Neither lenders nor borrowers look forward to liquidations, but this less than ideal scenario may just be the key to saving the global market.
It’s rare to think about collective concepts when it comes to lending. Fiduciary discussions often take a more binary stance. Where only the interests of the lender and the borrower themselves seem to matter.
Looking more towards the individual benefit, rather than the health of the market as a whole. But crypto lenders are now finding themselves having to expand that historic purview. Instead of just looking out for their own bottom line, they’re having to make tough choices in order to protect an entire economic infrastructure.
While liquidations are obviously devastating to bitcoin owners and lenders alike- what these liquidations can offer the market as a whole, future lenders and borrowers, is worth the pain of loss. Earlier this year, the crypto market saw a massive crash due largely to the economic strain that the novel coronavirus presented. While it was devastating to many, it afforded the crypto market something it was in dire need of- a stress test.
This recent test has served to reinforce the concept that bitcoin and cryptomarkets are indeed necessary and enduring, akin to the fiat markets they are in direct competition with. Not only that, but it taught users of cryptocurrencies a good many lessons about how the market works in its totality.
To understand the trade implications of this dip, turn toward your exchange. If you use services like Bitvavo, you’ll have access to entry-level information that will explain this far better and in more detail from a trading perspective. From a borrowing point of view, this crash brought into stark contrast to why dealing with responsible exchange platforms is the only way to go.
What is Crypto Lending?
Crypto lending isn’t really all that dissimilar from traditional lending practices: the lender gives people crypto and earns crypto in return from the interest on the collateral that is given as well as the loan repayments themselves. The real difference between crypto lending and traditional lending is two-fold, one- crypto lending deals entirely in crypto assets; and two, crypto lending is decentralized and doesn’t rely on credit scores.
Instead, clients deposit crypto assets to the lender as collateral. Once sufficient collateral is received, the client is supplied with a loan. Collateral based loans allow for individuals with poor or no credit to be eligible for lending assistance, creating a great divide between crypto lending and traditional lending practices.
This means that a borrower can use pre-existing or newly purchased crypto assets to secure a fiat or stablecoin loan. With crypto lending, the reverse can also be true, as borrowers can use fiat or stablecoins to get a loan of crypto assets. Whatever the borrower uses as collateral, lenders will “lock up” the collateral as crypto assets. Pumping up the market.
This lock up of crypto assets serves to increase the usefulness of whatever the lender is lending. Making the cryptocurrency, stablecoin, or fiat more useful by going toward a user who will actually be using it, pumping it back into the market as they use their loan capital to create something new, at the same time it all becomes crypto assets in the end, further propelling the cryptocurrency market of the lender. Becoming a massive win-win for the market itself, as it provides a novel option of how to use that crypto (instead of just trading or holding).
The crypto lending services then collect any interest made off of the client’s idle crypto asset accounts that are held by that lender. Increasing the net gains of the lender while giving them more capital to loan.
All crypto lenders worth their salt will be using these gains to finance further crypto loans. Ensuring transparency about this type of asset protection is very important when selecting a lender. In fact, responsible lenders serve to stabilize a historically unstable market, all by putting standard “HODL” coins back to work. Pushing for continued adoption and use of any given coin or token.
Why Do Liquidations Matter?
Because of this scheme, where lenders use the interest from held crypto assets to fund further loans- it becomes the modus operandi of the responsible crypto lender to protect both the borrower and the interest earned. Because as we’ve said above, a working market is a healthy market.
In this paradigm, lenders are loath to liquidate assets, as it shrinks the foundation of their lending parameters. Which chips away at the very idea of what keeps crypto lending sustainable- the cyclic, lend, earn, loan scheme. However, the lending institutions have a responsibility to their entire customer base and the wider market. Should the market dip, liquidations must occur to protect the infrastructure of the business and borrowers.
Responsible crypto lenders will tell their clients at what point in a market drop liquidations must occur. While liquidation isn’t the only plausible response to a massive drop in the market; many crypto lenders will offer their clients the ability to pay off a portion of their loan, or add more assets as collateral to make up for the dip- prior to liquidations. But should these contingencies not be available to the borrower, the lender must liquidate.
Why?
Should lenders not engage in liquidations, there is little to no incentive for a borrower to maintain their payment scheme or refresh their assets in the time of a severe downturn. This is where liquidations become so important and wildly necessary within the network. They keep the entire crypto lending infrastructure from becoming obsolete in a downturn. Liquidations becoming the insurance policy against non-payment. So while no one actually ever hopes to require a liquidation, it’s pretty encouraging to know that the liquidations will happen should the need arise, helping to ensure stability.
The Interconnectedness of the Market
Because of the way that lenders interact with assets, and assets then interact with the wider markets, either through innovation or continued borrowing- one can easily see how the entire framework of crypto lending is so closely tied to the health of the blockchain community and vitality of overall market values.
In the traditional market, while they behave similarly, should the market completely implode (a la 2018), governments are generally ready with bailout money in hand. Essentially obliterating the need for liquidations. This is because these large institutions realize that a healthy market base is the cornerstone of a wider economy (much like that of the crypto scheme). Should one system fail, the entire machine could falter. The only way in which crypto markets differ in this respect is that it’s incredibly unlikely that governments will be jumping in to bail out crypto anytime soon. But this reality doesn’t make a healthy crypto market any less important to an economy.
This means that market stability and health are left the sole responsibility of network users. To include lenders, borrowers, and literally everyone else. Showing once again that the difficult, yet responsible actions of a fair few can serve to protect entire communities