Risk/Reward is defined as “the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment.” The spectrum generally follows this progression, starting from lower to higher risk/reward:
Short-term debt — Long-term debt — Property — High-yield debt — Equity
It’s fair to assume that any crypto-related investment activity would fall on the far right of the spectrum, this includes lending. Investing in cryptoassets is typically viewed as high-risk, but most do it under the expectation of extraordinary returns, especially when looking at the past 10 years — there’s seldom been an asset class that has outperformed the crypto market. This fact alone has driven many investors/speculators to chase for a “moonshot”. However, this market behaves no differently to others, cycles are constant and in times of uncertainty investors will turn to safe havens/low-risk alternatives for returns. During the 2018–19 bear market, lending platforms were seen as providing exactly that, but is the risk/reward truly worth it? Let’s examine below:
Rates on 31/07/2019 (they’ve changed significantly since last week due to uncertainty in financial markets)
The above chart illustrates a wide variety of securities with some of the most popular crypto lending markets. You may notice that crypto lending is on the far right, with a riskier profile than cryptoassets — this is because of the added element of counterparty risk. To understand how rates are determined on crypto lending platforms I highly recommend reading this Medium by Roy Learner. Essentially, rates are determined by supply/demand and thus far due to the speculative nature of this activity we’ve seen a wide range of Annual Percentage Rates (APR) depending on the cryptoasset. Stablecoins and Bitcoin have benefited from higher rates ranging from 6% — 10%, with the exception of special circumstances where the rates will go up considerably (DAI is currently~12% APR on Compound, was at 15% last week). Rates on other cryptoassets such as ETH, BAT, REP etc. have ranged substantially lower from 0.1% — 2% (anything higher should be considered rather suspect).
By taking the above figures and comparing them to traditional fixed income securities we can attempt to price the risk/reward. For example, US treasury bonds — the 10 year currently yields around 1.75%. These bonds are generally perceived to be risk-free because it is debt backed by the US government — the chance of default is very low. You can even earn around the same just by keeping USD in a money market account that pays interest based on current rates. Going by that rationale, is 2% APR or lower enough to justify lending your cryptoassets and being subject to counterparty risk? Clearly not, one would expect much higher returns. Another example are high-yield (junk) bonds which currently have a yield of around 6% — even though they carry a greater chance of default, most are still backed by solid companies with assets that bond holders are entitled to in the event of a default. So, an investor would get 6% with more security for his/her principal, in comparison with crypto lending platforms where the risks are much higher and undefined. Again, the risk/reward doesn’t seem reasonable for 6% APR or lower. Referring back to Ari Paul’s article, crypto lending should be treated similarly to start-up loans and therefore should come with much higher yields (upwards of 20%) to justify the risk/reward. So far, only the Compound DAI market has gotten close to that number, during its peak reaching around 18% APR. But since it is a stablecoin it limits an investors exposure to the upside (and downside), effectively creating an opportunity cost.
Because borrowers want to limit their exposure to volatile cryptoassets, the largest loan originations we’ve seen on crypto lending platforms have been in stablecoins — higher demand = higher yield (~8% and above). Because this is significantly higher than what most banks offer nowadays, it’s evident why there’s been a large influx on the supply-side. But what’s the opportunity cost of keeping your majority portfolio in stablecoins to earn around 8% per year?
YTD returns for top 10 cryptoassets as of 31/07/2019 (excluding Tether and BitcoinSV)
As we can see in the table above, there’s been a notable turnaround in prices for the crypto market since the beginning of the year. Just looking at Bitcoin — year-to-date it’s returned around 220%, so for any investor with a portfolio allocation in cryptoassets these are the type of returns one would expect. Since investing in this space carries a lot of risk, it doesn’t seem logical to take on additional counterparty risk and opportunity cost to earn 8% per year, especially since there are less risky alternatives available in the traditional financial markets that bear similar returns. Although the “hodling” strategy has its drawbacks, it also has its merits in generating the largest returns for investors who are patient and keep custody of their own holdings. Ultimately, everyone has their own investment strategy and risk appetite, but investors should be a lot more cautious with the concept of “risk-free” income in crypto lending.
This equally applies to lending markets in volatile cryptoassets. For example, if you lend your BTC to some unknown counterparty for an extra 6% per year, but your funds are victim to a hack or default by a borrower, the supposed gain on that investment can turn into a 100% loss. If blockchain and the crypto market achieves even a fraction of disruption on various industries, the return on investment should be more than enough to satisfy the ambitions of any investor. The largest opportunity cost would be to miss out on such returns for a couple extra percent a year.
Now one could argue that crypto credit and lending platforms have numerous advantages over legacy finance. Notably more accessibility (no KYC/AML, credit checks etc.), liquidity, transparency (on decentralized) and simplicity for anybody who’s interested in generating interest income. I’m in full agreement with the above, the advantages of these platforms (especially decentralized ones) cannot be denied and it will be very exciting to see what the future holds for projects innovating in this space.
