At the time of writing, the global market capitalisation of crypto assets (bitcoin, Ethereum and the like) is in excess of US$400bn. While still much smaller than other more traditional asset classes, this is considerable growth in market cap from a year ago, and yet – considering the perception of inherent volatility in crypto as an asset class – bitcoin at times has been less volatile recently than many stocks in the S&P 500, oil, and the high tech FAANG (Facebook, Amazon, Apple, Netflix & Google) stocks.
Amidst this backdrop of growth in value and in relative stability this past year in the underlying crypto asset class, one fascinating growth story that has come about is the emergence of a market for lending against crypto asset collateral. Such loan volumes are approaching US$10bn this year, from a much lower start of circa US$1bn this past year. While the proportion of DeFi lending against crypto (Decentralised Finance – or peer to peer financial contracts on the blockchain) is growing quickly, the lion’s share of such lending has been offered on an institutional basis by a relatively small number of bespoke firms which have developed a speciality in this area.
While these firms are far from being household names, the likes of Genesis, Celsius, BlockFi, etc. are well known in the crypto space and have constructed what seem to be scalable business models with a focus particularly against lending on crypto assets. Just as banks do with standard fiat (e.g. GBP, USD, EUR) banking, these firms take on crypto deposits and pay interest to crypto depositors from the margin that they receive from crypto borrowers. These firms do not offer the equivalent of deposit protection, akin to the Financial Services Compensation Scheme, nor do they fall under banking regulations as they typically do not have fiat exposure. The usual risk warnings therefore need to be heeded before engaging. As a legal matter, FCA regulations and other relevant market and customer protection rules also apply.
The rates on such deposits are relatively attractive in the current low interest rate environment, with some cryptoassets placed with such platforms yielding in excess of 5%. These rates differ at any given moment and platforms such as www.loanscan.io provide an overview of the rates across different collaterals including crypto assets that are linked to fiat known as “stablecoins.” Borrowing terms are generally around 50% loan to value (or “LTV”, meaning that the equivalent of US$1000 in bitcoin collateral would need to be placed to withdraw a loan of US$500), although this rate can be higher or lower depending on the lender and on the volatility of the specific underlying crypto asset. Typically the higher the volatility the lower the LTV will be, so that ultimately less can be borrowed against the given collateral.
Several different models have been pursued by crypto lending firms for managing their credit risk exposures, with some choosing systematic approaches with automatic close outs of the loans (“margin calls”) should the value of the underlying crypto collateral fall below a certain threshold – typically well in excess of the LTV offered. While such automatic margin calls ensure appropriate risk management for the lending firm, they also can happen relatively quickly and do not afford the borrower much time – if any – to send funds and thus top up the loan collateral. Some other firms offer more flexible margin call terms albeit typically at higher rates. The lowest rates seen in the market for the latter approach for example in lending against bitcoin trend towards 4%.
DeFi crypto lending is another story entirely, with depositor rates sometimes even approaching 20% but without any particular counterparty intermediating the trade – and so no possibility for a user to seek any comeback if anything were to go awry with the underlying DeFi code. Considerable investment has been going into DeFI recently, with some likening this space to the Initial Coin Offering (“ICO”) bubble that happened only a few years ago, albeit with it seems less retail interest. However, the idea of decentralising finance has already been tested in more regulated environments – principally the peer-to-peer platforms – and it seems that only in time will some jurisdictions look to bring DeFi into the regulatory perimeter and so perhaps bring additional volumes also into this space as comfort levels increase.
As we have been reminded by COVID, there is no possibility to have a crystal ball to predict crypto valuations in 2021, despite what seem to be positive indications in the overall macro environment (e.g. ongoing QE and the increasing debt levels of nation states). Nevertheless, as the crypto asset market matures it seems the innovations in lending against crypto and increasingly via DeFi contracts in addition to institutional lenders seems to be on the rise. It is definitely a sector that we are watching closely.
By Charles Kerrigan, Partner at CMS (https://cms.law/) and Sean Kiernan, CEO at Greengage (https://www.greengage.co/). Charles works on advisory and transactional mandates on this topic and Greengage has facilitated over $100m in lending against crypto on a B2B basis with regulated partners.