Is crypto credit dead, or does it just need better execution? That question asked with more urgency in the wake of Genesis Global Capital January 19 filed for bankruptcy. That, in turn, led to the death of other crypto lenders, including Celsius Network and Voyager Digital in July 2022, and BlockFi, which filed for Chapter 11 bankruptcy protection in late November 2022.
Unlike many traditional lenders, like banks, cryptocurrency lenders don’t necessarily have capital or liquidity buffers to help them through tough times. The securities held – cryptocurrencies – usually suffer from high volatility; thus, when the market plunges, it can hit crypto lenders like an avalanche.
Edward Moya, senior market analyst at Oanda, told Cointelegraph, “The death of crypto lender Genesis reminds traders that they still need to clean up more in the cryptoverse. You don’t need exposure to FTX and the theme may continue for some crypto companies that are struggling.
Making these comments, Francesco Melpignano, CEO of Kadena Eco, a layer-1 blockchain, expects “the contagion of this crisis to continue to reverberate this year and maybe some next.”
‘It’s a failure of risk management’
Is crypto credit kaputt? That’s a question Duke University finance professor Campbell Harvey has been asking lately. He replied: “I don’t think so.” He believes the business model remains sound and there is room for future finance.
Many traditional loans are now overcollateralized, after all. That is, the guarantee provided may be more expensive than the loan, which is unnecessary from the borrower’s point of view and creates a less efficient financial system. Of course, the problem with many crypto credit transactions is the opposite – they are undercollateralized.
However, a safe middle ground can be reached if there are professional risk management practices for crypto credit, said Harvey, the author of the book, DeFi and the Future of Finance.
He believes that the bankrupt crypto company failed to plan for the worst market scenario and not because of a lack of knowledge. “They know the history of crypto,” Harvey told Cointelegraph. Bitcoin (BTC) has fallen more than 50% at least half a dozen times in its short history and creditors should have made provisions for significant drawdowns – and then some. “It was a failure of risk management,” Harvey said.
Crypto lending companies also failed to diversify their portfolio of borrowers by number and type. The idea here is that if a hedge fund like Three Arrows Capital (3AC) collapses, it probably won’t hurt its creditors. Genesis Global Trading lent $2.4 billion to 3AC – far too much for a company of its size to lend to a single borrower – and now has a claim for $1.2 billion against the now-insolvent fund.
Traditional lenders usually do due diligence on borrowers to check their business prospects before lending money, with collateral often adjusted based on the counterparty’s risk. However, there is no evidence that crypto lenders have failed.
What could explain the neglect of basic risk management practices? “It’s easy to start a business when prices are going up,” Harvey said. Everyone is looking for money. It’s simple to push the worst-case scenario plan to the side.
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The appeal of crypto loans in good times is that they offer individual or business liquidity without having to sell digital assets. The loan can be used for personal or business expenses without creating a tax event.
Some suggest we are now in a time of transition. Eylon Aviv, principal at venture capital firm Collider Ventures, considers cryptocurrency lending to be “an important primitive for the growth of the crypto ecosystem,” but as he further explained to Cointelegraph:
“We are currently caught in the limbo of a transition between centralized actors [Genesis, 3AC, Alameda Research] those with scalable solutions with poor risk management and workable handshake deals; and decentralized actors [Compound, Aave] which have robust but non-scalable solutions.
Why DCG?
Genesis is part of Digital Currency Group (DCG), a venture capital firm founded by Barry Silbert in 2015. It is the closest thing the crypto industry has to a conglomerate. Its portfolio includes Grayscale Investments, the world’s largest digital asset manager; CoinDesk, a crypto media platform; Foundry, a Bitcoin mining operation; and Luno, a London-based crypto exchange. “One of the biggest question marks on everyone’s mind is what is the fate of DCG?” Moya said.
If DCG were to go bankrupt, “a mass liquidation of assets could shock the crypto market,” said Oanda’s Moya. However, he believes the market may not have to return to the bottom, despite DCG playing a big role in the crypto world. Moya added:
“A lot of bad news for the space has been priced in and DCG’s bankruptcy will hurt many crypto companies, but it’s not game over for Bitcoin and Ethereum holders.”
“It is rumored that [Genesis] bankruptcy is part of the plan with creditors, “Tegan Kline, co-founder and chief business officer of the software development company Edge and Node, told Cointelegraph. If it is not like that, “the filing means that DCG and Genesis will not release coins on the market and this is one of the most recent reasons. [market] price action has been positive,” Kline said.
Kline thinks DCG has enough resources to weather the storm. It depends “on how well DCG can ring-fence itself from Genesis,” added Kline. “DCG has a valuable portfolio of ventures. Based on that, my bet is that it is likely to survive by raising external capital or giving some equity to creditors.
