Cryptocurrency Lending Market Overview
Original title: "Chain Hill Capital: Encrypted Lending and Its Impact on the Market"
Original source: Chain Hill Capital, Carrie
The most common crypto lending method is that borrowers use their crypto assets as collateral to obtain fiat currency or stable currency loans, and lenders Earn interest income by providing assets. Another way is for borrowers to borrow crypto assets using fiat or stablecoins as collateral, but this is rare. The market demand for encrypted lending comes from the following aspects:
Trading activities – including arbitrage, leverage, market making and other trading activities, this is the most important demand. For example, OTC service providers or market makers need to borrow funds to meet a large number of transactions; traders use borrowing to increase leverage, or borrow assets to short sell for arbitrage;
Tax optimization – Many countries and regions currently include the sale of encrypted assets as a taxable event, and depending on the jurisdiction, the tax rate may be as high as 40% to 50%. (Data source: CNBC) Therefore, if you directly sell encrypted assets, you need to pay high capital gains tax, but you only need to pay about 10% interest per year through encrypted lending;
Access liquidity – By mortgaging encrypted assets to borrow legal currency, miners, ICO teams and encrypted start-ups can solve short-term liquidity needs while retaining the future potential upside value of their cryptocurrency investment;
Token Economy – such as Yield Farming
Encrypted lending flowchart
There are many structural differences between the encrypted lending market and the traditional lending market (banks, online lending, etc.).
Encrypted lending is divided into two types: centralized lending and decentralized lending.
Centralized lending
This is a custody-based lending, its main features are Users cannot control their own assets, and the user's private key is controlled by the platform. Specifically, users must deposit their crypto assets into the platform wallet. The platform either lends the user's assets out through a peer-to-peer model, or merges the assets and lends them to the counterparty through OTC. In the case of borrowers, the platform locks their assets as collateral and lends them fiat or stablecoins. Depending on the operating strategy of the platform, some platforms will use the user's mortgage assets for loans. Borrowers obtain encrypted assets, stable coins or fiat currency through the lending platform. When the borrower fails to repay the loan, its collateral will be liquidated. According to the type of users targeted, centralized lending can be divided into two categories: personal lending and institutional lending.
Decentralized lending (DeFi lending)
DeFi lending is based on smart contracts without A permissioned protocol set, which is a non-custodial lending where the platform does not have access to the user's private keys and the user controls their assets. And, unlike the centralized platform, here, all lending processes are automated without platform review. Currently, most DeFi lending is based on the Ethereum blockchain, and data is publicly available on the blockchain. Through DeFi lending, users can also borrow encrypted assets or stable coins, but cannot borrow fiat currencies.
Industry Status< /h4>
The most important event in the first quarter of 2020 is the impact of the new crown epidemic on the entire encryption market. In the face of unprecedented market volatility, the encrypted lending market has shown good resilience. The liquidation rates of centralized lending institutions and DeFi lending are less than 10% and 20%, respectively. With the rapid recovery of the encryption market, the growth of the encryption lending industry accelerated in the second quarter, and both the assets invested by investors and the overall number of users have experienced a substantial increase.
In the second quarter, the amount of active lending (referring to loans that have not yet been repaid) across the industry increased by 100% from the previous quarter to nearly US$5.2 billion. Value increased 98% sequentially to $10 billion. Even after adjusting for underlying asset price increases, there is still a significant increase of about 50% in collateralized assets. The growth in Q2 was largely driven by growth in products for individuals (Blockfi, Nexo, Celsius, Compound) and the launch of a more robust derivatives trading platform for institutions (Genesis).
The growth of the DeFi lending sector is even more pronounced, with active lending increasing by 252% and collateral increasing by 183%. This is because:
1) Many DeFi projects have expanded their services. dYdX, Maker, and Compound have successively launched new products to the market. Among them, Compound has made the biggest innovation. By issuing COMP tokens and transforming into a DAO, Compound has seen its AUM grow by 700% as a result of users staking massive amounts of their assets for “stakes” in the platform. Then came the explosive growth of governance tokens and the prevalence of liquidity mining.
2) Demand for stablecoins DAI and USDC surged. This may be due to the desire to hold long-term positions in ETH and maximize profits in the current bull market.
Data source: defipulse
Data source: genesis
From In terms of active lending, centralized platforms account for nearly 90% of the market, much larger than the market size of DeFi. The market share of DeFi lending has dropped by 50% from the third quarter of 2019 to the first quarter of 2020. In the second quarter, due to the mining boom, its market share has rebounded. Will the lending activities driven by the mining boom continue to be repaid? Time verification is required. In centralized lending, institutions occupy the main market share. Although it has declined after the third quarter of 2019, it still far exceeds the individual market. Generally speaking, the most important customers of the current encrypted lending market are institutions.
