Can You Borrow Crypto Without Collateral?

Explaining collateral in traditional finance and decentralized finance - how to lend and borrow in crypto without collateral.

Filip Dimkovski
By Filip Dimkovski
Joel Taylor
Edited by Joel Taylor

Published April 30, 2022.

Ever since money & currency have been a thing, loans & borrowing have also been right along. Even though the currencies & means through which a loan is done might change (products, security, fiat, crypto), it's still the same thing - the lender giving an asset to the borrower, while the borrower has to return it on pre-determined means (usually with interest). To increase their security, lenders started asking for collateral - something of value (usually an item) that has (more or less) a similar monetary value as the loan is given out. A typical example of this would be a mortgage. A borrower asks for cash, while the lender (like a bank) asks for a security that has approximately the same value as the cash given out (like a house).

With the rise of cryptos and crypto finance, people wanted to expand finance to this space - so crypto borrowing, lending, and transferring also became a popular thing. The same principles apply - the lender asks for collateral from the borrower, and then gives out the cash. When it comes to crypto, collateral usually comes in the form of a stable coin. If the borrower needs 1 ETH, the lender would ask for collateral of at least 3,000 USDT (assuming that 1 ETH = 3,000 USDT)

Why Is Collateral Used for Borrowing Crypto?

As is the case with traditional finance, lenders must be confident in the person they're giving out crypto to. They ask for collateral so they won't lose money in case the borrower acts irresponsibly (like defaulting on a loan) or simply refuses to pay the loan altogether. Think of crypto collateral as a pawn shop - you go to the pawnshop with a precious item (let's say some jewelry) that approximately has the same value as the loan you're getting. In case you default on the loan or fail to pay it back, the lender can take your collateral and sell it. The same holds true in crypto.

How to Borrow Crypto Without Collateral

Even in traditional finance, borrowing without collateral is given out only when specific criteria are met. An example of this would be having a good credit score. However, thanks to smart contracts, borrowing without collateral has become not only possible, but easy to do in the crypto space.

The term for a crypto loan that doesn't require collateral is called a flash loan. A flash loan is a loan that the lender temporarily gives out to the borrower, yet it must be returned before the transaction is fully processed. This is possible thanks to blockchain technology and the way it works - the lender gives out the money (in the form of crypto) and automatically receives it back when the smart contract has its criteria met. If the borrower fails to repay the lender, the smart contract automatically reverses the transaction as if it never happened in the first place.