A Guide for Credit Professionals

By Sidney Powell, CEO and co-founder of Maple

Introduction

The traditional financial sector has innovated significantly over the past decade.  Nevertheless, the emergence of the crypto lending sector has left many of its products and services looking like a staid fax machine compared to the shiny new smartphone that is crypto lending. 

As the percentage of the purely digital financial sector underpinned by crypto technology grows, so does the need for a comprehensive understanding of its intricacies, especially for financial services professionals. This article delves into the core aspects of crypto lending, offering insights into the mechanisms, challenges, and best practices that define this burgeoning sector. From understanding the nature, value, mechanics, and risks of assets at play to navigating the regulatory maze, this guide aims to equip professionals who already have a fundamental understanding of crypto credit concepts, with the knowledge they need to navigate this dynamic landscape confidently.

Understanding What You Lend: The Crypto Assets

In the dynamic world of crypto lending, understanding the nature and role of involved assets is paramount. This includes having a clear grasp of their value as collateral, the operational and compliance risk of taking ownership of those assets in the event of default, and the value of these assets to offset a loan in case of recovery after default.  Major cryptocurrencies, such as Bitcoin, Ethereum, and notably stablecoins, have distinct characteristics and roles. 

At its zenith, the stablecoin market cap soared to $250 billion, and though it has since receded to around $140 billion, its influence and size remain profound.  The initial surge in stablecoin market cap was propelled by speculative interest in cryptocurrency, centralized exchange volumes, and DeFi (decentralized finance) yield farming – allowing lenders to lock in tokens for a set period, using smart contracts to reap interest. However, the landscape is evolving. As centralized exchanges grapple with restricted banking access, they’re pivoting to stablecoin deposits over traditional fiat currency. 

Moreover, an increasing number of businesses are embracing stablecoins for payments. This is akin to opting for email over snail mail – it’s faster and more efficient for many uses, not least by cutting out middlemen, and has emerged as both a replacement and a complement for traditional payment methods.

But it’s not just about stablecoins; the price volatility inherent to crypto assets creates unique challenges for lending. Additionally, the rise of tokenized assets, most notably T-Bills which back the largest stablecoins today, in crypto lending is reshaping the collateral landscape, enhancing both the diversity and quality of assets available for lending. In essence, to navigate the crypto lending space effectively, one needs a more in-depth understanding of the nuances of these digital assets.

Who are the parties involved?

In the realm of crypto lending, the customer profile is as diverse as a potluck dinner. On the borrower side, the landscape is dominated by trading firms. Additionally, trading firms and market makers are pivotal in providing liquidity, and various funds employ back leverage strategies. 

Conversely, on the lending side, entities range from funds specifically mandated to deploy in crypto and DAOs overseeing treasuries, to high-net-worth individuals who amassed their wealth through crypto. Notably, the retail sector’s involvement has seen a decline since 2022 in response to heightened concerns about counterparty risk following the bankruptcies of Celsius, BlockFi, 3AC, FTX and Genesis, as well as broader declines in crypto asset prices dampening their interest in the sector.

Smart contracts automate agreements and bolster enforcement between the two sides.  Unlike traditional lending arrangements, where asset recovery may require legal steps after a default, and come with high legal costs, smart contracts are a kind of “robot lawyer”.  In the best case, the existence of a smart contract completely avoids any after-the-fact dispute by automating many parts of a lending transaction.

To ensure their reliability, these contracts undergo audits, and risk mitigation strategies include measures like enforcing minimum lockups to ward off flash loans and segregating assets into distinct pools to minimize oracle-related issues. 

Collateralization: Securing the Loan

Collateralization in crypto is fundamentally the same as in any other type of lending – providing an asset as a guarantee for the lender.  A common difference between the two is that crypto lending, especially DeFi lending, is frequently over-collateralized, often due to market volatility.

However, the type of crypto asset chosen as collateral is an important consideration. Liquid assets like Bitcoin and Ethereum differ significantly from altcoins or lower cap tokens, especially when considering the size of the collateral in relation to its daily transaction volume. It’s essential to note that the primary concern isn’t the fundamental value of the asset but its observed liquidity—specifically, the duration required to exit a position without the asset going underwater. 

Currently, a prevalent loan-to-value (LTV) ratio in the industry is around 65%, with liquidation typically occurring between 80-85%. Historically, in 2021 and 2022, centralized finance (CeFi) platforms like Genesis, Celsius, or BlockFi held collateral directly, leading to situations where overcollateralized borrowers became creditors in the event of lender insolvency. However, the trend is shifting towards using smart contracts or Qualified Custodians as Collateral Agents. 

