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.