Lenders need to understand the legalities surrounding cryptocurrency lending in order to assess whether or not they should lend.
Legal issues surrounding crypto assets involve establishing security rights over them, protecting against market volatility, and devising mechanisms and processes to respond to blockchain related changes during collateralization.
Collateral
Collateral is an asset a borrower pledges as security for a loan in case they default, such as real property (such as their house), marketable securities such as stocks or bonds or personal guarantees.
Cryptocurrency is an innovative asset class that can serve as collateral for loans. But using cryptocurrency as collateral comes with certain risks associated with cybersecurity risks, liquidity concerns and its technical complexity.
Cybersecurity risks involve hacking and theft that could impact collateral held by borrowers, forcing lenders to establish clear contractual and practical protections against these risks in order to enforce their security interests in case of default. Lenders should also have clear procedures in place for verifying ownership of cryptocurrency wallets as well as accessing them which should be included within their loan agreements; in addition, price volatility of cryptocurrencies makes them unsuitable as collateral assets.
Due Diligence
Due diligence is an integral component of many professional endeavors, such as mergers and acquisitions. It involves gathering and analyzing information in order to make informed decisions and minimize risks; for example, reviewing a target company’s fiscal history and records.
Cryptocurrency lending platforms typically conduct due diligence on all of their users and third-parties, taking into account factors like background, associations and business purpose of individuals they engage. They may also perform sanctions checks against any exposed parties (PEP) as well as identify financial crime risk such as money laundering and terrorist financing.
Cryptocurrency loans typically take the form of collateralized loans, where users’ cryptocurrency holdings act as security for the loan and can then be liquidated to recover it through liquidation. Some platforms require overcollateralization as an insurance against losses for lenders. They may also use valuation systems to monitor value changes over time so as to identify when there may be risk of default on a loan agreement.
Security Interests
Crypto lending platforms enable users to monetize digital assets without selling or disposing of them, by taking out loans against them without selling or disposing of them. The type of cryptocurrency (protocol token, application token, stablecoin or non-fungible token) determines how a loan transaction will be structured – including tax considerations and transfer limits as well as compliance requirements that must be adhered to under investment company or securities regulations.
Parties involved will need to determine how a lender can protect itself against material fluctuations in crypto collateral during a loan term, and devise appropriate mechanisms and processes for demanding additional collateral from borrowers as necessary. Furthermore, lenders will need to understand which rights a borrower holds in terms of placing crypto into custody with limited or no access for management yielding revenues as is often the case.
Taxes
U.S. taxpayers typically do not owe taxes when taking out crypto loans; however, it’s still wise to understand their tax implications prior to signing on for one. For example, using cryptocurrency that has appreciated in value as collateral could trigger capital gains taxes upon liquidation; therefore it’s vitally important that repayment occurs promptly so your collateral doesn’t get sold at auction and liquidated.
If you borrow funds for investment purposes – like yield farming – their interest can also be deducted on your tax return. While the IRS has yet to issue more specific crypto loan tax guidelines, keeping a detailed record of your transactions and keeping informed on regulations will allow you to manage them effectively and using a solution like Koinly will make this process even simpler.
