The Crypto Lending Industry — a Ticking Time Bomb, Rather Than a Shortcut to Mainstream Adoption
In his book “Extraordinary Popular Delusions and the Madness of Crowds”, Charles Mackay says that men think in herds and go mad in herds, while they only recover their senses slowly, and one by one. That was written in 1841. Today, it is even more relevant.
The most illustrious collective obsession in the past decade is cryptocurrencies. For the last couple of years, we witnessed industry-specific shocks with varying implications, be it exchange hacks, scam schemes, or else. Although covered in controversies, in the long-term, the rise of cryptocurrencies should be considered as a positive for the global financial markets landscape.
When something still relatively unknown and shaky starts scratching the surface of a recent painful matter like the credit markets, though, we tend to get more sensitive and start asking questions. Since 2018 the cryptocurrency lending industry has managed to grow up to $5 billion, and the upward trend continues. The expansion has raised some questions and a glaring sense of a painful déjà vu.
Every credit market in our history had, at some point, formed a bubble which has later on burst with implications of a different scale. Today, we have several reasons to believe the crypto lending industry may be the next in turn.
The asset’s fundamentals
The idea of cryptocurrency lending is to use your digital assets as collateral and borrow cash. In return, you are paying interest, similar to the way traditional credit lines work. However, the problem here is laid in the fundamentals of the underlying asset.
Aside from stablecoins, cryptocurrencies are known for their extreme volatility. This means a credit crisis in the crypto lending industry may end up way more devastating than the subprime mortgage crisis. Even in the peak of the Financial Crisis, when the banks’ portfolios held millions of practically worthless real estate, it was clear that, at some point, the market would recover, and the assets would regain a part, if not their entire value. Due to the nature of the asset class, the whole crisis was a matter of going through the storm and waiting for the sun to rise again.
Bitcoin, on the other hand, is prone to sudden and significant price swings. An exchange hack, a sudden crash, a scam scheme like the PlusToken one, a massive sell-off, or another event may bring chaos to the market. From the perspective of crypto lending services, such fragility is concerning. In a scenario where the market is in a steep downturn, borrowers’ assets would depreciate quickly. Depending on how fast the market dives, borrowers may be unable to ensure more collateral, which would lead to lending companies liquidating the collateral on their books. A simultaneous default on a number of loans and the massive follow-up sell-orders from lenders would further exacerbate the market’s downturn.
Insufficient risk management tools
One of the lending companies’ key selling points is that they don’t perform credit checks, thus making crypto loans available to anyone. This means the only real risk management tool in the industry is the Loan-to-Value indicator, which estimates the value of the collateral that the borrower should deposit to be granted a loan. If, for example, the LTV is 50%, then to get a loan of $5 000, the borrower should ensure $10 000 worth of collateral. Once the LTV goes out-of-bounds, the borrower is urged to deposit additional collateral or sell a part of his cryptocurrencies to repay the loan. Failure to do so triggers an automated collateral liquidation.
To minimize the default risk, some lenders try to over-collateralize by setting LTVs as low as 20%. Even if the loans are over-collateralized, in case there is a significant drop in the crypto market, and the LTV jumps, the only outcome is collateral liquidation. However, at that point, the collateral might already be worth significantly less than the outstanding value of the loan. Moreover, a simultaneous default of several borrowers would generate an immense selling pressure at a time when there won’t be enough buyers.
The LTV is designed to mitigate losses, rather than protect from default risk. This shows that lenders and borrowers are equally vulnerable to the market’s unpredictability.
The risk of becoming systemically important
For now, the crypto lending companies are strictly focused on operating in their niche. However, should they penetrate other fields like the exchange or the banking business, then the isolated problems may gain systemic importance, thus draw the market in a downtrend spiral.
It is also worth noting that the growth of the industry goes hand-to-hand with its institutionalization. At first, sophisticated investors like hedge funds were attracted to the niche due to its volatility and profit opportunities. Today, they are holding a more market-neutral position, using lending services to balance their portfolios and navigate between short and long positions on the Bitcoin and altcoin markets. The industry matures and starts resembling the interbank FX market, where the USD, as the base currency, is exchanged against secondary currencies. In the cryptocurrency world, the base currency is Bitcoin, while altcoins serve as the secondary currencies.
Тhe rapid expansion of the crypto lending market and its apparent potential would also result in new companies entering the niche. The industry would have no other choice than to follow the steps of other credit markets. Increased competition would mean the only way to attract new clients is by loosening the lending policies. Loans would get riskier, and the chance of default would increase. This is how we come back to the initial argument — the problem with the asset’s fundamentals and whether they can guarantee the steady operation of the lenders.
Should we be concerned?
It is too early to say. Until the bubble bursts, the implications of a credit crisis are just assumptions. Take the subprime mortgage crisis, for example. No one had an idea about all the things going behind the scenes in terms of structuring new products and the size of the CDS market. All we knew was the niche was booming, and buying a home was as easy as buying ice cream.
If we are lucky enough and the crypto market remains capsulated, the worst-case scenario would be a default of a part of the lending companies, possibly those with loosened credit control. For their clients, it would mean a loss of their crypto assets. If, on the other hand, markets’ interconnectedness and the risk of volatility spill-overs increase, then we may have to face a chain-like effect and destabilization, transferring through the entire system. Most likely to be affected by such a scenario are hedge funds with significant exposure to the digital assets class.
In the end, everything depends on the size of the crypto lending niche and whether it penetrates other markets. For now, it remains small — the daily Bitcoin transactions are in the range of $500 million to $1 billion. In comparison, the volume on the FX markets is estimated at $6.6 trillion per day. Considering the rapid rate of expansion that we are currently witnessing, though, we may soon reach a point when the cryptocurrency market becomes an integral part of the global financial system.
If we should be honest, the prerequisites for a potential cryptocurrency credit crisis to unfold are all present — a lack of regulation, cheap credit for everyone, little-to-no due-diligence, and, most importantly, excessive optimism. The last time we had all these on the table, things got ugly.