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.

Crypto lending pitfalls Part II

Continued from Part I: Contrary to popular belief, most crypto lending activity facilitated by previously mentioned platforms is not peer-to-peer – it is customers lending directly to the platform, which then deploys customers’ assets into more lucrative strategies to generate yields.

Crypto lending: where did the yield come from?

Such yield is what various market participants had been looking for in the crypto space. Two popular trades throughout 2021 were the GBTC arbitrage and the futures market contango. By taking advantage of specific pricing dynamics between Bitcoin’s spot market and selected derivatives like the Grayscale Bitcoin Trust and Bitcoin futures contracts, various market participants were doing profitable, yet market-neutral arbitrage.

These two strategies were the sources that contributed a big junk to the various yield products that emerged. The more the demand grew though, the more these arbitrage possibilities with both the futures market and with GBTC funds disappeared though. With these arbitrage trades being gone, where did the yields come from now?

It was mainly DeFi protocols. What has been referred to as the DeFi summer of 2020 helped kick off a wider range of crypto lending activities. With GBTC and bitcoin futures arbitrage plays gone, many so-called CeDeFi players tapped into DeFi protocols to provide highly competitive yields, particularly when compared to the yields in traditional markets.

Nonetheless, yields ranging from 10% to up to 20% on stablecoins left many market observers wondering, where they were coming from. Notwithstanding the fact that many DeFi protocols experienced high capital inflows during their initial hype cycles, most of the yields were generated through protocol token inflation, which only nominally enabled such high pay-outs by DeFi protocols and thus CeDeFi crypto lenders. Soon enough, it dawned on more and more market participants that these mechanisms would have a hard time being sustainable and that if a lender does not know where the money comes from, then he most likely is where the money comes from.

There is no real yield in DeFi

It’s now clearer than ever: With the majority of DeFi protocols, there is no yield in the actual sense of the word. By definition, there cannot be as of yet. Why is this? Hardly any DeFi protocol is connected to the real-world economy. However, this is exactly, where a sustainable source of yield would have to be coming from. It is economic returns, which are the result of deploying capital successfully to meet consumer needs in the real economy, that generate real yield. In other words: Yield is the generated flow above maintenance costs or depreciation of the carrying capacity of some stock of economically productive assets. DeFi is generally lacking exactly this.

Not only are there no real yields in DeFi, but such yields can also only be artificial since credit is not adequately measurable. The popular metric referred to as “Total Value Locked (TVL)” is highly deceivable. TVL, as it is measured today, does factor in a lot of double counting. This makes the concept into a bloated number that hardly bears any substantial meaning. As a matter of fact, TVL obfuscates the actual leverage in a DeFi protocol as well as the DeFi ecosystem as a whole.

This fact cannot be understated: Because the real scope of leverage cannot be assessed adequately, the total ecosystem’s leverage remains un-auditable and therefore un-audited. And with leverage not accounted for, yields cannot even be properly underwritten. This in turn means that there is no way of knowing if the yield that is being given is adequate compensation for the risk taken. Consequentially, DeFi protocols are not something that lends itself to crypto lending as risk management as of today is hard to come by.

Read more about the topic in the upcoming Part III where we cover counter party and collateral risk and a solution to the current crypto lending market situation.

Crypto lending pitfalls – Part 1

An analysis of the recent developments of lending venues and algorithmic DeFi protocols has exposed systemic risks in crypto-asset lending and the crypto markets as a whole. Today’s current painful learnings however should lead us to build out professional crypto money markets.

Macro conditions at glance

‘You never know who’s swimming naked until the tide goes out.’ This well-known quote from Warren Buffet proves to be true time and time again. Such has also been the case in crypto the last few weeks. With the current unfavorable macro conditions, crypto market prices have started to come down significantly.

Only in mid-May, the Terra ecosystem utterly collapsed, bringing down previously perceived flagship projects like the Luna token, its stablecoin UST as well as its DeFi protocol Anchor. As part of the deleveraging process, not only retail lost vast amounts of money, but also institutional players were said to have taken substantial hits.

While speculation ran rampant in the weeks following the Terra collapse, Celsius Network’s sudden email announcement that they would no longer allow withdrawals, swaps, and other functions confirmed the various concerns out there. In a Lehman-Brother-type situation, lenders are now forced to ask the question of confidence: Who can still be trusted?

The problem of systemic risk in crypto

Borrowing and lending are among the most fundamental components of any functional economy. Today’s money markets that make up some of the biggest markets in finance attest to that. The possibility to lend and borrow is every bit as important to today’s evolving crypto markets as it is to traditional markets. It is only in truly broken societies that credit does not exist.

Thus, actors facilitating the lending and borrowing of crypto assets play an indispensable role in contributing to the crypto industry’s overall growth. Yet, things become rather problematic when individual players become a systematic risk as has been exemplified by what happened with Terra and Celsius. Their abrupt unwinding caused the markets to panic, which created knock-on effects leading to liquidations cascades and price collapses across the board. Since Celsius’ illiquidity problems have come to the surface, more crypto lenders, as well as prominent hedge funds, have been exposed to have suffered from the events. Due to a domino effect, digital asset broker Voyager Digital and crypto hedge fund firm Three Arrows Capital filed for bankruptcy, while BlockFi signed a deal for a potential bail-out takeover by FTX.

While proper risk management is absolutely key, it has been unmistakably shown by now that some players applied unprofessional risk assessment strategies such as, for example, lacking insight into counterparty solvency. For example, Voyager Digital appears to have had a lending book of about $1.1 billion, of which $665M were tied to 3AC. This means that the company lent 60% of its book to one single firm.

Amplified by the reoccurrence of bull markets, such institutions managed to grow big because of a general lack of due diligence on the part of market actors during these bull phases. But not only this: Contrary to popular belief, most crypto lending activity facilitated by these platforms is not peer-to-peer – it is customers lending directly to the platform, which then deploys customers’ assets into more lucrative strategies to generate yields.

Read more about the topic in the upcoming Part II, where we cover yields, counter party and collateral risk and a solution to the current crypto lending market situation.