The Crypto Borrowing Landscape

Over the past 18 months, there has been a proliferation of appealing options for lenders to earn interest on passive crypto-assets; however, the same cannot be said for those on the other side of the market: the borrowers of crypto-assets.

In this post, we will outline the current borrowing landscape, both centralized and decentralized. Then, we will outline our new product, CoinList Lend, which we believe provides a superior alternative to synthetic borrowing for both professional and institutional traders.

This post assumes a sophisticated understanding of market dynamics, derivatives, and risk/reward frameworks. It is written from the perspective of a professional institutional trader; and although we encourage everyone to follow along, we understand that it may not be suitable for all readers. If you are interested in learning about lending crypto-assets and the basic mechanics of the crypto lending market, please follow this link. If you are interested in learning more about synthetic borrowing in depth, follow this link.

Introduction

Rewind the clock to 2016–2017. The price of Bitcoin was skyrocketing, but most professional traders were still sitting on the sidelines. Huge arbitrages persisted between various exchanges and geographies; however, unless they had gone long Bitcoin (or Ether) prior to the run-up, most traders didn’t have inventory or the infrastructure to capture these arbitrages. In order to capture the upside, market participants naturally had to absorb some amount of long exposure and all of the associated volatility and risk. Given the potential profits, many professional traders still took the plunge. However, it was clear there was a need for a crypto borrowing market.

Today we have a much richer ecosystem for lending crypto that encompasses both decentralized and centralized systems; however, the market is still far from perfect. Decentralized options such as Compound, MakerDAO, Dharma, ETHLend, and their peers provide open access but layer on additional regulatory and technology risks and lack anonymity or a diversity of assets. Existing centralized options such as Genesis Capital, BlockFi, and Celsius limit some concerns of regulatory risk and anonymity but may not have flexible terms or transparent pricing that professional traders are accustomed to.

Let’s look take a look at the existing marketplace.

Centralized Borrowing Overview

General Mechanics: Our imaginary borrower, Alice, onboards with a lender by completing any KYC/AML verification requirements, and she signs any borrowing documentation provided by the lender. When she is ready to borrow, she calls or messages the lender, who will provide an interest rate on her desired asset, along with a collateral level and tenor. If she agrees to those terms, she deposits collateral in order to receive the asset directly from the lender.

Who: Key players include OTC (Genesis Capital, BlockFi, Celcius) or exchange-traded (Bitfinex, Poloniex) lenders

Advantages

• Anonymity: Both the lender and the borrower will remain anonymous to everyone except the intermediary. It may still be possible to identify the borrowing and lending patterns of the counterparty, but with sufficient scale and/or efforts of the intermediary, these efforts may be thwarted.
• Compliance & Regulation: By borrowing from a single known counterparty, the borrower is only required to diligence that single party and in the case of a dispute or other negative event both the lender and the borrower have entered into a legal agreement that can be enforced through traditional channels.
• Stable Rates & Terms: Borrowers and lenders can set the rates and tenor prior to the agreement which allows the borrower to accurately project potential PnL for their trade.

Disadvantages & Risks

• Liquidity Fragmentation: Exchange-based borrowing tends to feature extreme liquidity fragmentation across the order book for a single asset due to the wide array of choices on rates and tenor. In principle, an open order book should create a more efficient market, but this is rarely the case for exchange-based borrowing.
• Information Asymmetry: OTC lenders have significantly more information on the market rates for each asset than their counterparties. Typically a borrower can only solicit the price by direct communication with each potential lender and even then can only discover one side of the bid-ask spread.
• Increased Credit Risk: Although the trader reduces compliance and regulatory risk by transacting with a single known counterparty, they are concentrating their credit risk into a single counterparty. Hacks, defaults, or general mismanagement by the intermediary may result in a total loss of collateral.
• High Barriers to Entry: Most OTC desks won’t take on new clients who do not meet sufficient trading minimums, typically in the hundreds of thousands of dollars per trade. This leaves a gap in the market for the smaller professional traders that comprise most of the market.
• High Costs and Duration Mismatches: Lenders typically have the upper hand in negotiating collateral levels, margin call thresholds, and loan tenor. Although some borrowers may receive preferential treatment, in general, they are subject to stiff prepayment penalties, harsh collateral requirements, and above-market rates with durations that do not match their needs.

Decentralized Borrowing Overview

General Mechanics: Alice sends collateral, typically ETH or ERC-20 tokens, to a smart contract, and she receives the asset in a wallet of her choice. She can typically receive 66.67% of her collateral as a loan in another asset. Interest rates may be fixed or variable depending on the service. Key players include Compound, dYdX, ETHLend, MakerDAO, Dharma, etc.

Advantages

• Open Access: There are no barriers to participation in decentralized lending protocols. As long as the customer owns crypto-assets, they can participate from anywhere in the world.
• Efficient Price Discovery: For the most part, these lending protocols are transparent and rates are algorithmically determined by the supply and demand of the assets in the smart contract. There are no brokers or middlemen, and the available rates are published openly.