Data source: Credmark
Data source: Credmark
Encryption The overall interest rate level in the lending market is showing a downward trend, but the interest rate of centralized lending is relatively stable, remaining at 6%-7%. DeFi lending interest rates fluctuate greatly, reaching a maximum of 11% in the fourth quarter of last year. Although the overall yield of liquidity mining is high in the second quarter of 2020, the lending interest rate itself has dropped due to the surge in supply.
Data source: Credmark, Chain Hill Capital< p>The average lending interest rate difference in the encrypted lending market is 2%, and the situation between different currencies is quite different. The lending interest rate differentials of the three currencies ETH, DAI, and USDC, which account for the largest proportion of Defi lending, are 0.4%, 0.4%, and 2.7% respectively.
Data source: loanscan
Comparing the interest rates of the traditional lending industry, it can be found that the interest rate spread of lending is very large, the interest rate of depositors is far lower than the level of encrypted lending, and the overall interest rate level of lenders is also higher than that of encrypted lending high. Generally, low-interest loans can only be obtained by companies and individuals with high credit ratings.
Lower interest rates on money market or savings accounts, data source: bankrate
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Excluding other fees, the actual interest rate will be higher, data source: bankrate
The overall loan-to-value ratio (LTV) of crypto lending has changed little over the past year. Although the LTV of DeFi lending has increased, it is still the lowest at about 32%; the LTV of centralized lending is around 55%.
The reason why the LTV of DeFi lending is far lower than that of the central encryption lending platform is:
1) The risk control mechanism is different. Due to the anonymity of the DeFi platform, it is impossible to verify the real identity and credit of the user, coupled with the high volatility of the encryption market and the relatively low liquidity of the DeFi trading platform, therefore, it is necessary to ensure that the lender’s interest is guaranteed through a higher LTV. security of funds. In contrast, centralized lending platforms can reduce the risk of default through comprehensive due diligence. For example, BlockFi will verify the assets of the counterparty and require the counterparty to have 20 years of experience in financial transactions.
2) Market demands are different. DeFi lending activities are currently mainly driven by liquidity mining and governance tokens, and cannot provide fiat currency lending, so users are less willing to take on debts; while users of centralized lending platforms are more motivated by transaction needs, including providing Liquidity and the use of leverage, they usually have higher leverage requirements. Institutional demand for stablecoins continues to grow in order to go long. According to research from Credmark, trading data shows that, among leveraged positions, 68% of borrowers increased their long positions through leverage.
Data source: Credmark
It is worth noting that the LTV of centralized lending for personal loans is far lower than that of institutions, and the LTV of centralized lending for personal loans is closer to the level of Defi.
Data source: Credmark
to be resolved Problems
External problems
Centralized platform moral hazard. Because users' assets are hosted on the platform, and encrypted lending platforms are not subject to supervision and insurance protection like banks (some platforms have custody insurance), the moral hazard is relatively high. The recent bankruptcy of the centralized lending platform Cred is a good example. Cred committed serious fraud and misuse of funds. They first lent client assets to usury institutions, and invested the remaining funds in encrypted hedge funds. In the market on March 12, the hedge funds they invested in closed down. In order to deal with the financial loopholes, they borrowed money from loan sharks to invest in hedge funds, but platform executives stole part of the funds. Ultimately, Cred filed for bankruptcy with assets valued at between $50 million and $100 million and liabilities between $100 million and $500 million. In addition, many centralized lending platforms have a re-mortgage business model, which requires high risk management capabilities of the platform. In the absence of regulatory constraints, excessive lending is likely to occur, eventually forming a systemic risk.
Technical risk. Smart contracts are relatively new technology, and transactions recorded on the blockchain are irreversible. Therefore, when using smart contracts to transfer funds and manage lending contracts, errors can cause irreparable losses. Moreover, many projects and codes have not passed strict inspections, and once there are loopholes, they will be exploited by hackers. According to a CipherTrace report, as of the end of October, losses from theft and hacking (excluding misappropriation and fraud) this year totaled $468 million, and about 20% of these hacks, or about $98 million, came from DeFi.
