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Introduction
A crypto loan refers to any loan involving cryptocurrency assets. Most crypto loans are collateralized, meaning the borrower must provide cryptocurrency as collateral to secure the loan. This is typically known as a crypto-backed loan. However, a few lending platforms have started to offer crypto loans without collateral. This seemingly unconventional approach has been gaining some adoption within the ecosystem. This article intends to explore non-collateralized crypto lending in-depth, examining its advantages, risks, and various alternatives.
Related Content: Why Take a Loan Against Your Crypto
How do Crypto Loans without Collateral work?
A crypto loan without collateral is simply when a borrower receives crypto without pledging any assets. In other words, the borrower doesn’t put up any collateral to secure a loan. This type of loan is also known as an unsecured or non-collateralized loan. The majority of crypto lenders shy away from providing unsecured loans due to the higher risk and the challenges in underwriting them.
The most common type of non-collateralized crypto loan is a so called flash loan.
What is a Crypto Flash Loan and How Does It Work?
This is a type of loan in the decentralized finance (DeFi) ecosystem that leverages smart contracts to allow users to borrow assets without the need for collateral or a credit score. What makes these loans unique is that borrowed assets have to be paid back within the same blockchain transaction block. If not, the entire blockchain transaction will be reversed. It’s often used to exploit vulnerabilities in smart contracts
To initiate a loan, the borrower must create a smart contract consisting of three key components:
Borrow: This component initiates the flash loan and specifies the amount to be borrowed from a lending protocol.
External interactions: This part of the smart contract contains the interactions with other smart contracts and DeFi platforms.
Repayment: Lastly, the smart contract needs to show how the borrowed funds (along with a transaction fee) will be repaid to the lending protocol within the same transaction.
Flash loans are primarily used for arbitrage, where borrowed capital is used to profit from market inefficiencies. It can also be used to facilitate collateral swaps, which quickly replaces the collateral used for a DeFi loan.
Benefits of Flash Loans
Flash loans have gained some traction in the DeFi ecosystem since they allow borrowers to take advantage of market inefficiencies and quickly execute transactions without the time and complexities required for a traditional loan. The main benefits are the following:
Low Friction: Instant access to assets without using collateral or a credit score
Arbitrage: Enables people to seamlessly take advantage of arbitrage opportunities
Risks and Drawbacks of Flash Loans
As with any DeFi application, flash loans have several key risks. The two biggest ones are:
Expertise: In order to leverage flash loans, you need enough expertise to write the smart contract responsible for taking a flash loan and successfully using the borrowed funds.
Gas Fees: Flash loans often incur significant gas fees on a blockchain network since it involves multiple smart contract interactions.
Narrow use cases: Flash loans serve a very niche set of use cases because they need to be repaid within the same blockchain transaction block. You can’t use these for anything in the real world, like paying down debt or financing a big purchase.
Where Can You Get A Crypto Loan With No Collateral?
Several crypto lending platforms, primarily within the DeFi ecosystem, offer loans without requiring collateral. Among these, the most prominent platforms include:
Aave: As one of the oldest and largest DeFi lenders, they specialize in over-collateralized loans and also provide flash loans.
Uniswap: Leading decentralized exchange (DEX) that allows users to access flash loans.
Equalizer Finance: Dedicated platform for flash loans on many different blockchains such as Ethereum, Binance Smart Chain, and others.
What is the Role of Collateral in Crypto Lending?
Crypto lenders often require over-collateralization as a risk management strategy, requiring that the value of collateral surpass the borrowed funds. In instances where the value of the collateral drops significantly, borrowers are required to add additional collateral to avoid liquidation. If the borrower fails to do so, the lender will sell the borrower’s collateral to recoup their funds.
While over-collateralization is the norm, you might be able to find a lender providing under-collateralized loans. Under-collateralized loans can be appealing for some borrowers due to the reduced upfront collateral requirements. However, it typically has higher interest rates since it’s riskier for lenders compared to over-collateralized loans.
Why Do Most Crypto Loans Require Collateral?
The majority of cryptocurrency loans are secured by crypto collateral. The reason for this is two-fold:
Safeguard for lenders: The collateral offers a tangible recourse in the event of borrower default. Should a borrower fail to repay, the lender has the authority to liquidate the provided collateral.
Lower interest rate for borrowers: Collateral not only reduces the risks for lenders but also serves as the basis for lower interest rates. In the event of borrower default, the lender can sell the collateral to recoup their funds, creating a safety net that enables them to offer more competitive interest rates.
Arch’s Solution
Non-collateralized crypto loans serve a very specific purpose. However, if this doesn’t meet your needs, Arch's crypto-backed loans is an excellent alternative. Arch offers over-collateralized loans in fiat or crypto against your Bitcoin, Ethereum, and other cryptocurrencies.
At Arch, we recognize the responsibility that comes with managing your assets. That is why we never rehypothecate any collateral. Arch holds all customer assets on a one-to-one basis and does not lend them out to others. You can have peace of mind knowing that your assets will remain securely held in leading qualified custodians which protect your assets in the event of insolvency or bankruptcy.
If you want to learn more about crypto-backed loans through Arch, please book a call with our team here. If you’re ready to get started, sign up here.