Finding leverage

Gm, everyone. Finding the willpower to not do something can be tough. Not eating the last piece of Thanksgiving pumpkin pie. Not misusing and mismanaging customer crypto assets. Fine, one is tougher than the other. But…?

That brings us to today: It turns out that a lot of lenders in the crypto space struggled with that second one. Crypto lending doesn’t always have to be precarious, though. Let’s take a look at how it might change.

—Vincent

Crypto Has a Lending Problem

Lending has been a major wealth creation tool in the crypto space—and the demand for lending products shows as much. At the height of the crypto lending cycle, Genesis alone had a behemoth loan book with $50 billion in outstanding loans. (Of course, that total has withered down to $2.8 billion for reasons we'll get into soon.)

But still—lending has been big business in our industry. And it seems everyone in crypto has had a reason to love it:

• Traders loved lending because quick loans made it possible for them to double down on their favorite trades.

• Entrepreneurs loved lending because it allowed them to raise capital very quickly without selling crypto or pitching to venture capitalists. Simply put? Building got quicker.

• CEOs of troubled companies loved lending because it easily covered holes in their balance sheets, and often for extended periods of time.

So how does crypto lending work? The gist is this: Lenders offer loans in exchange for collateral worth more than 100% of the loan value.

• So if a lender were extending $100 worth of Applecoin loans this past month in honor of apple picking season…

• The lender would demand $110 worth of some other asset (US dollars, stablecoin, another cryptocurrency) as collateral.

This would mean that even in the face of rapidly deteriorating crypto prices, the lenders could either make margin calls (aka ask for more collateral) or just sell the crypto collateral to break even.

But that’s how things are supposed to go—not always how they went. Most of the lenders we read about during the frenzy of crypto lending earlier this year did not manage their collateral in this way. Some of them—such as Celsius and Genesis—ended up handing out loans for *checks notes* no collateral at all.

For loans that were overcollateralized, those aforementioned lenders would on occasion lend out the collateral that had been given for a loan to another borrower. This means that if you had given a lender $110 worth of the USDC stablecoin to get a $100 Applecoin loan, the lender would turn around and make another loan by giving that $110 USDC to another borrower.

That’s called rehypothecation, and it makes it very difficult for the lender to break even. If you put all of your Applecoin in a DeFi protocol that was hacked and couldn’t repay the loan, the lender would have to wait until the other borrower paid back their loan in full in order to make up the difference.

So why do it in the first place? Crypto lenders began with overcollateralized loans because they don’t have the capacity to do the type of underwriting that banks do. Without massive compliance and accounting teams, these lenders can’t manage the required risk.

But that breeds risk of another kind. Without addressing these risks, crypto lenders will continue to fall victim to market crashes. Salt Lending, Voyager, BlockFi, Genesis, and Celsius were the losers in this last cycle, but there will be more failures to come if lenders don’t revamp their loan books—and their core strategies.

Where do we go from here? Hopefully to a place where lenders keep loans overcollateralized and keep the collateral locked. Regulators can also play a part by creating rules that require proper collateral management.

Because lending still has value. It can be an effective way of building the crypto space, but if lending itself is only focused on creating higher yields on parked crypto assets and not on improving the technology within the space, then it will always create a systemic risk that will threaten the (actual) productive assets in crypto.

And that’s what you need on your radar today in crypto. Have you ever pulled out a loan with a crypto lender? What was your experience? Reply to this email and let us know. And tune in Tuesday for another Coinsider Radar.