Regulatory risk. The open and permissionless nature of DeFi makes it not subject to geographical restrictions, and people in any country/region can access and use it without authentication. This means that it is difficult to have applicable regulations to regulate it. Therefore, many people think that DeFi may become a paradise for money launderers. Indeed, in the face of a brand new thing, regulators still need time to explore suitable regulatory solutions, and the current scale of DeFi may not be enough to attract regulatory attention. However, once the industry takes off, regulators are likely to start paying attention to DeFi risks. For DeFi lending (and the entire crypto industry), regulation is always a potential risk.
Inherent Problem--Product Limitations
According to the credit degree of the loan, currently Commercial bank loans are mainly divided into four forms: credit loans, guaranteed loans, mortgage loans, and pledged loans. Except for credit loans, the latter three are collectively referred to as secured loans. Credit loans have a high degree of credit, do not require mortgages and third-party guarantors, and are only issued based on the credit of the lender. The biggest difference between a secured loan and a secured loan is whether a mortgage or a third party guarantee is required. These two forms of lending complement each other to meet different needs.
Based on the data in the 2018 mid-term report, the proportions of the four kinds of loans in my country's listed banks are 42% for mortgage loans, 30% for credit loans, and 30% for guaranteed loans 17%, mortgage loan 11%. That is to say credit loans accounted for 30% of listed bank loans.
As mentioned earlier, due to the lack of user credit scores and KYC, DeFi lending can only control risks through over-collateralization. The current collateralization ratio is about 350-700%, which means that users may need to mortgage up to 700 units of crypto assets to borrow 100 units.
Of course, DeFi lending can do a lot with the concept of mortgage lending alone. According to the May 2020 report of the Federal Reserve Bank of New York, the size of mortgage loans in the United States is $14.30 trillion. However, the current collateral for DeFi lending is very limited, and can only be collateralized by encrypted assets.
In short, if the problems of high mortgage rate and asset restrictions can be solved, DeFi lending or blockchain-based lending will have more application scenarios and users group.
Development trend
In addition to the gradual improvement of supervision and the maturity of technology , the encrypted lending market may have the following development trends.
Products are gradually maturing
This includes the introduction of low-mortgage loans and credit loans. At present, some projects are making related attempts.
For example, Aave pioneered the unsecured loan model "Flash Loans", which is designed for developers and can be used without any collateral The loan is made immediately under the condition that the loan and the interest must be returned in the same transaction, and the whole process must be completed in one Ethereum block (15 seconds).
If the principal and interest are not returned to the fund pool before the end of the transaction, the smart contract will undo all previous operations to ensure the safety of the agreement and funds . Aave's flash loan innovation is very strong, and it can be used as a basic tool to build more applications. Second, Aave attempted to introduce "unsecured" loans through their credit authorization system. When a user deposits assets into Aave, he enables other users to borrow an amount smaller than their deposit without collateralizing themselves. Aave offers both overcollateralization with low risk of default but low returns, as well as flash loans and unsecured loans with increased risks but higher returns. This is a great attempt by the crypto lending market to offer non-overcollateralized loans to users and, if successful, will satisfy more borrowers.
In addition, with the resolution of blockchain cross-chain information transmission technical problems and the development of oracle technology, interconnected blockchain networks can achieve cross-platform Seamless sharing and ID access to verify the user's credit history, identity proof, income and employment proof, thereby establishing a blockchain-based credit proof for the user, and introducing real assets as collateral. Oracles like Chainlink already allow the blockchain to have a two-way conversation with off-chain data sources. Some cryptocurrency lending platforms have integrated Chainlink, and borrowers can use cars, real estate and other off-chain assets as collateral in the future.
Through these developments, DeFi lending can realize mortgage loans other than credit loans and encrypted assets, and its product form and user scale will be further developed.
Convergence with traditional markets
Banks may be interested in the crypto lending market. With the advent of the era of zero interest rates, the loan interest rates of national fiat currencies around the world are at historically low levels, and the bank's loan profit margin is declining. As banks and other traditional institutions realize the attractiveness of crypto asset yields, or as their clients’ demand for crypto lending services grows, we may see some institutions start offering crypto asset custody and lending.
Even without considering the yield gap between crypto assets and traditional assets, the high interest rate and relative security of crypto lending may be enough to attract more institutional players to enter this field. Genesis, for example, saw its institutional lender clientele grow 47% at the end of the third quarter and 275% from a year earlier.
DeFi will likely continue to exist as an independent, emerging market for a long time to come. But in the end, the creativity of smart contracts will affect the traditional lending market and be applied by traditional institutions and platforms, forming a combination that not only retains the advantages of centralized institutions, but also provides some functions of decentralization.
