• 2022 Liquidity problems at numerous companies from the crypto lending sector
• Insolvencies due to the withdrawal of customer funds, partly illegal practices
• DeFi as a solution for crypto lenders?
In 2022, several crypto lenders got into trouble due to liquidity problems. Among other things, in the summer – as a result of the Terra/LUNA debacle – Celsius Network, one of the largest market players in the crypto lending sector to date, filed for bankruptcy, while the NFT-supported lending platform BendDAO narrowly escaped a liquidity crisis. In November, the crypto lender BlockFi fell victim to the market quake in the crypto sector triggered by the FTX bankruptcy and also had to file for Chapter 11 bankruptcy. Other companies in the industry, such as the crypto company Genesis, which also lends out digital coins, are currently struggling to survive.
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In the once-promising growth sector of crypto lending, which boomed especially in the years leading up to the crypto market sentiment shift, the crypto winter has now uncovered numerous problems and damaged confidence in the companies operating there. But to what extent are the once respected companies themselves to blame for their decline, and what could solutions look like to make the once popular industry better positioned in the future?
The business model of crypto lending companies
All crypto lenders – whether in distress or not – have in common that they lend cryptocurrencies deposited by market participants to other market participants, usually companies. “Crypto lending is the process of connecting people who have excess crypto assets and want to earn returns on their money by depositing it on a platform that lends those funds to people who want to borrow crypto and are willing to provide collateral deposit and pay interest on a loan”, describes “CoinDesk” the business model of the companies active in crypto lending. According to Reuters, crypto lending is “essentially banking — for the crypto world.”
In fact, savers – like a bank account – deposit cryptocurrencies with a crypto lender and receive interest, which according to “Reuters” mostly depends on the deposited token. Crypto lenders themselves typically make their profits from the spread between interest payments to depositors and fees charged by borrowers. Unlike banks, which until recently were still suffering from the low-interest phase, crypto lenders offered returns of up to 20 percent on the paid-in capital – and were able to attract numerous customers, above all. According to Reuters, the fact that they wooed customers with easier access and less paperwork compared to banks may also have contributed to their popularity.
Reasons for the wave of bankruptcies in crypto lenders
However, according to Coindesk, the problems for the crypto lending firms began when, due to the increased volatility in the crypto sector, the number of depositors and borrowers decreased and more and more customers started to withdraw their funds. Since the cryptocurrencies, which the borrowers had deposited as collateral, also lost value due to the price slide for all coins, the companies increasingly ran into liquidity problems. Particularly explosive: In some cases, according to the crypto news site, the lenders even waived collateral altogether. Citing an example is crypto lending pools like Clearpool, which is an “unsecured lending protocol” where borrowers “do not pledge assets [müssen]and the credits […] are “secured” by their reputation and their supposedly good creditworthiness”. According to “Coindesk”, interest rates are set dynamically in such lending pools and are based on the amount of capital that is withdrawn from the credit line granted.
In addition, some crypto lenders used illegal or at least particularly risky practices – which went unnoticed due to the lack of oversight in the industry. The crypto lenders hardly had to follow any rules in terms of transparency or the handling of the managed capital. “Coindesk” says, for example, that some companies took on particularly risky – and in hindsight bad – bets or capital was loaned out again that wasn’t actually there. According to the Vermont Securities Commission, Celsius Network is also said to have some kind of Ponzi scheme have given, in which old investors were paid out with the money of new customers. In addition, money from the marketing budget was used to make particularly high interest payments. It is undisputed that this system had to collapse as soon as the boom in the crypto markets ended. However, not all crypto lending companies may have experienced abuse of customer deposits or illegal practices. However, since these are private companies, the exact reasons for the imbalance are often not transparent.
In this way, the industry could possibly be reformed and saved
As with all bad news from the crypto sector, stricter regulation was proposed as a proposal to avoid further bankruptcies among crypto lenders, according to Coindesk. This could ensure that the deposits are better managed and thus the solvency of the companies is secured.
It is obvious that more transparency is needed in the industry – but there are other ways to achieve this besides regulation. “Unironically, the second case of mass deleveraging via crypto underscores the need for the transparency that DeFi offers,” Walter Teng, vice president of investment strategy at analytics firm Fundstrat, told Coindesk. Both DeFi – short for decentralized finance – and the crypto lending industry share the common vision that financial services in the future can dispense with the traditional financial companies that have so far served as middlemen and instead bring users with corresponding needs directly together. In fact, crypto lenders in the DeFi space have fared better than other industry peers in the recent turmoil, according to the crypto news site. One reason for this is that in DeFi everyone has to play by the same rules and no friendship conditions are possible for supposedly trustworthy people or companies. In addition, DeFi platforms would normally require their users to over-collateralize their loans and the deposits would also be protected from access by human actors as they are not kept in one place.
The Decrypt website also brings up another way the crypto lending industry could be made more secure for its users: Proof of Reserves. According to Investopedia, this is a “transparent audit practice for cryptocurrency companies that provides an unbiased report of the companies’ asset reserves. Third-party auditors access cryptographic signatures that represent the total balance of client assets and ensure that the custodian of those assets has an equal (or greater) amount of reserve funds to cover all potential customer withdrawals”. According to “Decrypt”, this proof – combined with public wallet addresses and external auditors – is “a potential long-term solution for crypto companies” to prevent liquidity crises.
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