Before looking into the problem behind cryptocurrency backed loans, let us first understand how loans with government-issued money work.
By now, you must be aware that money such as USD, GBP, INR are all regulated and issued by the respective central banks of that country (this money is known as fiat money). Cryptocurrencies, on the other hand, are not issued by and are not regulated by any central bank and/or government and hence most of the people refer to the cryptocurrency and blockchain technology as a decentralized concept.
How do traditional loans work?
It’s pretty simple. You borrow a huge amount of money (by providing some security such as assets including land, house, gold, etc.) and then pay it in small installments over a period of time. This is the simplest definition. Now, at the end of the loan term, you always end up paying more than the amount that you have borrowed. There is one basic reason behind this. Someone is lending their hard-earned money to you in bulk, and you are paying back in small installments over a long period of time. In short, (s)he is investing in you. (S)He may have invested in some other place, but (s)he gave it to you. Now every investment should be associated with profit, and hence you have to pay more so that they earn a profit.
One other, very minor aspect, associated with financial institutions such as banks is the fluctuations in the value of money over the period of the loan. They take into consideration this fact and may include these fluctuations into the calculations of the interest rate. This is done such that they still make a profit even when the value of their currency declines.
How is cryptocurrency different from fiat money?
Cryptocurrencies, as earlier mentioned are decentralized, meaning, no bank or government has control over them, except you. Because of this, you can send money to anyone anywhere without the interference of any intermediary and hence this is the best example of peer-to-peer transactions.
On the other hand, fiat money always has an intermediary such as a bank. Every transaction has to go through them, and they have control over your money. They may stop your transactions, freeze your accounts and so much more. In brief, fiat money is controlled by the banks and the government.
This control of fiat money by banks and governments and the non-control of cryptocurrency has another effect – The fluctuations in the value of money. The fluctuations in the value of fiat money are not as high as compared to that of cryptocurrency.
For example, bitcoin has fallen with respect to USD by as much as -460% within the last 12 months, which when compared to INR and the Euro is 12% and -4% respectively within the same period. Hence, most people refer to cryptocurrency as volatile and unstable.
How do cryptocurrency backed loans work?
The asset against which you are given a loan is cryptocurrency only. You have to submit your coins against which you will be given an amount. It is this simple and works exactly the same as a traditional loan.
So what’s the difference in the traditional loan and cryptocurrency backed loan?
For a traditional loan, you will have to go to a bank or a financial institution. You have all the drawbacks associated with a bank and fiat money that, since the banks and governments control the money. The bank takes numerous days to process the loan which is associated with the processing fee of the loan. However, the plus point is that there are fewer fluctuations in the value of money.
In case of cryptocurrency backed loans, you don’t have to deal with banks and all the information is just transparent. You just apply for a loan to a facilitator, submit your coins and voila, your loan is approved and fiat money is swiftly transferred to your bank account.
So if cryptocurrency backed loans are so easy, what is holding them back?
- Cryptocurrency is a new concept and is yet to become a mainstream currency. Many people consider it just as an investment rather than a form of tender. Hence, in the majority part of the world, you will not find kiosks or vendors that accept cryptocurrencies.
- Government regulations, like in India, make it difficult to deal and carry out transactions with cryptocurrency.
- There are not many banks and facilitators who provide cryptocurrency backed loans.
- The major reason, for people not borrowing cryptocurrency-backed loans, is because of the extreme volatility in the market. This makes it difficult for even the lenders to lend money in exchange for cryptocurrencies.
It’s hard to find a solution to this problem as government regulations differ from country to country. But if you have a facilitator near you, you can seek short-term loans. These will not harm you, neither harm the lender, as the fluctuations for a small period can be considered small.