Crypto Lending: A Primer for Investors — Part II: Crypto-Backed Crypto Loans
DISCLOSURE: The ecosystem landscape included in this post is intended to provide generalized guidance; nothing in this analysis is intended as investment advice, a recommendation or an introduction to particular funding or capital resource.
Almost all of our previous discussion can be brought to bear in describing how crypto-backed crypto loans work. Moreover, the important questions are still the same: who are the lenders, and who are the borrowers? Why do they engage in these transactions? What forces shape the market, and how do the players involved react to those forces?
There are some places out in the world where borrowers can borrow crypto like BTC with other crypto as collateral. Half of Genesis Capital’s loan book is in BTC terms, and altcoin loans make up a small, but real portion as well.
(Genesis Capital Loans Outstanding by Asset through 1Q2020. Source: Genesis Capital)
Bitrue, an exchange, has branched out into crypto-backed crypto lending as well.
(Source: Bitrue)
Transactions like this are probably best analogized, in the traditional world, to a form of securities lending. In this manner, holders of BTC and other desirable crypto are able to earn extra return for lending out their assets to counterparties who need the borrow. Usually, this transaction facilitates short selling, but the borrow could equally be used for financing a futures trade or something similar.
In equities, the short interest, or percentage of shares outstanding borrowed in securities lending transactions, is usually a sign of market sentiment with respect to a particular stock. The list of stocks with the highest short interest on the NYSE is a murderer’s row of underperforming companies.
(Equities with highest short interest trading on NYSE. Source: highshortinterest.com)
To our knowledge, there’s no similar metric at work for cryptocurrencies, probably owing to the fact that most altcoins aren’t worth very much relative to BTC, but perhaps in the future we’ll be able to examine similar figures for aid of valuation.
The bigger story when it comes to crypto-backed crypto lending can be found in the world of decentralized finance (DeFi). DeFi is a catchall term for the activities in a booming sector of the industry, one which leverages the power of smart contracts to automatically settle complicated financial transactions. As a side note, this subject can become rather complicated as it deals heavily with nitty-gritty distributed computing, and even geniuses like Vitalik Buterin struggle to communicate what precisely is going on in clear terms. We’ll cover it just enough to discuss what the financial implications of these opportunities are.
A smart contract is a kind of application built using a programming language which was created by Ethereum’s founders. Unlike Bitcoin, Ethereum is much more useful in this way — at the same time as its founders built a cryptocurrency, they also built a way for people to communicate and interact using crypto-based functions. Good uses for smart contracts would include applications like escrow in real estate transactions — you could program the smart contract to accept funds from a buyer, hold them, and release them to a seller automatically upon the resolution of certain conditions specified when you built the app.
These smart contracts were quickly brought to bear in crypto’s favorite application, trading. Decentralized exchanges were built using smart contracts to allow the trading of cryptocurrencies without the need to interact with “off-chain” platforms. Of course, there’s nothing crypto traders love more than leverage, so organizations like MakerDAO popped up to facilitate decentralized lending. Brady Dale, writing for Coindesk in July, wrote about the shift in possibilities these new applications opened: “Immature and experimental though it may be, the technology’s implications are staggering. On the normal web, you can’t buy a blender without giving the site owner enough data to learn your whole life history. In DeFi, you can borrow money without anyone even asking for your name.”
MakerDAO pioneered a model which is ubiquitous today, in that they allowed anyone to borrow crypto from a smart contract with the provision of collateral equal to 150% of borrow. In particular, MakerDAO allowed traders to deposit ETH and receive a stablecoin, DAI, whose value is algorithmically pegged one-to-one to the US dollar. The smart contract would create this DAI and store the collateral, while also handling functions like margin calls. It would even liquidate the collateral if the borrower didn’t recapitalize the loan. Since its founding, traders have pledged more than $500mm of collateral to borrow DAI off the smart contract.
(Source: DeFi Pulse)
The next evolution in DeFi was a project called Compound, which put a spin on MakerDAO’s business. It allowed a two-way market of borrowers and lenders to meet on the smart contract. Moreover, it allowed a breadth of settlement assets: borrowers could borrow stablecoins like DAI and USDT, but also bread-and-butter cryptocurrencies like ETH, BAT, or 0x, while putting up as collateral any combination of the same. Lenders, too, could lend any one of their held assets. In order to align incentives, the smart contract behind Compound varies rates of interest (independently for depositors and borrowers) and collateral multipliers across assets.