Positive impact of the lending market on the market
Increasing the attractiveness of encrypted assets
First, let's compare the two sets of data.
Charles Schwab, a financial services provider with more than 12 million active brokerage accounts, has data on the top ten positions of its users with $50 million to $10 million in assets According to statistics, it is found that millennials are second only to Tesla and Facebook in their interest in encrypted assets. Bitcoin (GBTC) ranks fifth in the share of holdings among millennials, but Bitcoin does not appear in the top ten holdings of the other two older generations of investors.
Data source: Charles Schwab
The leading centralized encryption lending institution BlockFi Did another interesting statistic where they collected data on interest accounts on their platform with balances between $5,000 and $10 million. Two phenomena were found:
1) All users own non-stable currency encrypted assets far more than stable coins, and Bitcoin is the most popular;< /p>
2) Boomers prefer to own stablecoins over encrypted assets other than Bitcoin. According to BlockFi’s Fiat Preference Index, baby boomers have a far higher preference for fiat than other generations.
Data source: BlockFi
Data source: BlockFi
These two sets of data may suggest that lending platforms like BlockFi are more attractive to baby boomers than financial service providers to hold crypto assets. The stable currency provides an investment similar to the high-yield treasury bonds in the 1980s, allowing investors to have access to the encrypted market other than holding highly volatile encrypted assets. Stablecoins on lending platforms are mainly used to fund crypto-asset-backed loans such as Bitcoin. Taking BlockFi as an example, lenders can earn 8.6% APY. Compared with the APY of less than 0.5% for deposits in the bank, this is undoubtedly a huge attraction. Therefore, stablecoin loans collateralized by highly liquid crypto-assets will be popular with high-net-worth individuals (baby boomers), family offices, and investment fund portfolios. These groups will provide more capital and liquidity to the crypto ecosystem, helping Generation X, Millennials, and Generation Z to carry out productive economic activities, including starting a business, buying real estate, and buying more crypto assets.
For investors who have already recognized encrypted assets, if they can obtain additional interest income while enjoying potential capital gains by holding encrypted assets, then they hold Interest in crypto assets will also be stronger. In conclusion, the lending market is conducive to attracting more potential investors into the crypto asset industry.
Establish a more mature encryption market infrastructure
At the beginning of the article, it is mentioned that the largest encryption lending Demand comes from transactions. Many traders and investors increase their crypto holdings by borrowing cash or another crypto asset as collateral. This effectively introduces leverage, adding additional liquidity. Lending provides another way to short the market. If the lending platform can improve its functions to make short selling as simple as trading futures, then short selling will be more widely used and promote market price discovery.
Therefore, lending solutions can assist market makers, arbitrage trading, and other important market activities, thereby helping the entire crypto market to increase liquidity and reduce market volatility. For traditional financial markets, margin trading and leverage are key infrastructures, and encrypted lending can better improve this market infrastructure, thereby attracting more investors, especially institutional investors. The entry of more investors will further increase the liquidity of the encryption market and reduce market volatility, thus forming a virtuous circle.
Centralized lending platforms also provide alternatives to exchanges for users who need to realize or do not want to hold positions, allowing users to Achieve the goal, and also have the effect of tax optimization.
In addition, the development of the encrypted lending market has the potential to generate an encrypted industry-specific interest rate market and promote the development of new types of derivative instruments, such as interest rate swaps.
Potential risks
There is a view that the growth of the encrypted lending market will lead to excessive financialization of the market , as issuance of securities through multiple layers of claims and securities based on these bonds increases the supply of cryptoassets in circulation and disrupts the nature of ownership and the rights of original holders. This model of mortgaging encrypted assets to borrow funds and buying more encrypted assets will continue to amplify the leverage of the market, and if it develops to a certain extent, it may form a systemic risk. When the market falls, if investors fail to liquidate their multi-layered positions in a timely manner, it may lead to the collapse of the lending platform and amplify market volatility.
This concern is not unreasonable, because encrypted lending is essentially the same as traditional lending, and moderate leverage must be maintained in order to operate healthily. But for now, encrypted lending is still dominated by excess borrowing, which does not meet the above-mentioned systemic risk conditions.
To sum up, the encrypted lending industry is a basic part of the blockchain-based financial infrastructure and has broad prospects for development in the future. For the current encrypted lending market, it is necessary to solve the moral hazard of the centralized platform, improve the security of smart contract technology, respond more actively to regulation, and maintain innovation capabilities, so as to provide a better market infrastructure for the encrypted market and obtain development outside the encrypted industry. This is what the industry should focus on.
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