Where’s the Liquidity? Crypto Lending Explained

Celsius’ recent pause on withdrawals, swaps and transfers has left many asking: How does crypto lending really work?


crypto lending


key takeaways

  • Crypto lenders offer yields on crypto deposits, such as stablecoins, by lending them on interest — similar to traditional banking practices
  • Crypto lending platforms are divided into two major categories: noncustodial (decentralized) and custodial (centralized)

On June 13, 2022, Celsius investors woke up to an alarming statement from the crypto lending platform: “Celsius is pausing all withdrawals, swap, and transfers between accounts.”

For a platform that prides itself on its high returns without the problems of traditional finance, it left many asking, “How does crypto lending really work, and where did all the liquidity go?”

What is crypto lending, and how does it work?

Let’s start with the basics. On the face of it, crypto lending works the same as traditional banking, but for digital assets. Crypto lenders offer yields on crypto deposits, such as stablecoins, by lending them on interest. The key distinction is in the type of deposit and the type of lender.  

There are two very different categories of crypto lending platforms: noncustodial (decentralized) and custodial (centralized). Noncustodial is a new approach, whereas custodial lending uses the traditional model with slight variation. Celsius is an example of the latter. To understand why problems crop up in the custodial lending model, we need to explain the differences in liquidity sourcing and collateralization requirements.   

The categories of crypto loans explained  

Custodial (centralized) crypto lending

Custodial crypto lending looks and feels like a bank for cryptocurrencies — without the same regulatory oversight and consumer protections. It manages all deposits and loans on a centralized platform and internal balance sheet. Anyone who wishes to earn interest on their crypto savings sends their tokens to a custodial wallet address where they lose direct control of the asset. In return, the platform invests the assets at their discretion — whether through lending at interest or alternative yield farming.

Noncustodial (decentralized) crypto lending

A noncustodial lending platform enables decentralized peer-to-peer or peer-to-pool lending. Unlike its traditional counterpart, it allows depositors (lenders) to maintain ownership of their tokens — and the source of yield is clear. Lenders earn interest and borrowers pay interest. Platforms can automate functions traditionally managed by banks or custodians using blockchain smart contracts.     

Crypto liquidity defined

Crypto liquidity, like in traditional markets, is the efficiency with which any digital asset can be converted into cash or token equivalent — without affecting the market price. Think of total asset liquidity as a pool of water, and asset price as the water level. The larger the pool, the slower the level changes.

Equity markets traditionally measure liquidity in cash, but crypto markets measure it across an ever-growing list of token pairs. This web can be hard to follow, but doing so is critical to understanding how crypto lending platforms maintain liquidity.

Where and how crypto lending platforms source liquidity 

Noncustodial (decentralized) crypto lending

Decentralized crypto lenders, such as Aave, source liquidity through a network of different liquidity pools. So instead of lenders and borrowers setting the terms of their peer-to-peer loans, the protocol works by using automated smart contracts to set the interest rates of each pool. 

Aave’s liquidity pool protocol aims to incentivize outside lenders to keep the pools liquid and borrowing functional. 

For example, if an ether (ETH) pool is low in liquidity, then these smart contracts will automatically increase the interest rates to attract lenders to that pool and encourage borrowers to repay their loans. When lenders add ETH, they receive Aave’s token equivalent in the form of aETH. This asset is different from a wrapped token because there is no central custodian. Smart contracts hold ETH deposits and automatically reward the lender with loan interest. 

Custodial crypto (centralized) lending

In contrast, centralized crypto lenders such as Celsius source liquidity from their centrally controlled pool of total deposits. They manage interest rates and approve loans on a case-by-case basis. Unlike decentralized noncustodial lenders, centralized lenders return yields from various sources outside of interest payments. For example, Celsius invests customer deposits in something called liquid staking. 

