Why Do People Borrow Using Constant P2P Lending?

I like to dabble in different types of investments, and as a consequence of this I have small amounts of “play money” (that is, money I can afford to completely lose) in almost all the different categories of investment available to someone who isn’t an accredited investor. One of the first investments I tried (and still use, through LendingClub) was peer-to-peer (P2P) lending, largely because it’s so simple to understand. The idea behind it is that people who need a loan (e.g., to pay off credit card debt) borrow money directly from other individuals. The borrowers get loans for situations they normally couldn’t (or they get better rates), and the lenders get better returns than they would for the debt investing normally available to them.

The biggest problem with P2P lending as an investor is that when a borrower defaults, you lose the money you had lent them. This risk is partially addressed by the interest rates being higher for riskier borrowers. You can also spread your lending over as many borrowers as possible so that you don’t take a big loss when a single one defaults. To give an idea of typical default rates at LendingClub, the interest rates on most of my loans are around 12%, but my effective rate of return has bounced between 6–8% (suggesting a ~5% default rate). These are solid returns, but I’m getting a bit less than 6% right now, and my returns could go much lower (maybe even becoming negative) as the pandemic-induced recession affects more people.

Cryptocurrency-Backed P2P Lending

A different type of P2P lending has been advertised to me for a while now that removes this risk — P2P lending where the loans are backed by cryptocurrencies. In this case, borrowers must put up some cryptocurrency as collateral in order to procure their loan. The advantage for the lender is that they don’t completely lose out when a borrower defaults. Instead, the borrower’s collateral is liquidated and used to pay back the lender. The collateral is also liquidated if its value falls too close to the loan value, to ensure that lender will be repaid. The advantage for the borrower is that they can secure much lower interest rates by putting up the collateral.

Asset-backed loans aren’t new (two of the biggest categories of debt for individuals are asset-backed: mortgages and car loans), but the novelty behind crypto-backed loans are that they can be handled by “smart contracts” (programs that run automatically based on preset rules). With smart contracts, the lender doesn’t need to have any trust in the borrower. Once the collateral is locked up in the smart contract, the only way the borrower can recover their crypto is to pay off the loan.

Constant, the crypto-backed P2P lending service I learned of, offers lenders 7% returns. This is a great rate (higher than I’m getting from my traditional P2P lending at present), but it’s even more impressive because it’s essentially risk-free. I can only think of 3 reasons why you might lose money with a crypto-backed loan, and they’re all much more dramatic (so hopefully less likely) than borrower defaults.

  1. The business isn’t legit. If Constant’s owners decide to take the money and run (like the cryptocurrency exchanges of yore), then you would lose any money you put into it. I don’t think this is likely because the owners would be risking jail time and a lot of general unpleasantness.
  2. Crypto value crashes too fast to be liquidated. The collateral is liquidated when its value drops to 110% of the loan value. If crypto markets crash so fast that the collateral value drops from 110% to less than 100% before it can be sold, then the liquidation wouldn’t actually cover your loan. I don’t think this is likely because as volatile as crypto is, flash crashes are still few and far between.
  3. Your account gets hacked. Since money can be taken out of a Constant account in the form of crypto, you don’t have the same fraud protection as with most financial institutions. But as long as you use 2 factor authentication, it is very difficult for someone else to get into your account.

For a long time, I didn’t bother with Constant because I assumed there was no market for it. Who would want to pay 7% interest when they already had enough money for whatever they wanted to buy (they would just need to sell their crypto)? However, the promise of 7% returns risk-free was enough to finally get me to try it, and to my surprise they originate $100k+ in loans daily, and all my loans have been filled the same day.

Note: since I wrote this, Constant switched to a lending pool model. Basically, rather than individual lenders matching directly with individual borrowers, lenders pay into a pool that borrowers draw from. It doesn't really change the mechanics of being a lender except that now loans are filled instantly and if you can get slightly better rates for longer loan terms (7% on 1 month up to 7.5% on 6 months).

My initial concern was unfounded, and borrowers are really using this service. But that still leaves the question: why take a loan rather than just selling your crypto?

Potential Uses for Crypto-Backed Loans

The classic loan use cases (home improvement, large purchase, etc.) make even less sense when you look at the details of how Constant’s loans work. First, they are paid back in a lump sum at the end of the term, rather than in monthly installments like most personal loans. This means repayment won’t feel very manageable/affordable for someone who needs to take out a loan for a big chunk of cash in the first place. Second, the terms are short: the most common loan term is 30 days, and as far as I can tell no loans are for longer than a year. If you can save up enough money to pay back a loan in a couple months, it really begs the question: why not just wait for a couple months instead of taking out a loan?

