Ever since the creation of money and banking, financial services companies have been issuing credit and debt to allow individuals and companies to finance various personal and business expenditures. The digital asset lending industry is proving to be one of the first breakout use cases within the crypto ecosystem providing tangible utility to users.
According to a report by Credmark, the crypto lending market reached $8 billion in total lifetime loan originations as of Q4 2019. The market size has increased since then and now exceeds $10 billion in total loan originations. As a point of comparison, the global consumer and peer-to-peer lending marketplace has annual transaction volume of $85 billion. This is a more established market that comprises private online lending portals such as Lending Club, Funding Circle, Zopa, auxmoney, and Prosper.
One of the market leaders serving institutional clients, Genesis Capital, recently released their Q1 report which highlights the firm’s best quarter to date. The firm added $2 billion in new loan originations, doubling the previous record of $1 billion set the previous quarter, and up 354% from the same quarter last year. Notably, active loans were up ~20% from the previous quarter despite a 50% intraday drawdown in the price of Bitcoin in mid-March.
Genesis Capital Head of Institutional Sales, Dan Torrey, described the growth of the market commenting, “The growth drives from the fact that there were very few effective options available to institutional investors and institutional players in the crypto market. That was the reason we got into the business, and that is why it has continued to grow.”
Celsius Network, one of the leading retail-focused crypto lending platforms also experienced explosive growth in the last two years, serving 100,000 retail and 260 institutional users across 160 countries. The company claims they recently crossed the $1 billion threshold in aggregate consumer deposits and originated over $8.2 billion in institutional coin loans since launching their service in 2018.
Celsius Founder and CEO Alex Mashinsky stated, “Everyone calls us ‘crypto lending’, but there’s two very distinct and separate businesses: interest income and lending. Primarily, I call Celsius an ‘interest income’ business, because 90% of our customers first come to us to earn interest and don’t need a loan. They used to keep their coins in cold storage or on an exchange, which pays no interest, whereas we pay our users 80% of what we earn on such deposits. Now, everyone can deposit their crypto with Celsius and earn high interest income as we lend their coins to institutions, similar to how Fidelity or Schwab lend your stock without your knowledge via SEC lending.”
Lending Provides New Use Cases for Crypto Traders and Holders
The crypto lending market has gained traction as the crypto market’s capitalization grew and individuals and institutions realized their crypto holdings could be an excellent source of collateral. Crypto holders may want to access dollars while still holding on to their crypto, and thus they can collateralize dollar loans with their crypto stash. More sophisticated investors may want to realize the tax benefits of leveraging their crypto to access dollars, instead of selling and triggering a taxable event subject to capital gains tax. Similarly, miners with ongoing operational expenses can take out loans to fund operations while maintaining their crypto exposure.
All of these strategies are directionally long strategies in which the user chooses to maintain exposure believing the asset will appreciate in value. Taken a step further, speculators may open margin loans to leverage their initial crypto positions, which can compound returns during market upswings. On the other side of the trade, traders can use these lending platforms to borrow the assets required to enter a short position, hoping to profit from a decrease in price.
Celsius’ Alex Mashinsky noted, “The real shorting is only 20-25% of our loans. Most of the borrowing involves large institutions like Genesis and Galaxy using Celsius to do price arbitrage and market making, which does not take a directional bet on Bitcoin. For example, they may want to take advantage of an opportunity where the price of Bitcoin trades $300 lower on BitMEX than on Binance. They have to buy Bitcoin on one exchange and sell on another at the same time. If the price suddenly drops 10%, they are exposed to losing 10%. But by borrowing Bitcoin, they are able to offset the risk of a large directional move and capture the spread in price.”
Genesis’ Dan Torrey echoed this idea saying, “The demand is not so much directionally shorting the market, but rather to hedge the market, which includes Bitcoin, Ethereum, Litecoin, Ripple, and stablecoins.”
On the depositor side, lenders can receive attractive rates of return lending out their crypto reaching as high as 10% APY in some instances. This is particularly attractive compared to the current national average savings account rate of 0.10% APR. Typical commercial bank savings account rates will remain low for the foreseeable future as central banks pin interest rates near zero to stimulate the economy in the wake of the coronavirus induced recession. If the crypto lending markets can maintain high single digit interest rates, millions of users will organically enter the crypto ecosystem.
Crypto lending is mostly asset-based lending which removes much of the friction in the loan underwriting process as debt is collateralized with crypto. For retail borrowers, loans are often over-collateralized, meaning users need to post crypto-collateral with value greater than the loan value. Due to crypto’s liquidity, ease of transfer, and ease of verification, individuals can get approved for a loan within minutes without the need for onerous credit checks or collateral appraisals. Since crypto assets are traded 24/7, the exact value of collateral is easily known reducing the risk to the loan issuer and enabling tighter net interest spreads (the difference between the interest they charge the borrower and pay the depositor).
Discussing asset-specific activity, Genesis’ Dan Torrey noted, “In January 2019, our loan book was at least 70% Bitcoin. Today, it is less than 50%. That doesn’t mean there isn’t demand to borrow Bitcoin, it just means there has been greater growth for other assets like Ethereum, Ripple, Zcash, and others. But, the single biggest shift over the past 16 months has been the demand for cash and stablecoins. We’re really bullish on stablecoin usage, not just for our clientele who use it as fiat currency, but also the broader use cases.”
CeFi Vs DeFi
The crypto lending market is split into two verticals: Centralized Finance (“CeFi”) and Decentralized Finance (“DeFi”). CeFi loan facilities act like typical financial services companies. They use in-house risk management procedures to match borrowers and lenders, assess creditworthiness, determine interest rates, and custody the assets. A few of the leading CeFi lending facilities include Genesis Capital, Celsius Network, Lendingblock, Unchained Capital, and BlockFi. For this service, they may charge origination points on new loans and receive net interest margin.
DeFi projects use open source protocols and smart contracts to automate the loan origination process, aiming to remove fee-collecting intermediaries entirely. A few of the top DeFi lending protocols are MakerDAO, Compound, Aave, and Nuo Network.
Since these platforms are over-collateralized and require digital assets as collateral, the industry has converged on Total Value Locked as a crude metric to demonstrate the growth of the space. In the past year, total notional U.S. dollar value locked in DeFi lending protocols has increased from $380 million to $667 million currently, an increase of 75%. The same metric peaked at $1 billion in February this year.
Since the source code is open and public, DeFi lending protocols possess security risks and are vulnerable to hackers, evident with the recent dForce and bZx exploits. However, they also provide increased transparency and visibility into the underlying loan operations. Anyone can verify the solvency of specific loans and track the growth of the nascent market in real time.
Although centralized lending platforms have the lion share of volume and activity at the moment, DeFi may challenge the status quo and force their centralized counterparts to compress their margins. As the crypto industry continues to grow, CeFi and DeFi lending markets will increase in volume and liquidity and may ultimately challenge incumbent financial institutions, staying true to crypto’s core ethos.