Lending your crypto could generate attractive returns. But how safe is it?

“We give back the return we generate to our clients, who gave us the assets,” says Alex Mashinsky, CEO of Celsius Network, one of the largest lenders, with $ 28.6 billion in assets and 1, 5 million customers. “Just like you can borrow against Apple or Google stocks, you can borrow against your Bitcoin,” he adds.

Still, investors don’t get a free lunch. In addition to the risk of asset lending that could drop overnight, there is an array of business and market specific dangers. Regulators are also going in circles, ordering the closure of some lending services in some states.

“Much of this money continues on the blockchain,” says Paul Brody, EY Global’s blockchain practice manager. If the market collapses and does not recover quickly, he adds, it could have a cascading effect as borrowers default.

Lending digital assets is fast becoming a big business. Companies like Celsius and BlockFi now manage billions of dollars each in crypto. Genesis, an institutional lender and prime broker owned by Digital Currency Group, provided $ 35.7 billion in crypto loans in the third quarter, up 586% year-over-year. Nexo, another lender, claims it has $ 12.3 billion in assets and paid $ 200 million in interest.

Like banks and brokerage firms, crypto lenders offer interest-bearing accounts, secured loans, credit cards, and other services. And they compete aggressively for capital, offering token bonuses and rewards. Borrow $ 1,000 for $ 10,000 in Bitcoin on the Abra lending platform and you will receive $ 5 from a token called CPRX. BlockFi now has a co-branded credit card with

Visa

(ticker: V) including 1.5% cashback in Bitcoin on all purchases. Celsius and Nexo increase returns with their exclusive tokens.

Investors also earn returns on crypto through exchanges and decentralized finance networks, or DeFi. More than $ 260 billion in crypto is now stuck in “smart contracts” on DeFi platforms, according to DeFiLlama.com.

Why are the returns so high? The answer is a mix of risk, market inefficiencies, and strong demand for crypto and stablecoin borrowing.

The lending model is similar to that of a traditional brokerage: crypto lenders offer secured loans backed by clients’ securities. The principal for the loans comes from the holdings of other clients, and they receive a share of the interest paid, after the loan brokers take a share. Investors can usually withdraw their assets at will, although it may take a few days. Interest is paid in crypto or stablecoin, and it can adjust frequently, depending on market demand.

Most lenders offer structured rates, offering higher returns on smaller amounts. At BlockFi, Bitcoin gains 4.5% on 0.10 Bitcoin and 1% on 0.10 to 0.35 Bitcoin. Celsius returns a bit more, offering 6.2% on 0.25 Bitcoin and 3.05% above, at current rates.

Stablecoins often earn 10% on many platforms. Lenders increase returns with reward tokens and other bonuses, and stablecoins are in demand for trading, market making, and liquidity. Additionally, crypto owners can use Bitcoin as collateral for a stable loan, leveraging the asset’s earnings without selling it. “If you give me Bitcoin as collateral, I can only lend you a stablecoin,” says Mashinsky.

Another reason the returns are high: Traders can capitalize on large price spreads. Crypto markets are inefficient and decentralized, which creates opportunities for hedge funds, exchanges, market makers, and other firms to take advantage of the high spreads between buyers and sellers. “There is a lot of money in market making,” says Zac Prince, CEO of BlockFi. “But you need inventory to make deals. If you don’t want to buy Bitcoin directly, you borrow it.

How secure is the crypto loan? Companies say they use rigorous risk controls and place high collateral requirements, up to 200% of a loan’s value for highly volatile cryptos. Loans can be liquidated automatically if prices fall below certain levels. And loan brokers can issue margin calls, forcing borrowers to post collateral. “These companies have a vested interest in how their business model works, and that requires good protections for clients,” said Daniel Davis, crypto firm lawyer at Katten Muchin Rosenman law firm.

Yet investors shouldn’t rely on government loss protections. FDIC bank insurance or SIPC brokerage insurance is not available in crypto. The industry is not as tightly regulated as banks or brokerage houses. And while lenders can be careful with loan-to-value ratios and capital reserves, they can take liberties.

Celsius and BlockFi, for example, state in their risk statements that they can “pledge, pledge, mortgage, remortgage, sell, lend or otherwise … use any amount” of digital assets at their discretion. . The mortgage is the pledging of a guarantee for a loan; remortgage means repackaging the collateral into another loan. These practices often caused problems on Wall Street when counterparties like hedge funds collapsed.

“Crypto goes through a stressful event at least once a year and we come out of it clean,” says Mashinsky. “The regulators looked at us and said these guys knew what they were doing,” he adds. BlockFi referred Barron to its risk disclosure statement.

However, the crypto market is no longer trivial; it’s worth $ 2.3 trillion in total, and the leverage has been built up through futures and other derivatives. Tensions or selling pressures in one area could spill over into others; Leveraged borrowers, faced with margin calls or forced liquidations, may have to consolidate collateral if they can afford it, or abandon their positions if they cannot, defaulting on their repayments. ready. “These lending platforms are designed to withstand significant volatility, but if the overall market drops more than 30%, it could trigger a cascade of redemptions and challenges,” says Brody.

The crypto lending market is also opaque: a batch of assets can be loaned multiple times, and if one of them defaults, the original lender may need to be repaid from the capital reserves of the asset. ‘a business, assuming it’s first in line. Wall Street made a fortune selling and pooling secured loans before the company collapsed in the mortgage crisis. “There are similar risks in this area,” says Brody.

Regulators have taken note. The Securities and Exchange Commission threatened to sue

Global Coinbase

(COIN) if it launched a lending platform, prompting Coinbase to cancel its launch. Financial regulators in states such as Alabama, Kentucky, New Jersey, and Texas have launched investigations or “cease and desist” orders to Celsius and BlockFi. New York recently ordered the closure of two lenders, including Nexo, and requested information from three others.

The companies claim their products do not violate securities rules and are contesting close orders. Nexo says it did not offer a loan product in New York and points out that its finances are audited, including publicly available data on its reserves. “We have three law firms that give us the opinion that everything we do is compliant and legal wherever we operate,” explains Mashinsky. BlockFi says it believes its products and services are legal.

Abra CEO Bill Barhydt said the company “is digging very deep into risk management.” The accounts are managed by Prime Trust, a crypto trust company. The loans are highly secured, he adds, and Abra holds enough reserves to meet withdrawal requests, usually within one business day. Yet, he cautions, the crypto loan is not for everyone. “Bitcoins and

Ether
aren’t going to go away, but if you have alt-coins you could lose all your money, ”he says. “Enter with eyes wide open, no illusions of grandeur. ”

Write to Daren Fonda at [email protected]