Thank you for reading. Please don’t hesitate to reach out if you have any feedback or corrections.
For those who missed Part 1: covering decentralized credit and lending platforms.
Part 2 — Centralized
The idea of a centralized counterparty in crypto may sound counter-intuitive considering blockchain/DLTs originated for the purpose of removing the need for middle-men and entrusting them with our most-valuable assets. Nevertheless, to this day they remain prevalent and essential to the basic functioning of the ecosystem. Centralized exchanges are crucial fiat on-ramps and still the bridge between the “traditional” finance world and the crypto market. As is the case with any financial intermediary, it takes years of solid management practices to build trust and establish a reputation as a secure and reliable business partner, this equally applies to cryptocurrency exchanges. History has shown that trusting negligent entities can lead to disastrous losses and that even the most reputable are not immune to security breaches (e.g. Binance hack in May). It’s the way which they deal with the ramifications that makes the difference. Binance showed exemplary conduct following the hack by covering all the losses, being fully transparent with how it unfolded and taking the necessary steps to ensure that it never happens again. Unfortunately, other cases didn’t end with the same desirable outcome.
On the topic of lending, exchanges were some of the first to offer lending services, primarily to contribute to the margin lending pool. On certain exchanges, for example: Bitfinex, Poloniex and BitMEX users have the option to lend their cryptoassets to margin traders in return for interest income. This can be an attractive proposition especially during periods of high volatility where the rates become exorbitant and very profitable for lenders. It goes without saying that all funds are subject to counterparty risk in the form of custody security breaches, auto-liquidation systems malfunctioning, borrowers defaulting etc. Last month, Poloniex’s BTC margin lending pool suffered a significant loss due to a severe price crash in the CLAM market. With a total loss of around 1800 BTC, the principal of all lenders was reduced by 16%. Since this incident occurred they’ve slowly started refunding the losses to affected users, but it begs the question why an illiquid cryptoasset like CLAM was still available for margin trading and able to cause such a cascade of losses. Even more puzzling, rather than covering the loss themselves, Poloniex socialized the losses on their customers. This whole debacle serves as a strong reminder to the risk involved with margin lending. The topic of counterparty risk and crypto exchanges is a continuous tale of controversy and one that has been discussed heavily by a variety of good sources, which is why the objective of Part 2 is to focus solely on a new type of centralized crypto intermediary emerging from the lending space.
As mentioned in Part 1, the surge in popularity of crypto lending has led to the creation of many platforms, purposely addressing this demand. Presently there are two type of platforms, those who serve the institutional market for ex: Genesis Capital and those who serve the retail market, which this Medium will cover. Contrary to exchanges who the crypto community are very familiar with, these newly formed entities have established themselves in full force and are now in custody of millions worth of cryptoassets. In every industry competition is healthy and it’s great to see new players position themselves in the market reducing the dominance held by exchanges, nevertheless treading into unfamiliar water comes with risks and it’s important to evaluate who these projects are and the measures they take to keep your funds safe. To this day, there still hasn’t been major incident involving a centralized crypto credit and lending platform, but in this market it’s prudent to take past incidents as a valuable lesson for the future.
Due to their popularity the platforms covered below will be BlockFi, Nexo and Celsius Network.
- Description: BlockFi offers financial products designed to help cryptocurrency holders to do more with their digital assets. The company currently services clients worldwide, including 47 U.S. states, with interest earning accounts and low cost USD loans backed by crypto. BlockFi is the only independent lender with institutional backing from investors that include Galaxy Digital, Susquehanna, Akuna Capital, Fidelity, Recruit Strategic Partners, ConsenSys Ventures, SoFi, Coinbase Ventures, CMT Digital and Morgan Creek Digital.
