Crypto lending pitfalls Part III

Continued from Crypto lending pitfalls Part I and Part II and covering the topics of counterparty and collateral risk.

Be aware of counterparty and collateral risk

Apart from the fact that the general concept of yield is on rather shaky ground when it comes to DeFi, there are other tangible risks with crypto lending. For one, there is undetectable counterparty risk. When lending to a DeFi protocol, the lender does not know his counterparty because the DeFi’s asset pool represents a sort of omnibus account any party can borrow from. For a lender that needs to know his counterparties – not least because of regulation – not knowing one’s counterparty is an unacceptable risk.

Another elevated risk is that of collateral availability. Some crypto lending is collateralized lending. Borrowers need to over-collateralize the loan they are taking out. In the event the borrower defaults on his loan, the collateral provided acts as a cushion and security fallback for the lender. When it comes to DeFi protocols though, the question is: Collateral that winds up being locked in protocol, what mechanisms make sure the lender has access the collateral?

In the case of BlockFi, such collateral availability seems to have been the problem. It appears that the lending company had  a substantial amount of collateral from 3AC, which was itself invested in DeFi protocols. Although the collateral was above 100% it was mainly illiquid and hard to sell. So, while BlockFi managed to liquidate 3AC’s $1 billion of collateral, the lender still incurred a small loss.

Crypto lending risks reconsidered

We now have unfortunate but corroborating proof that crypto lending with DeFi protocols – as it is done by some CeDeFi players – is not only unsustainable but carries extreme tail risk. In the case of Terra, its demise can ultimately be traced back to its DeFi lending and borrowing protocol Anchor. By guaranteeing an astonishing APY of 20% during times of collapsing market yields, the DeFi protocol gradually but inevitably morphed into a Ponzi scheme.

As a matter of fact, UST barely had any other use case apart from serving as depository asset on Anchor. At its height, Anchor held more than $14B of UST, and became the sink for almost all of the UST in existence. This entailed circularity on the part of UST and Anchor. Once the high yields could not be sustained any longer, the house of cards would collapse as it did.

The existence of collateral risk the other hand was manifested in the case of Celsius. With its operations halted, it is very much the case that the collateral backing outstanding loans on Celsius is inaccessible. The issue is: what does collateral help if it cannot be accessed properly?

Furthermore, the Celsius case also highlighted the liquidity risk that is present in any crypto lending activity. As a major source of yield, the CeDeFi company staked their customers’ ETH as stETH on Lido Finance, Ethereum’s most prominent staking platform. With ETH being locked, whenever Celsius customers withdraw ETH from their accounts, the crypto lending company had to sell stETH on the open market for the corresponding amount of ETH.

When the stETH/ETH pair depegged, liquidity began to cease and Celsius was not able anymore to use their stETH to buy ETH because of a lack of market demand for stETH. This caused concerns about Celsius turning illiquid as the company could be unable to meet its Eth redemption demands. With funds being withdrawn from the platform, the CeDeFi company recently halted withdrawals altogether.

Professional crypto money markets to the rescue

As these last few weeks and their tangible problematic instances show, the crypto lending will have to change. For one thing, the introduction of a more clear-cut and binding regulation will do its part. Beyond regulation, it is time for professional crypto money markets to stand up.

CLST is building the necessary new money markets for this newly emerging money. The company was established a year ago based on the fundamental principle to establish a peer-to-peer institutional lending and borrowing venue for crypto market participants.

CLST addresses the inherent risks of counterparty invisibility in which lenders and borrowers directly face the counterparties. This fact forces risk management departments to assess their financial situation. It is CLST’s foremost goal to establish a money market for the new money in collateralized and uncollateralized transactions.

To read more about what professional crypto money markets look like, check out this previous post.