Liquid staking (stETH) 

Because staking ETH on Ethereum’s Beacon Chain locks the ETH until a future date — not yet fixed but expected to be mid-2023 — after the Merge, Lido Finance offers stETH, a liquid derivative for ETH holders interested in staking rewards. The token allows holders to accrue staking rewards but maintain flexibility to sell or transfer the asset. If they exchange the token with someone else, the new owner can claim future staking rewards. Nansen Research reported that Celsius owns a wallet holding over $450 million in stETH.

Differences in crypto lending collateral requirements

Crypto collateral is a borrower’s pledge of tokenized assets or currency to a lender — in the case they cannot repay their loan. The borrower retains ownership of collateral as long as the loan is paid back with interest. 

Traditional banking typically requires a small fraction of the loan as collateral and utilizes borrower credit scores to gauge lending risks. Because crypto lending prides itself on providing fast credit with no minimum credit score, it requires liquid collateral so that it can automate liquidations. So instead of using your house as collateral, you would need to use stablecoins, or other cryptoassets — although perhaps in the future, it will be easier for anyone to tokenize property. Because crypto markets are exceptionally volatile, lenders require a lower loan-to-value (LTV) ratio (not to be confused with total value locked, or TVL).

I know, it’s a lot to take in — so let’s review:

LTV — A loan-to-value ratio is the proportion of a loan’s value represented by the collateral. A 100% LTV ratio is a 1:1 ratio, meaning the borrower puts up the full value of the loan as collateral. 

TVL — Total value locked is the total value of cryptocurrency locked in a smart contract and represents the health and liquidity of any decentralized exchange or crypto lending protocol.

Both crypto lending categories require high LTV, but they differ in how they measure, report and force liquidations.  

Custodial crypto (centralized) lending

Centralized lending can use a variety of methods to monitor LTV. If a borrower’s LTV drops below the safety threshold, the centralized lender will warn the borrower that a portion of their collateral is at risk of liquidation through a margin call. If the value continues to drop, the lender will automatically trigger a partial or total liquidation of the borrower’s collateral.

But with centralized lending, this collateral requirement doesn’t directly protect depositors. Because centralized lenders shuffle deposits between various investments like stETH and stablecoins such as Tether (USDT), depositors have little insight into the total liquidity available on a centralized platform.

Celsius’ announcement suspending withdrawals on Jun. 13, 2022, increased selling pressure on stETH, pushing the price further below the price of ETH. Many speculated that this divergence is what prompted Celsius to freeze accounts. But because their total liquidity value isn’t public, there is no way of evaluating what triggered the fear. 

Noncustodial (decentralized) crypto lending

Decentralized lending, on the other hand, is fully transparent. Any liquidity provider can look up a platform’s TVL to measure total liquidity and overall health. There are no alarming tweets signaling that the core team suspended withdrawals. There are oracle pricing and smart contract risks, but decentralized lending, in principle, isn’t exposed to the risks of a centralized custodian.

For example, when a lender deposits ETH into an Aave ETH liquidity pool, smart contracts make the liquidity exclusively available for ETH borrowers. No central entity can scoop up the deposit and gamble with it off-chain. 

Blockchain price oracles constantly monitor the LTV ratios of each borrower so that if there is a risk of default, the protocol automatically liquidates the collateral to protect the lender. 

Crypto Lending Liquidity Risks

Both lending categories contain liquidity risks. In decentralized lending, price oracles can fail during market-wide liquidity crunches — exposing liquidation to price slippage and causing lenders to recoup only a portion of their deposit. And in centralized lending, central actors can invest customer deposits on leverage with the risk of draining too much liquidity from the platform. 

In fact, the liquidity problems of one side of the crypto lending world will often hurt the other. This contagion results from a complex interplay between wrapped tokens, staked ETH and stablecoins on decentralized exchanges such as Curve Finance.  

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This article was corrected to say ‘lenders require a lower loan-to-value (LTV) ratio’ instead of a higher LTV. In DeFi, lower LTV signifies stricter collateral requirements.

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