(An example of what the Compound dashboard offers — rates on deposits and borrows in several currencies, as well as the option to activate any combination of assets as collateral. Source: Compound)
It’s important to note that the spread between depositor and borrower interest rates (APY in the image above) does not get paid as profit to the owners of Compound. In fact, there aren’t really owners of Compound, in the sense that we’d think of it like any other business. The spread is purely intended to stabilize the lending markets.
We can visualize the evolution of these rates through time, courtesy of the people at DeFi Pulse. The rate on Maker has been the benchmark since at least 2017, but from time to time, smaller platforms have briefly offered much higher rates. Over the course of the last year, an annualized composite rate tracked by DeFi Pulse declined from an average of ~10% to less than 5% following the large crash in March.
(Source: DeFi Pulse)
(DeFi Pulse’s composite measure of lending rates across DeFi platforms since June 2019. Source: DeFi Pulse)
Of late, however, changes spurred by Compound have reshaped the rates market. Until June of this year, the sum of assets deposited and borrowed on Compound averaged a value of ~$100mm. In June, that number shot up to more than $600mm.
(Source: DeFi Pulse)
What caused that dramatic spike was a decision made by the team behind Compound to launch an exchange coin, COMP, which is designed to track the uptake and success of Compound as a platform. This makes it similar to the more well-known Binance coin, BNB. Despite being released before trading on Binance actually went live, BNB has done decently well for itself, and currently ranks #11 in market capitalization among all cryptocurrencies.
(BNB price and volumes traded since July 2017. Source: CoinMarketCap)
One feature that distinguishes COMP is the presence of voting rights — as Bradley Keoun and Omkar Godbole explained in Coindesk, COMP will “give holders a right to vote on decisions affecting the management of the protocol, such as technical upgrades or whether to incorporate new assets onto the platform.” In a good example of understatement, they add that “[e]ventually…holders might also be able to get a share of fees paid into the system or vote to buy back tokens”.
The team at Compound took those words to heart when launching COMP, and decided to implement a kind of dividend, or reward, into their platform. In a Medium post on May 27th, Robert Leshner, Compound’s founder, set out the terms of their plan: “All users and all applications built on top of Compound will continuously, and automatically receive governance rights, for free — in order to shape the future of the protocol.”
(Diagram explaining the COMP distribution program. Source: Compound)
This idea, that users of the platform would earn rewards for their use of the platform, kicked off an investment craze known today as “yield farming”. Per DeFi Pulse, a prominent blog and DeFi data tracker, yield farming is “the act of leveraging different DeFi protocols and products to earn a yield or a return on their assets, in some cases obtaining profits well over 100% APY through a combination of lending interest and token incentives.”
What’s that about “profits well over 100% APY”? Leoor Shimron’s Forbes article from June 22nd, titled “DeFi Yield Farmers And Crypto Investors Are Raking In 100%+ Annualized Yields,” offered more info. “For example,” Shimron wrote, “according to yesterday’s rates, a user who lent out 1,000 DAI (equivalent to $1,000), and took out a loan for $2,500 worth of the BAT crypto asset would have generated 77.48% APY in COMP rewards paid out daily, assuming a COMP token price of $360.” Easy!
(This widely shared article brought mainstream attention to yield farming. Source: Forbes)
“At the simplest level, a yield farmer might move assets around within Compound, constantly chasing whichever pool is offering the best APY from week to week,” noted Dale in his article for Coindesk. “Because these [COMP] positions are tokenized, though, they can go further…Liquidity mining supercharges yield farming.”
In the days following the announcement, DeFi enthusiasts realized just how lucrative token rewards like the program COMP offered were. More to the point, they realized those token rewards could be earned at a higher rate through the use of leverage, which they were able to obtain in the web of decentralized lending platforms.
