We tend to identify loans with borrowing money at an interest to pay off debts or make an expensive purchase. However, in the crypto trading world, borrowing is a strategic instrument professional traders opt to add leverage to their trading.
Borrowing funds helps traders to attain more capital and attain a better market position without selling their coveted and valuable crypto assets. How do traders do that? Let’s understand this with an example.
Suppose a trader acquires a loan in USD by using the BTC they own as collateral. They then use the newly acquired USD funds to buy more BTC or some other crypto in a market undergoing correction. In this situation, the trader buys the dip, i.e., they buy the crypto while it is at a cheaper price and benefit from the gains when the price of the crypto increases in the future. All this is done without diminishing any of their crypto holdings via a crypto loan.
Traditionally, banks use multiple checks, such as your credit score, your income, and the monthly payment plan you choose, to determine the size of the loan in proportion to the collateral they deposit. In crypto loans, these checks are replaced by the LTV ratio – the Loan to Value ratio.
Loan to value or LTV ratio, in simple words, tells how much money a borrower will get in relation to the value of the crypto asset that secures the loan. In crypto loans, a borrower has the freedom to choose the LTV ratio for their loan. In other words, a borrower is free to choose how much risk they are ready to take for a particular borrowing.
The collateral here is the cryptocurrency holdings a borrower chooses to pledge. Since the value of cryptocurrencies tend to be volatile, the LTV ratio also keeps on fluctuating. This LTV vs. price volatility tussle creates scenarios unique to the cryptocurrency sphere. Before we discuss them, let’s first talk about the LTV ratio in detail.
What is Loan-to-Value (LTV)? How do you calculate LTV?
The LTV ratio, or the loan-to-value ratio, is simply the ratio of the amount/size of loan to the value of your collateral. The equation for calculating your LTV is:
LTV = Loan Amount / Collateral Amount x 100%
While, the Loan Amount = Principal + Interest
Let’s take an example.
Suppose the value of your loan is $100,000, and for obtaining this loan, you deposit 7 BTC worth $30,000 each. The total value of the collateral comes out to be $210,000. Using the equation:
LTV = Loan Amount / Collateral Amount x 100%
LTV = 47.62%
Crypto lending platforms offer loans at varying degrees of LTV ratios for the borrowers to choose from. Higher the LTV ratio, greater the risk, and vice versa. Here risk implies the risk of liquidation or sell-off in case the value of the collateral becomes too low and LTV increases.
When applying for loans in the crypto market, you need to be aware of a few things, such as the exact amount you will need out of the loan, the amount of crypto you own, and do you actually have enough set aside that if the time comes, you will be able to add collateral to lower you LTV.
How does LTV fluctuate? What does it mean?
LTV can fluctuate on the basis of the value of your collateral. If the collateral value drops, the LTV increases. If the collateral value rises, the LTV decreases.
For example, you have taken a loan of $5000, and as collateral, you have put forward a crypto asset that values at $12,000 at that time. This would make your LTV value at 41.67%.
If the price of the crypto asset drops from $12,000 to $8,000, it will result in your LTV rising to 60%. Here you would be required to add more collateral to lower the LTV ratio to the original level or risk partial sell-off or liquidation.
Similarly, if the price of the crypto asset increases from $12,000 to $16,000, your LTV would drop to 31%. A lower LTV ratio presumes lesser risk for an investor. But it comes with more expensive fees/interest and less loan value against the collateral.
A loan with a high LTV ratio affords more loan value against the collateral but greater associated risks in case the market tumbles.
What is Liquidation?
Liquidation is the process of selling off a crypto asset to avoid further losses. Liquidating an asset can be done by either selling it at the current market price or closing out the position and taking whatever loss has been incurred. It is often done as a last resort when an investor has lost too much money on their investment and cannot afford to take any more losses.
You need to actively track your LTV to be careful and not suffer losses. If the price of the crypto asset you have put as collateral falls too low or reaches the margin call level, it could result in you being requested to either add more collateral to lower your LTV or directly face a forced liquidation of your assets.
You can be forced into liquidation if the valuation of the asset you invested in keeps on falling, resulting in your LTV rising. A threshold is usually set at a specific percentage – the Liquidation Call level. In case your LTV dangerously declines to the liquidation call level, it would result in your collateral getting forcefully liquidated, and you would be required to pay a liquidation fee proportionate to the value of your loan. You are usually informed in advance if this is to happen so that you can take action on time and avoid the risk of liquidation.
How to Use LTV as a Way to Avoid Liquidation
To avoid the risk of facing liquidation of your assets, you, as an investor, should always be aware of the current state of the market and the valuation of whatever assets you have taken a loan out on.
The crypto market is known to be volatile; liquidation can easily become a common occurrence for investors who do not manage their assets. In addition to disrupting your objectives, liquidation incurs needless liquidation charges and may cause you to lose your current position in the market. Investors should actively monitor their LTV and adjust as needed to reduce the likelihood of being forced into liquidation, particularly during extreme price swings.
To avoid the risk of falling prey to situations where you’d have to suffer from losses like liquidation, you should constantly be aware of the market and the valuations of your assets. The major thing to remember is that the price of your crypto assets can fall just as easily as it can go up, so manage your LTV against the rise and fall in value so as not to reach the threshold of liquidation.Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.