Liquidity Crisis in Crypto Lending. What Should We Learn? (Part I）

Lending has been one of the core fundamental financial services provided by institutions like commercial banks by matching the market supply and demand of fixed income and liquidity in an economy. In 2022, the global debt market is expected to reach US$7.83 trillion, seeing a YoY increase of 10.8% from US$7.07 trillion in 2021. Moreover, this figure is expected to reach US$11.29 trillion in 2026 [1].

Admist the surge of global debt, crypto lending is growing at an impressive rate as an emerging sector. As Genesis Trading, one of the main market players, published in their 2021 Annual Market Insights Report [2], its cumulative loan book exceeded $15 billion between March 2018 to the end of 2021, an increase of approximately 829% YoY compared to the $2 billion at the end of 2020.

While crypto-native lending institutions such as Anchorage, BlockFi, Celsius and Nexo continue to expand, traditional financial institutions are also entering the crypto lending business. For example, Goldman Sachs issued its first fiat loan on Bitcoin as collateral in April 2022.

Recently (June 2022), two top ranked crypto lending institutions, Celsius (one of the major net lenders in crypto market) and Babel Finance (one of the major net borrowers in crypto market), have announced restrictions on user withdrawals due to the market liquidity crisis triggered by UST and stETH depeg, raising industry-wide skepticism about crypto lending institutions’ operations management and risk control practice.

As a veteran of traditional financial infrastructure and nowadays a key end-to-end software vendor in crypto lending, the 1Token team prepared this article to share experiences and insights on how to thrive in the crypto lending industry, covering key points in crypto lending firms’ operations, risk, and treasury management.

What is Crypto Lending?

Crypto lending refers to the scenario, where the lenders issue loans to the borrowers based on the borrowers’ credit and / or collateral (either collateral or loan being cryptocurrency). The borrowers shall repay the principal within a specific period and pay interests at a certain frequency according to the term sheet.

Lenders and borrowers can be single or a group of individuals (‘C’ for customers) or institutions (‘B’ for business), where lenders provide sources of capital and borrowers provide allocations of capital.

The initial sources of capital usually come from the central bank and individual customers. In crypto lending, stablecoin issuers like Tether play the role of central banks, and exchanges / lending platforms / DeFi protocols play the role of commercial banks that offer Earn / Lending programs to individuals.

On the other hand, the final allocation of capital in crypto lending typically goes to institutions like quant traders, POW coin miners, or individual customers that are HODLers who seek short-term liquidity.

To help match capital from their initial sources (lenders) and the final allocations (borrowers), brokers / dealers make profit by providing financial services and taking commission / interest.

Brokers run matched loans, where the size and term of the loan from the lender matches 100% with the loan to the borrowers. While dealers maintain a cash pool consisting of lenders’ capital and borrowers’ collateral, usually managed by their treasury departments. As longer fixed term loans can generate higher yield and ensure capital utilization, there will be term maturity mismatch where their assets are more illiquid than their sources of capital.

Compared to brokers, dealers earn higher yield but more complexity and risk in their business model as they need to manage cash flow and allocate idle capital into other assets than loans, such as staking in other CeFi and DeFi counterparties. So dealers normally set up the treasury department and various business / investment desks, where the treasury plays a central dispatcher role by lending capital into internal desks. And those desks allocate the assets into their area of investments and even lend extra capital back to the treasury. We will further elaborate on this in future articles about Treasury Management.

Purpose of Crypto Lending Participants

What is the role and purpose of those participants in the crypto lending ecosystem? Here is an example.

1.A group of investors participate in the ‘Earn’ program from crypto lending institution A (typically a financial service platform or crypto exchange) with 1 million USDT, which might be 5% APY fixed term for 1 year, or 2% APY open term. The asset received from the investors is managed by A’s treasury department.

2.Crypto institution B seeks a 6 month loan of 1 million USDT from A’s Trading desk, so A’s trading desk applies to the treasury for capital.

3.A’s treasury department decides to lend 1 million USDT to A’s trading desk after analysis, the internal term is set as 0.5 year fixed and 10% APY. Since there is a mismatch in the maturity of the ‘Earn’ product and loan, treasury needs to manage the liquidity of USDT to meet potential redemptions.

4.A’s trading desk lends the aforementioned 1 million USDT to B, with 8% APY and fixed term 0.5 year, in return B posts 1,500 ETH (assume ETH spot price is $1,000 USDT) as collateral.

5.B uses capital for trading and hedging, with 12% APY.

6.A’s trading desk gets 1,500 ETH as collateral, the trading desk will stake ETH in another ETH staking platform for 2-5% APY open term.

Meanwhile, A might lend to more crypto lending institutions for interest, who may also lend the asset in the same way for the same purpose. Through one or multiple crypto lending institutions, the sources of capital would flow to the final borrowers.

Purpose of Lenders

The main purpose of lenders is to earn yield, who are usually risk-averse. Institutional lenders tend to issue fixed-term and fixed-rate loans, while retail lenders prefer to invest or lend in a more flexible way (short-term or open term) even though this means a lower yield.

Purpose of Broker / Dealers

As intermediary institutions bridging the borrowers and lenders (Crypto lending institution A above), the broker / dealer’s major purpose is to earn net interest margin by borrowing low and lending high at maximized capital utilization.

Those large brand names like Anchorage, BlockFi, Celsius, Genesis are dealers, while typical brokers yield funds who run back-to-back loans that supply fixed income capital to dealers.

Purpose of Borrowers

Borrowers typically have higher yield generation capabilities, and are willing to take higher risks (Crypto Institution B above). Typical examples are asset management institutions (such as Alameda Research) and POW coin miners. Specifically, their common purposes include:

(1) Leverage up for higher return. Borrowers leverage up through loans [3] to trade with higher buying power, therefore higher returns on their principal. Leveraging up via crypto lending amplifies the profit and loss, meanwhile avoiding the risk of forced liquidation by the exchange in arbitrage trading.

(2) Risk hedging. Through crypto lending, borrowers can borrow capital for risk hedging while holding their positions, which helps them avoid holding extra long positions.

(3) Short-term liquidity: Borrowers can borrow fiats to solve their short-term liquidity demands while holding their coin position in collateral. For example, crypto miners may borrow fiats using BTC as collateral to pay their utility bills.

Disclosure: This article is from 1Token, crypto native technology provider since 2015.
1Token is a software provider for crypto-financial institutions, offering a one-stop tech solution. For more information on 1Token, please visit https://1token.tech/

Reference
1.Lending Global Market Report 2022 – By Type (Corporate Lending, Household Lending, Government Lending), By Interest Rate (Fixed Rate, Floating Rate), By Lending Channel (Offline, Online) – Market Size, Trends, And Global Forecast 2022-2026
https://www.thebusinessresearchcompany.com/report/lending-global-market-report

2.Genesis 2021 Q4 Market Observations
https://genesistrading.com/wp-content/uploads/2022/01/Genesis21Q4QuarterlyReport-final3.pdf

3.Arcane Research: Banking on Bitcoin The State of Bitcoin as Collateral
https://www.ceicdata.com/en/indicator/united-states/non-performing-loans-ratio

4.NEXO vs Celsius: A Comparison of Crypto Lending Platforms
https://p2pmarketdata.com/blog/NEXO-vs-celsius/

5.The Crypto Credit Report, Issue 7, Q4 2020
https://credmark.com/pdf/CryptoCreditReport-Q4-2020.pdf

6.VanEck research：Crypto Lending and the Search for Yield
https://www.vaneck.com/us/en/blogs/digital-assets/matthew-sigel-crypto-lending-and-the-search-for-yield/