January 8, 2020
The world of crypto lending can be tough to navigate.
There are a lot of mistruths and omission-riddled conversations, passing as facts on the internet. Even with this misinformation, the crypto world should applaud itself for facilitating the birth and growth of its markets.
To continue that growth, the market needs to make sure investors can easily make their assets available to lend and borrow, especially when the market value for the ten most popular cryptocurrencies is well over $100 billion. If investors don’t have this capability, it would be a real problem for the crypto markets.
Multiple firms offer the ability to loan or borrow cryptocurrency. Many now allow the same capabilities as traditional banks, including the ability to issue loans in cryptocurrency, lending on a secured basis (where loans are secured by cash or other cryptocurrencies) or lend cash out to a broker and hold crypto as collateral.
The marketplace for borrowing and lending are akin to those of traditional cash and securities. Currencies and securities that have high price volatility, or perceived weakness, are more expensive to borrow while collateralized loans cost less than uncollateralized loans.
Brokers need to fund their balance sheets with traditional and cryptocurrencies as the cost for this capital is driven by the perceived risk in that broker’s portfolio. Similarly, heavy trading in crypto assets is not perceived as safe as trading treasuries. Lastly, borrowed crypto assets are re-hypothecated by various players like traditional cash and securities.
When lending and borrowing cryptocurrencies, both the lenders and borrows need to be aware of the below facts:
People borrow crypto to short-sell it in the market — betting that the price will go down. The thing is, you cannot sell something you don’t have. If you want to sell something short, you must borrow that asset to deliver when you sell it. Stock portfolios at leading brokerages, prime brokers and custodian banks are constantly being lent out to other institutions to allow others to short those positions. The real question is: do you want people shorting your crypto?
Lenders need to make sure they have some type of collateral to secure their loans. As mentioned before, crypto’s high volatility makes it a riskier loan so whether it’s collateral in a traditional sense or the borrower’s reliable track-record, this is paramount for lenders. If you loan cash or crypto to someone or some business without getting collateral, and they declare bankruptcy, you will likely lose some (if not all) of what you lent them.
Borrowers should know that if they want to borrow cash against their crypto, they will only get a fraction of the value of it in cash. The lent amount depends on which crypto it is and its value. For this reason, stable coins typically get less of a haircut when pledged as collateral for a cash loan.
Crypto brokers are likely less credit-worthy than well-established brokers and banks. Therefore, they pay you more for US dollar loans to them (the market also forces them to do so). These are considered loans because institutions like Coinbase are not regulated banks and they may not also provide lenders the same protections. These protections include segregated accounts and capital which guard lenders and borrowers from defaulting.
As there are important facts and market realities to consider whether you are planning on taking out a crypto loan or lending, there are plenty of myths that have led lenders and borrowers astray.
Crypto lending platform Genesis Trading recently stated: “Borrowing and lending using cryptocurrencies and cash are providing new and safe opportunities for our clients to maximize the growth of their retirement accounts.”
While it’s in Genesis’ best interest to encourage crypto lending, the word ‘safe’ is inappropriate. Any loan, whether it’s made to a broker, bank or everyday person, is only as safe as the borrower’s credit quality. In this case, lending to a crypto broker doesn’t have the same protections afforded to other institutions under traditional banking laws under which other institutions operate.
It’s not just crypto lending companies that overstate the future of this practice. Darrell Duffie, a professor from Stanford University, recently proclaimed that the world of crypto lending will “up-end” the traditional banking model due to the high rates offered on crypto.
When considered in the context of an unsecured crypto loan, this misleading statement overlooks several facts. First, you need to hold the crypto to capture the yield received from lending it. The rates on crypto are higher because cryptocurrencies are riskier to hold – remember that the crypto being lent out to the broker is being used to deliver on someone else’s short sell.
It’s also important to remember that there are some high crypto rates that some of the advertised high rates are often caused by short sellers expecting huge profits at certain points in time.
These rates aren’t steady, and their lending transaction fees should also be considered. If you hear that you can lend Bitcoin and make 5%, make sure that you get the 5%. Your crypto broker may be taking a piece of that 5%. If you are going to invest your coin or cash with a crypto broker, you need to understand all the fine print regarding rates and fees.
Also, in the case of when you lend cash and are collateralized by crypto, make sure you understand whether it is you holding the collateral, or the counterparty. Like with any investment opportunity, brokers want to make crypto loans as appealing as possible. Having a firm understanding of the real numbers will minimize that risk.
Make sure you know the facts before trading. The world of crypto banking is different from your traditional bank as the yields on lending crypto, as attractive as they may sound, may not produce returns commensurate with the risks.
Remember, you can lose all your money doing this – there is no banking regulator or backstop, like the FDIC.
As an owner of cash or cryptocurrency, there are a handful of answers you should demand before you get involved with a loan.
- What is the credit quality of my counterparty?
- What are the risks of a default?
- What protections do I have in the event of default?
The answers may or may not be straight-forward, yet as you continue to ask these questions to your brokers, you will find the omissions in each broker’s answers can be significantly different.
You will find some who offers better terms to some customers than they do others. It behooves you to gather all the information you can regarding crypto lending. Just make sure you read it with a dubious eye.
Murphy McCann is an advisor at iTrustCapital.
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