Recent years saw spectacular growth in the digital asset lending market, with growth in locked assets, the number of users, and attention grabbing interest rates that seem too good to be true.
Sadly, it has also been apparent that the increase in these numbers has been accompanied by a decrease in understanding of the basic risks associated with lending, or less charitably, a decrease in transparency, disclosure of risks, or commitment to responsible lending.
As consumers (and to a lesser extent institutional) funds have flown into the market seeking attractive returns, the risks taken by lenders to generate those returns have grown, and often been wilfully ignored.
Many lending businesses, including some very visible behemoths, have been significant contributors to this build up of risk in the ecosystem.
These risks include protocol basis risk, directional market risk, and good old fashioned credit risk.
By protocol basis risk, we mean returns generated on one asset by converting it into another “equivalent” asset that offers higher returns on a “risk free” basis, usually involving a protocol. Recent events show clearly that “equivalent” and “risk free” in this context are anything but.
By directional market risk, we mean risk that the returns generated from an asset are dependent on the price of the asset.
Simply put, it’s easier to generate returns in bull markets, and inexperienced or short sighted businesses have put aside safer but lower risk-neutral approaches to generating yields in favour of directional betting.
Lastly, basic credit risk analysis has been viewed as old fashioned.
Lenders desperate to deploy consumer deposits to generate yields have relaxed collateralization requirements, to the point that the majority of borrowing by institutional clients is now under collateralised, and in many cases completely uncollateralized.
The inevitable defaults by borrowers leave institutional lending platforms exposed, and their retail users facing losses, withdrawal suspensions, and an uncertain future.
Does this mean an end to crypto borrowing and lending?
No it doesn’t and nor should it.
The need to borrow is a fundamental one in financial markets, and the desire to earn safe passive income is equally important. We at Lendingblock are confident that we will see a shift to more responsible lending, more healthy skepticism of get-rich-quick returns, and the green shoots of spring heralding the end of this crypto lending winter.
(Disclaimer: The author is the CEO at LendingBlock)