Today's guest essay was written by Mauricio Di Bartolomeo, the co-founder of digital currency lending company Ledn.
Loans are as old as money. Throughout history, whether seeds or gold, every form of currency has had its lending market. Now, Bitcoin, with its decentralized and transparent nature, has staked its own claim in the financial landscape. And just like the currencies that came before it, for Bitcoin to truly thrive, it also needs a robust lending market.
However, thus far, most attempts to create a bitcoin credit market have failed spectacularly, with disastrous repercussions.
The demand for bitcoin and digital asset lending services surged during the 2020 run-up, with 10s of billions of client assets flowing towards both centralized and decentralized lending platforms.
Fueled in part by lax macroeconomic monetary policies and the crypto sector's explosive growth, this environment allowed bad actors to operate recklessly, misleading consumers without facing significant checks and balances.
This lack of oversight ultimately led to the collapse of the digital asset lending industry beginning in 2022, including the cascading bankruptcies of lenders including BlockFi, Celsius and a unit of Genesis.
Although accusations of fraud in some of these cases will be a matter for the courts to decide, the sudden domino-like collapse of dozens of digital asset lending firms highlighted an underlying flaw: their operating structures were inherently unsustainable.
These structures lacked a crucial "ring-fencing" of lending risk, and lenders did not provide the transparency needed for clients to understand their credit underwriting process or the concentration risks in their lending activities.
his outdated structure, coupled with insufficient risk management, was akin to dry wood eagerly awaiting a spark — and Terra/Luna, Three Arrows Capital (3AC) and FTX were an entire box of matches.
Historically, a lending model without ring-fenced risks is viable only when a lender of last resort exists, such as the Federal Reserve in the context of traditional banks.
This backstop doesn't exist for Bitcoin, which means the industry needs to develop a new model — one that doesn't lean on government or state institutions.
Systemic weaknesses exposed
The 2022 events highlighted several systemic risks that need addressing, including the ring-fencing of individual product risk.
To give a general rundown of how firms like BlockFi, Celsius and Voyager failed, it has often been the case that crypto credit providers intertwined client assets with the risks of the company's yield products. This means that the client's loan, backed by bitcoin or another cryptocurrency, was in jeopardy if a company's "yield" initiative failed and led to bankruptcy.
Another hazard lies in concentration risk from lending counterparties, or the firms crypto lenders would work with to generate yield on client holdings.
When promised rates become unsustainable, these platforms face a dilemma: restrict lending to manageable limits and reduce client rates, or continue unchecked lending despite surpassing comfortable risk thresholds. Proper management of this concentration risk is fundamental to risk management.
Transparency can make or break these relationships. Take Voyager, for example, which reportedly tied up nearly 58% of their loan portfolio with Three Arrows Capital. Alarmingly, to our knowledge, 3AC did not provide essential financial statements to their lenders, a fundamental requirement for any lender to properly assess the financial health of their counterparties.
One can't help but wonder: Would clients have been so keen to lend to Voyager if they had the full picture from the start? Other firms had similar concentrations with Genesis and/or Alameda Research.
The blueprint for future success
After the rollercoaster that was the past 18 months, digital lending platforms are stepping up their game. Here's the lowdown on what's changing at some firms:
Read the full article here.
– Mauricio Di Bartolomeo
@cryptonomista