- Launch Date: 4 March 2019
- Supported Assets: BTC, ETH, LTC, GUSD
- Borrow APR (Annual Percentage Rate): Starts at 4.5%
- Lend APR: 1.5% — 6.2%
- LTV Ratio (Loan-to-Value): 20% — 50%
- Total Volume: $120 million in client assets (On 31/05/2019)
- Custody: Gemini
- Security Measures: “BlockFi client assets are securely stored at a unique wallet address generated by Gemini, a New York trust company licensed by the New York State Department of Financial Services. Gemini is a fiduciary under §100 of the New York Banking Law and held to specific capital reserve requirements and banking compliance standards. Gemini also has digital asset insurance coverage and is SOC 2 Type 1 security compliant on its exchange and custodian platform. When you send over collateral for your loan, the crypto is transferred into Gemini’s cold storage system. This is a type of offline storage that is only accessible in a secure, access-controlled facility that is protected from cyber attacks. For more information about their security protocols, please visit their website at gemini.com/security. Once the funds are transferred to Gemini, client assets will not be accessible by the borrower until the loan has been paid off.” (Source)
- Overview: Hitting the market with institutional backing gives immediate credibility to a company and that’s exactly what BlockFi had. Within 2 weeks after launching they attracted more than $25 million worth of crypto deposits and with good reason, they offered attractive interest rates for both BTC and ETH. It’s a no-brainer right? If you’re invested long-term why not collect an extra 6.2% APR, especially since they use Gemini as custodian; a trust company regulated by NYSDFS. From a security perspective you probably won’t find better on the market. However, by investigating further, there are elements to take into consideration before depositing your cryptoassets. The tweet thread below highlights some legitimate concerns:
Aside from the tax implications for U.S. citizens, the primary point to address is the collateral and LTV ratios for the loans. As displayed on their website, users can apply for loans with an LTV ratio as low as 20% and up to 50%, therefore to take out a loan of $10,000 one would have to deposit upwards of $20,000 worth of cryptoassets as collateral, with margin calls beginning at 70% LTV. According to their risk model this is sufficient to limit their exposure, but one has to question is this truly enough? The crypto market is no stranger to extreme volatility, in the event of a massive drop in prices will they manage to liquidate enough collateral to pay back lenders. Vice-versa, let’s assume that some of their clients are borrowing cryptoassets to short sell them, if the market rallies significantly and borrowers’ default, who will incur losses? Most probably lenders. Now these are hypothetical scenarios that haven’t occurred yet but it’s important to mention the risks considering they promote the interest account as a free way to earn Bitcoin. If you’re subject to credit risk it definitely isn’t free! Not to completely discredit them, they do have disclaimers explicitly citing the risk involved but some of the information they provide can be misleading.
The last element to address is: what do you own when you deposit your cryptoassets, are you still holding BTC, ETH etc. or rather corporate debt? The above tweet provokes an interesting reflection point. Please make sure to read “Thoughts on Cryptocurrency Lending” by Ari Paul. His analysis is spot on, is the 6% yield enough to justify the risk in lending your cryptoassets to unknown counterparties? It’s all about risk/reward, which will be fully covered in the next medium.
- Description: Nexo is the most advanced platform for instant crypto loans, and the only blockchain company to provide its services in 45+ fiat currencies and in more than 200 jurisdictions. Nexo gives digital asset holders the best of both worlds — instant access to cash and retaining ownership of their assets. Its global operations are powered by the profound lending experience of Credissimo, a leading FinTech Group serving millions of people across Europe for over 10 years, while multiple banking and financial service regulators. Nexo’s instant lending platform combines seamless user-experience with military-grade security and with 256-bit encryption. Clients funds are held in individually assigned multi-signature wallets in cold storage, held with the only qualified audited and Goldman Sachs-backed custodian BitGo.
- Launch Date: 30 April 2018
- Supported Assets: BTC, ETH, NEXO, BNB, XRP, LTC, Stablecoins
- Borrow APR: 8%
- Lend APR: 6.5% — 8%
- LTV Ratio: 15% — 90% (depending on which cryptoasset used as collateral)
- Total Volume: $500 million loans processed (On 26/06/2019)
- Custody: BitGo
- Security Measures: “The safety of clients funds is the first priority for Nexo. Cold storage Wallets are provided by the leader in multi-signature encryption technology BitGo. These custodial assets are covered for up to $100,000,000.00 by the London-based insurance company Lloyd’s with its syndicate of underwriters which act under its umbrella. And this premium service comes in at no additional cost (details can be found here and here).” (Source)
- Overview: Nexo was created by Credissimo an already established European FinTech company. This gave them substantial credibility when launching their crypto lending platform and clearly their years of experience in the FinTech industry prior to crypto gave them an edge in building a seamless experience for users to engage in credit markets. This brought a lot of attention to the project helping them raise over $52 million through an ICO. Their native token “NEXO” entitles holders to receive a dividend of 30 percent of company profits and can be used to repay loans with a 50 percent discount on interests. Overall their product offering is similar to BlockFi, where users can deposit cryptoassets (at this time only stablecoins supported) to earn interest or use them as collateral to borrow fiat. Regarding security, Nexo uses reputable companies for custody and insurance meaning that there’s a rather low risk of losing funds due to a security breach. Nonetheless, counterparty risk remains in the form of borrowers defaulting, insolvency problems, liquidation malfunctions etc. As highlighted in the whitepaper, the Nexo Oracle is an automated system responsible for maintaining all processes within the platform, this includes everything from loan contracts to risk management. At this time, there are no reports of any issues or incidents on Nexo so the underlying technology has thus far performed as designed.