“One of the many strategies that were applied,” per DeFi Pulse, “was taking out USDT loans with DAI as collateral and investing them in the corresponding market on Compound….BAT [later] became the most profitable market for COMP farming.” The craze grew as other platforms started to offer algorithmic approaches towards increasing COMP farming. The smart wallet project InstaDApp, which helps both to aggregate DeFi apps as well as solve some of their common user experience issues, implemented a widget on their website offering to users the chance to “Maximize $COMP Mining”.
(Selection from InstaDApp’s dashboard, highlighting widgets added to facilitate yield farming. Source: InstaDApp)
More esoteric channels allowed the truly yield hungry to embark on ever more bizarre leveraged transactions. Balancer, another DeFi platform, announced its own token rewards program in the days following COMP’s dramatic run-up in price, while bZx launched their own shortly thereafter. “Liquidity pools,” a platform variant of decentralized exchanges, began programs to reward trading activity, and on June 26th a triumvirate of DeFi platforms — Ren, Synthetix, and Curve — opened a reward program called the “farming meld,” complete with complicated diagram explaining how the rewards would flow.
(This diagram is purported to explain how traders, or “THE PUBLIC,” can farm yield through Ren, Synthetix, and Curve’s partnership. Source: DeFi Prime)
Credit ought to be given to the attempts, however limited, made by most DeFi proponents to inform would-be farmers of the risks inherent in these operations. One of the sections in Dale’s Coindesk explainer asked “How Risky Is It?,” to which he replied, “Enough…We’ve seen big failures in DeFi products. MakerDAO had one so bad this year it’s called ‘Black Thursday.’..These things do break and when they do money gets taken.” Meanwhile, writing for DeFi Prime in September, Seth Goldfarb asked, “Are investors and proponents properly considering the risk associated with lending stablecoins?” He continued to expand on several potential sources of risk, including “Smart Contract Vulnerability,” “Changing Governance,” and “Financial Risk”. “[T]here remain significant hurdles to properly evaluate [sic] DeFi products as investment opportunities and investments in DeFi should be considered high-risk, accordingly,” he wrote. And at the end of their explainer, “Zero to DeFi,” the team at DeFi Pulse outlined a set of potential risks towards engaging with DeFi lending, among which this: “You could die rendering your cryptocurrency inaccessible to friends or family”.
More skeptical voices have emerged in response to the buzz surrounding yield farming. Leshner, the founder of Compound, called the activity a “self-organizing anarchy,” while Vitalik Buterin, the founder of Ethereum, shared his own concerns:
How should investors begin to assess the risks involved in trading DeFi, or in farming yield? In the first place, it’s important to remember that the main product on offer, through all of this, is more like a floating-rate note, and less like a fixed-term loan. Dale, writing in Coindesk, put it neatly: “[T]he interest [earned on DeFi loans] is quite variable. You don’t know what you’ll earn over the course of a year. USDC’s rate is high right now. It was low last week.” Compound, according to their docs, actually varies the rate of interest earned on any asset per confirmed block (!). And while there’s some assumption of continuity there, that amount of variance ought to give pause to those seeking to make a comparison between DeFi loans and traditional fixed-income investing.
(This source code from Compound calculates the “APY” often cited in discussions of yield farming. The doc adds, “Note that the supplyRatePerBlock value may change at any time.” Source: Compound Docs)
When the yield on a bond issued by Coca-Cola rises — which itself would only happen when unexpected events, like a factory explosion or FDA investigation, occur — investors who are enticed to buy the bond by the higher yield on offer are guaranteed to earn that yield over the remaining life of the bond, assuming Coca-Cola does not default. If the yield should later fall back to prior levels, those investors who bought when the yield was high will in fact profit, because their bond will be worth more than it used to be. Now, that is not to say that their cash flows change: a bond issued with a 2% coupon will pay a 2% coupon until it matures. But over time, they earn the yield described at time of purchase.
Not so for the same investor lending into a lucrative DeFi contract. They only earn that high rate of interest as long as it persists in the market, so there’s no way of actually assessing what the gains on any particular trade will be. If at trade time the lending rate on Compound for ETH is 20% annualized, and an investor lends 1000 ETH, they will earn one block’s worth of a 20% annual interest rate. The average time between blocks for ETH has long been about 15 seconds, implying a very little amount of time for that high rate of interest to accrue.
