll-backs, or split / forks in a particular blockchain.
- Tax and other issues: Tax, transfer limits and other currency regulations may affect both how loan proceeds are transferred from the lender to the borrower, and the repayment of principal and interest from the borrower to the lender. The regulatory classification of the underlying crypto asset will inform the tax considerations and whether transfer limits may exist. Accordingly, the lender will need to consider the form of the crypto asset, be it a protocol token, application token, non-fungible token, etc., and determine its form of property, and how that will that impact loan considerations. A qualification as currency, tangible, or intangible property each carry different implications for structuring loan agreements.
- Repayment: How will the loan be repaid? For example, will it be repaid through cash installments or cryptocurrency?
- Security enforcement: What contractual mechanisms and remedies are in place to enable it to enforce on its security in a timely manner?
If you are interested in participating in the crypto lending space, it is important that you consult legal counsel who have expertise in the secured lending and crypto space to ensure you are properly managing your risk.
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Author
Chris Munch is a professional cryptocurrency and blockchain writer with a background in software businesses, and has been involved in marketing within the cryptocurrency space. With a passion for innovation, Chris brings a unique and insightful perspective to the world of crypto and blockchain. Chris has a deep understanding of the economic, psychological, marketing and financial forces that drive the crypto market, and has made a number of accurate calls of major shifts in market trends. He is constantly researching and studying the latest trends and technologies, ensuring that he is always up-to-date on the latest developments in the industry. Chris’ writing is characterized by his ability to explain complex concepts in a clear and concise manner, making it accessible to a wide audience of readers.
