Both cryptocurrency and traditional financial tools are finally merging with crypto-backed fiat loans; crypto-traders have the tricky task of navigating the markets, spend parts of their gains and yet remain fully invested.
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Whilst the cryptocurrency and blockchain industry continues to disrupt the finance industry, crypto-backed loans are still subject to significant challenges, most notably market volatility; imagine taking out a loan using your crypto as collateral but the value of that crypto used as collateral begins to drop.
It’s not a pretty sight for the borrower or lender; for example, a fiat loan of $50,000 could require $125,000 worth of cryptocurrency to back it, and should that crypto value drop below $75,000 for example, a margin call will force the borrower to either increase the collateral or reduce the loan.
It requires a fair amount of risky plate spinning and for the trader seeking a fiat loan, these market dips pose a serious risk to their short and long-term goals, however, it doesn’t quite have to be this way.
Companies are emerging in this space but their loan structures don’t appeal to traders and collectively, these companies have originated less than $100 million of loans. Because borrowers must always be prepared to top-up their collateral, lenders must chance the risk that a margin call does not happen, causing the loan to no longer be covered by the collateral and this keeps the market shallow, with borrowers and lenders unwilling to participate.
Deribit, a cryptocurrency futures and options trading platform has observed these faults in the market and have identified a remedy. Derivatives, and more specifically put options, are a practical solution to this problem.
Put options are insurance contracts and they can be utilized to ensure the collateral, therefore its value will never drop below the value of the loan, making it possible that the borrower can always repay, and the lender is always repaid.
How it works, In Figures
– A $50,000 loan maturing on 28th of December 2018, yielding a 14% interest rate can be insured by the lender by utilizing Deribit put options.
– Taking out insurance requires a premium to be paid; as of July 13th 2018, the premium for relevant put options maturing December 28th 2018 was $1,499.
– Total interest paid by the borrower amounts to $3,202, after the cost of the put option, the lender has an almost risk free $1,672 worth of interest margin.
– This interest margin is 3.3% over this period, or, 7.2% on an annual basis.
Put options benefit the borrower primarily as their margin call risk is now minimalized and a loan repayment is practically guaranteed. Even if the collateral value hits zero, the borrower does not have to pay extra cash to repay this loan.
Deribit has very effectively created an option for traders who are seeking to increase capital, it also grants lenders the security they seek to enter the market themselves; Deribit, one of the most liquid crypto exchanges has granted the crypto-backed lending market a boost in trust and security.