Lend against Crypto? – A $10 billion loan market emerges at the end of 2020
At the time of writing, the global market capitalization of crypto assets (bitcoin, Ethereum, etc.) exceeds US$400 billion. Although still much smaller than other more traditional asset classes, this is a considerable growth in market capitalization compared to a year ago, and yet – given the perception of the inherent volatility of crypto as an asset class – bitcoin has at times been less volatile recently than many stocks in the S&P 500, oil and FAANG high-tech stocks (Facebook, Amazon, Apple, Netflix and Google).
Against this backdrop of value growth and relative stability over the past year in the underlying crypto asset class, one fascinating growth story that has occurred is the emergence of a loan market against collateral for crypto assets. These loan volumes are approaching US$10 billion this year, compared to a much lower start of around US$1 billion last year. While the proportion of DeFi loans against crypto (decentralized finance – or peer to peer financial contracts on the blockchain) is growing rapidly, the lion’s share of these loans have been offered on an institutional basis by a relatively small number of bespoke companies. who have developed a specialty in this field.
Although these companies are far from household names, companies like Genesis, Celsius, BlockFi, etc. are well known in the crypto space and have built what appear to be scalable business models with a particular focus on lending against crypto assets. Much like banks do with standard fiat banking services (e.g. GBP, USD, EUR), these companies accept crypto deposits and pay interest to crypto depositors from the margin they receive from crypto borrowers. These companies do not offer the equivalent of deposit protection, akin to the financial services compensation scheme, nor do they fall under banking regulation as they are generally not exposed to fiat. The usual risk warnings should therefore be heeded before committing. Legally, FCA regulations and other relevant market and customer protection rules also apply.
Rates on these deposits are relatively attractive in the current low interest rate environment, with some crypto-assets placed on such platforms yielding over 5%. These rates differ at any time and platforms such as www.loanscan.io provide an overview of rates on different collateral, including fiat-linked crypto assets called “stablecoins”. Borrowing terms are typically around 50% loan-to-value (or “LTV”, which means the equivalent of $1,000 in bitcoin collateral would need to be placed to withdraw a $500 loan), although this rate could be higher or lower depending on the lender and on the volatility of the specific underlying crypto asset. Generally, the higher the volatility, the lower the LTV will be, so ultimately less can be borrowed against the collateral given.
Several different models have been followed by crypto credit companies to manage their credit risk exposures, with some choosing systematic approaches with automatic loan closings (“margin calls”) if the value of the underlying crypto collateral falls below. below a certain threshold – usually well beyond the LTV offered. While these automatic margin calls ensure proper risk management for the lending company, they can also happen relatively quickly and do not leave much time for the borrower – if any – to send funds and thus complete the loan guarantee. Some other companies offer more flexible margin call terms, but usually at higher rates. The lowest rates observed on the market for this last approach, for example in loans against bitcoin, tend towards 4%.
DeFi crypto lending is a whole different story, with deposit rates sometimes even approaching 20% but no particular counterparty brokering the trade – and therefore no possibility for a user to seek a return should something go wrong with it. the underlying DeFi code. Considerable investment has been flowing into DeFI recently, with some comparing this space to the initial coin offering (“ICO”) bubble that happened only a few years ago, although it seems less interested by the retail trade. However, the idea of decentralizing finance has already been tested in more regulated environments – primarily peer-to-peer platforms – and it seems only over time that some jurisdictions will seek to integrate DeFi into the mainstream. regulatory scope and therefore perhaps to bring in additional volumes as well. into this space as comfort levels increase.
As COVID has reminded us, there is no possibility of having a crystal ball to predict crypto valuations in 2021, despite what appear to be positive indications in the global macro environment (e.g., the ongoing QE and rising nation-state debt levels). Nevertheless, as the market for crypto assets matures, it seems that innovations in lending against crypto and increasingly via DeFi contracts in addition to institutional lenders seem to be on the rise. This is definitely an area that we are watching closely.
By Charles Kerrigan, Partner at CMS (https://cms.law/) and Sean Kiernan, CEO of Greengage (https://www.greengage.co/). Charles works on advisory and transactional mandates on this topic and Greengage has facilitated over $100 million in crypto lending on a B2B basis with regulated partners.