Disadvantages & Risks

• Variable Rates: Pooled liquidity (Compound and dYdX) necessitates variable interest rates. With an increase in borrowing demand, rates can go up, sometimes dramatically. This is usually a non-starter for traders who need to lock in the borrowing costs before executing a trade.
• Smart Contract Risk: Smart contract technology, while powerful, is still in its infancy. Development of smart contracts can take months, and their deployment presents a broad attack surface. The most well-funded projects will conduct many security audits, but the smart contracts still might contain unknown security risks. Although these risks will likely abate over time, professional traders are understandably nervous to send hundreds of thousands of dollars (or more) to smart contracts.
• Compliance and Regulation: Smart contracts similarly present a compliance risk for institutional traders. If an asset manager stores crypto in a smart contract, are they potentially at risk of violating the custody rules? Similarly, given the lack of identity verification, are institutional investors comfortable transacting with and borrowing from completely unknown counterparties? These questions are currently unknown, but the perceived risk has kept many participants away.
• Lack of Anonymity: Professional traders tend to be a highly secretive crowd, and for good reason: any information leakage may allow other traders to front-run or pounce on an exploited arbitrage. Current decentralized borrowing platforms are entirely public with all transactions posted on-chain. The use of on-chain forensics techniques may allow other market participants to identify their competitors’ trading strategies.

Decentralized & Decentralized Liquidity Shortage

Centralized and decentralized lending platforms both suffer from a liquidity shortage due to many of the issues mentioned above. Larger institutional borrowers have functionally stayed away from decentralized platforms due to perceived risks and cannot source enough working capital on reasonable economic terms from the limited network of centralized lenders. As a result, borrowers have generally turned to a more liquid but riskier alternative: synthetic borrowing.

Synthetic Borrowing Overview

For those unfamiliar with the mechanics of synthetic borrow trade, we will summarize its mechanics using an example before detailing the core advantages and disadvantages.

Synthetic Borrowing — Example Trade

Today is May 6th. Alice has $500,000 in working capital that she wants to swap for Bitcoin to be able to arbitrage a few exchanges. Alice does not want to buy Bitcoin though. She thinks the price is too high and is concerned that a fall in the price of Bitcoin will eat into her arbitrage revenue. Alice knows she does not meet the minimum threshold to be on-boarded as an OTC client, and liquidity on exchange lending/borrowing order books is not sufficient for her needs. She decides to borrow Bitcoin synthetically.

To do so, Alice buys $500,000 worth of Bitcoin on Coinbase @ ~$6,000 per Bitcoin. $500,000 / $6,000 = 83 BTC. She then sends 8.3 BTC to BitMEX, and uses the 8.3 BTC on her BitMEX account as collateral to short 10x leverage June futures: 8.3 BTC x 10 = 83 BTC. Now Alice is hedged, she is long 83 BTC Bitcoin on Coinbase and short 83 BTC on BitMEX.

Voila! She now has 83–8.3 = 74.7 BTC in excess Bitcoin on Coinbase available for working capital to make markets, arbitrage, etc.

This all seems fair and easy at this point, but we will peel back the onion to examine the risk/reward of that synthetic loan relative to a standard Bitcoin loan.

Advantages

There are three primary advantages of synthetic borrowing relative to centralized or decentralized alternatives.

• Deep BTC Liquidity: Both spot and derivatives exchanges enjoy deep liquidity for BTC/USD pairs. There will always be a market to synthetically borrow BTC; however, there are limited futures markets available for other crypto-assets.
• Open Access: Alice (or anyone) can easily engage in synthetic borrowing with minimal barriers to entry, even though many crypto derivatives exchanges attempt to block certain jurisdictions. There are virtually no minimum dollar thresholds.
• Low Borrowing Costs: Synthetic borrowing trades generally will yield a lower interest rate than a standard crypto loan; however, like everything in markets, there is no free lunch. The trader must compensate for the lower interest rate by taking on additional risks.

Disadvantages & Risks

We have prepared a deep dive on the risks of synthetic borrowing that is available here. However, we have summarized the major concerns below.

• Liquidation Risk: Liquidation happens on a derivatives exchange when your unrealized PnL becomes greater than the collateral deposited. The higher the leverage, the lower the implied rate on a synthetic loan, but also the higher the risk of getting liquidated. This liquidation risk can be exacerbated by wild market orders (or potential market manipulation) e.g., BitStamp & BitMEX event.
• Basis Risk: Futures positions tend to be rolled or extended before expiry to avoid increased volatility. Basis risk is the risk of seeing the spot versus futures spread move against the position.
• Negative Gamma Risk: Running short futures versus long spot effectively puts the trader in a negative gamma position, which means that your positions move against you regardless of the market movements: you get shorter when Bitcoin goes up and longer when Bitcoin goes down. This is highly technical and will be looked at in more detail in our following post on synthetic borrowing.

Here, we have examined the different alternatives available to crypto borrowers. Realizing that the market is still underserved for efficiently sourcing working capital, CoinList has launched a lending/borrowing platform: CoinList Lend.

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 mechanics

CoinList Lend was developed in response to a common question from our core customers: how can I earn additional income from my long-term holdings of crypto-assets? 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.