A new wave of lenders
DCG aside, the crypto credit sector may expect some changes before the end of 2023. Harvey anticipates a new wave of emerging crypto lenders, led by traditional financial companies (TradFi), including banks, to replace the now defunct ranks of crypto lenders. “Traditional firms with expertise in risk management will enter the space and fill the void,” predicted Harvey.
These banks are now telling themselves about, “We have expertise in risk management. These lenders have cratered and now there is an opportunity to step in and do the right thing,” said Harvey.
“I totally agree,” added Collider Venture’s Aviv, who believes TradFi will be on the way soon. The main players will be centralized entities like banks and financial companies, but Aviv expects to see more players with decentralized protocols built on top of Ethereum and other blockchains. “The winners will be consumers and users, who will receive better, cheaper and more reliable services.”
Shawn Owen, interim CEO of SALT Lending, told Cointelegraph, “The emergence of traditional financial companies in the crypto lending market is a development that we see coming, and shows the mainstream acceptance and potential of this innovative industry.”
Some emerged unscathed
SALT Lending is building one of the earliest centralized platforms to allow borrowers to use crypto assets as collateral for fiat loans. Has registered with the United States Financial Crimes Enforcement Network and has a history of third-party audits. Although they do not conduct credit checks on borrowers, they do perform Anti-Money Laundering and Know Your Customer checks, among other checks. Still, SALT Lending is not out of the recent turmoil.
The company froze withdrawals and deposits to the platform in mid-November 2022 because “the collapse of FTX has affected our business,” it said. Around this time, crypto securities company BnkToTheFuture announced that it would end its efforts to acquire its parent, SALT Blockchain. SALT Lending’s consumer credit license was recently issued in California as well.
We don’t publish this as a breaking news. We are pausing to deal with the fall out of FTX and to confirm that non of our counter parties have additional risks so that we can proceed with maximum caution with all efforts directed at not going bust. more info soon.
– Shawn Owen (@Shawn_OwenJ) November 15, 2022
The “pause” on withdrawals and deposits, as the company called it, was still in effect earlier this week. However, a Salt Lending source told Cointelegraph that: “We are in the final stages of going through a restructuring out of court that will allow us to continue normal business operations. We will have an official statement on this soon.
Still, in the midst of all the upheaval, Owen stressed that with proper management, the practice of borrowing and lending crypto assets “can be an important tool for achieving growth and financial stability.”
More regulation coming?
Looking ahead, Owen expects more regulation of the cryptocurrency credit sector, including measures “such as the implementation of capital and liquidity buffers, similar to those required of traditional banks,” he told Cointelegraph.
Some practices like rehypothecation, where a lender reuses collateral to secure another loan, may be scrutinized. Owen also expects to see more interest in “cold storage” loans, “where borrowers can monitor funds for the duration of the loan.”
Others agree that regulation will be on the table. “The DCG debacle is over [had] the effect is extremely detrimental to institutional investors, which also means that retail investors will feel the brunt of it,” Melpignano from Kadena Eco told Cointelegraph. “I liken it to a one-two punch that will give regulators the ammunition they need to be aggressive against the industry.” He added:
“The bright side is that the industry finally has a catalyst for clear regulations to enter the space – entrepreneurs need regulatory clarity to build tomorrow’s use cases and attract institutional investment.”
‘Poisonous medicine’
Maybe it’s too early to ask, but what lessons have been learned from the January 19th bankruptcy filing? The bankruptcy of Genesis “reinforces the narrative that crypto lending should happen transparently on-chain,” Melpignano said. “Due to the dire situation for the industry in the short term, the chain loan protocol will not be affected by all the unfortunate events of 2022.” In his view, this hinders the use case for decentralized finance – a more transparent and accessible financial system.
“If there is a core lesson to learn from last year, it is not to idolize and trust ‘thought leaders’ and ‘talking heads,'” said Aviv. The industry should push for “maximum transparency and voice.”
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“High leverage is the most toxic drug in finance, not just in crypto,” Youwei Yang, chief economist at crypto miner Bit Mining, told Cointelegraph. This is perhaps the most important lesson, but the need for better risk management protocols is also now clear. People have learned that “letting go of standards while hyped [up] the market situation could be disastrous after the liquidity is pulled out,” Yang added.
Stronger and ‘Readier’
Aviv said that crypto credit will survive in the future of crypto “and become stronger through the other side” by using on-chain assets “that implement and simplify sound and regulation.” He expects continued innovation in this space, including “new forms of real-world asset-like collateral, transparent custodianship and enforceability through new account abstraction primitives.”
Overall, cryptocurrency lending remains a useful financial innovation, but practitioners need to adopt some of the most sophisticated risk management practices developed by traditional financial firms. “The idea is good, but the execution fails,” Duke University’s Harvey sums up. “The second wave will be more prepared.”