The surge of cryptocurrencies and “hodling” investment strategies of 2017 precipitated a flood of crypto asset-backed lending platforms coming to market.
The idea is a simple – take the concepts and models of traditional asset-backed lending and implement them with new “crypto assets” like Bitcoin and Ether. So if cryptocurrency miners or hodlers need short term access to fiat currency to pay expenses but don’t want to liquidate their positions, they can take out loans against the value of their crypto assets.
As such, platforms like ETHLend, SALT Lending, Nuo Lend and a plethora of others provide an alternative vehicle for investors who want to simultaneously hold and use their cryptocurrency.
Similarly, institutional traders looking to take out short term crypto-denominated loans for use in margin trading and taking short positions can also have their cake and eat it too.
But crypto asset-backed lending isn’t quite the same as taking out a second mortgage on your house. Crypto markets are notorious for their volatility, and the two largest assets – Bitcoin and Ether – have experienced dramatic price downturns since the beginning of the year, though these have stabilized as of late.
This can make the process of issuing and receiving crypto loans a precarious one.
“The volatility of the cryptocurrency market represents a challenge when using these assets as collateral for loans,” said Stani Kulechov, CEO of Aave – the parent company of the decentralized peer-to-peer lender ETHLend:
“Cryptocurrency lending platforms need to make sure the value of the loan doesn’t surpass the value of the collateralized assets, causing borrowers to default, leaving them in a bind.”
Still Going Strong
A plunge in the value of the collateralized assets below the value of the loan effectively forces a margin call where the borrower must deposit additional assets or cash to cover possible losses. While surely inconvenient, this hasn’t in an of itself been a dealbreaker for the nascent sector.
“Our clients are very responsive to market prices and margin call scenarios, meaning they tend to act quickly to deposit more collateral or pay off a portion of their loan,” said Joseph Kelly, CEO of crypto-backed loan provider Unchained Capital.
“The real test for platforms like ours was the price drop in January and February when Bitcoin retreated 70 percent from $19,000 to $6,000 over the course of a few weeks. During that period 90 percent of our loans were margin called and 80 percent of clients responded within eight hours.”
While heavy downturns can potentially be disastrous for lenders if borrowers aren’t able or are unwilling to top up their loans, Kulechov argues that the value of crypto lending platforms is more demonstrable in these slumping conditions.
“It is a concept that is even more appealing during market downturns, as it’s not ideal for investors to close their positions in a bear market,” he explained. “Lending platforms solve their crypto liquidity problem, while holding onto those assets until the exchange rate normalizes or rises.
Lending platforms are seeing respectable user growth amid the challenging conditions. According to Dapp.com, ETHLend and Nuo Lend have processed upwards of 4,500 and 1,800 transactions, respectively, since launching in May 2018.
“These are very good numbers for their first five months in business,” said Kyle Lu, CEO of Dapp.com, adding:
“Demand is still emerging. True mass adoption is still around the corner. Right now it’s mostly miners (especially for Bitcoins) who have the urgency to lend cash and sometimes the holders of some ERC-20 tokens who are interested.”
Doing The Homework
Extrapolating proven risk management and modeling techniques from traditional asset-backed lending to the crypto space appears to be – if done correctly – an effective means for these platforms to protect from excessive market swings.
Zac Prince, CEO of BlockFi – another crypto loan provider, said that his firm offers a loan-to-value ratio of 35 percent, meaning that a borrower can take out $35 in loans for every $100 worth of collateral deposited.
“We’ve found that our 35 percent loan-to-value has made our loans especially resistant to the current market fluctuations,” he said:
“In the nine months we’ve been lending, we haven’t had a single customer default on a loan.”
ETHLend offers a more generous loan-to-value of between 50 and 55 percent, with Kulechov explaining that: “We protect lenders by allowing collateral calling, which means if the collateral value drops to a certain threshold such as 100 percent of the loan amount, the lender can call the collateral.”
Kelly explained that Unchained Capital will issue a formal margin call if the asset incurs a 25 percent drop from the price of origination and will liquidate a client’s collateral at a 45 percent price drop assuming no additional collateral was deposited.
While the consumer-focused versions of of crypto asset-backed lending platforms are getting some play, others argue that these models are overly fraught with risk and technical hurdles to be scalable and sustainable in the near term.
“There are still several infrastructure problems. How do you source prices? How do you hedge against counterparty risk? How do you deal with hacks and custody issues?” explained Lucas Nuzzi, director of technology research at Digital Asset Research, adding that it’s only a matter of time before these issues are dealt with constructively:
“While it goes against the general ethos of Bitcoin in general as a provably scarce asset, I do think it’s going to happen in one way or another.”
However, Nuzzi sees this development happening initially in the institutional space rather than the consumer realm, particularly for activities like margin trading – as is being currently explored by platforms like dYdX and Dharma.
For example, Genesis Global Trading, the over the counter crypto platform, reported in mid-October that it had lent more than half a billion dollars since March to institutional borrowers looking to take short positions and hedge investments.
“Thinking about all the oracle requirements of consumer platforms versus just doing margin trading, it’s much easier to gauge counterparty risk,” said Nuzzi:
“As of right now I really can’t see these consumer lending platforms really getting much traction just because we just don’t have the basic tools to guarantee that counterparty risk is covered.”