Crypto lending is a fairly new face at the table, bringing with it plenty of unique challenges and unknowns. Not initially designed for mainstream systems, it hasn’t been the smoothest transition to incorporate cryptocurrency into the traditional world of finance and lending.
Just over a decade ago, the world was in turmoil over Bitcoin being spent on something as regular as pizza. What is now known as Pizza Day occurred when Laszlo Hanyecz spent 10,000 BTC at Domino’s. While the world was unsure sure if it should be considered real tender or Monopoly money, Bitcoin is now worth well over $342 billion.
Colbeck Capital Management said the jump into cryptocurrencies and virtual finance realms is changing the game in a big way. Hosted on the blockchain, nontraditional financial landscapes are starting to take shape. One such example is DeFi.
What Is DeFi?
This Ethereum-based marketplace is made up of decentralized applications (Dapps) designed to remove inefficiencies and challenges of crypto finance.
Jason Colodne, Managing Partner at Colbeck Capital Management explains that e ach Dapp works through a smart contract protocol, which includes a set of rules to create a predictable organizational scheme. In some ways, DeFi took a lot of notes from traditional finance structures. This disturbs some of the purists who wanted cryptocurrency to stand for something new and unsullied by traditional banking’s design and deep flaws.
But cryptocurrency itself never claimed originality. It only promised a permissionless, trustless foundation that does not rely on intermediaries to hold money.
How Lending Works on Blockchain
For a currency that is not officially considered a currency, crypto has taken on a nature of its own, and lenders are scrambling to evolve. With user-generated, non-custodial, peer-to-contract loans of the decentralized blockchain, the lending occurs within a pool of funds.
A user can borrow, deposit, or exit at any time without penalty. The interest rates change in real time and are calculated by algorithms. Pools that have high liquidity tend to offer cheap borrowing. Pools with lower liquidity will cost more to pull from. Blocks are counted in 15-minute segments when interest rates will change according to the supply and demand of the market. Stablecoins, for example, fluctuated from 2-20% over the course of 2020.
How Do Defaults Work With Blockchain Lending?
There are certain risks when it comes to lending on the blockchain. “How do lenders incentivize repayment from a person with no name, no credit score, and no physical address?” considered Colbeck Managing Partner Jason Colodne. “They only accept over-collateralized loans.” This is not a new concept, with similar instances happening since the Middle Ages.
Those collateral assets end up being worth 150-200% of the value of the loan, which results in very little chance of default. The Dapp protocol ends up taking on the role of debt collector, liquidator, and rate calculator. This also means there are no margin calls in crypto. If you dip below the protocol for collateral ratio, your liquidation is immediate and paired with a penalty to repay that loan.
A wise borrower will leave a buffer zone in case of sudden price drops. In one case in May 2021, over 775,000 traders in ETH and BTC had a total of $8.5 billion worth of crypto liquidated from their accounts when the prices dropped and their positions were automatically sold.
Why Borrow From Blockchain Lenders?
Why pledge 200% collateral to borrow half in cryptocurrency? Just as a homeowner might use their home as collateral to cover an equity line of credit needed for an unexpected expense, there are times when blockchain lenders provide liquidity to those who want to use their crypto asset without selling it outright or incurring taxes.
“Prior to this, holding a digital currency was no different than holding a bar of gold in a safe,” said Jason Urbam, CEO at Drawbridge Lending. “There’s no utility in that. By lending it out, they can unleash the value of that asset.”
Some even use their borrowed assets to leverage their long or short positions, said Colodne. This includes buying one currency when it is cheap and selling when it is at its highest. If you deposit stablecoins (backed by an underlying asset, like the U.S. dollar) because you believe ETH is underpriced, you can use that collateral to borrow the ETH. When or if the price rises, you can then sell the ETH for more of the same stablecoin (which would be U.S. dollars in this example).
The Unique Pull of DeFi
DeFi is connected to its users by not just offering value but also payment to get individuals to join the network. Users who drove liquidity to the lending protocol Compound Finance were given COMP tokens that earned a yield for their efforts. While this might seem a bit odd, it only feels strange because it is new to the lending world.
This led to more yield farming that boosted DeFi as users swapped between borrowing and lending to grow their yields. The flash loan nature of blockchain fully supported this effort, offering more control to the users interested in exploiting these opportunities.
Lending models are not completely up to speed though, warned Colbeck Capital Management. They are certainly not set up for someone who is not ready to put up high collateral for low returns. Revamps to the architecture of Ethereum should occur within the next year and lower some of the risk. Unsecured lending solutions are also being explored, though they offer complex issues of their own in the brave new world of blockchain finance.
About Jason Colodne
Jason Colodne is a managing partner and co-founder of Colbeck Capital Management. He is the senior transaction partner and oversees all aspects of investment portfolio management.
Before starting Colbeck, he was managing director and head of the Strategic Finance Division at Morgan Stanley. Prior to joining Stanley, Colodne was head of Proprietary Distressed Investing and the Hybrid Lending Group in the Fixed Income Currencies and Commodities Division at Goldman Sachs.
About Colbeck Capital Management
Colbeck Capital Management was established to offer non-traditional lending solutions particularly to companies in periods of transition. Managing partners Jason Beckman and Jason Colodne founded Colbeck in 2009.