While 2022 saw the efficacy of smart contracts in liquidating collateral during major CeFi collapses such as the 3AC stETH liquidations, 2023 highlighted their limitations, especially when illiquid assets were overly used as collateral, as seen with CRV. Ultimately, whether in CeFi or DeFi, the prudent selection of collateral and setting appropriate liquidation levels remain paramount.

Ensuring Legal Recourse: Navigating the Regulatory Landscape

Even with the existence of smart contracts, understanding  the regulatory landscape is crucial for ensuring legal recourse in crypto lending. Central to this is the Master Loan Agreement, which delineates the relationship between borrowers and lenders, outlining events of default, representations, warranties, and remedies. 

However, crypto lending is not without its challenges, especially when considering cross-border transactions and varying regulations.  When it comes to jurisdiction, New York and the UK are predominant choices because they handle the highest volume of debt and loan agreements with established and well-tested court systems. Yet, many borrowing entities opt for domiciliation in the Cayman Islands or BVI. While these jurisdictions acknowledge the legitimacy of New York legal agreements, they resort to their local BVI or Cayman governing laws during dispute adjudication and default or bankruptcy proceedings.

Pricing and Terms: Striking the Right Balance

Credit assessments in the crypto lending landscape ensure a harmonious balance between risk and reward; they are an essential preparation.  The interest rates in this domain are influenced by several factors, including the credit risk premium, technology premium, and considerations of liquidity and duration. A significant determinant of pricing efficiency is the unrestricted flow of stablecoins into the crypto ecosystem. In 2021, this arena witnessed notable inefficiencies, with crypto loan prices soaring to a 15% APR before receding to 6-7% for unsecured stablecoin loans by mid-2022, primarily driven by an oversupply of stablecoins seeking productive deployment. 

When determining loan durations, the industry leans towards shorter terms, often open-ended, which means they can be recalled at 48 hours notice, or spanning 30 days. While there’s potential for extending loan durations, it introduces the hazard of mismatches between asset and liability durations. To ensure a harmonious balance between risk and reward, credit assessments play a crucial role in the crypto lending landscape.

Liquidity: Ensuring Seamless Transactions

Liquidity in the crypto world is essential for smooth operations and actually meeting borrower demand for loans. While liquidity pools and decentralized exchanges play a pivotal role in managing liquidity risks, the journey to this point wasn’t without challenges. Peer-to-peer (P2P) lending initially struggled with directly matching borrowers and lenders. However, innovation emerged with Compound’s shift to the peer-to-pool model, likened to the transition from order books to Automated Market Makers (AMM). This approach treated inventory more fungibly, with centralized entities absorbing balance sheet risks and mediating loans. Maple’s evolution mirrors this trend, transitioning from P2P experiments in February 2020 to embracing the peer-to-pool model by May 2021. Ultimately, to maintain this fluid ecosystem, strategies focusing on timely loan repayments and withdrawals are paramount.

Financial Reporting: Transparency and Trust

Transparent financial reporting in the crypto world is like turning on the lights in a haunted house – it reveals what’s really there and dispels the myths. While the integration of crypto transactions into traditional financial statements is advancing, the journey is riddled with challenges, demanding innovative solutions. 

However, transparency goes beyond mere reporting. Overcollateralization, for instance, might mitigate a lender’s potential losses, but it doesn’t diminish the default probability. Notable incidents, like FTX’s attempt to reclaim collateral from Genesis or the legal tussles involving Celsius and Bitfinex, underscore the importance of scrutinizing a borrower’s financial health. A lender must assess the liquidity of a borrower’s balance sheet, as limited liquidity could necessitate steeper collateral requirements. 

Quality of assets, favoring cash, Bitcoin, and Ethereum over a mix of altcoins, and the profitability of the borrower also plays a crucial role. After all, a non-profitable entity might need additional equity to cover interest or debt repayments. In essence, while crypto lending offers transformative opportunities, vigilance and thorough financial assessment remain paramount.

Conclusion

The world of crypto lending is more than just a technological marvel; it’s a testament to the evolving nature of finance and the boundless possibilities that come with it. As we’ve journeyed through the various facets of crypto lending, it’s evident that while the sector offers immense opportunities, 

It also demands a nuanced understanding and meticulous approach. For banking and credit professionals, embracing this new frontier means not just keeping pace with change but leading it. By adhering to best practices, staying informed, and fostering transparency and trust, professionals can harness the potential of crypto lending, shaping a future where finance is more inclusive, efficient, and innovative. As the digital economy continues to expand, think of this guide as your GPS, ensuring you don’t get lost in the crypto jungle and leading you to a treasure trove of opportunities. 

Happy crypto adventuring!

Stock image credit: TheDigitalArtist/Pete Linforth via Pixabay