What is Crypto Credit and How Does It Work?

Crypto credit, also known as crypto lending, is the practice of lending cryptocurrencies to borrowers at an interest rate. This can be done through either decentralized lending platforms (like Aave and Compound) or centralized lending platforms (like Abra and Nexo).

Crypto credit allows lenders to earn interest on their cryptocurrency holdings, while providing borrowers with access to funds and liquidity. Borrowers are typically required to put up some form of collateral, such as a cryptocurrency, to secure the loan. If/when a borrower’s collateral value falls below a certain threshold, they will need to add more collateral (”top it up”) to required level to avoid liquidation and maintain their borrowed position.

This article is the first in a series on Crypto Credit by Friktion Institutional.

Why do people borrow?

• Lack of credit facilities and services from traditional banks which are unfamiliar with the management of crypto credit exposure
• People with no access to financial services (eg: unbanked)
• Need for open or fixed term cash liquidity, without giving up on the potential upside for cryptocurrencies (able to secure an open-term loan almost instantly)
• To short tokens and take on directional exposure to the market

What is Collateral?

Before a lender issues a loan, it must establish some confidence that the borrower has the ability to repay it. For this reason, most lenders require some form of security (in the form of collateral) as a way to minimize risk for lenders. The loan-to-value (LTV) ratio is the proportion of a loan’s value in relation to the collateral value. A LTV of 50% means that the max value lent will be half the value of the collateral put up by the borrower.

In general, lenders will typically require collateral that is easy to value and liquidate (eg: USDC, USDT, BTC, ETH) in the event of default. The type of collateral that is accepted will also depend on the lender’s policies and the specific terms of the loan. There are several considerations that can affect the quality of the collateral, including its current market liquidity, the Float to FDV ratio (% circulating supply), and the venues where it is traded. For example, collateral that is traded on multiple Tier 1 exchanges and has a deep order book is likely to be more liquid and easier to sell in the event of default.

How much collateral is enough?

Collateralized lending vs Under-collateralized lending

Collateralized and undercollateralized crypto lending are two different approaches to issuing loans seen in the crypto credit markets today. Collateralized lending involves the borrower securing the loan by locking in collateral equivalent to the value of the loan based on the venue’s risk guidelines (or greater than the value of the loan in the case of a overcollateralized loan). In contrast, undercollateralized lending does not require the borrower to provide collateral equal to or larger in value than the loan. In the following sections, we will take a closer look at the trade-offs between these two approach and consider how they affect the decisions of lenders and borrowers.

(i) Collateralized Lending

The overwhelming majority of DeFi (decentralized finance) credit markets today are overcollateralized, requiring borrowers to put up more collateral than the amount they seek to borrow. This provides a cushion against potential losses and can protect lenders in the event of high volatility events. Since the issuance happens with on-chain smart contracts, the process does not rely on a borrowers credit worthiness outside the platform. Despite recent market turbulence, DeFi protocols like Aave and Compound have continued to function quite smoothly and operate with reliablity and security for borrowing and lending cryptocurrencies in comparision to their centralized alternatives.

However, a tradeoff of overcollateralized lending is that borrowing isn’t capital efficient (net vs gross leverage) and limits the growth of the crypto credit market. Overcollateralized loans do not align with many “real-world” (off-chain) reasons to take on a loan, such as borrowing money without having the capital in-kind to begin with.

(ii) Undercollateralized Lending

In undercollateralized lending, a borrower has to put up some form of collateral, but the value of that collateral is less than the amount of the loan being taken. In the event of a default, the lender may not recover the full amount of the loan through the sale of the collateral. This introduces new challenges and requires robust and transparent underwriting standards to price loans and manage counterparty, duration, and credit risk. In a undercollateralized lending market, continuously assessing borrower risks is paramount to scalability, requiring mechanisms to minimize and enforce that borrowers cannot misrepresent their assets and liabilities. Third-party risk assessment and off-chain credit scores can help to mitigate these risks and improve the health of such loans.

Given these additional risks, well-designed undercollateralized credit markets will see naturally higher interest rates on these loans than in an (over)collateralized market. We refer to this risk premium as a credit spread.

Institutional borrowers, with appropriate risk management, may find undercollateralized lending as a capitally efficient way of accessing credit. Since such borrowers are not required to lock up the full collateral value, it offers them a faster and more flexible way to access credit, subject to their credit worthiness. This can help them to grow their businesses and take advantage of new opportunities more quickly and efficiently.

Liquidation

Liquidation refers to the process of selling off collateral that has been posted as part of a loan. This typically happens when the value of a borrower’s collateral drops below a set threshold and the platform (or smart contract for DeFi apps) initiates a liquidation process to protect the lender from potential losses. For example, a user on Compound borrowed 800 USDC and deposited 1 ETH as collateral (when 1 ETH = $1000). If the value of ETH falls to $900, the borrow balance will exceed the liquidation threshold. This means that the collateral (1 ETH) will be eligible for liquidation to cover the loan.

Any equipped actor can serve as a liquidator, repaying bad debt and taking on the return collateral. The liquidator will call the “absorb function” (which relinquishes ownership of the accounts collateral) and returns the value of the collateral minus a penalty fee to the liquidated user.

In an undercollateralized model, subject to the amount and type of collateral posted, an underwriter can serve the role of liquidator. However, lenders take the risk that a borrower experiences a full-scale default in which case a portion of principal may never be repaid.

Initial Margin and Maintenance Margin

• Initial margin is the amount of money or collateral that is required to open a new position, and it is typically expressed as a percentage of the total value of the position.
• Maintenance margin refers to the minimum amount of money or collateral that the user must maintain in their account in order to keep their position open. If the value of the user’s account falls below the maintenance margin level, the user will be required to deposit additional funds or risk their collateral getting liquidated.

Risk in Crypto Lending

• Smart contract risks: DeFi lending platforms which rely on a set of financial contracts built and deployed on-chain are vulnerable to exploitation by malicious actors taking advantage of a logical or economic manipulation. An example is Eisenberg’s attempt to economicly exploit the DeFi platform Aave.
• Counterparty risk: A borrower is unable to fulfill their obligations (i.e. becomes insolvent). Avoiding concentration to a small group of borrowers is a key component of any lending platform. An example is the recent default by Orthogonal Trading on Maple Finance, an undercollateralized lending platform.
• Duration Risk: Potential changes in the value of a loan due to changes in interest rates. The longer the duration, the more sensitive it is to changes in interest rates.
• Credit Risk: The risk of a borrower defaulting on the loan. This can happen if the borrower is unable to make the required loan payments or if the value of the collateral falls below the required level.

Crypto credit is an exciting and maturing sector of the crypto financial markets. As demand for yield and capital rises and crypto markets grow in mainstream adoption, opportunities are emerging for borrowers and lenders alike. In the next part of the series, we will explore the state of the crypto credit market and take a closer look at some of the key players and trends driving its growth.