The one thing many do not think about when considering crypto lending is stability of the lender they’re using. Just exactly what happens if everything goes belly-up?
- Crypto lenders need to be clear about how customer funds will be treated in the event of bankruptcy, even before they file
- The current market downturn has exposed holes in some projects, but it also marks a time to build and improve upon existing models
Given ongoing volatility and concerns around liquidity in the market, some within the crypto lending industry might want to rethink their structures and practices. In the wake of an unraveling of the market with bankruptcies at Three Arrows Capital, Voyager Digital and most recently Celsius, measures to better protect customers are de rigueur.
For one, Voyager’s bankruptcy has significant consequences for its customers — considering its user agreement didn’t actually guarantee the safeguarding of their funds. But that doesn’t apply to every crypto lender; each one is likely to have different user agreements and operate in a unique way in terms of how account holders are treated.
Customers at risk of becoming creditors with unsecured claims
Daniel Besikof, a partner at law firm Loeb & Loeb in New York, said Voyager treated its account holders as unsecured creditors.
“The way that the [user] agreement contemplates how the assets will be held, and then how the company actually holds or uses those assets are the key data points for determining how those assets are likely to be treated in a bankruptcy,” he told Blockworks in an interview.
With the benefit of hindsight, he said Voyager’s business model was difficult to justify for him. “They essentially loaned out the customer’s deposits to just a small handful of borrowers, the largest being [Three Arrows Capital], evidently with scant collateral coverage.”
Besikof added that most customers might not have grasped that they had signed on for higher risk than simply investing in cryptocurrency assets.
“I don’t think many of those customers realized that Voyager itself was perhaps an even bigger investment risk because the customer assets were being loaned out to people on which the customers had presumably done no underwriting,” he said.
It may have also been the case that the lender wasn’t explicit about the exact risks involved, and wasn’t clear that crypto funds would be considered property of the bankrupt estate in case it had to go through insolvency proceedings.
In the future, Besikof expects investors to choose alternative custodian methods such as hardware wallets and off-chain storage solutions.
“Off-chain storage solutions may become something that is more popular and probably should become more popular because at least that way customers can minimize the risk of exchange insolvency,” he said, adding that it may be tough for some less secure exchanges to find savvy customers.
Checks on percentages of funds loaned and borrowed
Daniel Tal, a lead at decentralized finance project ICHI, told Blockworks the current market downturn has exposed holes in some projects, but it also marks a time for users and developers to build new protocols that improve on existing models.
“This space is still somewhat experimental, and we’re learning continuously on where to invest, how to invest in a safe way,” Tal said.
Because of the industry’s nascence, regulators still haven’t had the time to catch onto hitches in the system. That’s probably because smart regulation should come from people who understand the space and the way it functions.
Crypto lending is similar to traditional lending, but involves digital assets. But some commentators say the high yields promised by platforms like Celsius are unsustainable. They’re also possibly a misnomer — because overly high returns are more of a bet than a genuine yield — unless lenders are transparent about how they can manage it.
Lending and borrowing platforms offer minimal information as to where the funds that they’re borrowing go.
There should be certain risk parameters for large companies that deposit funds from a centralized Web2 space into decentralized finance (DeFi) protocols, such as audits on the percentage of funds being loaned or borrowed, Tal suggested.
“We saw these events of deleveraging where people took on…more than they can handle,” Tal said. “Models need to be built sustainably, in the sense that they strip away from a derivative perspective to take away the risk of volatility. I think that’s one of the biggest risks in swapping and collateralizing these funds.”
The blockchain developer pointed to how traditional loans work: If you want to secure a bank loan to buy a Toyota Camry, you would not only need to offer some asset as collateral in case you default on repayment, but also provide an explanation as to why you need that money. The crypto lending space could take a cue from that example, where having safe liquidity strategies allows for customers to know where their funds will end up.
To him, there are currently no best-practice models in the lending space. “I don’t think anyone is doing it in a safe way. What is possible is to be able to direct people’s loans in a smart way — and that’s something that needs to be built.”
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