A Brief Introduction
In my most recent, and first ever, post about my story getting into the crypto space, I briefly mentioned that I'd started lending a portion of my holdings to margin traders via something called margin funding. Today I'd like to dive deep into the world of margin funding and discuss what it is, the risks, and more advanced optimization options (bots and lending clubs). So, let's jump into it!
What is 'Margin Funding'?
Okay, so first off let's get rid of the term 'margin funding' because what you're really doing when you choose to fund a margin trader is lending coins to them. When you offer a margin funding loan and it is accepted by a margin trader this is what happens.
1 - You lose control of your coins
This sounds scary (especially since the one cardinal rule of cryptos is CONTROL YOUR PRIVATE KEYS), but as we'll discuss later, there are a lot of safe guards in place on most lending platforms to ensure you get your coins back when your loan ends.
2 - A margin trader gains control of your coins
As I'm sure you can guess, when you lose your coins someone gains them. In margin funding that person is the margin trader who accepted your loan offer.
3 - Your coins get sold or held
Once a margin trader controls your coins they will then either use them for a long position or a short position. These are really just bets on if the price of a coin will rise or fall.
If the margin trader believes that a coin is overvalued and is likely to fall in price, they will likely take up a short position on the coin. This means they sell your coins with the intent to buy them back at a lower price.
If the margin trader believes that a coin is undervalued and is likely to rise in price, they will likely go long on the coin. This means they will hold your coins with the belief that they will appreciate faster than your interest rate. Note: in many cases this means they will actually trade your coins instead of holding them, but the main thing is they never actually sell your loan, they just move it between currencies.
4 - The loan is closed
A margin funding loan is closed when one of three actions are taken.
The first is if Margin trader chooses to close his or her position. This can be after a profit or a lose.
The second is if the loans duration runs out. This means the margin trader agreed to only hold a position for X days at most and he or she has now met that time limit. If this happens the margin funding loan will finish, but the margin traders position may not necessarily close. Often trading exchanges allow traders to auto renew old loans with new ones. So, margin traders can keep their positions open. As a lender you don't need to care about this.
The third, and most rare, is if a margin trader's position goes wrong and he or she can't provide collateral to assure the exchange that he or she won't default on his or her loan. This request for more collateral is called a margin call, and if the trader can't cough up collateral fast, the exchange will forcefully liquidate the trader's position to ensure the margin funder's loan is paid back in full. This is one of the ways exchanges ensure that, while you may not have control of your coins, you aren't likely to get burned.
5 - The loan is repaid + interest
Once a margin funding loan is closed, the lender gets paid. First, the lender gets the principal (the base amount the lender loaned out). Then the lender gets his or her loan's interest. This is usually paid out after the loan is closed, but in some cases it may be paid out, on an hourly, daily, or weekly basis, while the loan in still open. This interest is your profit.
What Are The Risks?
So, as you might have guess no profit making investment is without risk. In the case of margin funding there are really only two risks and both are not very large.
The first is a margin position not closing fast enough. This will rarely (likely never) happen, but it is a risk. So, as an investor you need to understand it. When a margin call is not met and an exchange tries to liquidate a margin trader's position they are in essence selling anything and everything the margin trader has to cover the loan and its interest. This has the obvious pit fall of requiring a buyer. If a market collapses quickly and there a too few buyers an exchange could (theoretically) not be able to sell a margin trader's position and collateral fast enough resulting in too little profit to cover to loan and its interest. This is very, very, very unlikely and many exchanges have pledged to cover loses in this event up to a point, but the risk still remains. If you don't own your coins, you are relying on someone to give them to you. This requires trust.
The second risk, and most would say more likely, is an exchange going under with your coins. This can happen for a ton of different reasons, but whatever the reason, if an exchange stops being solvent it is very possible your coins will not get paid back to you in full (or even at all). This is a real risk though it still isn't incredibly likely.
To minimize these risks. Try to lend on exchanges with stricter margin call rules because the earlier and exchange can liquidate a margin trader's account in the event of a fast market collapse, the better chance you'll get your coins in full. Additionally, lend on exchanges whom you think are responsible. Big and profitable, while not an exact indicator of solvency (Mt. Gox...) do tend to be more reliable.
How To Lend With Advanced Tools
When you loan your coins you're making and offering loans to margin traders by hand. This means you are giving your time (which, believe it or not, is worth something), and you're prone to human error. Let's streamline this process.
First off, get your coins. Coinbase is my favored fiat to crypto exchange, https://www.coinbase.com/join/5913d2e6279855026d5d3d73 (affiliate link).
Then move them to the exchange you'd like to lend on. I recommend Poloniex and Bitfinex as they are both large and as a result, have lots of loan bots and lending clubs already established.
Now, once your coins are on your exchange of choice you'll have to move them to your funding wallet. This is different for each exchange, but on Poloniex it can be done via the 'Quick Transfer' feature.
Now, it's time to get your lending bot setup. For Poloniex, I highly recommend Polobot because it's both a bot and lending club (I'll go over that in detail later). For Bitfinex, I've heard CoinLend is good. Additionally, if you want to minimize risk you can lend on multiple exchanges at once. This may require multiple bots and a lot of setup, but it does reduce the risk of your exchange going under.
Once you're signed up for your lending bot of choice you'll have to go though and adjust some settings. This are generally straight forward, but optimal setting change with time. So, I'll let you figure that out on your own. Note: If you choose to use PoloBot, ask their forum about settings. They're active knowledgable, and nice.
Now, the final step before you get your loans going is linking your bot with your exchange. This is done via a bot of tech called an API. I won't go into what an API is here, but suffice to say, with out APIs the world would grind to a halt. To connect your bot to your exchange, you'll need to first create an API access point (this process is done by the exchange and will likely be somewhere under advanced settings). Then you'll need to copy your Secret and Public API keys to your bot's site and input them. Finally, if possible, disable trades and withdraws on your bot's API access point to ensure that, even in the case of your API keys being stolen, no one can do anything worse than lend your coins out at crappy rates.
That's it! Your bot should be placing loan offers on your behalf at what it believes it are optimal rates and will check you account often to re-loan your loans (and their interest).
However, before I leave you to go automate your wealth, I'd like to briefly touch on lending clubs and why I think they make sense. A lending club is basically a group of lenders who've chosen to unionize. By doing this, they can collectively choose to offer higher rates because they, collectively, control a large part of an exchange's loans. This is collective bargaining at its simplest, and when done right, it can result in all loaners receiving higher rates.
I'm personally a member of PoloBot, which is a bot service, but has built in collective minimum lending rates that it will not allow your personal bot to lend below. This means over time as more people join PoloBot's ranks, we will become a Poloniex lending cartel that mutually agrees to only lend at rates above a certain minimum. This is is built into PoloBot, but there are plenty of other lending clubs that allow disconnected margin lenders to agree on minimum lending rates with the hope of increasing rates industry wide.