This is less complex than it sounds. If you approach your traditional bank for a loan, they’ll assess your credit history, want a lot of information about your financial circumstances and give you plenty of forms to fill. Loans are either secured against something (a house) or unsecured and reliant on your ability to repay them.
Crypto loans involve much less paperwork but are only available when secured against existing crypto collateral. If for example you own 1 BTC and it is worth €48,000 you could borrow roughly €28,000 against it as a Stablecoin or regular fiat money.
The relationship between your collateral (worth €48k) and the loan (in this example $28k) is called Loan to Value ratio (LTV) which is about 58% (28/48).
In addition to the collateral, you’ll also have what is known as a Margin Call. As the price of bitcoin is volatile the value of your collateral might decline. The loan provider won’t want your collateral’s value to decline below the value of the loan issued, so the Margin Call is a trigger that says, ‘if your collateral declines in value by 35% you need to provide more collateral, or we’ll start selling it to adjust the LTV’.
You will get a warning, but once that Margin Call level is reached you’ll have to make a decision, and importantly, once you take out a loan the CEFI provider owns the funds, so they don’t need your permission to sell. Nexo’s blog provides more detail about the importance of liquidations.
Why take out a Crypto Loan?
You might be wondering why someone would want to borrow against their crypto, and not just sell it if they need fiat or a Stablecoin? Here are a few reasons why:
Tax efficiency: Selling your crypto in many countries is a taxable event. By taking a loan against it you can realise value without paying the capital gains.
Yield Hunting: Some investors are happy to pay 5% on the loan of a Stablecoin as they feel confident they can earn much higher returns elsewhere e.g in DEFI. They are however, exposed to the risk of liquidation from a sharp drop in the value of their collateral.
Pay off a Mortgage: If you have a fiat liability, like a Mortgage, you can pay it off without selling your crypto by taking out a loan, thereby avoiding the tax.
Pay Interest With Appreciation: Many people want to realise value from their crypto but don’t want to part with it. A loan is a compromise as the interest can be paid from any appreciation in your collateral, leaving you free to spend what you borrowed.
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