- Description: Celsius Network is a democratized interest income and lending platform accessible via a mobile app. Built on the belief that financial services should only do what is in the best interests of the community, Celsius is a modern platform where membership provides access to curated financial services that are not available through traditional financial institutions. Crypto holders can earn interest by transferring their coins to their Celsius Wallet and borrow USD against their crypto collateral at interest rates as low as 4.95% APR.
- Launch Date: July 2018
- Supported Assets: BTC, ETH, LTC, XRP, OMG, BCH, ZRX, XLM, DASH, TUSD, GUSD, USDC, DAI
- Borrow APR: 4.95% — 8.95%
- Lend APR: 2.5% — 8.1%
- LTV Ratio: 25% — 50%
- Total Volume: $1.2 billion in loan origination
- Custody: BitGo
- Security Measures: “We currently use BitGo as our custodian. They are the best in the business, being used by many of the top exchanges and companies. Whenever coins are being lent out from our pool of assets, they are over-collateralized. This means that anytime an institution borrows coins from us, they provide up to 120% of the value in another form of collateral.” (Source)
- Overview: Celsius Network is a mobile app lending platform. They were quick to gain in popularity for releasing a user-friendly app and offering attractive interest rates on multiple cryptoassets. Like Nexo, they did an ICO raising $50 million and released their token “CEL” with similar utility functions. In regard to security, there isn’t a lot of published information on their system other than a short FAQ, which only states that BitGo is custodian. After some research, I’ve found only one article written by Philip who’s a Celsius Network community member. He delves into their security practices by contacting the Celsius team and BitGo, thanks to his research we get a fairly better understanding of how it works. The fact that Celsius has not published this information on their website or blog is rather concerning, just a simple FAQ with no details is insufficient. Looking at the Tech Paper, we understand the underlying technology of the platform. All credit market related operations i.e., loan contracts and risk management are done through their internal algorithms. Meaning that users are still subject to counterparty risk like the examples cited above. With no prior incidents, the Celsius platform appears to be functioning as designed. There is a rumour circulating on social media that Celsius is providing under-collateralized loans to institutions. Even though its unsubstantiated, if proven to be true there would be serious implications for users loaning out their cryptoassets because they’ve done so under the pretense that all loans are over-collaterized. The Celsius team should address these rumours.
Decentralized vs. Centralized
The objective of this Medium wasn’t to take part in the decentralized vs. centralized debate by taking sides on which alternative is better, but rather to examine each platform and objectively present the facts about the safety of your funds. During this research I observed a contrast between how both platforms operate and thought the best way to conclude would be to highlight it. This contrast exists in the level of transparency on:
- Publicly verifiable data — On decentralized platforms because everything is done on-chain, there’s complete visibility on all platform related-operations: market size/AUM, loans, collateral ratio, liquidations etc. Just by looking at the various analytics tools (for example: LoanScan, MKR Tools, Curious Giraffe) one can evaluate the general financial health of the system. In contrast to centralized platforms, where there’s almost no transparency due to lack of publicly released audits, figures and analytics tools. With no clarity into the financials, it is very difficult to reach a conclusive assessment of the risks. This can be simply addressed if the projects hired an auditor and published regular reports. In an effort to bring awareness to this transparency issue, Compound is offering a 50 ETH bounty for anyone that can prove centralized platforms are misrepresenting their numbers.
- Risk management — It goes without saying that competent risk management is one of the most important elements to safeguard users’ funds. In this regard both platforms take a substantially different approach. Decentralized platforms, e.g. MakerDAO, uses a permission-less risk management system where MKR token holders can vote to adjust risk parameters to keep it from failing. Similarly, margin calls and liquidations are also initiated in a permission-less manner. If a debt position reaches it’s liquidation ratio external parties can bid for the collateral at a discounted price and bring it back to a safe level. On the other hand, centralized platforms utilize their own internal systems to oversee risk management. Unfortunately, there’s a severe lack of transparency into these systems and how they function, making it yet again, very difficult to reach a conclusive assessment on the risks. Users are forced to entrust the teams responsible for risk management are competent enough to build robust systems to prevent loss of funds.
This is where blockchain demonstrates some clear benefits over legacy systems, specifically by removing the need to trust a central counterparty and enabling fully transparent, publicly audit-able financial services. Taking the credit and lending platforms cited above, we notice that the risks are understood and clearly defined when using the decentralized platforms — smart contract risk, protocol or blockchain malfunctions. However, it is rather obscure in the centralized — because we don’t have the necessary information or tools to verify how their internal systems function, anything ranging from cold storage hacks to borrowers defaulting could materialize into users losing their cryptoassets. To prevent this from happening, it is highly recommended for these platforms to increase transparency into their operations and for users to conduct their own research on each platform before depositing.
Thank you for reading. Please feel free to reach out in case of any feedback or corrections.