The Basics of Crypto Lending Markets
This post is intended for anybody interested in lending their crypto-assets and requires no advanced financial knowledge. If you are interested in learning more about lending and borrowing in the crypto markets, please check out our other posts on the crypto borrowing landscape or the hidden risks of synthetic borrowing.
You lend, but who borrows?
Unless you spent the last 18 months hiding in a cave, you’ve have seen a dramatic increase in options to earn interest/income on your passive crypto-assets. The promise is by and large the same: “Deposit your assets in our wallet/smart contract/platform, and we promise you x% of interest, paid directly in crypto.” This all seems great! Rewind to last year, and there was simply no concept of earning income on your passive crypto-assets.
If you are lending, then that means someone must be borrowing. Have you ever stopped to wonder who is paying for the privilege of borrowing your Bitcoin, Ether, and other digital assets? And why on earth would they pay you to borrow when they could just as easily go to any number of exchanges and buy Bitcoin?
Why would you borrow crypto?
This seemingly simple question usually gets answered with a “to go short, of course!” This is true — more on that later — but is only a small subset of the wider motivations. Let’s first review who are the actual borrowers of your crypto.
Making Markets
Meet Alice, a young and talented trader, who wants to start a crypto trading business. She is not interested in starting a hedge fund and hodling until lambo: she wants to build a consistent money-making business with minimal risk. In fact, she may not even believe in Bitcoin and might secretly think crypto is bad — and certainly does not want to own any digital asset for any long period of time. Instead, she decides to provide liquidity to the market — and get paid for it. She is a Market-Maker (“MM”).
The job of a MM is to ALWAYS be available to buy at a certain price (the bid) and ALWAYS be available to sell at a certain price (the offer). If you buy on the bid for less than you sell on the offer, you make money.
This screenshot shows the order book on Coinbase Pro. If Alice was always willing to buy @ $5,861.50 and always willing to sell @ $5,862.00, and the market has roughly as many buyers as sellers, she will always make money. She doesn’t make very much money, specifically, Alice will earn $5,862.00-$5,861.50=$0.50 (minus any fees) for every buy/sell she transacts.
Buy low, sell high! Seems easy, but have you ever wondered how you do that? If it was as simple as it sounds, then everyone would be doing it and the profits would disappear. So why isn’t everyone a MM? One factor is working capital.
Try and connect to any spot exchange now and enter a bid. First, you will be required to deposit some USD in your account. If you try to enter an offer, you need to already have some crypto in your wallet on that exchange. In crypto markets, almost every exchange requires your account to be pre-funded. In the context of a trading business, that USD and crypto is called working capital. In order to be a MM, you will need at least an equal amount of fiat working capital and crypto working capital (or both pairs of a crypto-to-crypto market).
Back to Alice now. She is in a bit of a pickle: she wants to provide liquidity to the market but doesn’t want to buy and hold Bitcoin. How, she wonders, will she manage to enter offers without going long a huge sum of Bitcoin? Before we answer that, let’s look at another couple of scenarios.
Arbitraging
Alice has noticed that the price of Bitcoin on US exchanges and Korean exchanges is pretty different. Namely, Bitcoin bought on a Korean exchange with Korean Won is nearly 0.5% more expensive than in the U.S. with U.S. Dollars. She then devises a simple strategy: I will buy Bitcoin in the U.S., send it to my wallet in Korea, and sell it there (ignoring USD/KRW FX risk). That way, she will only own Bitcoin for a short amount of time: about 30 minutes, assuming a 3 block confirmation time. This is an arbitrage trade.
Then she thinks again — Bitcoin can easily moves 0.5% in 30 minutes! If the price of Bitcoin goes down in the time it takes for her to transfer to Korea, then she will be losing money. The only way for her to guarantee the 0.5% profit in this trade is by buying and selling Bitcoin AT THE SAME INSTANT. In order to do that, she will need to have assets on both the Korean exchange and on the U.S. exchange.
Again, she is defeated. She can’t afford to be long millions upon millions of Bitcoin…
OTC Trading
Alice is starting to run out of ideas. While browsing the web, she realizes that a lot of MMs also provide Over-The-Counter (“OTC”) trading services. OTC trading is the equivalent of VIP services for clients trading large orders. These VIP customers can call up an OTC trading desk and trade $100,000 or more worth of crypto at one single price, That’s it, Alice thinks. If I set up an OTC operation, I can show offers without necessarily owning the asset first. If a client buys one of her offers, she will have time to go in the market to buy back what she just sold to make delivery to the buyer in due time.
