Crypto assets can be borrowed against
This is a guide about using crypto assets as collateral for loans in DeFi. Not financial advice.
What is DeFi Borrowing?
DeFi borrowing is the act of borrowing one crypto asset where the loan is collateralized (secured) by another. For example, a typical DeFi loan might consist of borrowing $20,000 in DAI or USDC (USD stable coins) secured by $50,000 worth of Bitcoin. The borrowed funds can be used for any purpose, such as leveraged investing or paying for personal expenses.
Just like loans in traditional finance, DeFi loans have a corresponding interest rate and loan-to-value limits. Interest is automatically applied to the borrowed amount. When the loan is intitiated, collateral is locked up. When the loan is payed, the collateral is unlocked. If the loan is not repayed, locked-up collateral will be liquidated.
Like all DeFi applications, the loan itself is implemented via smart contracts. Everything is automatic, permissionless (no approval process), and decentralized. There are no loan officers or credit checks. Liquidation of collateral is automatic.
The process of DeFi borrowing is very simple, consisting of the following steps:
- Lock up collateral, such as Bitcoin or Ethereum. The funds are now controlled by a decentralized smart contract.
- Initiate loan of any amount up to the limit allowed by the lending platform, generally based on the value of locked collateral.
- Receive borrowed funds.
- Use borrowed funds for any purpose.
- Repay loan.
- Unlock collateral.
Why would we want to take out a DeFi loan as opposed to a traditional loan such as a mortgage, HELOC, auto loan, personal loan, or credit card debt? Here are some benefits:
- No intermediaries (loan officers, banks).
- Loans are instant.
- No credit checks.
- Loans may be used for any purpose.
- Easy to refinance (initiate a new loan to pay off the old one).
- On some platforms, such as Compound, yield can be earned on the collateral even when borrowed against (think of taking out a loan on investment property whlie also earning rent from it).
DeFi loans are not without their drawbacks:
- Rates are often variable and can change dramatically and quickly.
- Collateral values can be highly volatile, leading to potential unintended collateral liquidation.
- Network fees can be high depending on which underlying network is used.
- Bugs in smart contracts can lead to loss of funds.
Not tax advice. Talk to an accountant/tax advisor.
One of the most common uses of DeFi loans is to access liquidity from crypto assets which have gone up in value over time, without triggering a taxable event.
One way that this liquidity can be used is to rebalance a portfolio without initiating taxable events. Borrowed funds can be used to open positions in new assets and gain exposure to the price movement of those assets. The net result of this is a leveraged long portfolio. To some, this is desirable. It is possible, however, to use some portion of the borrowed funds to initiate short positions in the collateral asset, so that the net portfolio becomes unleveraged.
Stable coins such as DAI and USDC can be transferred to an exchange and transferred to a traditional bank account as USD. Additionally, some payment processor such as PayPal are beginning to enable transactions funded directly with cryptocurrencies. A long-term investor in crypto assets may end up with substantial unrealized gains. A DeFi loan is one way to gain access to liquidity without selling off assets. How will the loans be repaid? If we assume a fixed market supply of the collateral, as is the case with Bitcoin, and a perpetually inflating supply of the borrowed asset, as is the case with USD, then the borrowing limit will tend to go up over time, making liquidity available long-term. It may also be desirable to sell of certain assets at certain times, and hold onto yet another asset for the long-term. DeFi loans enable the kind of flexibility required to manage a portfolio this way while minimizing taxable events.
The process for leveraged investing via DeFi loans is very simple:
- Lock up collateral, such as Bitcoin.
- Borrow a reserve asset, such as DAI or USDC.
- Use the borrowed liquidity to purchase more of the collateral asset.
- Lock up the newly-acquired asset.
- Borrow more of the reserve asset.
- Repeat (optional).
As in all markets, leverage increases risks. Both upside and downside will be amplified, and there is a cost (interest) to carry the debt.
DeFi loans enable shorting of a crypto asset. The process for shorting via DeFi loan is as follows:
- Borrow the asset targeted for the short position. Collateralize the loan with a reserve asset, such as DAI or USDC.
- Sell the borrowed asset.