We will note that for transactions like the one outlined by Shimron in his Forbes article, which we quoted above, there are truly sizeable amounts of tokens being handed over in the form of rewards at trade time. But recall that the “100% APY” figures being thrown about are annualized rates, meaning they assume that the same rate can be guaranteed over the course of a whole year. COMP was only launched on June 15th. This ought to be taken as a cautionary tale for investors seeking to pile into yield farming, lured by impossibly high rates. It is difficult to expect that these rates will persist for an amount of time long enough to approach those advertised rates. And finally, it ought to be noted that the rewards leading to these “100% APY” figures are still denoted in volatile altcoins. There is no guarantee that, even if the amount of token needed to make “100% APY” were achieved, those tokens would be worth anything once it was all said and done.
A proper accounting of duration is merely the most innocent of the risks surrounding an investment in DeFi. Most of the strategies involved in farming yield boil down to taking out leveraged loans on the platforms offering the highest token rewards. DeFi Prime described InstaDApp’s “Maximize $COMP Mining” widget bluntly: “Essentially, it’s mining using a leveraged position: people borrow and deposit assets simultaneously in order to get more COMP.” Brady Dale in Coindesk described it similarly: “It’s possible to lend to Compound, borrow from it, deposit what you borrowed and so on. This can be done multiple times and DeFi startup Instadapp even built a tool to make it as capital-efficient as possible.” A financial system that relies on obscure forms of leverage to power an alluring set of returns should raise blaring red flags — just ask Michael Burry.
And even if the duration of the loans and the crumbly ziggurat of leverage on which it stood weren’t enough to make savvy investors pass and live on to fight another day, there is a core component yet unexamined: the nature of the borrower on the other side of the loan. When a deposit is made at a bank, that too is a short term loan, which bears a varying rate of interest. Since the Great Depression, however, the Federal Deposit Insurance Corporation has backed the credit of these banks’ depositary holdings with a government guarantee, making them essentially risk-free. When a crypto lender solicits deposits from investors into their platform, the investor can make their own decision whether to lend with respect to both the creditworthiness of the lender and its book of borrowers as well as the rate on offer to them. When a trader deposits stablecoins or other crypto at a DeFi platform, they are made to make their decision in a vacuum, with only the rate on offer to guide their thinking, and no real information about the trustworthiness of the smart contract or the borrowers on the other side running the system.
Alan Keegan, formerly the CSO at Tiger Trading, reframed much of the discussion surrounding DeFi aptly: “[G]iven the unknown risk of default, the uncertainty around how default losses are distributed, and, in the case of DAI, the additional risk that DAI maintains [its] peg (plus the additional issue of paying the stability fee if I’m getting my DAI from a CDP) — these ‘high interest rate deposits’ look pretty unattractive. You’re taking on three different layers of risk you need to be compensated for in order to have your money in that deposit. So [DeFi lending] is not this fantastical world of, ‘why don’t you have your money on 11% internet loan instead of in a bank?’ It’s more ‘why do you have your money in a bank instead of holding exposure to an unknown default risk, an unknown default policy, and an unknown currency peg risk[?]’” (emphasis original)
In our read, the risks of DeFi lending at any level are rather high, and the returns uncertain. More to the point, the risks of yield farming are increased by the leverage permitted by smart contract implementations, and the returns are made even more uncertain by their dependence on the volatile price of token rewards. Investors interested in committing their or their clients’ capital to these endeavors would be smart to limit dramatically the amount of funds they allocate here.
Important Disclosures and Other Information
This informational piece is intended to inform Wave Financial’s audience of the current status of the crypto industry. Nothing in this material should be interpreted as an offer or recommendation to buy, sell or hold any security or other financial product. Wave Financial LLC is a registered investment adviser, registered with the state of California. Registration with the state authority does not imply a certain level of skill or training. Additional information including important disclosures about Wave Financial LLC also is available on the SEC’s website at www.adviserinfo.sec.gov. Or, learn more information about Wave Financial at www.wavegp.com.
The ecosystem landscape included in this post is intended to provide generalized guidance; nothing in this analysis is intended as investment advice, a recommendation or an introduction to particular funding or capital resource.