Thinking about it more deeply, Alice realizes that there is something intrinsically wrong with that approach. If she has to rush to settle the trade (i.e., deliver the asset she sold to the buyer), she will put that large order into the market and the market will move against her. In order to guarantee the price she sold, she would have to painstakingly put those orders in small amounts over time in order to avoid moving the price herself. And in that time, the price might naturally move against her! What a pickle!
The Solution: Borrowing
Alice shares her worries with one of her investors, Zandra, who comes up with a solution: Zandra loves Bitcoin! She owns a lot of Bitcoin and she is happy to own Bitcoin forever. Zandra says, “Why don’t I lend you my Bitcoin. You can use it to make markets, trade arbitrages and show offers for your OTC clients. When you are done you can return the Bitcoin to me.” Alice realizes that she can rent the working capital she needs to trade instead of buying it.
In this model, Alice is not exposed to the price of Bitcoin. Bitcoin can moon or crash, but Alice will still return the same amount of Bitcoin to Zandra. Zandra is exposed to Bitcoin price movements, Alice is not: she is merely using Zandra’s Bitcoin. Besides, Zandra wasn’t doing anything with it!
Working capital is the lifeblood for any trader. Regardless of Alice’s trading skills, in order for her business to scale she needs access to more working capital. This need never diminishes over time: as she makes more markets, captures more arbitrages, serves more OTC, her need for working capital summarily increases. And if she had to own all the working capital, she would be exposed to huge potential price risks. Every financial institution and professional trader shares Alice’s challenge. Borrowing is the only scalable solution.
Lending and borrowing is vital to a healthy trading ecosystem
A common fallacy would be to think that the sole purpose of crypto borrowing is for short selling. This is simply false. Working capital is not only critical to traders like Alice, but also for the whole market and ecosystem. Unused assets are back in circulation instead of sitting in idle wallets, which means that volumes increase, spreads get tighter, and slippage decreases.
Asset markets are more efficient with a healthy lending and borrowing ecosystem.
Introducing CoinList Lend
Over the past two years, CoinList has grown to become the leading platform for compliant token sales and ecosystem growth, where the highest quality projects such as Filecoin and Blockstack work with institutional and accredited investors around the world. Through this work, CoinList has developed deep relationships across the industry with long-term holders of crypto-assets. CoinList Lend is a marketplace where long, passive holders and active professional traders meet to lend and borrow tokens.
CoinList Lend Overview
CoinList Lend was developed in response to a common question from our customers: how can I earn additional income from my crypto-assets holdings? In order to answer that question, we needed to understand the other side of the market: the crypto borrowers. Over the past months, we dove deep into the institutional borrowing market, speaking with market-makers, hedge funds, and OTC desks. CoinList Lend is the product of that outreach and research. We believe it is a superior solution for both lenders and borrowers. Its main characteristics are:
Benefits of CoinList Lend
- Asset Diversity: CoinList Lend offers 16 assets for borrow, including many thinly traded issuances sourced from our deep network of issuers and investors. We expect to offer many more assets in the near future and we accept 9 assets for collateral, plus fiat USD.
- Flexible Term: The crypto markets move quickly, and it can be hard to know exactly how long you need working capital. On CoinList Lend, you pay a fixed borrowing rate for every day that you borrow for a minimum of 1 day and a maximum of 30 days. Most importantly we don’t adjust the interest rates while the loan is outstanding.
- Transparent Fees: Lenders receive 80% of the borrowing fee, CoinList 20%, making it the tightest bid/offer alternative in the market. We expect to publish the available interest rates publicly in the near future.
- Anonymity: CoinList is the counterparty to both legs of the loan. Lenders and borrowers do not interact with each other, protecting their anonymity and their trading strategies. Just as important, both lenders and borrowers can trust CoinList’s established AML practices.
- Customization: CoinList Lend assigns a credit score to each counterparty and adjusts initial and variation margin requirements accordingly.
- Collateral Security: On CoinList Lend, borrowers typically post between 115% and 160% depending on their credit score and loan/collateral correlation. CoinList holds the collateral and manages the margin calls. We never lend out your collateral.
- Low Minimums: CoinList Lend aims to serve the broadest cross-section of the crypto lending market. We offer much lower minimums than most OTC desks: the minimum loan size on CoinList Lend is only $50k.
Next steps
Interested? We would love to hear from you. Register your interest to lend or borrow here or email us at lend@coinlist.co.
Matthieu Jobbé-Duval is the Head of Financial Products at CoinList. Previously Matthieu was the co-lead on developing the Bitcoin trading desk for Barclays in London. Matthieu has spent the last 10 years trading derivatives at global investment banks.
Scott Keto is Director of Strategy and Business Development at CoinList. Previously, Scott was a portfolio manager at Athena Capital Advisors and has held a variety of investment roles at venture firms across the globe.
