The idea of using cryptocurrencies as collateral for loans is not a new one, and it has actually been around for some time now. A lot of experts believe that using crypto-backed loans might have a strong impact on the market. While there were several companies, exchanges, and credit card firms that have attempted to enter the crypto space and establish themselves, none of them has managed to dominate the markets.

However, the idea of crypto-backed loans did not go away, and there were multiple ICOs that presented the idea. They even managed to raise decent amounts of money for it, with several of them becoming stable companies. Others found a solution in Ethereum's smart contracts, which are now being used for decentralized lending.

Even so, none of these services managed to become big in the world of lending. There are many obstacles to establishing this type of business. But, experts believe that a major player will emerge sooner or later and that cryptocurrency-backed loans will change the space for users and investors alike. Some ways that a service like that will change the space is by increasing market liquidity, decreasing the costs of transactions, making the process of obtaining crypto easier, and more.

Cryptocurrencies that are most likely to be used for money lending businesses are Bitcoin, Ethereum, and XRP, which are the three largest coins by market cap right now. Loans like this would work through utilization of a deposit of one of these cryptos (or another big altcoin) as collateral.

Before they receive a loan, a borrower would be assessed for creditworthiness, which can be determined through various details about them, including online activity, demographic data, and alike. By calculating creditworthiness, the lender will also be able to determine the interest rate on the loan, as well as the ratio of collateral that will be used.

After this, borrowers would deposit their cryptocurrency, and receive a part of its value in another asset, such as fiat currency. A loan can be P2P or a conventional institutional loan, and its nature will depend on the nature of issuer — whether the issuer is an organization or an individual.

Taxes which are under the GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) are a problem for a lot of cryptocurrency users. Because of them, all transactions such as exchanging coins, using them as a method of payment for services or goods are triggering capital losses and gains. Tax on short-term capital gains is around 30% in the US, with a lot of other countries having just as high capital gains taxes.

However, if an intermediary lender is used for obtaining the money, these taxes can be prevented. In other words, borrowing fiat currencies while backing them with crypto, and then making purchases with fiat will not be included in capital gains and losses. Instead, users can spend the money and wait for long-term capital gains to be applied to their holdings. This will happen if cryptos are being held for over a year, and the tax is at around 10%.

Apart from helping out with taxes, using crypto-backed loans is margin trading. This is a situation where funds are being borrowed against certain financial assets (stocks, cryptocurrencies) in order to use the market movement to increase gains or losses. This can be done on numerous bigger exchanges already.

The potential downside of this is that terms of service might be very strict and not as friendly. Collateral requirements often end up being very high in these situations, the reliability of the service is questionable, and the interest rates can be quite extreme. The only way to reduce interest rates or collateral requirements would be for a competitive market to exist, which is currently not the case.

Finally, there is the last great benefit, which is the easing of the trading friction, which is something that happens when exchanging one coin for another becomes difficult for some reason. Reasons for this may vary and can include limited liquidity, a dramatic difference in cost between the assets, and alike.

The usual practice for avoiding such issues is to use an altcoin for buying Bitcoin or Ethereum, and then trade this for another altcoin. Of course, these exchanges also come with their own costs, which makes them a less-than-favorable solution.

The trading friction can, instead, be reduced by using a lending service. This has caught the attention of several large players in the crypto market, who are already exploring different possibilities of this method. Through crypto-backed loans, users will be able to borrow one crypto against another. As an example, they can use BTC as collateral in order to actually borrow Ethereum. As a consequence, the liquidity of the markets would increase, while transaction friction would decrease.

Crypto-backed loans offer many different conveniences, as explained earlier. However, it is important to remember that they do come with a fair share of risks, as well.

One of the biggest issue with cryptocurrencies is their high volatility. Whenever prices change dramatically, the possibility of a margin call exists. Simply put, a margin call is something that occurs when the value of an asset used as a collateral drops. At this point, the lender usually requires more to be added to collateral. Another option is for the lender to sell the existing collateral and cover all potential losses.

Considering that the borrower chose not to sell the assets, and instead just deposits them for a while, it is clear how this solution is a bad one for them.

Scams are nothing new in the crypto world, which is not that surprising. Cryptos are a new form of money, that lacks regulations, stability, support or protection from a centralized authority, and as such, they attract a lot of scammers.

Recent reports from China claim that between one-third and one-fourth of all crypto-backed lending platforms in this country are scams and Ponzi schemes. Naturally, this is not only limited to platforms in China, and the situation regarding cryptocurrencies is more or less equal in most parts of the world. Scammers would often try to operate in gray areas so that they can scam people out of their money while not actually breaking the law.

They try to take advantage of cryptocurrencies, lack of regulations, their decentralized nature, and alike. While scammers are known to start entire companies in order to scam people, these firms often go out of business. However, the damage is already done by the time this happens, and scammed users are the ones who have to suffer the consequences.

The industry is also at risk due to regulators themselves. Most major markets are still being regulated, which means that changes can happen at any time. This can seriously endanger lending firms and their current deals. While regulations are highly necessary, most people agree that this situation is anything but fair to all parties involved.

In general, crypto lending has a large potential to impact both, the market, and the lending industry. Advantages of this type of money lending are many, but there are also risks that borrowers should keep in mind. Experts believe that this will grow to be a large industry in the future, but a lot needs to happen in order for their predictions to come true.

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