While Constant makes basically no sense for classic loan uses, I have come up with some potential reasons borrowers might have.

1. Leverage to buy more Crypto

I suspect the main reason people borrow through Constant is to get leverage on their crypto (similar to margin trading, if you’re familiar with that). Basically, they’re making a bet that crypto prices will go up, and they’re confident enough about this that they’re willing to stake the crypto they already have on this bet.

How exactly does this work? Suppose you’re convinced the price of Bitcoin will rise substantially this month. You already own $15k in Bitcoin, but you want more and don’t have the cash for it. With Constant, you can take out a $10k loan by putting up your $15k in Bitcoin (they require 150% loan value as collateral), and buy more Bitcoin, so you now have $25k in Bitcoin. If the price increases by 20%, at the end of the month you’ll have $30k in Bitcoin, and after paying back the $10k loan you’ll have $20k in Bitcoin (it would actually be a bit lower because of interest and fees, but this is roughly the right amount). If you instead had just held on to your original $15k in Bitcoin, it would now be worth $18k. So through the leverage afforded by Constant, you gained an extra $2k.

Of course, this comes with a big risk. Suppose the value of Bitcoin dropped by 20% instead. If you had just held on to your original Bitcoin, it would now be worth $12k. But with leverage, the $25k of Bitcoin would drop to $20k, and you’re still on the hook for $10k, so after paying back the loan you would have $10k — an extra $2k in losses.

2. Avoiding Fees/Waits

Another thought I had is that borrowers might use Constant to avoid the fees and waits associated with exchanges. After doing a tiny bit of digging, I no longer think this is a valid use case, but the reasons why are relevant to the last potential use case so I’ll still discuss this one.

Here was my thought: it typically costs a ~3% fee to convert crypto to fiat on exchanges, and it might take a few days to get your fiat cash out. A 30 day loan on Constant has a smaller fee (1% origination + 7/12=0.58% interest) than that, and you can withdraw the fiat as soon as your collateral is posted. If you intended to default on the loan, this might still look like a better option than selling.

However, a few details rule this reason out. First, there is a 10% late repayment fee, so if you’re aiming to default then the fee goes from ~1.6% to ~11.6%, which is a steep price to pay to get your money a little faster. Second, from what I can tell, if you default Constant keeps all your collateral, they don’t return the excess value. This would turn a ~10% fee into potentially a 50% fee. Because of the fee structure behind defaults, this use case seems very unlikely.

3. Avoiding tax burden

The final reason I came up with seems possible, but I think it’s unlikely to make up a large portion of the loans. If someone wants to sell their crypto holdings, they’ll need to pay capital gains tax on it. Assuming they’ve held their crypto for a long time, they’d be on the hook to pay almost 20% of the crypto’s value in taxes.

I’m not familiar enough with the details to know if this is true, but it seems plausible to me that taking out a loan has no tax load, even if you don’t pay it back and it gets covered by your collateral. So in this case, a ~10% late repayment fee would be less than the ~20% tax rate associated with just selling, and the borrower would come out ahead.

However, this assumes that the collateral value has dropped down to 110% of the loan value, otherwise the borrower loses more from the excess collateral value than they would from taxes. So in a sense this would depend on them betting that their crypto’s value will drop ~30% over the course of the loan (from 150% loan value to 110% loan value), in which case they’d be better off selling while the crypto value is still high. Maybe this could be mitigated by purchasing a variety of options on crypto, but I haven’t thought of a straightforward way to guarantee that you come out ahead. Overall, it’s quite a convoluted way to try to pay 10% tax instead of 20%, but I wouldn’t completely rule it out because I’m sure people have done more to avoid less.

The bottom line

The only reasonable use case I can come up with for using Constant as a borrower is for leverage, and it doesn’t seem far-fetched that this is what borrowers are doing. After all, if they bought crypto in the first place, it’s clear that they have a big appetite for risk. But from the perspective of a lender, it doesn’t really matter what the borrowers are doing with the money. The loans are essentially risk-free, and there’s enough demand for them to fill all the loans I would make.

For now I will continue to dabble in Constant, but it’s possible that as I grow more confident in the company that I’ll move a significant chunk of my savings there. If it’s as risk-free as it seems, it’s a much more lucrative place to park my money than a savings account or treasury bonds.

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