- Later, rebuy the asset (hopefully at a lower price) and repay the loan, unlocking the reserve asset collateral.
Interest Rate Arbitrage
In recent times, traditional USD loans tend to be available for lower rates than DeFi loans. It's entirely possible (and likely profitable) to arbitrage interest rates by borrowing in one market at a lower rate and lending in another at a higher rate. It's important to keep in mind the risks of the different markets, particularly those which are unique to DeFi markets such as volatile collateral prices, interest rates, and smart contract risk.
While there's theoretically no limit to the kinds of crypto assets which can be used as collateral, in practice the collateral types are limited to those supported by the DeFi lending platforms. Generally, a good collateral asset is one that appreciates and has some level of price stability against the borrowed asset.
Most DeFi loans are variable-rate. Rates are entirely set by the market, as anyone can become a lender and supply or remove available liquidity at any time. The more liquidity there is available to borrow, the lower rates become. The dynamics are very similar to traditional lending markets. During crypto bull markets, rates tend to increase as there is more demand for liquidity to make leveraged investments. During bear markets, the inverse is true.
Some markets, such as AAVE, offer fixed-rate loans. The fixed rate comes at a premium, which is a higher interest rate.
Finding the Lowest Rate
Tools such as DeFi Rate can be used to evaluate interest rates across all markets and find the lowest rate. Keep in mind that these tools are limited, and sometimes there are markets with better rates than is shown.
🤔 It might be useful if someone implemented a smart contract to automatically borrow against a given asset from the lowest-rate market, and automatically refi as rates change (the inverse of a yield aggregator).
Repayment is performed by transferring borrowed assets back into the smart contract. This is done via the lending platform UI. When funds are paid, collateral is instantly unlocked and the borrower regains full control of the collateral asset.
DeFi lending platforms have pre-defined debt-to-collateral ratios which must be maintained by the borrower. For example, a platform may specify that collateral must always be worth at least 150% of the borrowed amount. This means that if prices of the collateral asset drop and the ratio of loan to collateral value drops below 150%, some of the collateral will be automatically liquidated to maintain the allowed ratio. There is generally an additional liquidation penalty if this happens as well. It is therefore a good practice to account for market volatility and avoid unintentional liquidation by maintaining a leverage ratio which is well within the limits. In other words, borrow significantly less than the limit.
Compound has an extremely simple lending and borrowing interface. Simply lock up collateral and borrow against it. The UI shows how much is borrowed vs. the borrowing limit.
Aave is a lending market very similar to Compound. Its interface and functionality is somewhat more complex as it supports swapping as well. At the time of writing, borrowing limits are higher on Aave.
As of March 2021, Aave supports the Polygon network, so it can be used with lower fees than Compound, which is currently only on the Ethereum main chain. Just switch Metamask to the Polygon network when accessing the normal Aave UI and select the Polygon network in the UI.
Maker is a bit different than Compound and Aave in that the purpose of Maker is to enable creation of Dai, a decentralized stable coin. Instead of borrowing, collateral is staked with Maker to mint DAI, and a stability fee is paid. In effect, this is very similar to locking collateral, taking out a loan against the collateral, and paying interest.
To borrow on Maker, use the Oasis Borrow web3 app: https://oasis.app/borrow/
Liquity offers 0% loans with an up-front borrowing fee.
Self-Paying Loans: Alchemix
Alchemix is a newer, unique DeFi lending platform which offers self-paying loans. Collateral is deposited in Yearn Finance (YFI) and the interest earned from YFI is automatically applied to reduce the loan amount. Over time, more and more of the collateral is unlocked and may be withdrawn without paying back the loaned amount. Stablecoin collateral (DAI) is locked up, and 50% of the collateral may be borrowed as alUSD, which is designed to be a stable token pegged against the price of USD. Borrowed alUSD can be exchanged for DAI.
Alchemix essentially offers an advance on future yield.
Alchemix is a very innovative product which raises many interesting questions. This is a good subject for future research.
Collateralized borrowing in DeFi is a poweful tool with many unique properties and uses. Like any DeFi product, it is subject to smart contract risk. If risk is adequately managed, DeFi loans are a great way to access liquidity in a tax-efficient manner.
Good luck and have fun!